15

---

 

We are a development stage company, have been unprofitable since our inception, and will incur substantial additional operating losses for at least the next twelve months as we continue to implement commercial operations and allocate significant and increasing resources to research, development, clinical trials, and other activities. Accordingly, our historical operations and financial information are not indicative of our future operating results, financial condition, or ability to operate profitably as a commercial enterprise.

Research and Development

R&D Team

We have recruited and currently employ a talented interdisciplinary team of scientists and engineers who are developing our products. The team includes engineering leaders from within the dialysis field who provide state of the art as well as historical insights into dialysis equipment. The team also includes seasoned engineers from related medical fields providing us with cutting edge technology in the areas of fluidics, sensors, and electronics. In addition, we have retained a medical device consulting firm, The Aubrey Group, Inc., an FDA-registered third-party contract developer and manufacturer of medical devices, to provide engineering support in the development and build of the PAK thru the end of 2008. In 2009, we will transition into verification and validation of the PAK utilizing our scientists and engineers as well as outside consultants.

We incurred $12.7 million and $18.9 million in research and development costs in the three and nine months ended September 30, 2008, respectively, including the August 4, 2008, $10.2 million fair value accrual for a potential 9.23 million shares issuance to effectuate the Technology Transaction in accordance to the Second Interim Award. Less the accrual for shares issuable, we incurred $2.5 million and $8.7 million in research and development costs in the three and nine months ended September 30, 2008, respectively. This compares to $2.1 million and $4.8 million incurred in the three and nine months ended September 30, 2007.

Third-party Arrangements

In July 2007, we entered into an agreement with Aubrey for the design and development of subsystems of the PAK. The PAK will be designed for intermittent hemodialysis or CRRT in a clinical setting as well as for treatments in a home setting. The development is expected to be complete by the end of 2008. At the inception of the agreement, total labor and material costs over the term of the Aubrey agreement was budgeted at approximately $5.1 million which we anticipate to be under budget at completion. We can terminate the agreement at any time with 30 business days notice.

We also contract with other third parties to assist in our research and development efforts and to supplement our internal resources while we continue to grow our organization.

Management’s Discussion and Analysis 

Results of Operations for the three and nine months ended September 30, 2008.

We have not generated any revenues since inception. We incurred a net loss of $11.1 million and $22.8 million for the three and nine months ended September 30, 2008, respectively, compared to a net loss of $4.5 million and $12.1 million for the three and nine months ended September 30, 2007, respectively. The increase in net loss was primarily due to (i) research, development and other expenses related to advancing our kidney failure treatment technologies, (ii) stock compensation expense related to options and warrants granted to directors, officers, employees, and consultants, (iii) legal fees, (iv) common stock issuances as compensation for consulting services, (v) accruals for alleged licensor expenses and interim awards issued in the arbitration with NQCI, and (vi) increased company personnel. At September 30, 2008, we had positive working capital of $1.4 million compared to positive working capital of $15.0 million at the beginning of the year.

Liquidity and Capital Resources

We expect to incur operating losses and negative cash flows for the foreseeable future. During the fourth quarter 2006, we raised approximately $27.3 million (net of placement fees of $2.1 million) through a private placement. Our ability to execute on our current business plan is dependent upon our ability to develop and market our products, and, ultimately, to generate revenue.

16

---

We expect to incur negative cash flows and net losses for the foreseeable future. Based upon our current plans, we believe that our existing cash reserves will not be sufficient to meet our operating expenses and capital requirements before we achieve profitability. Accordingly, we may seek to raise additional funds through public or private placement of shares of preferred or common stock or through public or private financing. Our ability to meet our cash obligations as they become due and payable will depend on our ability to sell securities, borrow funds, reduce operating costs, or some combination thereof. We may not be successful in raising necessary funds on acceptable terms, or at all. As a result of these conditions, there is substantial doubt about our ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

Upon receipt of the approximate $27.3 million raised through private placement in the fourth quarter of 2006, we strategically began our operating activities and research and development efforts which resulted in a net loss of $17.1 million in 2007 and $18.2 million in the nine months ended September 30, 2008. In addition, we invested $25.0 million in high grade money market funds and marketable securities of which we sold $19.2 million of the investments, leaving a balance of $5.8 million as of September 30, 2008. 

