Vanda Pharmaceuticals
Annual Report 2010

Plain-text annual report

UNITED STATES SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549Form 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2010oo TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934Commission File No. 001-34186VANDA PHARMACEUTICALS INC.(Exact name of registrant as specified in its charter)Delaware(State or other jurisdiction ofincorporation or organization) 03-0491827(I.R.S. EmployerIdentification No.)9605 Medical Center Drive, Suite 300Rockville, Maryland 20850(240) 599-4500(Address and telephone number, including area code, of registrant’s principal executive offices)Securities registered pursuant to Section 12(b) of the Exchange Act:Title of Each Class Name of Each Exchange on Which RegisteredCommon Stock, par value $0.001 The Nasdaq Stock Market LLC (NASDAQ Global Market)Rights to Purchase Series A Junior Participating Preferred Stock The Nasdaq Stock Market LLC(NASDAQ Global Market)Securities registered pursuant to Section 12(g) of the Exchange Act: NoneIndicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the ExchangeAct. Yes o No Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes  No oIndicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive DataFile required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or forsuch shorter period that the registrant was required to submit and post such files). Yes o No oIndicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not becontained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.(Check one):Large accelerated filer oAccelerated filer Non-accelerated filer oSmaller reporting company o(Do not check if a smaller reporting company)Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act of1934). Yes o No As of June 30, 2010, the aggregate market value of the Common Stock held by non-affiliates of the registrant was $181,889,829, based on theclosing price of the registrant’s Common Stock, as reported by the NASDAQ Global Market. Shares of Common Stock held by each executiveofficer, director and stockholders known by the registrant to own 10% or more of the outstanding stock based on public filings and otherinformation known to the registrant have been excluded since such persons may be deemed affiliates. This determination of affiliate status is notnecessarily a conclusive determination for other purposes.The number of shares of the registrant’s Common Stock, par value $0.001 per share, outstanding as of March 4, 2011 was 28,103,441.The exhibit index as required by Item 601(a) of Regulation S-K is included in Item 15 of Part IV of this report.DOCUMENTS INCORPORATED BY REFERENCESpecified portions of the registrant’s proxy statement with respect to the registrant’s 2011 Annual Meeting of Stockholders, which is to be filedpursuant to Regulation 14A within 120 days after the end of the registrant’s fiscal year ended December 31, 2010, are incorporated by reference intoPart III of this Form 10-K. Vanda Pharmaceuticals Inc.Form 10-KTable of Contents PagePart I Cautionary Note Regarding Forward-Looking Statements 2 Item 1. Business 3 Item 1A. Risk Factors 19 Item 1B. Unresolved Staff Comments 40 Item 2. Properties 40 Item 3. Legal Proceedings 40 Item 4. (Removed and Reserved) 40 Part IIItem 5. Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of EquitySecurities 40 Item 6. Selected Consolidated Financial Data 43 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 44 Item 7A. Qualitative and Quantitative Disclosures about Market Risk 58 Item 8. Financial Statements and Supplementary Data 58 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 58 Item 9A. Controls and Procedures 58 Item 9B. Other Information 59 Part IIIItem 10. Directors, Executive Officers and Corporate Governance 59 Item 11. Executive Compensation 59 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 59 Item 13. Certain Relationships and Related Transactions, and Director Independence 59 Item 14. Principal Accountant Fees and Services 60 Part IVItem 15. Exhibits and Financial Statements Schedules 60 Signatures 61 Exhibit Index 87 1 PART ICAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTSVarious statements in this report are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Actof 1995. Forward-looking statements may appear throughout this report, including without limitation, the following sections: Item 1“Business,” Item 1A “Risk Factors,” and Item 7 “Management’s Discussion and Analysis of Financial Condition and Results ofOperations.” Words such as, but not limited to, “believe,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” “targets,” “likely,”“will,” “would,” and “could,” or the negative of these terms and similar expressions or words, identify forward-looking statements.Forward-looking statements are based upon current expectations that involve risks, changes in circumstances, assumptions anduncertainties. Important factors that could cause actual results to differ materially from those reflected in our forward-looking statementsinclude, among others: • the extent and effectiveness of the development, sales and marketing and distribution support Fanapt® receives; • our ability to successfully commercialize Fanapt® outside of the U.S. and Canada; • delays in the completion of our clinical trials; • a failure of our products, product candidates or partnered products to be demonstrably safe and effective; • our failure to obtain regulatory approval for our products or product candidates or to comply with ongoing regulatoryrequirements; • a lack of acceptance of our products, product candidates or partnered products in the marketplace, or a failure to become orremain profitable; • our expectations regarding trends with respect to our costs and expenses; • our inability to obtain the capital necessary to fund our research and development activities; • our failure to identify or obtain rights to new products or product candidates; • our failure to develop or obtain sales, marketing and distribution resources and expertise or to otherwise manage our growth; • limitations on our ability to utilize some or all of our prior net operating losses and research and development credits; • a loss of any of our key scientists or management personnel; • losses incurred from product liability claims made against us; and • a loss of rights to develop and commercialize our products or product candidates under our license and sublicense agreements.All written and verbal forward-looking statements attributable to us or any person acting on our behalf are expressly qualified intheir entirety by the cautionary statements contained or referred to in this section. We caution investors not to rely too heavily on theforward-looking statements we make or that are made on our behalf. We undertake no obligation, and specifically decline any obligation,to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.We encourage you to read the discussion and analysis of our financial condition and our consolidated financial statements containedin this annual report on Form 10-K. We also encourage you to read Item 1A of Part 1 of this annual report on Form 10-K, entitled “RiskFactors,” which contains a more complete discussion of the risks and uncertainties associated with our business. In addition to the risksdescribed above and in Item 1A of this report, other unknown or unpredictable factors also could affect our results. There can be noassurance that the actual results or developments anticipated by us will be realized or, even if substantially2 realized, that they will have the expected consequences to, or effects on, us. Therefore no assurance can be given that the outcomes statedin such forward-looking statements and estimates will be achieved.ITEM 1. BUSINESSOverviewVanda Pharmaceuticals Inc. (We, Vanda or the Company) is a biopharmaceutical company focused on the development andcommercialization of products for central nervous system disorders. We believe that each of our products and partnered products willaddress a large market with significant unmet medical needs by offering advantages over currently available therapies. Our productportfolio includes: • Fanapt® (iloperidone), a compound for the treatment of schizophrenia. On October 12, 2009, we entered into an amended andrestated sublicense agreement with Novartis. We had originally entered into a sublicense agreement with Novartis on June 4, 2004pursuant to which we obtained certain worldwide exclusive licenses from Novartis relating to Fanapt®. Pursuant to the amendedand restated sublicense agreement, Novartis has exclusive commercialization rights to all formulations of Fanapt® in theU.S. and Canada. On January 11, 2010, Novartis launched Fanapt® in the U.S. Novartis is responsible for the further clinicaldevelopment activities in the U.S. and Canada, including the development of a long-acting injectable (or depot) formulation ofFanapt®. Pursuant to the amended and restated sublicense agreement, we received an upfront payment of $200.0 million and areeligible for additional payments totaling up to $265.0 million upon the achievement of certain commercial and developmentmilestones for Fanapt® in the U.S. and Canada. We also receive royalties, which, as a percentage of net sales, are in the lowdouble-digits, on net sales of Fanapt® in the U.S. and Canada. In addition, we are no longer required to make any futuremilestone payments with respect to sales of Fanapt® or any future royalty payments with respect to sales of Fanapt® in theU.S. and Canada. We retain exclusive rights to Fanapt® outside the U.S. and Canada and we have exclusive rights to use any ofNovartis’ data for Fanapt® for developing and commercializing Fanapt® outside the U.S. and Canada. At Novartis’ option, wewill enter into good faith discussions with Novartis relating to the co-commercialization of Fanapt® outside of the U.S. andCanada or, alternatively, Novartis will receive a royalty on net sales of Fanapt® outside of the U.S. and Canada. OnFebruary 23, 2010, the U.S. Patent and Trademark Office (PTO) issued a notice of allowance for our patent application for themicrosphere long -acting injectable (or depot) formulation of Fanapt®. On August 3, 2010, the PTO informed us that the patenthad been issued with a patent term adjustment of 605 days, extending the patent expiration date to June 26, 2024. Subsequently,on October 28, 2010, the PTO informed us that it had granted an additional patent term adjustment of 59 days, making the totalextension 664 days and making the patent expiration date August 24, 2024. We continue to explore the regulatory path andcommercial opportunity for Fanapt® oral formulation outside of the U.S. and Canada. On November 1, 2010, the TherapeuticGoods Administration of Australia’s Department of Health and Ageing, accepted for evaluation our application for marketingapproval of the oral formulation of Fanapy®. • Tasimelteon, a compound for the treatment of sleep and mood disorders, including Circadian Rhythm Sleep Disorders (CRSD).The compound binds selectively to the brain’s melatonin receptors, which are thought to govern the body’s natural sleep/wakecycle. Compounds that bind selectively to these receptors are thought to be able to help treat sleep disorders, and additionallybelieved to offer potential benefits in mood disorders. We announced positive top-line results from our Phase III trial of tasimelteonin transient insomnia in November 2006. In June 2008, we announced positive top-line results from the Phase III trial oftasimelteon in chronic primary insomnia. The trial was a randomized, double-blind, and placebo-controlled study with324 patients. The trial measured time to fall asleep and sleep maintenance, as well as next-day performance. On January 19,2010, the U.S. Food and Drug Administration (FDA) granted orphan drug designation status for tasimelteon in a specific CRSD,Non-24-Hour Sleep/Wake Disorder (N24HSWD) in blind individuals without light perception. The FDA grants orphan drugdesignation to drugs that may provide significant therapeutic advantage over existing treatments and target conditions affecting200,000 or fewer U.S. patients per year. Orphan drug designation provides potential financial and regulatory incentives,including study design assistance, tax3 credits, waiver of FDA user fees, and up to seven years of market exclusivity upon marketing approval. On February 23, 2011,the European Commission (EC) designated tasimelteon as an orphan medicinal product for the same indication. We initiated twoclinical trials to pursue FDA approval of tasimelteon for the treatment of N24HSWD in blind individuals without light perceptionin the third quarter of 2010. The first trial is a randomized, double-blind, placebo-controlled study with a planned enrollment ofapproximately 160 patients with N24HSWD. The trial has a six month treatment period and includes measures of both nighttimeand daytime sleep, as well as laboratory measures of the synchronization between the internal body clock and the 24-hourenvironmental light/dark cycle. We also initiated a one-year safety study of tasimelteon for the treatment of N24HSWD. This trialis an open-label safety study with a planned enrollment of approximately 140 patients with N24HSWD. We plan to conductadditional clinical trials over the next one to two years to support the use of tasimelteon as a circadian regulator and thesubmission of a New Drug Application (NDA) to the FDA and a marketing authorization application to the European MedicinesAgency (EMA). On January 6, 2011, an end-of-Phase II meeting was held with the FDA to discuss the development plan fortasimelteon in the treatment of N24HSWD. Tasimelteon is also ready for Phase II trials for the treatment of depression. Given therange of potential indications for tasimelteon, we may pursue one or more partnerships for the development andcommercialization of tasimelteon worldwide.Throughout this annual report on Form 10-K, we refer to Fanapt® within the U.S. and Canada as our partnered product and werefer to Fanapt® outside the U.S. and Canada and tasimelteon as our products. All other compounds are referred to herein as our productcandidates. In addition, we refer to our partnered