 

We have focused much of our efforts on development of the PAK, which has not been derived from the technology covered by the License Agreement. Through the productive research and development efforts of the PAK, we have completed functional prototypes of our hospital and home PAKs that we plan to commercialize after 510(k) clearance from the Food and Drug Administration (FDA) which we plan 510(k) submission by next year. Prior to the 510(k) submission to the FDA for clinical use under direct medical supervision, the units will undergo final verification and validation. It generally takes 4 to 12 months from the date of a 510(k) submission to obtain clearance from the FDA, although it may take longer. We expect that our monthly expenditures will increase as we shift resources towards developing a marketing plan for the PAK.

 

We have used some of our resources for the development of the WAK which we have demonstrated a feasibility prototype. Commercialization of the WAK will require development of a functional prototype and likely a full pre-market approval by the FDA, which could take several years. Our rights to the WAK derive in part from a License Agreement dated September 1, 2006 between Operations and National Quality Care, Inc, pursuant to which we obtained the exclusive rights to the technology designated therein. Once the Technology Transaction has closed and the results of the arbitration proceeding are final, we will determine whether to devote additional resources to development of the WAK.

 

If we ever become obligated to pay all or a substantial portion of the $690,000 in alleged expenses related to the License Agreement and the interim award of $1.87 million in attorneys’ fees pursuant to the NQCI arbitration, doing so could have a material adverse effect on our liquidity and financial ability to continue with ongoing operations as currently planned.

 

Because neither the PAK nor the WAK is yet at a stage where it can be marketed commercially, we are not able to predict the portion of our future business which will be derived from each.

Research and Development

We employ an interdisciplinary team of scientists and engineers who are developing the PAK and a separate, interdisciplinary team developing the WAK. In addition, we have retained Aubrey to assist with the engineering of the PAK. The PAK will be engineered to perform both hemodialysis, hemofiltration and ultrafiltration under direct medical supervision. A variation of this device will be developed for chronic home hemodialysis. An initial laboratory prototype of the PAK, capable of performing the functions of a hemodialysis machine, and demonstrating our unique new fluidics circuit, was completed at the end of 2007. The first physical prototype including industrial design of the PAK was completed in October 2008. Further refinements to this prototype are now in progress. The final product design of the PAK will be completed shortly and units will undergo final verification and validation prior to a 510(k) submission for clinical use under direct medical supervision. A clinical study is not required for this submission.

In a clinical feasibility study conducted in London in March 2007, a research prototype of the WAK was successfully demonstrated in eight patients with end-stage renal disease. Patients were successfully treated for up to 8 hours with adequate clearances of urea and creatinine. The device was well tolerated and patients were able to conduct activities of normal daily living including walking and sleeping. There were no serious adverse events although clotting of the dialyzer occurred in two patients. To our knowledge, this is the first successful demonstration of a wearable artificial kidney in man. Provided that the Technology Transaction closes, we will be making substantial improvements to the WAK. This work will result in a WAK Generation 2.0. Pending the FDA approval of an investigational Device Exemption (IDE), additional clinical studies will be conducted upon completion of the Generation 2.0 WAK prototype.

17

---

Contractual Obligations and Commercial Commitments

 

Contractual Obligations:		Total			Less than 1 year			1 - 3 years			3 - 5 years			More than 5 years
Capital Lease Obligations		$	-		$	-		$	-		$	-		$	-
Operating Lease Obligations (1)			1,176,889			107,113			786,199			283,576			-
Research & Development Contractual Commitments			77,996			77,996			-			-			-
Other Liabilities			12,167			12,167			-			-			-
		$	1,267,051		$	197,276		$	786,199		$	283,576		$	-

  (1) Operating lease commitments for our corporate office facility, product development facility, Dr. Gura’s office which is a related party transaction, and two corporate apartments as well as for copiers and T1 access.