products, products and product candidates collectively as our compounds. Moreover,we refer to drug products generally as drugs or products.Since we began our operations in March 2003, we have devoted substantially all of our resources to the in-licensing and clinicaldevelopment of our compounds. Our ability to generate revenue and achieve profitability largely depends on Novartis’ ability tosuccessfully commercialize Fanapt® in the U.S. and to successfully develop and commercialize Fanapt® in Canada and upon our ability,alone or with others, to complete the development of our products or product candidates, and to obtain the regulatory approvals for andmanufacture, market and sell our products and product candidates. The results of our operations will vary significantly fromyear-to-year and quarter-to-quarter and depend on a number of factors, including risks related to our business, risks related to ourindustry, and other risks which are detailed in Item 1A of Part I of this annual report on Form 10-K, entitled “Risk Factors”.Our activities will necessitate significant uses of working capital throughout 2011 and beyond. We are currently concentrating ourefforts on supporting Novartis’ commercial launch of Fanapt® in the U.S. and our two on-going clinical trials for tasimelteon. Inaddition, we have engaged in discussions with several foreign regulatory agencies to review their filing requirements with respect toFanapt®. We also plan to continue the clinical, regulatory and commercial evaluation of tasimelteon, including exploring the path to aNDA for tasimelteon.Our founder and Chief Executive Officer, Mihael H. Polymeropoulos, M.D., started our operations early in 2003 after establishingand leading the Pharmacogenetics Department at Novartis. In acquiring and developing our compounds, we have relied upon our deepexpertise in the scientific disciplines of pharmacogenetics and pharmacogenomics. These scientific disciplines examine both geneticvariations among people that influence response to a particular drug, and the multiple pathways through which drugs affect people. Webelieve that the combination of our expertise in these disciplines and our drug development expertise may provide us with preferentialaccess to compounds discovered by other pharmaceutical companies, and will allow us to identify new uses for these compounds. Thesecapabilities should also enable us to shorten the time it takes to commercialize a drug when compared to traditional approaches.Fanapt® and tasimelteon both target large prescription markets with significant unmet medical needs. We believe that Fanapt® mayaddress some of the shortcomings of other currently available drugs, based on its observed safety profile and the extended releaseinjectable formulation for Fanapt® that Novartis plans to develop further. Approved drugs in both the sleep and mood disorders marketshave sub-optimal safety and4 efficacy profiles. We believe tasimelteon may represent a breakthrough in each of these markets, based on the compound’s demonstratedefficacy and safety to date and its novel mechanism of action.Our strategyOur goal is to create a leading biopharmaceutical company focused on developing and commercializing products that address criticalunmet medical needs through the application of our drug development expertise and our pharmacogenetics and pharmacogenomicsexpertise. The key elements of our strategy to accomplish this goal are to: • Pursue the clinical development and regulatory approval of our products and product candidates. On May 6, 2009, theFDA granted U.S. marketing approval of Fanapt® for the acute treatment of schizophrenia in adults. On October 12, 2009, weentered into an amended and restated sublicense agreement with Novartis. We had originally entered into a sublicense agreementwith Novartis on June 4, 2004 pursuant to which we obtained certain worldwide exclusive licenses from Novartis relating toFanapt®. Pursuant to the amended and restated sublicense agreement, Novartis has exclusive commercialization rights to allformulations of Fanapt® in the U.S. and Canada. On January 11, 2010, Novartis launched Fanapt® in the U.S. We retainexclusive rights to Fanapt® outside the U.S. and Canada and we have exclusive rights to use any of Novartis’ data for Fanapt®for developing and commercializing Fanapt® outside the U.S. and Canada. We have successfully completed a Phase III trial oftasimelteon in transient insomnia and announced positive top-line results in November 2006. In addition, we have successfullycompleted a Phase III trial of tasimelteon in chronic primary insomnia and announced positive top-line results in June 2008. OnJanuary 19, 2010, the FDA granted orphan drug designation status for tasimelteon in a specific CRSD, N24HSWD in blindindividuals without light perception. The FDA grants orphan drug designation to drugs that may provide significant therapeuticadvantage over existing treatments and target conditions affecting 200,000 or fewer U.S. patients per year. Orphan drugdesignation provides potential financial and regulatory incentives, including study design assistance, tax credits, waiver of FDAuser fees, and up to seven years of market exclusivity upon marketing approval. On February 23, 2011, the EC designatedtasimelteon as an orphan medicinal product for the same indication. We initiated two clinical trials to pursue FDA approval oftasimelteon for the treatment of N24HSWD in blind individuals without light perception in the third quarter of 2010. We plan toconduct additional clinical trials over the next one to two years to support the use of tasimelteon as a circadian regulator and thesubmission of a NDA to the FDA and a marketing authorization application to the EMA. On January 6, 2011, an end-of-PhaseII meeting was held with the FDA to discuss the development plan for tasimelteon in the treatment of N24HSWD. Tasimelteon isalso ready for Phase II trials for the treatment of depression. • Enter into partnerships to extend our commercial reach. We may seek commercial partners for Fanapt® outside the U.S. andCanada. At Novartis’ option, we will enter into good faith discussions with Novartis relating to the co-commercialization ofFanapt® outside of the U.S. and Canada, or, alternatively, Novartis will receive a royalty on net sales of Fanapt® outside of theU.S. and Canada. In addition, given the range of potential indications for tasimelteon, we may pursue one or more partnershipsfor the development and commercialization of tasimelteon worldwide. • Apply our pharmacogenetics and pharmacogenomics expertise to differentiate our products and product candidates. Webelieve that our pharmacogenetics and pharmacogenomics expertise will yield new insights into our products and productcandidates. These insights may enable us to target our products and product candidates to certain patient populations and toidentify unexpected conditions for our products and product candidates to treat. • Expand our product portfolio through the identification and acquisition of additional compounds. We intend to continue todraw upon our clinical development expertise and pharmacogenetics and pharmacogenomics expertise to identify and pursue theacquisition of additional clinical-stage compounds.5 Development programsWe have the following products and partnered products in clinical development:Product or product candidate Target indications Clinical statusFanapt® (Oral) Schizophrenia FDA approval May 6, 2009; Commercial rights in the U.S.and Canada sublicensed to Novartis on October 12, 2009;Launched in the U.S. by Novartis in January 2010Fanapt® (Injectable) Schizophrenia Ready for Phase II trial; Novartis responsible for furtherclinical developmentTasimelteon Sleep Disorders, includingCRSD Phase III trial for transient insomnia completed in 2006 Phase III trial for chronic primary insomnia completed in 2008Two Phase III trials for N24HSWD in blind individualswithout light perception initiated in the third quarter of 2010 Depression Ready for Phase II trialFanapt®Fanapt® is a compound for the treatment of schizophrenia. On May 6, 2009, the FDA granted U.S. marketing approval of Fanapt®for the acute treatment of schizophrenia in adults. On October 12, 2009, we entered into an amended and restated sublicense agreementwith Novartis. We had originally entered into a sublicense agreement with Novartis on June 4, 2004 pursuant to which we obtained certainworldwide exclusive licenses from Novartis relating to Fanapt®. Pursuant to the amended and restated sublicense agreement, Novartis hasexclusive commercialization rights to all formulations of Fanapt® in the U.S. and Canada. On January 11, 2010, Novartis launchedFanapt® in the U.S. Novartis is responsible for the further clinical development activities in the U.S. and Canada, including thedevelopment of a long-acting injectable (or depot) formulation of Fanapt®. Pursuant to the amended and restated sublicense agreement, wereceived an upfront payment of $200.0 million and are eligible for additional payments totaling up to $265.0 million upon theachievement of certain commercial and development milestones for Fanapt® in the U.S. and Canada. We also receive royalties, which, asa percentage of net sales, are in the low double-digits, on net sales of Fanapt® in the U.S. and Canada. In addition, we are no longerrequired to make any future milestone payments with respect to sales of Fanapt® or any future royalty payments with respect to sales ofFanapt® in the U.S. and Canada. We retain exclusive rights to Fanapt® outside the U.S. and Canada and we have exclusive rights to useany of Novartis’ data for Fanapt® for developing and commercializing Fanapt® outside the U.S. and Canada. At Novartis’ option, wewill enter into good faith discussions with Novartis relating to the co-commercialization of Fanapt® outside of the U.S. and Canada or,alternatively, Novartis will receive a royalty on net sales of Fanapt® outside of the U.S. and Canada.Therapeutic opportunitySchizophrenia is a chronic, debilitating mental disorder characterized by hallucinations, delusions, racing thoughts and otherpsychotic symptoms (collectively referred to as “positive symptoms”), as well as moodiness, anhedonia (inability to feel pleasure), lossof interest, eating disturbances and withdrawal (collectively referred to as “negative symptoms”), and additionally attention and memorydeficits (collectively referred to as “cognitive symptoms”). Schizophrenia develops in late adolescence or early adulthood in approximately1% of the world’s population. Most schizophrenia patients today are treated with drugs known as “atypical” antipsychotics, which werefirst approved in the U.S. in the late 1980s. These antipsychotics have been named “atypical” for their ability to treat a broader range ofnegative symptoms than the first-generation “typical” antipsychotics, which were introduced in the 1950s and are now generic. Atypicalantipsychotics are generally regarded as having improved side effect profiles and efficacy relative to typical antipsychotics and6 currently comprise approximately 90% of schizophrenia prescriptions. Currently approved atypical antipsychotics include, in addition toFanapt®, Risperdal® (risperidone), including the depot formulation Risperdal® Consta®, and Invega® (paliperidone), including the depotformulation Invega® Sustennatm, each by Ortho-McNeil-Janssen Pharmaceuticals, Inc., Zyprexa® (olanzapine), including the depotformulation Zyprexa® Relprevvtm, by Eli Lilly and Company, Seroquel® (quetiapine) by AstraZeneca PLC, Abilify® (aripiprazole) byBMS/Otsuka Pharmaceutical Co., Ltd., Geodon® (ziprasidone) by Pfizer Inc., Saphris® (asenapine) by Schering-Plough, Latuda®(lurasidone) by Dainippon Sumitomo Pharma, and generic clozapinePursuant to the amended and restated sublicense agreement, Novartis is responsible for the further clinical development of the long-acting injectable or depot formulation of Fanapt®. The depot formulation is administered once every four weeks and we believe will be acompelling complement to the oral formulation for both physicians and patients. Novartis conducted a two-month Phase I/IIa safety trialof this formulation in schizophrenia patients, in which it demonstrated the benefit of consistent release over a four-week time period withno greater side effects relative to oral dosing. The commercial potential for the extended-release injectable formulation has beendemonstrated by the success of the injectable formulation for risperidone, Risperdal® Consta®, which achieved worldwide sales ofapproximately $1.5 billion in 2010, according to Alkermes Company press releases.Intellectual propertyFanapt® and its metabolites, formulations, genetic markers and uses are covered by a total of ninteen patent and patent applicationfamilies worldwide. The primary new chemical entity patent covering Fanapt® expires normally in 2011 in the U.S. and expired in 2010in most of the major markets in Europe. In the U.S., the United States Drug Price Competition and Patent Term Restoration Act of 1984,more commonly known as the “Hatch-Waxman Act” provides for an extension of new chemical entity patents for a period of up to fiveyears following the expiration of the patent covering that compound to compensate for time spent in development. We believe that Fanapt®will qualify for the full five-year patent term extension and, in addition, will be eligible for 6 months of pediatric exclusivity. In Europe,statutes provide for ten years of data exclusivity (with the potential for an additional year if the drug is developed for a significant newindication). No generic versions of Fanapt® would be permitted to be marketed or sold during this 10-year (or 11-year) period in mostEuropean countries. Consequently, assuming that patent term restoration and pediatric exclusivity are granted by the PTO and FDA andthat we receive regulatory approval in Europe, we expect that Novartis’ rights to commercialize Fanapt® will be exclusive until May 2017in the U.S. and for at least 10 years from approval in Europe. Additionally, on February 23, 2010, the PTO issued a notice of allowancefor our patent application for the microsphere long-acting injectable (or depot) formulation of Fanapt®. On August 