The table excludes the agreement with Aubrey in relation to the PAK development which can be terminated at any time with 30 business days notice. Due to development efficiencies not anticipated at the inception of the Aubrey agreement, we will incur less actual costs and expenses than the $5.1 million budgeted amount. With the expected completion by end of 2008, we estimate we will incur a total cost of $3.3 million under this agreement.

Off-Balance Sheet Arrangements

As of September 30, 2008, we had no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, results of operations or cash flows.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. Generally accepted accounting principles require management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities. We base our estimates on experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that may not be readily apparent from other sources. Our actual results may differ from those estimates.

We consider our critical accounting policies to be those that involve significant uncertainties, require judgments or estimates that are more difficult for management to determine or that may produce materially different results when using different assumptions. We consider the following accounting policies to be critical:

Marketable Securities

We classify investments with maturity dates greater than three months when purchased as marketable securities. Investments, including certificates of deposit with maturity dates greater than three months when purchased and which have readily determined fair values, are classified as available-for-sale investments and reflected in current assets as marketable securities at fair market value. Our investment policy requires that all investments be investment grade quality and no more than ten percent of our portfolio may be invested in any one security or with one institution.

Short-term investments classified as available-for-sale were as follows:

		September 30, 2008
		Aggregate Fair Value			Gross Unrealized Gains / (Losses)			Estimated Fair Value
Commercial paper		$	3,708,821		$	-		$	3,708,821
Corporate securities fixed rate			651,811			-			651,811
Total		$	4,360,632		$	-		$	4,360,632

18

---

There were no gross unrealized gains or losses as of September 30, 2008.

Shares Issuable

Pursuant to the Second Interim Award, stating that, if the Technology Transaction is submitted to and approved by our stockholders, 9,230,000 shares of our common stock should be issued to NQCI to effectuate the transaction, we accrued for the 9.23 million shares of our common stock. As the Second Interim Award states that a registration statement for any issued shares must be declared effective within 90 days, and such contingency is not within our control, we have recorded the issuance as a liability, rather than as equity. The fair value of the 9.23 million shares was measured using the closing price of our common stock on August 4, 2008, the date of the Second Interim Award, and revalued, marked to market, as of the end of this interim reporting period, September 30, 2008. The fair value of the accrued shares on August 4, 2008, was $10,153,000 which was revalued at $4,615,000 as of September 30, 2008, resulting in a $5,538,000 non-operating gain to the statement of operations for the three and nine months ended September 30, 2008. The net fair value of $4,615,000 was accrued under “Shares issuable” as of September 30, 2008. Stockholders’ approval and issuance of the shares are pending to date. The shares issuable liability will be marked to market until a determination is made that the Technology Transaction will not be submitted to our stockholders, the stockholders vote not to approve the transaction, or they vote to approve the transaction and the shares are issued and registered. The price of our stock has declined since September 30, 2008, and as of November 18, 2008, the closing price was $0.27 per share, reducing the shares issuable liability from $4.6 million to approximately $2.5 million as of that date. We anticipate that we will continue to incur losses, which will continue to increase the shareholder deficit.

Although we may seek stockholder approval for the issuance of the 9.23 million shares of our common stock to effectuate the Technology Transaction, we are uncertain whether the SEC will approve a form of proxy to solicit stockholder approval of the transaction, our stockholders will vote to approve the transaction, shares will be issued to NQCI, or the SEC will declare effective a registration statement to register the shares for resale. If the Technology Transaction does not close, the arbitrator may issue alternative relief. In the event of an alternate award, the above accrual may be adjusted and the accrual or the actual settlement will be recorded to coincide with the alternate award. If the Technology Transaction is approved and the shares are issued and registered or the registration requirement is eliminated or waived, that would eliminate the shares issuable liability, and increase stockholders equity by the amount of the liability.

 

Stock-Based Compensation

Statements of Financial Accounting Standards (SFAS) No. 123 (revised 2004), Share-Based Payment , (SFAS 123(R)) and Securities and Exchange Commission issued Staff Accounting Bulletin (SAB) No. 107 (SAB 107) require the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. We have applied the provisions of SAB 107 in our adoption of SFAS 123(R).

In determining stock based compensation, we consider various factors in our calculation of fair value using a Black-Scholes pricing model. These factors include volatility, expected term of the options, and forfeiture rates. A change in these factors could result in differences in the stock based compensation expense.

ITEM 3. Quantitative and Qualitative Disclosures about Market Risk

We invest our cash in short term high grade commercial paper, certificates of deposit, money market accounts, and marketable securities. We consider any liquid investment with an original maturity of three months or less when purchased to be cash equivalents. We classify investments with maturity dates greater than three months when purchased as marketable securities, which have readily determined fair values and are classified as available-for-sale securities. Our investment policy requires that all investments be investment grade quality and no more than ten percent of our portfolio may be invested in any one security or with one institution.

Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk arising from changes in the level or volatility of interest rates; however, interest rate movements do not materially affect the market value of our portfolio because of the short-term nature of these investments. A reduction in the overall level of interest rates may produce less interest income from our investment portfolio. The market risk associated with our investments in debt securities is substantially mitigated by the frequent turnover of our portfolio.

ITEM 4. Controls and Procedures

Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, conducted an evaluation of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report (September 30, 2008), as is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Our disclosure controls and procedures are intended to ensure that the information we are required to disclose in the reports that we file or submit under the Securities Exchange Act of 1934 is (i) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (ii) accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as the principal executive and financial officer, to allow timely decisions regarding required disclosures.

19

---

Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective. Our management has concluded that the financial statements included in this report present fairly, in all material respects our financial position, results of operations and cash flows for the periods presented in conformity with generally accepted accounting principles.

It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system will be met. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events.

Changes in Internal Control

There have been no changes in our internal control over financial reporting, as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting. 

20

---

PART II — OTHER INFORMATION

ITEM 1. Legal Proceedings.

On September 1, 2006, Operations entered into a Merger Agreement with NQCI which contemplated that we would acquire NQCI as a wholly owned subsidiary pursuant to a triangular merger, or we would issue shares of our common stock to NQCI stockholders in consideration of the assignment of the technology relating to our WAK and other medical devices which, as listed under “Technology” on the License Agreement, are “all existing and hereafter developed Intellectual Property, Know-How, Licensor Patents, Licensor Patent Applications, Derivative Works and any other technology, invented, improved or developed by Licensor, or as to which Licensor owns or holds any rights, arising out of or relating to the research, development, design, manufacture or use of (a) any medical device, treatment or method as of the date of this Agreement, (b) any portable or continuous dialysis methods or devices , specifically including any wearable artificial kidney, or Wearable Artificial Kidney, and related devices, (c) any device, methods or treatments for congestive heart failure, and (d) any artificial heart or coronary device” (the “Technology Transaction”). The agreement provided that Operations had no obligation to issue or deliver any shares after December 31, 2006, unless the Parties mutually agreed to extend such date, which they did not. In addition, on December 29, 2006, NQCI served us with written notice that it was terminating the Merger Agreement, which we accepted. Accordingly, the merger was not consummated. Copies of the License Agreement and the Merger Agreement are attached as Appendix B and Appendix C, respectively, to the preliminary proxy statement filed October 31, 2008, with the Securities and Exchange Commission.

On December 1, 2006, Operations initiated arbitration proceedings against NQCI for its breach of the License Agreement, which remains pending. NQCI claimed the License Agreement was terminated, and we sought a declaration that the License Agreement remained in effect until the Closing of the Merger or Technology Transaction. We later amended our claims to seek damages for NQCI’s failure to perform its obligations under the License Agreement. NQCI filed counterclaims seeking to invalidate the License Agreement and claiming monetary damages against us. NQCI also filed claims against Dr. Gura, claiming he breached his obligations to NQCI by agreeing to serve on our board of directors. Following a hearing and extensive briefing, the arbitrator denied both parties’ claims for damages. Although NQCI never filed an amendment to its counterclaims to seek specific performance, on June 9, 2008, the arbitrator issued an Interim Award granting specific performance of the Technology Transaction.