3, 2010, the PTOinformed us that the patent has been issued with a patent term adjustment of 605 days, extending the patent expiration date to June 26,2024. Subsequently, on October 28, 2010, the PTO informed us that it has granted an additional patent term adjustment of 59 days,making the total extension 664 days and making the patent expiration date August 24, 2024. Several other patent applications coveringmetabolites, uses, formulations and genetic markers relating to Fanapt® extend beyond 2020.We acquired worldwide, exclusive rights to the new chemical entity patent covering Fanapt® and certain related intellectual propertyfrom Novartis under a sublicense agreement we entered into in 2004, which was restated and amended in 2009. Please see “Licenseagreements” below for a more complete description of the rights we acquired from and relinquished to Novartis with respect to Fanapt®.TasimelteonTasimelteon is an oral compound in development for sleep and mood disorders, including CRSD. The compound binds selectivelyto the brain’s melatonin receptors, which are thought to govern the body’s natural sleep/wake cycle. Compounds that bind selectively tothese receptors are thought to be able to help treat sleep disorders, and additionally are believed to offer potential benefits in mooddisorders. We announced positive top-line results from our Phase III trial of tasimelteon in transient insomnia in November 2006. In June2008, we announced positive top-line results from the Phase III trial of tasimelteon in chronic primary insomnia. On January 19, 2010,the FDA granted orphan drug designation status for tasimelteon in a specific CRSD,7 N24HSWD in blind individuals without light perception. The FDA grants orphan drug designation to drugs that may provide significanttherapeutic advantage over existing treatments and target conditions affecting 200,000 or fewer U.S. patients per year. Orphan drugdesignation provides potential financial and regulatory incentives, including study design assistance, tax credits, waiver of FDA userfees, and up to seven years of market exclusivity upon marketing approval. On February 23, 2011, the EC designated tasimelteon as anorphan medicinal product for the same indication. We initiated two clinical trials to pursue FDA approval of tasimelteon for the treatmentof N24HSWD in blind individuals without light perception in the third quarter of 2010. We plan to conduct additional clinical trials overthe next one to two years to support the use of tasimelteon as a circadian regulator and the submission of a NDA to the FDA and amarketing authorization application to the EMA. On January 6, 2011, an end-of-Phase II meeting was held with the FDA to discuss thedevelopment plan for tasimelteon in the treatment of N24HSWD. Tasimelteon is also ready for Phase II trials for the treatment ofdepression.Therapeutic opportunitySleep disorders are segmented into three major categories: primary insomnia, secondary insomnia and CRSDs. Insomnia is asymptom complex that comprises difficulty falling asleep or staying asleep, or non-refreshing sleep, in combination with daytimedysfunction or distress. The symptom complex can be an independent disorder (primary insomnia) or be a result of another conditionsuch as depression or anxiety (secondary insomnia). CRSD results from a misalignment of the sleep/wake cycle and an individual’sdaily activities or lifestyle. The circadian rhythm is the rhythmic output of the human biological clock and is governed primarily by thehormone melatonin. Both the timing of behavioral events (activity, sleep, and social interactions) and the environmental light/dark cycleresult in a sleep/wake cycle that follows the circadian rhythm. Examples of CRSD include transient disorders such as jet lag and chronicdisorders such as shift work sleep disorder and N24HSWD. Based on market research we have conducted with LEK Consulting webelieve that CRSD represents a significant portion of the market for sleep disorders.While there are no FDA-approved treatments for insomnia specifically related to CRSD, there are a number of drugs approved andprescribed for patients with sleep disorders. The most commonly prescribed drugs are hypnotics, such as generic zolpidem, Ambien®(zolpidem) by sanofi-aventis(including Ambien CR®), Lunesta® (eszopiclone) by Sepracor Inc., Sonata® (zaleplon) by KingPharmaceuticals, Inc. and Silenor® (doxepin) by Somaxon Pharmaceuticals, Inc. Hypnotics work by acting upon a set of brain receptorsknown as GABA receptors, which are separate and distinct from the melatonin receptors to which tasimelteon binds. Several drugs indevelopment also utilize a mechanism of action involving binding to GABA receptors. Members of the benzodiazapine class of sedativesare also approved for insomnia, but their usage has declined due to an inferior safety profile compared to hypnotics. Anecdotal evidencealso suggests that sedative antidepressants, such as trazodone and doxepin, are prescribed off-label for insomnia. FDA approved drugsfor the treatment of insomnia also include Rozeremtm (ramelteon) by Takeda Pharmaceuticals Company Limited, a compound with amechanism of action similar to tasimelteon.Limitations of current treatmentsWe believe that each of the drugs currently used to treat insomnia has inherent limitations that leave patients underserved. The keylimitations include the potential for abuse, significant side effects, and a failure to address the underlying causes of sleeplessness: • Many of the products prescribed commonly for sleep disorders, including Ambien®, Lunesta®, and Sonata®, are classified asSchedule IV controlled substances by the United States Drug Enforcement Administration (DEA) due to their potential for abuse,tolerance and withdrawal symptoms. Drugs that are classified as Schedule IV controlled substances are subject to restrictions onhow such drugs are prescribed and dispensed. • Many drugs approved for and used in sleep disorders also induce a number of nuisance side effects beyond the more seriousabuse and addiction effects associated with most approved products. These8 side effects include next-day grogginess, memory loss, unpleasant taste, dry mouth and hormonal changes. • We believe that none of the drugs used and approved for sleep, other than Rozeremtm, work through the body’s naturalsleep/wake cycle, which is governed by melatonin. We believe that, for patients whose sleep disruption is due to a misalignmentof this sleep/wake cycle (as is the case in CRSD), a drug that naturally modulates the sleep/wake cycle would be an attractivenew alternative because it would address the underlying cause of the sleeplessness, rather than merely addressing its symptoms.Potential advantages of tasimelteonWe believe that tasimelteon may offer efficacy similar to the most efficacious of the approved sleep drugs, and that it may providesignificant benefits to patients beyond those offered by the approved drugs. We believe that tasimelteon is unlikely to be scheduled as acontrolled substance by the DEA because Rozeremtm, which has a similar mechanism of action to tasimelteon, was shown not to havepotential for abuse and was not classified as a Schedule IV controlled substance by the DEA. However, despite the fact that the drugshave a similar mechanism of action, our Phase III results have demonstrated that tasimelteon may offer superior sleep maintenance toRozeremtm. Tasimelteon also appears to be safe and well-tolerated, with no significant side effects or effects on next-day performance. Forpatients with CRSDs, tasimelteon may be able to align the patient’s sleep/wake cycle with his or her lifestyle, something we believe noapproved sleep therapy has demonstrated. For example, in our Phase II trial of tasimelteon in transient insomnia with 37 healthyparticipants, tasimelteon induced a statistically significant (p<0.025) shift in circadian rhythm of up to five hours on the first night.Overview of Phase III clinical trialsIn November 2006, we reported positive top-line results in a randomized, double-blind, multi-center, placebo-controlled Phase IIItrial that enrolled 412 adults in a sleep laboratory setting using a phase-advance, first-night assessment model of induced transientinsomnia. The trial examined tasimelteon dosed 30 minutes before bedtime at 20, 50 and 100 milligrams versus placebo.Tasimelteon achieved significant results in multiple endpoints, demonstrating a benefit in both sleep onset, or time to fall asleep, andsleep maintenance, or ability to stay asleep. Based on these trial results, we believe that tasimelteon will compare favorably to efficacyachieved by currently approved insomnia drugs, not only for CRSDs but also for other types of insomnia. The Phase III trial alsodemonstrated that tasimelteon was safe and well-tolerated, with no significant side effects versus placebo and no impairment of next-dayperformance or mood.In June 2008, we reported positive top-line results in a randomized, double-blind, placebo-controlled Phase III trail in chronicprimary insomnia that enrolled 324 patients. The trial examined tasimelteon at 20 and 50 milligrams versus placebo over a period of35 days. The trial measured time to fall asleep and sleep maintenance, as well as next-day performance.We initiated two clinical trials to pursue FDA approval of tasimelteon for the treatment of N24HSWD in blind individuals withoutlight perception in the third quarter of 2010. The first trial is a randomized, double-blind, placebo-controlled study with a plannedenrollment of approximately 160 patients with N24HSWD. The trial has a six month treatment period and includes measures of bothnighttime and daytime sleep, as well as laboratory measures of the synchronization between the internal body clock and the 24-hourenvironmental light/dark cycle. We also initiated a one-year safety study of tasimelteon for the treatment of N24HSWD. This trial is anopen-label safety study with a planned enrollment of approximately 140 patients with N24HSWD. We plan to conduct additional clinicaltrials over the next one to two years to support the use of tasimelteon as a circadian regulator and the submission of a NDA to the FDAand a marketing authorization application to the EMA.9 Potential indication for depressionWe believe that tasimelteon may also be effective in treating depression. Agomelatine, another drug that acts on the brain’s melatoninreceptors, has demonstrated efficacy and safety in the treatment of depression that compared favorably to an approved antidepressant,Paxil® (paroxetine) by GSK, in a Phase III trial. While the precise mechanism for the effect of drugs like tasimelteon, agomelatine andRozeremtm, which act on the brain’s melatonin receptors, is currently unknown, it is possible that, by improving sleep, these drugs couldimprove mood, since depressed patients are likely to have sleep disorders. It is also possible that mood disorders such as depression havean association with circadian rhythm misalignments.We believe that tasimelteon will be differentiated from approved antidepressants in several ways. In the Phase III trial of agomelatinedescribed above, agomelatine showed significantly improved mood in two weeks, versus four weeks for Paxil®. Consequently,tasimelteon may, with its similar properties to agomelatine, offer a more rapid onset of action than approved antidepressants. We believethat tasimelteon should also have an improved side effect profile when compared to approved products because we believe that it shouldnot have the sexual side effects, weight gain, and sleep disruption associated with these products. Tasimelteon is ready for Phase II trialsin depression. It has demonstrated an antidepressant effect in animal models and has completed several Phase I and II trials, including onewith four weeks of exposure, showing none of the serious side effects associated with the approved antidepressants.Intellectual propertyTasimelteon and its formulations, genetic markers and uses are covered by a total of six patent and patent application familiesworldwide. The primary new chemical entity patent covering tasimelteon expires normally in 2017 in the U.S. and in most Europeanmarkets. We believe that, like Fanapt®, tasimelteon will meet the various criteria of the Hatch-Waxman Act and will receive five additionalyears of patent protection in the U.S., which would extend its patent protection in the U.S. until 2022. In Europe, data exclusivity willprotect tasimelteon for at least ten years from approval. Additional patent applications directed to specific sleep disorders and to methodsof administration, if issued, would provide exclusivity for such indications and methods of administration until at least 2026.Our rights to the new chemical entity patent covering tasimelteon and related intellectual property have been acquired through alicense with BMS. Please see “License agreements” below for a discussion of this license.License agreementsOur rights to develop and commercialize our products and product candidates are subject to the terms and conditions of licensesgranted to us by other pharmaceutical companies.Fanapt®We acquired exclusive worldwide rights to patents and patent applications for Fanapt® through a sublicense agreement withNovartis. A predecessor company of sanofi-aventis, Hoechst Marion Roussel, Inc. (HMRI), discovered Fanapt® and completed earlyclinical work on the compound. In 1996, following a review of its product portfolio, HMRI licensed its rights to the Fanapt® patents andpatent applications to Titan Pharmaceuticals, Inc. (Titan) on an exclusive basis. In 1997, soon after it had acquired its rights, Titansublicensed its rights to Fanapt® on an exclusive basis to Novartis. In June 2004, we acquired exclusive worldwide rights to these patentsand patent applications as well as certain Novartis patents and patent applications to develop and commercialize Fanapt® through asublicense agreement with Novartis. In partial consideration for this sublicense, we paid Novartis an initial license fee of $0.5 millionand were obligated to make future milestone payments to Novartis of less than $100.0 million in the aggregate (the majority of which weretied to sales milestones), as well as royalty payments to Novartis at a rate which, as a percentage of net sales, was in the mid-twenties. InNovember 2007, we met a milestone under this sublicense agreement relating to the acceptance of our filing of the NDA for Fanapt® forthe treatment of schizophrenia and made a corresponding payment of $5.0 million to Novartis. As a result of the FDA’s approval of theNDA for Fanapt®10 in May 2009, we met an additional milestone under this sublicense agreement which required us to make a payment of $12.0 million toNovartis.On October 12, 2009, we entered into an amended and restated sublicense agreement with Novartis which amended and restated ourJune 2004 sublicense agreement with Novartis relating to Fanapt®. Pursuant to the amended and restated sublicense agreement, Novartishas exclusive commercialization rights to all formulations of Fanapt® in the U.S. and Canada. Novartis began selling Fanapt® in theU.S. during the first quarter of 2010. Novartis is responsible for the further clinical development activities in the U.S. and Canada,including the development of a long-acting injectable (or depot) formulation of Fanapt®. Pursuant to the amended and restated sublicenseagreement, we received an upfront payment of $200.0 million and are eligible for additional payments totaling up to $265.0 million uponthe achievement of certain commercial and development milestones for Fanapt® in the U.S. and Canada. We also receive royalties, which,as a percentage of net sales, are in the low double-digits, on net sales of Fanapt® in the U.S. and Canada. In addition, we are no longerrequired to make any future milestone payments with respect to sales of Fanapt® or any future royalty payments with respect to sales ofFanapt® in the U.S. and Canada. We retain exclusive rights to Fanapt® outside the U.S. and Canada and we have exclusive rights to useany of Novartis’ data for Fanapt® for developing and commercializing Fanapt® outside the U.S. and Canada. At Novartis’ option, wewill enter into good faith discussions with Novartis relating to the co-commercialization of Fanapt® outside of the U.S. and Canada or,alternatively, Novartis will receive a royalty on net sales of Fanapt® outside of the U.S. and Canada.We may lose our rights to develop and commercialize Fanapt® outside the U.S. and Canada if we fail to comply with certainrequirements in the amended and restated sublicense agreement regarding our financial condition, or if we fail to comply with certaindiligence obligations regarding our development or commercialization activities or if we otherwise breach the amended and restatedsublicense agreement and fail to cure such breach. Our rights to develop and commercialize Fanapt® outside the U.S. and Canada may beimpaired if we do not cure breaches by Novartis of similar obligations contained in its sublicense agreement with Titan for Fanapt®. Weare not aware of any such breach by Novartis. In addition, if Novartis breaches the amended and restated sublicense agreement withrespect to its commercialization activities in the U.S. or Canada, we may terminate Novartis’ commercialization rights in the applicablecountry and we would no longer receive royalty payments from Novartis in connection with such country in the event of suchtermination.TasimelteonIn February 2004, we entered into a license agreement with BMS under which we received an exclusive worldwide license undercertain patents and patent applications, and other licenses to intellectual property, to develop and commercialize tasimelteon. In partialconsideration for the license, we paid BMS an initial license fee of $0.5 million. We are also obligated to make future milestone paymentsto BMS of less than $40.0 million in the aggregate (the majority of which are tied to sales milestones) as well as royalty payments basedon the net sales of tasimelteon at a rate which, as a percentage of net sales, is in the low teens. We made a milestone payment to BMS of$1.0 million under this license agreement in 2006 relating to the initiation of our first Phase III clinical trial for tasimelteon. We are alsoobligated under this agreement to pay BMS a percentage of any sublicense fees, upfront payments and milestone and other payments(excluding royalties) that we receive from a third party in connection with any sublicensing arrangement, at a rate which is in the mid-twenties. We have agreed with BMS in our license agreement for tasimelteon to use our commercially reasonable efforts to develop andcommercialize tasimelteon and to meet certain milestones in initiating and completing certain clinical work.The license agreement with BMS was amended on April 15, 2010 to, among other things, extend the deadline by which we mustenter into a development and commercialization agreement with a third party for tasimelteon until the earliest of: (i) the date mutuallyagreed upon by BMS and us following the provision by us to BMS of a full written report of the Phase III clinical studies on which weintend to rely for filing for marketing authorization for tasimelteon in its first major market country (Phase III report); (ii) the date of theacceptance by a regulatory authority of the filing by us for marketing authorization for tasimelteon in a major market country followingthe provision by us to BMS of the Phase III report; or (iii) May 31, 2013.11 If we have not entered into such a development and commercialization agreement with respect to certain major market countries bythe foregoing deadline, then BMS will have the option to exclusively develop and commercialize tasimelteon on its own in those countriesnot covered by such an agreement on pre-determined financial terms, including milestone and royalty payments. In addition to theforegoing, pursuant to the April 15, 2010 amendment, our deadline for filing a NDA for tasimelteon was extended until June 1, 2013.Either party may terminate the tasimelteon license agreement under certain circumstances, including a material breach of theagreement by the other. In the event that BMS has not exercised its option to reacquire the rights to tasimelteon and we terminate ourlicense, or if BMS terminates our license due to our breach, all rights licensed and developed by us under this agreement will revert orotherwise be licensed back to BMS on an exclusive basis.Government regulationGovernment authorities in the U.S., at the federal, state and local level, as well as foreign countries and local foreign governments,regulate the research, development, testing, manufacture, labeling, promotion, advertising, distribution, sampling, marketing, importand export of our products. Other than Fanapt® in the U.S., all of our compounds will require regulatory approval by governmentagencies prior to commercialization. In particular, human pharmaceutical products are subject to rigorous pre-clinical and clinical trialsand other approval procedures of the FDA and similar regulatory authorities in foreign countries. The process of obtaining theseapprovals and the subsequent compliance with appropriate domestic and foreign laws, rules and regulations require the expenditure ofsignificant time and human and financial resources.United States government regulationFDA approval processIn the U.S., the FDA regulates drugs under the Federal Food, Drug and Cosmetic Act and implements regulations. If we fail tocomply with the applicable requirements at any time during the product development process, approval process, or after approval, wemay become subject to administrative or judicial sanctions. These sanctions could include the FDA’s refusal to approve pendingapplications, withdrawals of approvals, clinical holds, warning letters, product recalls, product seizures, total or partial suspension ofour operations, injunctions, fines, civil penalties or criminal prosecution. Any such sanction could have a material adverse effect on ourbusiness.The steps required before a drug may be marketed in the U.S. include: • pre-clinical laboratory tests, animal studies and formulation studies under Current Good Laboratory Practices (cGLP) • submission to the FDA of an investigational new drug application, or IND, which must become effective before human clinicaltrials may begin • execution of adequate and well-controlled clinical trials to establish the safety and efficacy of the drug for each indication forwhich approval is sought • submission to the FDA of an NDA • satisfactory completion of an FDA inspection of the manufacturing facility or facilities at which the drug is produced to assesscompliance with Current Good Manufacturing Practices (cGMP) • FDA review and approval of the NDAPre-clinical studies generally are conducted in laboratory animals to evaluate the potential safety and activity of a drug. Violation ofthe FDA’s cGLP regulations can, in some cases, lead to invalidation of the studies, requiring these studies to be replicated. In the U.S.,drug developers submit the results of pre-clinical trials, together with manufacturing information and analytical and stability data, to theFDA as part of the IND, which must become effective before clinical trials can begin in the U.S. An IND becomes effective 30 days afterreceipt by the FDA unless before that time the FDA raises concerns or questions about issues12 such as the proposed clinical trials outlined in the IND. In that case, the IND sponsor and the FDA must resolve any outstanding FDAconcerns or questions before clinical trials can proceed. If these concerns or questions are unresolved, the FDA may not allow the clinicaltrials to commence.Pilot studies generally are conducted in a limited patient population, approximately three to 25 subjects, to determine whether thedrug warrants further clinical trials based on preliminary indications of efficacy. These pilot studies may be performed in the U.S. afteran IND has become effective or outside of the U.S. prior to the filing of an IND in the U.S. in accordance with government regulationsand institutional procedures.Clinical trials involve the administration of the investigational new drug to human subjects under the supervision of qualifiedinvestigators. Clinical trials are conducted under protocols detailing, among other things, the objectives of the study, the parameters to beused in assessing the safety and the effectiveness of the drug. Each protocol must be submitted to the FDA as part of the IND prior tobeginning the trial.Typically, clinical evaluation involves a time-consuming and costly three-Phase sequential process, but the phases may overlap.Each trial must be reviewed, approved and conducted under the auspices of an independent Institutional Review Board, and each trialmust include the patient’s informed consent. • Phase I: refers typically to closely-monitored clinical trials and includes the initial introduction of an investigational new drug intohuman patients or health volunteer subjects. Phase I trials are designed to determine the safety, metabolism and pharmacologicactions of a drug in humans, the potential side effects associated with increasing drug doses and, if possible, to gain earlyevidence of the drug’s effectiveness. Phase I trials also include the study of structure-activity relationships and mechanism ofaction in humans, as well as studies in which investigational new drugs are used as research tools to explore biologicalphenomena or disease processes. During Phase I trials, sufficient information about a drug’s pharmacokinetics andpharmacological effects should be obtained to permit the design of well-controlled, scientifically valid Phase II studies. The totalnumber of subjects and patients included in Phase I trials varies, but is generally in the range of 20 to 80 people. • Phase II: refers to controlled clinical trials conducted to evaluate appropriate dosage and the effectiveness of a drug for a particularindication or indications in patients with a disease or condition under study and to determine the common short-term side effectsand risks associated with the drug. These trials are typically well-controlled, closely monitored and conducted in a relativelysmall number of patients, usually involving no more than several hundred subjects. • Phase III: refers to expanded controlled and uncontrolled clinical trials. These trials are performed after preliminary evidencesuggesting effectiveness of a drug has been obtained. Phase III trials are intended to gather additional information about theeffectiveness and safety that is needed to evaluate the overall benefit-risk relationship of the drug and to provide an adequate basisfor physician labeling. Phase III trials usually include several hundred to several thousand subjects.Phase I, II and III testing may not be completed successfully within any specified time period, if at all. The FDA closely monitors theprogress of each of the three phases of clinical trials that are conducted in the U.S. and may, at its discretion, reevaluate, alter, suspend orterminate the testing based upon the data accumulated to that point and the FDA’s assessment of the risk/benefit ratio to the patient. Aclinical program is designed after assessing the causes of the disease, the mechanism of action of the active pharmaceutical ingredient ofthe drug and all clinical and pre-clinical data of previous trials performed. Typically, the trial design protocols and efficacy endpoints areestablished in consultation with the FDA. Upon request through a special protocol assessment, the FDA can also provide specificguidance on the acceptability of protocol design for clinical trials. The FDA or we may suspend or terminate clinical trials at any time forvarious reasons, including a finding that the subjects or patients are being exposed to an unacceptable health risk. The FDA can alsorequest additional clinical trials be conducted as a condition to drug approval. During all clinical trials, physicians monitor the patients todetermine effectiveness and to observe and report any reactions or other safety risks that may result from use of the drug.13 Assuming successful completion of the required clinical trials, drug developers submit the results of pre-clinical studies and clinicaltrials, together with other detailed information including information on the manufacture and composition of the drug, to