The Interim Award stated that the total aggregate shares of stock to be received by NQCI stockholders at the Closing should equal 48% of all Operations shares outstanding as of the date of the Merger Agreement. On September 1, 2006, there were 10,000,000 shares of Operations common stock outstanding. NQCI proposed four possible share interest awards, arguing that it was entitled to between 9,600,000 and 17,130,293 shares, representing a 48% or 54% interest based on Operations shares outstanding at the time of the Merger Agreement or our present number of outstanding shares.

On August 4, 2008, the arbitrator issued a Second Interim Award, modifying the initial Interim Award, stating that, if we desire to close the Technology Transaction, we must obtain approval from a majority of our stockholders and issue 9,230,000 shares of our common stock. Although the first Interim Award stated that 48% of the outstanding shares should be issued, the Second Interim Award states that the number of shares issued should be 48% of 19,230,000 shares, the total number of shares necessary to put our 52% interest at 10,000,000 shares. As of October 31, 2008, there were 14,704,687 shares of our common stock issued and outstanding. Accordingly, following Closing of the Technology Transaction, NQCI stockholders would own approximately 39% of our total outstanding shares, making NQCI our largest stockholder. The arbitrator found that, with the exception of shareholder approval, virtually all conditions to Closing the Technology Transaction have been waived, including virtually all of NQCI’s representations and warranties concerning the Technology. Upon Closing of the Technology Transaction, all of the Technology will be our sole and exclusive property.

The Second Interim Award also states that, contrary to the assertions made by NQCI, the License Agreement will remain in full force and effect until the Technology Transaction closes or the arbitrator determines that it will never close. Upon Closing of the Technology Transaction, the License Agreement will terminate, and we will own all of the Technology.

On January 3, 2008, the arbitrator issued an order denying NQCI’s motion to amend its counterclaim to add us as a successor company following the merger. However, in the Second Interim Award, the arbitrator found that we are the successor to Operations as a result of the merger, even though we are not a party to any of the agreements or the arbitration, and ordered that our shares should be issued to NQCI rather than shares of Operations.

21

---

The arbitrator has not ordered us to close the Technology Transaction. However, the Second Interim Award states that, if our stockholders fail to approve the issuance of stock to effectuate the Technology Transaction, all of the Technology covered by the License shall be declared the sole and exclusive property of NQCI, and the arbitrator shall schedule additional hearings to address two questions: whether the PAK technology is included within that Technology, and whether NQCI is entitled to compensatory damages and the amount of damages under these circumstances. During the arbitration, NQCI took the position that we had misappropriated trade secrets regarding the WAK and used them to create the PAK. The arbitrator found that we had not misappropriated NQCI’s trade secrets. However, should the Technology Transaction not close for any reason, and the arbitrator rules that the licensed Technology must be returned to NQCI, the arbitrator could find that the PAK is derived in whole or in part from the licensed Technology, and could rule that Operations must “return” the PAK technology to NQCI or that NQCI is entitled to compensatory damages or both.

On August 15, 2008, the arbitrator awarded NQCI $1.87 million of over $4 million it claimed in attorneys’ fees and costs, stating that NQCI’s lack of success and other factors warranted a substantial reduction in the sums claimed. The arbitrator stated in pertinent part: “National’s success in the arbitration has been only partial and this is directly relevant to the question of the quantum of attorneys’ fees which should be awarded. … National sought eight or nine figure damages, but was awarded none. … Further, National asserted claims for fraud, interference with contract, and other torts, all of which were rejected. His lack of success warrants a substantial reduction in the sums claimed.” NQCI asked for a total of $4.04 million in attorneys’ fees and costs. The arbitrator awarded NQCI a total of $1.87 million.

In an August 29, 2008 Order Re Issuance of Xcorporeal Shares, the arbitrator stated that the shares should be issued directly to NQCI’s stockholders. However, on September 4, 2008, the arbitrator issued an order that we should issue and deliver the 9,230,000 shares directly to NQCI, rather than directly to NQCI stockholders, if we obtain stockholder approval and elect to proceed with the Technology Transaction.