the FDA, in theform of an NDA, requesting approval to market the drug for one or more indications. In most cases, the NDA must be accompanied by asubstantial user fee. The FDA reviews an NDA to determine, among other things, whether a drug is safe and effective for its intended use.Before approving an NDA, the FDA will inspect the facility or facilities where the drug is manufactured. The FDA will not approvethe application unless cGMP compliance is satisfactory. The FDA will issue an approval letter if it determines that the application,manufacturing process and manufacturing facilities are acceptable. If the FDA determines that the NDA, manufacturing process ormanufacturing facilities are not acceptable, it will outline the deficiencies in the submission and will often request additional testing orinformation. Notwithstanding the submission of any requested additional information, the FDA may ultimately decide that the NDA doesnot satisfy the regulatory criteria for approval and refuse to approve the NDA by issuing a “not approvable” letter which is notsubsequently withdrawn or reversed by the FDA.The testing and approval process requires substantial time, effort and financial resources, and each may take several years tocomplete. The FDA may not grant approval on a timely basis, or at all. We may encounter difficulties or unanticipated costs in our effortsto secure necessary governmental approvals, which could delay or preclude us from marketing our products and product candidates.Furthermore, the FDA may prevent a drug developer from marketing a drug under a label for its desired indications or place otherconditions on distribution as a condition of any approvals, which may impair commercialization of the drug. After approval, some typesof changes to the approved drug, such as adding new indications, manufacturing changes and additional labeling claims, are subject tofurther FDA review and approval. Similar regulatory procedures must also be complied within countries outside the U.S.If the FDA approves the NDA, the drug becomes available for physicians to prescribe in the U.S. After approval of our productsand product candidates, we have to comply with a number of post-approval requirements, including delivering periodic reports to theFDA, submitting descriptions of any adverse reactions reported, and complying with drug sampling and distribution requirements. Wealso are required to provide updated safety and efficacy information and to comply with requirements concerning advertising andpromotional labeling. Also, our quality control and manufacturing procedures must continue to conform to cGMP after approval. Drugmanufacturers and their subcontractors are required to register their facilities and are subject to periodic unannounced inspections by theFDA to assess compliance with cGMP which imposes certain procedural and documentation requirements relating to quality assuranceand quality control. Accordingly, manufacturers must continue to expend time, money and effort in the area of production and qualitycontrol to maintain compliance with cGMP and other aspects of regulatory compliance. The FDA may require post market testing andsurveillance to monitor the drug’s safety or efficacy, including additional studies, known as Phase IV trials, to evaluate long-term effects.In addition to studies requested by the FDA after approval, we may have to conduct other trials and studies to explore use of theapproved product for treatment of new indications, which require FDA approval. The purpose of these trials and studies is to broaden theapplication and use of the product and its acceptance in the medical community.We use, and will continue to use, third-party manufacturers to produce our products and product candidates in clinical andcommercial quantities. Future FDA inspections may identify compliance issues at our facilities or at the facilities of our contractmanufacturers that may disrupt production or distribution, or require substantial resources to correct. In addition, discovery of problemswith a product or the failure to comply with requirements may result in restrictions on a product, manufacturer or holder of an approvedNDA, including withdrawal or recall of the product from the market or other voluntary or FDA-initiated action that could delay furthermarketing. Newly discovered or developed safety or effectiveness data may require changes to a product’s approved labeling, includingthe addition of new warnings and contraindications.On September 27, 2007, the Food and Drug Administration Amendments Act, or the FDAAA, was enacted into law, amending boththe FDC Act and the Public Health Service Act. The FDAAA makes a14 number of substantive and incremental changes to the review and approval processes in ways that could make it more difficult or costlyto obtain approval for new pharmaceutical products, or to produce, market and distribute existing pharmaceutical products. Mostsignificantly, the law changes the FDA’s handling of postmarked drug product safety issues by giving the FDA authority to require postapproval studies or clinical trials, to request that safety information be provided in labeling, or to require an NDA applicant to submitand execute a Risk Evaluation and Mitigation Strategy, or REMS.The FDAAA also reauthorized the authority of the FDA to collect user fees to fund the FDA’s review activities and made certainchanges to the user fee provisions to permit the use of user fee revenue to fund the FDA’s drug product safety activities and the review ofDirect-to-Consumer advertisements.In addition, new government requirements may be established that could delay or prevent regulatory approval of our products andproduct candidates under development.The Hatch-Waxman ActIn seeking approval for a drug through an NDA, applicants are required to list with the FDA each patent with claims that cover theapplicant’s drug. Upon approval of a drug, each of the patents listed in the application for the drug is then published in the FDA’sApproved Drug Products with Therapeutic Equivalence Evaluations, commonly known as the Orange Book. Drugs listed in the OrangeBook can, in turn be cited by potential competitors in support of approval of an abbreviated new drug application, or ANDA. An ANDAprovides for marketing of a drug that has the same active ingredients in the same strengths and dosage form as the listed drug and hasbeen shown through bioequivalence testing to be therapeutically equivalent to the listed drug. ANDA applicants are not required to conductor submit results of pre-clinical or clinical tests to prove the safety or effectiveness of their drug, other than the requirement forbioequivalence testing. Drugs approved in this way are commonly referred to as “generic equivalents” to the listed drug, and can often besubstituted by pharmacists under prescriptions written for the original listed drug.The ANDA applicant is required to certify to the FDA concerning any patents listed for the approved drug in the FDA’s OrangeBook. Specifically, the applicant must certify that: (i) the required patent information has not been filed; (ii) the listed patent has expired;(iii) the listed patent has not expired, but will expire on a particular date and approval is sought after patent expiration; or (iv) the listedpatent is invalid or will not be infringed by the new drug. A certification that the new drug will not infringe the already approved drug’slisted patents or that such patents are invalid is called a Paragraph IV certification. If the applicant does not challenge the listed patents,the ANDA application will not be approved until all the listed patents claiming the referenced drug have expired.If the ANDA applicant has provided a Paragraph IV certification to the FDA, the applicant must also send notice of theParagraph IV certification to the NDA and patent holders once the ANDA has been accepted for filing by the FDA. The NDA and patentholders may then initiate a patent infringement lawsuit in response to the notice of the Paragraph IV certification. The filing of a patentinfringement lawsuit within 45 days of the receipt of a Paragraph IV certification automatically prevents the FDA from approving theANDA until the earlier of 30 months, expiration of the patent, settlement of the lawsuit or a decision in the infringement case that isfavorable to the ANDA applicant.The ANDA application also will not be approved until any non-patent exclusivity, such as exclusivity for obtaining approval of anew chemical entity, listed in the Orange Book for the referenced drug has expired. Federal law provides a period of five years followingapproval of a drug containing no previously approved active ingredients, during which ANDAs for generic versions of those drugscannot be submitted unless the submission contains a Paragraph IV challenge to a listed patent, in which case the submission may bemade four years following the original drug approval. Federal law provides for a period of three years of exclusivity following approval ofa listed drug that contains previously approved active ingredients but is approved in a new dosage form, route of administration orcombination, or for a new use, the approval of which was required to be supported by new clinical trials conducted by or for the sponsor,during which FDA cannot grant effective approval of an ANDA based on that listed drug.15 Foreign regulationWhether or not we obtain FDA approval for a product or product candidate, we must obtain approval by the comparable regulatoryauthorities of foreign countries before we can commence clinical trials or marketing of the product or product candidate in those countries.The approval process varies from country to country, and the time may be longer or shorter than that required for FDA approval. Therequirements governing the conduct of clinical trials, product licensing, pricing and reimbursement also vary greatly from country tocountry. Although governed by the applicable country, clinical trials conducted outside of the U.S. typically are administered with thethree-Phase sequential process that is discussed above under “United States government regulation.” However, the foreign equivalent of anIND is not a prerequisite to performing pilot studies or Phase I clinical trials.Under European Union regulatory systems, we may submit marketing authorization applications either under a centralized ordecentralized procedure. The centralized procedure, which is available for drugs produced by biotechnology or which are highlyinnovative, provides for the grant of a single marketing authorization that is valid for all European Union member states. Thisauthorization is a marketing authorization approval. The decentralized procedure provides for mutual recognition of national approvaldecisions. Under this procedure, the holder of a national marketing authorization may submit an application to the remaining memberstates. Within 90 days of receiving the applications and assessment report, each member state must decide whether to recognize approval.This procedure is referred to as the mutual recognition procedure.In addition, regulatory approval of prices is required in most countries other than the U.S. We face the risk that the resulting priceswould be insufficient to generate an acceptable return to us or our partners.Third-party reimbursement and pricing controlsIn the U.S. and elsewhere, sales of pharmaceutical products depend in significant part on the availability of reimbursement to theconsumer from third-party payors, such as government and private insurance plans. Third-party payors are increasingly challenging theprices charged for medical products and services. It will be time consuming and expensive for us or our partners to go through the processof seeking reimbursement from Medicare and private payors. Our compounds may not be considered cost-effective, and coverage andreimbursement may not be available or sufficient to allow us or our partners to sell our compounds on a competitive and profitable basis.The passage of the Medicare Prescription Drug and Modernization Act of 2003 imposes new requirements for the distribution and pricingof prescription drugs which may affect the marketing of our compounds.In many foreign markets, including the countries in the European Union and Japan, pricing of pharmaceutical products is subjectto governmental control. In the U.S., there have been, and we expect that there will continue to be, a number of federal and state proposalsto implement similar governmental pricing control. While we cannot predict whether such legislative or regulatory proposals will beadopted, the adoption of such proposals could have a material adverse effect on our business, financial condition and profitability.Marketing and salesOn October 12, 2009, we entered into an amended and restated sublicense agreement with Novartis. We had originally entered into asublicense agreement with Novartis on June 4, 2004 pursuant to which we obtained certain worldwide exclusive licenses from Novartisrelating to Fanapt®. Pursuant to the amended and restated sublicense agreement, Novartis has exclusive commercialization rights to allformulations of Fanapt® in the U.S. and Canada. Novartis began selling Fanapt® in the U.S. during the first quarter of 2010. Novartis isresponsible for the further clinical development activities in the U.S. and Canada, including the development of a long-acting injectable (ordepot) formulation of Fanapt®. Pursuant to the amended and restated sublicense agreement, we received an upfront payment of$200.0 million and will be eligible for additional payments totaling up to $265.0 million upon the achievement of certain commercial anddevelopment milestones for Fanapt® in the U.S. and Canada. We receive royalties, which, as a percentage of net sales, are in the lowdouble-digits, on net sales of Fanapt® in the U.S. and Canada. In addition, we are no longer required to make16 any future milestone payments with respect to sales of Fanapt® or any future royalty payments with respect to sales of Fanapt® in theU.S. and Canada. We retain exclusive rights to Fanapt® outside the U.S. and Canada and we have exclusive rights to use any ofNovartis’ data for Fanapt® for developing and commercializing Fanapt® outside the U.S. and Canada. At Novartis’ option, we will enterinto good faith discussions with Novartis relating to the co-commercialization of Fanapt® outside of the U.S. and Canada or,alternatively, Novartis will receive a royalty on net sales of Fanapt® outside of the U.S. and Canada. In addition, given the range ofpotential indications for tasimelteon, we may pursue one or more partnerships for the development and commercialization of tasimelteonworldwide.Patents and proprietary rights; Hatch-Waxman protectionWe and our partners will be able to protect our compounds from unauthorized use by third parties only to the extent that ourcompounds are covered by valid and enforceable patents, either licensed in from third parties or generated internally, that give us or ourpartners sufficient proprietary rights. Accordingly, patents and other proprietary rights are essential elements of our business.Fanapt® and tasimelteon are covered by new chemical entity and other patents. These patents cover the active pharmaceuticalingredient and provide patent protection for all formulations containing these active pharmaceutical ingredients. The new chemical entitypatent for Fanapt® is owned by sanofi-aventis, and other patents and patent applications relating to Fanapt® are owned by Novartis.BMS owns the new chemical entity patent for tasimelteon. We originally obtained exclusive worldwide rights to develop andcommercialize the compounds covered by these patents through license and sublicense arrangements. However, pursuant to the amendedand restated sublicense agreement with Novartis, Novartis obtained exclusive commercialization rights to all formulations of Fanapt® inthe U.S. and Canada. For more on these license and sublicense arrangements, please see “License agreements” above. In addition, we havegenerated intellectual property, and filed patent applications covering this intellectual property, for each of these compounds.The new chemical entity patent covering Fanapt® expires normally in 2011 in the U.S. and expired in 2010 in most of the majormarkets in Europe. The new chemical entity patent covering tasimelteon expires in 2017 in the U.S. and most European markets.Additionally, for each of our late-stage compounds, an additional period of exclusivity in the U.S. of up to five years following theexpiration of the patent covering that compound may be obtained pursuant to the Hatch-Waxman Act. Fanapt® will also be eligible for6 months of additional protection for successfully completing studies in the pediatric population. These studies, for which Novartis isresponsible, are required by the FDA approval letter. In Europe, statutes provide for ten years of data exclusivity with the potential for anadditional year if the company develops the drug for a significant new indication. No generic versions of Fanapt® would be permitted tobe marketed or sold during this 10-year (or 11-year) period in most European countries. Consequently, assuming that patent termrestoration and pediatric exclusivity are granted by the PTO and FDA and that we receive regulatory approval in Europe, we expect thatNovartis’ rights to commercialize Fanapt® will be exclusive until May 2017 in the U.S. and for at least 10 years from approval inEurope. Additionally, on February 23, 2010, the PTO issued a notice of allowance for our patent application for the microsphere long-acting injectable (or depot) formulation of Fanapt®. On August 3, 2010, the PTO informed us that the patent had been issued with apatent term adjustment of 605 days, extending the patent expiration date to June 26, 2024. Subsequently, on October 28, 2010, the PTOinformed us that it had granted an additional patent term adjustment of 59 days, making the total extension 664 days and making thepatent expiration date August 24, 2024. Several other patent applications covering metabolites, uses, formulations and genetic markersrelating to Fanapt® extend beyond 2020.Aside from the new chemical entity patents covering Fanapt® and tasimelteon, as of December 31, 2010 we had one pendingprovisional patent applications in the U.S., fifteen U.S. national stage applications under U.S.C. 371 and seven pending PatentCooperation Treaty applications. The claims in these various patents and patent applications are directed to compositions of matter,including claims covering other product candidates, pharmaceutical compositions, genetic markers, and methods of use.17 For proprietary know-how that is not appropriate for patent protection, processes for which patents are difficult to enforce and anyother elements of our discovery process that involve proprietary know-how and technology that is not covered by patent applications, wegenerally rely on trade secret protection and confidentiality agreements to protect our interests. We require all of our employees, consultantsand advisors to enter into confidentiality agreements. Where it is necessary to share our proprietary information or data with outsideparties, our policy is to make available only that information and data required to accomplish the desired purpose and only pursuant to aduty of confidentiality on the part of those parties.ManufacturingWe currently depend on, and expect to continue to depend on, a small number of third-party manufacturers to produce sufficientquantities of our products and product candidates for use in our clinical studies. We are not obligated to obtain our products and productcandidates from any particular third-party manufacturer and we believe that we would be able to obtain our products and productcandidates from a number of third-party manufacturers at comparable cost.If any of our products or product candidates are approved for commercial use in the future, we plan to rely on third-party contractmanufacturers to produce sufficient quantities for large-scale commercialization. If we do enter into commercial manufacturingarrangements with third parties, these third-party manufacturers will be subject to extensive governmental regulation. Specifically,regulatory authorities in the markets which we intend to serve will require that drugs be manufactured, packaged and labeled inconformity with cGMP or equivalent foreign standards. We intend to engage only those contract manufacturers who have the capability tomanufacture drugs in compliance with cGMP and other applicable standards in bulk quantities for commercial use.CompetitionThe pharmaceutical industry and the central nervous system segment of that industry, in particular, is highly competitive andincludes a number of established large and mid-sized companies with greater financial, technical and personnel resources than we haveand significantly greater commercial infrastructures than we have. Our market segment also includes several smaller emerging companieswhose activities are directly focused on our target markets and areas of expertise. Our partnered product and if approved in the future, ourother compounds, will compete with numerous therapeutic treatments offered by these competitors. While we believe that our compoundswill have certain favorable features, existing and new treatments may also possess advantages. Additionally, the development of otherdrug technologies and methods of disease prevention are occurring at a rapid pace. These developments may render our compounds ortechnologies obsolete or noncompetitive.We believe the primary competitors for Fanapt® and tasimelteon are as follows: • For Fanapt® in the treatment of schizophrenia, the atypical antipsychotics Risperdal® (risperidone), including the depotformulation Risperdal® Consta®, and Invega® (paliperidone), including the depot formulation Invega® Sustennatm, each byOrtho-McNeil-Janssen Pharmaceuticals, Inc., Zyprexa® (olanzapine), including the depot formulation Zyprexa® Relprevvtm, byEli Lilly and Company, Seroquel® (quetiapine) by AstraZeneca PLC, Abilify® (aripiprazole) by BMS/Otsuka PharmaceuticalCo., Ltd., Geodon® (ziprasidone) by Pfizer Inc., Saphris® (asenapine) by Schering-Plough, Latuda® (lurasidone) by DainipponSumitomo Pharma, and generic clozapine, as well as the typical antipsychotics haloperidol, chlorpromazine, thioridazine, andsulpiride (all of which are generic). • For tasimelteon in the treatment of insomnia, Rozeremtm (ramelteon) by Takeda Pharmaceuticals Company Limited, hypnoticssuch as Ambien® (zolpidem) by sanofi-aventis (including Ambien CR®), Lunesta® (eszopiclone) by Sepracor Inc., Sonata®(zaleplon) by King Pharmaceuticals, Inc., Silenor® (doxepin) by Somaxon Pharmaceuticals, Inc., generic compounds such aszolpidem, trazodone and doxepin, and over-the-counter remedies such as Benadryl® and Tylenol PM®.18 • For tasimelteon in the treatment of depression, antidepressants such as Paxil® (paroxetine) by GlaxoSmithKline (GSK), Zoloft®(sertraline) by Pfizer, Prozac® (fluoxetine) by Eli Lilly, Lexapro (escitalopram) by Lundbeck A/S /Forest Pharmaceuticals Inc.,Effexor® (venlafaxine) by Wyeth, Pristiq® (desvenlafaxine) by Pfizer, as well as other compounds such as Wellbutrin®(buproprion) by GSK, Cymbalta® (duloxetine) by Eli Lilly, Viibryd (vilazodone HCL) by Clinical Data Inc. and Valdoxan(agomelatine) by Novartis and Les Laboratories Servier.Our ability to compete successfully will depend in part on our ability to utilize our pharmacogenetics and pharmacogenomics anddrug development expertise to identify, develop, secure rights to and obtain regulatory approvals for promising pharmaceuticalcompounds before others are able to develop competitive products. Our ability to compete successfully will also depend on our ability toattract and retain skilled and experienced personnel. Additionally, our ability to compete may be affected because insurers and other third-party payors in some cases seek to encourage the use of cheaper, generic products, which could make our compounds less attractive.EmployeesAs of December 31, 2010, we had 28 full-time employees. Of these employees, 19 were primarily engaged in research anddevelopment activities. None of our employees are represented by a labor union. We have not experienced any work stoppages andconsider our employee relations to be good.Corporate informationWe were incorporated in Delaware in 2002. Our principal executive offices are located at 9605 Medical Center Drive, Suite 300,Rockville, Maryland, 20850 and our telephone number is (240) 599-4500. Our website address is www.vandapharma.com. Theinformation contained in, or that can be accessed through, our website is not part of this report and should not be considered part of thisreport.Available InformationVanda Pharmaceuticals Inc. files annual, quarterly, and current reports, proxy statements, and other documents with the Securitiesand Exchange Commission (SEC) under the Securities Exchange Act of 1934 (the Exchange Act). The public may read and copy anymaterials that we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public mayobtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains anInternet website that contains reports, proxy and information statements, and other information regarding issuers, including us, that fileelectronically with the SEC. The public can obtain any documents that we file with the SEC at www.sec.gov.We also make available free of charge on our Internet website at www.vandapharma.com our annual reports on Form 10-K, quarterlyreports on Form 10-Q, current reports on Form 8-K, and, if applicable, amendments to those reports filed or furnished pursuant toSection 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish itto, the SEC.Our code of ethics, other corporate policies and procedures, and the charters of our Audit Committee, Compensation Committee andNominating/Corporate Governance Committee are available through our Internet website at www.vandapharma.com.ITEM 1A. RISK FACTORSInvesting in our common stock involves a high degree of risk. You should consider carefully the risks and uncertaintiesdescribed below, together with all of the other information in this report, including the consolidated financial statements and therelated notes appearing at the end of this annual report on Form 10-K, with respect to any investment in shares of our commonstock. If any of the following risks actually occurs, our business, financial condition, results of operations and future prospectswould likely be materially and adversely affected. In that event, the market price of our common stock could decline and you couldlose all or part of your investment.19 Risks related to our business and industryNovartis began selling, marketing and distributing our first approved product, Fanapt®, in the U.S. in the first quarter of2010 and we will depend heavily on the success of this product in the marketplace.Our ability to generate revenue for the next few years will depend substantially on the success of Fanapt® and the sales of thisproduct by Novartis in the U.S. and Canada. The ability of Fanapt® to generate revenue at the levels we expect will depend on manyfactors, including the following: • the ability of patients to be able to afford Fanapt® or obtain health care coverage that covers Fanapt® in the current uncertaineconomic climate • acceptance of, and ongoing satisfaction, with Fanapt® by the medical community, patients receiving therapy and third partypayers • a satisfactory efficacy and safety profile as demonstrated in a broad patient population • the size of the market for Fanapt® • successfully expanding and sustaining manufacturing capacity to meet demand • cost and availability of raw materials • the extent and effectiveness of the sales and marketing and distribution support Fanapt® receives • safety concerns in the marketplace for schizophrenia therapies • regulatory developments relating to the manufacture or continued use of Fanapt® • decisions as to the timing of product launches, pricing and discounts • the competitive landscape for approved and developing therapies that will compete with Fanapt® • Novartis’ ability to successfully develop and commercialize a long-acting injectable (or depot) formulation of Fanapt® in theU.S. and Canada • Novartis’ ability to expand the indications for which Fanapt® can be marketed in the U.S. • Novartis’ ability to obtain regulatory approval in Canada for Fanapt® and our ability to obtain regulatory approval for Fanapt®in countries outside the U.S. and Canada • our ability to successfully develop and commercialize Fanapt®, including a long-acting injectable (or depot) formulation ofFanapt®, outside of the U.S. and Canada • the unfavorable outcome of any potential litigation relating to Fanapt®We entered into an amended and restated sublicense agreement with Novartis to commercialize Fanapt® in the U.S. and Canada andto further develop and commercialize a long-acting injectable (or depot) formulation of Fanapt® in the U.S. and Canada. As such, we willnot be involved in the marketing or sales efforts for Fanapt® in the U.S. and Canada. Our future revenues depend substantially onroyalties and milestone payments we may receive from Novartis. Pursuant to the amended and restated sublicense agreement withNovartis, we received an upfront payment of $200.0 million and are eligible for additional payments totaling up to $265.0 million uponNovartis’ achievement of certain commercial and development milestones for Fanapt® in the U.S. and Canada, which may or may not beachieved or met. We also receive royalties, which, as a percentage of net sales, are in the low double-digits, on net sales of Fanapt® in theU.S. and Canada. Such royalties may not be significant and will depend on numerous factors. We cannot control the amount and timingof resources that Novartis may devote to Fanapt® or the depot formulation of Fanapt®. If Novartis fails to successfully commercializeFanapt® in the U.S., fails to develop and commercialize Fanapt® in Canada or further develop a long-acting injectable (or depot)formulation of Fanapt®, if Novartis’ efforts are not effective, or if Novartis focuses its efforts on other schizophrenia therapies orschizophrenia drug candidates, our business will be negatively affected. If Novartis does not successfully commercialize Fanapt® in theU.S. or Canada, we will receive limited revenues from them. Although we have20 developed and continue to develop additional products and product candidates for commercial introduction, we expect to be substantiallydependent on sales from Fanapt® for the foreseeable future. For reasons outside of our control, including those mentioned above, sales ofFanapt® may not meet our expectations. Any significant negative developments relating to Fanapt®, such as safety or efficacy issues, theintroduction or greater acceptance of competing products or adverse regulatory or legislative developments, will have a material adverseeffect on our results of operations.If our compounds are determined to be unsafe or ineffective in humans, whether commercially or in clinical trials, ourbusiness will be materially harmed.Despite the FDA’s approval of the NDA for Fanapt® in May 2009 and the positive results of our completed trials for Fanapt® andtasimelteon, we are uncertain whether either of these products will ultimately prove to be effective and safe in humans. Frequently,products that have shown promising results in clinical trials have suffered significant setbacks in later clinical trials or even after they areapproved for commercial sale. Future uses of our compounds, whether in clinical trials or commercially, may reveal that the product isineffective, unacceptably toxic, has other undesirable side effects, is difficult to manufacture on a large scale, is uneconomical, infringeson proprietary rights of another party or is otherwise not fit for further use. If our compounds are determined to be unsafe or ineffective inhumans, our business will be materially harmed.Clinical trials for our compounds are expensive and their outcomes are uncertain. Any failure or delay in completingclinical trials for our compounds could severely harm our business.Pre-clinical studies and clinical trials required to demonstrate the safety and efficacy of our compounds are time-consuming andexpensive and together take several years to complete. Before obtaining regulatory approvals for the commercial sale of any of ourcompounds, we or our partners must demonstrate through preclinical testing and clinical trials that such compound is safe and effectivefor use in humans. We have incurred, and we will continue to incur, substantial expense for, and devote a significant amount of time to,preclinical testing and clinical trials.Historically, the results from preclinical testing and early clinical trials often have not predicted results of later clinical trials. Anumber of new drugs have shown promising results in clinical trials, but subsequently failed to establish sufficient safety and efficacydata to obtain necessary regulatory approvals. Clinical trials conducted by us, by our partners or by third parties on our or our partners’behalf may not demonstrate sufficient safety and efficacy to obtain the requisite regulatory approvals for our compounds. Regulatoryauthorities may not permit us or our partners to undertake any additional clinical trials for our compounds, and it may be difficult todesign efficacy studies for our compounds in new indications.Clinical development efforts performed by us or our partners may not be successfully completed. Completion of clinical trials maytake several years or more. The length of time can vary substantially with the type, complexity, novelty and intended use of thecompounds. The commencement and rate of completion of clinical trials for our compounds may be delayed by many factors, including: • the inability to manufacture or obtain from third parties materials sufficient for use in pre-clinical studies and clinical trials • delays in beginning a clinical trial • delays in patient enrollment and variability in the number and types of patients available for clinical trials • difficulty in maintaining contact with patients after treatment, resulting in incomplete data • poor effectiveness of our compounds during clinical trials • unforeseen safety issues or side effects and • governmental or regulatory delays and changes in regulatory requirements and guidelines21 If we or our partners fail to complete successfully one or more clinical trials for our compounds, we or they may not receive theregulatory approvals needed to market that compound. Therefore, any failure or delay in commencing or completing these clinical trialswould harm our business materially.We and our partners face heavy government regulation. FDA regulatory approval of our compounds is uncertain and weand our partners are continually at risk of the FDA requiring us or them to discontinue marketing any compounds thathave obtained, or in the future may obtain, regulatory approval.The research, testing, manufacturing and marketing of compounds such as those that we have developed or we or in regard topartnered products, our partners, are developing are subject to extensive regulation by federal, state and local government authorities,including the FDA. To obtain regulatory approval of such compounds, we or our partners must demonstrate to the satisfaction of theapplicable regulatory agency that, among other things, the compound is safe and effective for its intended use. In addition, we or ourpartners must show that the manufacturing facilities used to produce such compounds are in compliance with current GoodManufacturing Practices regulations or cGMP.The process of obtaining FDA and other required regulatory approvals and clearances can take many years and will require us and,in the case of partnered products, our partners to expend substantial time and capital. Despite the time and expense expended, regulatoryapproval is never guaranteed. The number of pre-clinical and clinical trials that will be required for FDA approval varies depending onthe compound, the disease or condition that the compound is in development for, and the requirements applicable to that particularcompound. The FDA can delay, limit or deny approval of a compound for many reasons, including that: • a compound may not be shown to be safe or effective • the FDA may interpret data from pre-clinical and clinical trials in different ways than we or our partners do • the FDA may not approve our or our partners’ manufacturing processes or facilities • a compound may not be approved for all the indications we or our partners request • the FDA may change its approval policies or adopt new regulations • the FDA may not meet, or may extend, the Prescription Drug User Fee Act (PDUFA) date with respect to a particular NDA and • the FDA may not agree with our or our partners’ regulatory approval strategies or components of the regulatory filings, such asclinical trial designsFor example, if certain of our or our partners’ methods for analyzing trial data are not accepted by the FDA, we or our partners mayfail to obtain regulatory approval for our compounds.Moreover, the marketing, distribution and manufacture of approved products remain subject to extensive ongoing regulatoryrequirements. Failure to comply with applicable regulatory requirements could result in, among other things: • warning letters • fines • civil penalties • injunctions • recall or seizure of products • total or partial suspension of production • refusal of the government to grant future approvals22 • withdrawal of approvals and • criminal prosecutionAny delay or failure to obtain regulatory approvals for our compounds will result in increased costs, could diminish competitiveadvantages that we may attain and would adversely affect the marketing of our compounds. Other than Fanapt® in the U.S., which isbeing marketed and sold by Novartis, we have not received regulatory approval to market any of our compounds in any jurisdiction.Even following regulatory approval of our compounds, the FDA may impose limitations on the indicated uses for which suchcompounds may be marketed, subsequently withdraw approval or take other actions against us, our partners or such compounds thatare adverse to our business. The FDA generally approves drugs for particular indications. An approval for a more limited indicationreduces the size of the potential market for the product. Product approvals, once granted, may be withdrawn if problems occur after initialmarketing.We and our partners also are subject to numerous federal, state and local laws, regulations and recommendations relating to safeworking conditions, laboratory and manufacturing practices, the environment and the use and disposal of hazardous substances used inconnection with discovery, research and development work. In addition, we cannot predict the extent to which new governmentalregulations might significantly impede the discovery, development, production and marketing of our compounds. We or our partners maybe required to incur significant costs to comply with current or future laws or regulations, and we may be adversely affected by the costof such compliance.We intend to seek regulatory approvals for our compounds in foreign jurisdictions, but we may not obtain any suchapprovals.Pursuant to our amended and restated sublicense agreement with Novartis, we retained the right to develop and commercializeFanapt® outside the U.S. and Canada. We intend to market our compounds outside the U.S. and Canada with one or more commercialpartners. In order to market our compounds in foreign jurisdictions, we may be required to obtain separate regulatory approvals and tocomply with numerous and varying regulatory requirements. The approval procedure varies among countries and jurisdictions and caninvolve additional trials, and the time required to obtain approval may differ from that required to obtain FDA approval. We have noexperience obtaining any such foreign approvals. Additionally, the foreign regulatory approval process may include all of the risksassociated with obtaining FDA approval. For all of these reasons, we may not obtain foreign regulatory approvals on a timely basis, if atall. Approval by the FDA does not ensure approval by regulatory authorities in other countries or jurisdictions, and approval by oneforeign regulatory authority does not ensure approval by regulatory authorities in other foreign countries or jurisdictions or by the FDA.We may not be able to file for regulatory approvals and may not receive necessary approvals to commercialize our compounds in anymarket. The failure to obtain these approvals could harm our business materially.Our compounds may cause undesirable side effects or have other properties that could delay or prevent their regulatoryapproval or limit their marketability.Undesirable side effects caused by our compounds could interrupt, delay or halt clinical trials and could result in the denial ofregulatory approval by the FDA or other regulatory authorities for any or all targeted indications, and in turn prevent us or our partnersfrom commercializing or continuing the commercialization of such compounds and generating revenues from their sale. We and ourpartners, as applicable, will continue to assess the side effect profile of our compounds in ongoing clinical development programs.However, we cannot predict whether the commercial use of our approved compounds (or our compounds in development, if and whenthey are approved for commercial use) will produce undesirable or unintended side effects that have not been evident in the use of, or inclinical trials conducted for, such compounds to date. Additionally, incidents of product misuse may occur. These events, among others,could result in product recalls, product liability actions or withdrawals or additional regulatory controls, all of which could have amaterial adverse effect on our business, results of operations and financial condition.23 In addition, if after receiving marketing approval of a compound, we, our partners or others later identify undesirable side effectscaused by such compound, we or our partners could face one or more of the following: • regulatory authorities may require the addition of labeling statements, such as a “black box” warning or a contraindication • regulatory authorities may withdraw their approval of the compound • we or our partners may be required to change the way the compound is administered, conduct additional clinical trials or changethe labeling