The Second Interim Award requires that we file a registration statement under the Securities Act to register for resale the shares to be issued to NQCI within 30 days after the closing of the Technology Transaction. The arbitrator acknowledged that our obligation is to file the registration statement and to use reasonable efforts to have the shares registered and not to guarantee registration and resultant actual public tradability. However, the arbitrator nevertheless ordered that the registration statement must be declared effective within 90 days. We have no control over whether the registration statement will be declared effective by the Securities and Exchange Commission, and no way to predict what further action, if any, the arbitrator may order if it is not declared effective.

The arbitrator has stated that he has not yet issued a final award that may be confirmed or challenged in a court of competent jurisdiction. A party to the arbitration could challenge the interim award in court, even after stockholders approve the transaction. In addition, the arbitrator could again change the award by granting different or additional remedies, even after stockholders approve the transaction. We cannot guarantee that the arbitrator would order that stockholders be given another opportunity to vote on the transaction, even if such changes are material. Arbitrators have broad equitable powers, and arbitration awards are difficult to challenge in court, even if the arbitrator makes rulings that are inconsistent or not in accordance with the law or the evidence.

Shares to be issued

We intend to seek approval from our stockholders to issue 9,230,000 shares of our common stock to NQCI in order to close the Technology Transaction and obtain ownership of intellectual property rights described above. As of November 17, 2008, there were 14,704,687 shares of our common stock issued and outstanding. Accordingly, following Closing of the Technology Transaction, NQCI would own approximately 39%of our total outstanding shares.

As a result, NQCI may have the ability to substantially influence the outcome of issues submitted to our stockholders. The interests of NQCI may not coincide with our interests or the interests of other stockholders, and it may act in a manner that advances its best interests and not necessarily those of other stockholders. One consequence to this substantial interest is that it may deter unsolicited takeovers, including transactions in which stockholders might otherwise receive a premium for their shares over then current market prices.

The Technology

The Merger Agreement provides that, at the Closing of the Technology Transaction, NQCI shall absolutely, unconditionally, validly and irrevocably sell, transfer, grant and assign to Operations all of the Technology, including, but not limited to, the inventions embodied or described in the Licensor Patents and Patent Applications as defined in the License Agreement.

Under the License Agreement, NQCI grants to us an exclusive license for 99 years (or, if earlier, until the expiration of NQCI's proprietary rights in the Technology) for an annual royalty of 7% of net sales, with a minimum annual royalty of $250,000. We are required to "make commercially reasonable efforts to develop and commercially exploit the Technology to generate revenues" during the term of the License Agreement. The License Agreement does not provide for termination in the event the Merger Agreement is terminated; instead it provides for an adjustment of the royalty to 6.5%, 7.5%, or 8.5% depending on the grounds on which the Merger Agreement was terminated. Either party has the right to terminate the License Agreement in the event of a material breach by the other party which remains uncured for a period of 30 days after notice. In the event of a termination of the License Agreement, we are required to cease all use of the Technology and return all "Licensee Confidential Information" to NQCI. The Technology relates primarily to the WAK.

 ITEM 1A. Risk Factors.

 

Investing in our common stock involves a high degree of risk. In addition to the information in this report, you should carefully consider the risks described under Risk Factors in Part I, Item 1 of our Annual Report on Form 10-KSB for the year ended December 31, 2007, and the revised risk factors noted below. If any of such risks actually occurs, our business, results of operations and financial condition will likely suffer. As a result the trading price of our common stock may decline, and you might lose part or all of your investment

22

---

An unfavorable result in the pending arbitration could have a material adverse effect on our capital structure, business and financial condition.

 

We consider the protection of our proprietary technology for treatment of kidney failure, which we have licensed and are developing, to be critical to our business prospects. We obtained the rights to the wearable artificial kidney (WAK) through a License Agreement with National Quality Care, Inc. (NQCI). On December 1, 2006, Operations initiated arbitration against NQCI for failure to fully perform its obligations under our License Agreement. NQCI filed counterclaims seeking to invalidate the License Agreement and claiming monetary damages against us. In interim awards, the arbitrator has found that the License Agreement will not survive if the Technology Transaction contemplated by the Merger Agreement entered into concurrently with the License Agreement fails to close. If this determination were upheld by a court of competent jurisdiction, we could be prevented from using the WAK technology we licensed from it. In addition, if it were found that our rights to the portable artificial kidney (PAK) are derived from the licensed technology, that could significantly impact our ability to develop, manufacture and sell our PAK, which would have a material adverse effect on our business and results of operations.

 

The interim awards state that NQCI is entitled to reimbursement for reasonable attorneys’ fees. NQCI has made a claim for approximately $3.9 million in such fees, which we have opposed and a lower amount of $1.87 million awarded by the arbitrator. The interim settlement of legal fees has been accrued in the three and nine months ending September 30, 2008. NQCI has also made a claim for reimbursement of approximately $690,000 in alleged expenses related to the License Agreement which has been accrued at June 30, 2008. If we ever become obligated to pay all or a substantial portion of such amounts, doing so could have a material adverse effect on our liquidity and financial ability to continue with ongoing operations as currently planned.

The interim awards also state that 9,230,000 shares of our common stock would have to be issued to effectuate the Technology Transaction, if Closing such a transaction were to be approved by our stockholders. The issuance of such shares would result in NQCI owning approximately 39% of our total outstanding shares, diluting current stockholders and giving it the ability to substantially influence the outcome of matters submitted to stockholders.

We expect to incur negative cash flows and net losses for the foreseeable future and may not be able to continue as a going concern.

 

As a result of our expectation of negative cash flows and net losses for the foreseeable future, based on our current plans, we believe our existing cash reserves will not be sufficient to meet our operating expenses and capital requirements before we achieve profitability. Our ability to meet our cash obligations as they become due will depend on our ability to secure financing on acceptable terms. Unless we are able to raise capital sufficient to support our operations there will be substantial doubt of our ability to continue as a going concern.

Approximately 42% of our stock is controlled by a single stockholder who has the ability to substantially influence the election of directors and the outcome of matters submitted to stockholders.

As of September 30, 2008, CNL, a limited liability company whose managing member is a member of our board of directors, directly owned 6,232,596 shares, which represent approximately 42.4% of our 14,704,687 shares of outstanding common stock. As a result, CNL presently and is expected to continue to have the ability to determine the outcome of issues submitted to our stockholders. The interests of this stockholder may not always coincide with our interests or the interests of other stockholders, and it may act in a manner that advances its best interests and not necessarily those of other stockholders. One consequence to this substantial stockholder’s interest is that it may be difficult for investors to remove management of the company. It could also deter unsolicited takeovers, including transactions in which stockholders might otherwise receive a premium for their shares over then current market prices.

Sales of common stock by our existing stockholders, or the perception that such sales may occur, could depress our stock price.

The market price of our common stock could decline as a result of sales by, or the perceived possibility of sales by, our existing stockholders, including stockholders who recently purchased their shares from CNL. Most of our outstanding shares were registered on a Form S-4 registration statement in connection with our October 2007 merger, and are eligible for public resale. Approximately half of our shares of common stock are currently held by our affiliates and may be sold pursuant to an effective registration statement or in accordance with the volume and other limitations of Rule 144 under the Securities Act of 1933, as amended, or pursuant to other exempt transactions. Future sales of common stock by significant stockholders, including those who acquired their shares in private placements or who are affiliates, or the perception that such sales may occur, could depress the price of our common stock.

ITEM 2. Unregistered Sales of Equity Securities; Use of Proceeds from Registered Securities.

 

For the three months ended September 30, 2008, we did not have unregistered sales of equity securities or use of proceeds from registered securities.

23

---

ITEM 6. Exhibits.

No.		Description of Exhibit
10.1		Lease for Operating Facility
31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1		Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2		Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

24

---

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Date: November 19, 2008	By:	/s/ Robert Weinstein
		Robert Weinstein Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)

25

---