of the compound and • our reputation may sufferAny of these events could prevent us or our partners from achieving or maintaining market acceptance of the affected compound orcould substantially increase the costs and expenses of commercializing the compound, which in turn could delay or prevent us fromgenerating significant revenues from its sale.Even after we or our partners obtain regulatory approvals of a product, acceptance of such compound in the marketplace isuncertain and failure to achieve market acceptance will prevent or delay our ability to generate revenues.Even after obtaining regulatory approvals for the sale of our compounds, the commercial success of these compounds will depend,among other things, on their acceptance by physicians, patients, third-party payors and other members of the medical community as atherapeutic and cost-effective alternative to competing products and treatments. The degree of market acceptance of any compound willdepend on a number of factors, including the demonstration of its safety and efficacy, its cost-effectiveness, its potential advantages overother therapies, the reimbursement policies of government and third-party payors with respect to such compound, our ability to attractcorporate partners, including pharmaceutical companies, to assist in commercializing our compounds, receipt of regulatory clearance ofmarketing claims for the uses that we or our partners are developing and the effectiveness of our and our partners’ marketing anddistribution capabilities. If our approved compounds fail to gain market acceptance, we may be unable to earn sufficient revenue tocontinue our business. If our approved compounds do not become widely accepted by physicians, patients, third-party payors and othermembers of the medical community, it is unlikely that we will ever become profitable.If we fail to obtain the capital necessary to fund our research and development activities and commercialization efforts, wemay be unable to continue operations or we may be forced to share our rights to commercialize our products and productcandidates with third parties on terms that may not be attractive to us.Our activities will necessitate significant uses of working capital throughout 2011 and beyond. As of December 31, 2010, our totalcash and cash equivalents and marketable securities were approximately $198.0 million. Our long term capital requirements are expectedto depend on many factors, including, among others: • the amount of royalty and milestone payments received from our commercial partners • our ability to commercialize Fanapt® outside the U.S. and Canada • costs of developing sales, marketing and distribution channels and our ability to sell our products • costs involved in establishing manufacturing capabilities for commercial quantities of our products • the number of potential formulations, products and product candidates in development • progress with pre-clinical studies and clinical trials • time and costs involved in obtaining regulatory (including FDA) clearance24 • costs involved in preparing, filing, prosecuting, maintaining and enforcing patent, trademark and other intellectual propertyclaims • competing technological and market developments • market acceptance of our products • costs for recruiting and retaining employees and consultants • costs for training physicians and • legal, accounting, insurance and other professional and business related costsWe expect to receive royalty payments and hope to receive milestone payments relating to Fanapt® in connection with our amendedand restated sublicense agreement with Novartis. However, if Fanapt® is not as commercially successful as we expect and we do notreceive such payments, we may need to raise additional capital to fund our anticipated operating expenses and execute on our businessplans. In our capital-raising efforts, we may seek to sell debt securities or additional equity securities or obtain a bank credit facility, orenter into partnerships or other collaboration agreements. The sale of additional equity or debt securities, if convertible, could result indilution to our stockholders and may also result in a lower price for our common stock. The incurrence of indebtedness would result inincreased fixed obligations and could also result in covenants that could restrict our operations. However, we may not be able to raiseadditional funds on acceptable terms, or at all. If we are unable to secure sufficient capital to fund our planned activities, we may not beable to continue operations, or we may have to enter into partnerships or other collaboration agreements that could require us to sharecommercial rights to our products to a greater extent or at earlier stages in the drug development process than is currently intended. Thesepartnerships or collaborations, if consummated prior to proof-of-efficacy or safety of a given product, could impair our ability to realizevalue from that product. If additional financing is not available when required or is not available on acceptable terms, we may be unableto fund our operations and planned growth, develop or enhance our technologies or products, take advantage of business opportunities orrespond to competitive market pressures, any of which would materially harm our business, financial condition and results ofoperations.We have a history of operating losses, anticipate future losses and may never become profitable on a sustained basis.We have been engaged in identifying and developing compounds since March 2003, which has required, and will continue torequire, significant research and development expenditures.As of December 31, 2010, we had accumulated net losses of $253.6 million, and we cannot estimate with precision the extent of ourfuture losses. Our ability to generate revenue and achieve profitability largely depends on Novartis’ and our ability to sell Fanapt®.Although Novartis launched Fanapt® in the U.S. in the first quarter of 2010, it is too early to determine whether or not Fanapt® will be acommercial success. Fanapt® may not be as commercially successful as we expect, Novartis may not succeed in gaining marketacceptance of Fanapt® in the U.S. or developing and commercializing Fanapt® in Canada, and we may not succeed in commercializingFanapt® outside of the U.S. and Canada. In addition, we may not succeed in commercializing any other compounds. We cannot assureyou that we will be profitable even if our compounds are successfully commercialized. We may be unable to fully develop, obtainregulatory approval for, commercialize, manufacture, market, sell and derive revenue from our compounds in the timeframes we project,if at all, and our inability to do so would materially and adversely impact the market price of our common stock and our ability to raisecapital and continue operations.There can be no assurance that we will achieve sustained profitability. Our ability to achieve sustained profitability in the futuredepends, in part, upon: • our and our partners’ ability to obtain and maintain regulatory approval for our compounds, both in the U.S. and in foreigncountries • Novartis’ ability to successfully market and sell Fanapt® in the U.S. and Canada and achieve certain product development andsales milestones25 • our ability to successfully commercialize Fanapt® outside the U.S. and Canada • our ability to enter into agreements to develop and commercialize our products and product candidates • our ability to develop, have manufactured and market our products and product candidates • our and our partners’ ability to obtain adequate reimbursement coverage for our compounds from insurance companies,government programs and other third party payors • our ability to obtain additional research and development funding from collaborative partners or funding for our products andproduct candidatesIn addition, the amount we spend will impact our profitability. Our spending will depend, in part, upon: • the progress of our research and development programs for our products and product candidates, including clinical trials • the time and expense that will be required to pursue FDA and/or foreign regulatory approvals for our compounds and whethersuch approvals are obtained • the time and expense required to prosecute, enforce and/or challenge patent and other intellectual property rights • the cost of operating and maintaining development and research facilities • the cost of third party manufacturers • the number of product candidates we pursue • how competing technological and market developments affect our compounds • the cost of possible acquisitions of technologies, compounds, product rights or companies • the cost of obtaining licenses to use technology owned by others for proprietary products and otherwise • the costs of potential litigation and • the costs associated with recruiting and compensating a highly skilled workforce in an environment where competition for suchemployees may be intenseWe may not achieve all or any of these goals and, thus, we cannot provide assurances that we will ever be profitable on a sustainedbasis or achieve significant revenues. Even if we do achieve some or all of these goals, we may not achieve significant or sustainedcommercial success.Our ability to use net operating loss carryforwards and tax credit carryforwards to offset future taxable income may belimited as a result of transactions involving our common stock.In general, under Section 382 of the Internal Revenue Code of 1986, as amended (Code), a corporation that undergoes an“ownership change” is subject to limitations on its ability to utilize its pre-change net operating losses, or NOLs, and certain other taxassets to offset future taxable income. In general, an ownership change occurs if the aggregate stock ownership of certain stockholdersincreases by more than 50 percentage points over such stockholders’ lowest percentage ownership during the testing period (generally threeyears). Transactions involving our common stock, even those outside our control, such as purchases or sales by investors, within thetesting period could result in an ownership change. A limitation on our ability to utilize some or all of our NOLs could have a materialadverse effect on our results of operations and cash flows.If our contract research organizations do not successfully carry out their duties or if we lose our relationships with contractresearch organizations, our drug development efforts could be delayed.Our arrangements with contract research organizations are critical to our success in bringing our products and product candidates tothe market and promoting such marketed products profitably. We are dependent on contract research organizations, third-party vendorsand investigators for pre-clinical testing and clinical trials26 related to our drug discovery and development efforts and we will likely continue to depend on them to assist in our future discovery anddevelopment efforts. These parties are not our employees and we cannot control the amount or timing of resources that they devote to ourprograms. As such, they may not complete activities on schedule or may not conduct our clinical trials in accordance with regulatoryrequirements or our stated protocols. The parties with which we contract for execution of our clinical trials play a significant role in theconduct of the trials and the subsequent collection and analysis of data. If they fail to devote sufficient time and resources to our drugdevelopment programs or if their performance is substandard, it will delay the development, approval and commercialization of ourproducts and product candidates. Moreover, these parties may also have relationships with other commercial entities, some of which maycompete with us. If they assist our competitors, it could harm our competitive position.Our contract research organizations could merge with or be acquired by other companies or experience financial or other setbacksunrelated to our collaboration that could, nevertheless, materially adversely affect our business, results of operations and financialcondition. If we lose our relationship with any one or more of these parties, we could experience a significant delay in both identifyinganother comparable provider and then contracting for its services. We may be unable to retain an alternative provider on reasonable terms,if at all. Even if we locate an alternative provider, it is likely that this provider may need additional time to respond to our needs and maynot provide the same type or level of service as the original provider. In addition, any provider that we retain will be subject to currentGood Laboratory Practices or cGLP, and similar foreign standards and we do not have control over compliance with these regulations bythese providers. Consequently, if these practices and standards are not adhered to by these providers, the development andcommercialization of our products or product candidates could be delayed.We rely on a limited number of third party manufacturers to formulate and manufacture our products and productcandidates and our business will be seriously harmed if these manufacturers are not able to satisfy our demand andalternative sources are not available.Our expertise is primarily in the research and development and pre-clinical and clinical trial phases of product development. We donot have an in-house manufacturing capability and depend completely on a small number of third-party manufacturers and activepharmaceutical ingredient formulators for the manufacture of our products and product candidates. Therefore, we are dependent on thirdparties for our formulation development and manufacturing of our products and product candidates. This may expose us to the risk ofnot being able to directly oversee the production and quality of the manufacturing process and provide ample commercial supplies tosuccessfully launch and maintain the marketing of our products and product candidates. Furthermore, these third party contractors,whether foreign or domestic, may experience regulatory compliance difficulty, mechanical shut downs, employee strikes, or otherunforeseeable events that may delay or limit production. Our inability to adequately establish, supervise and conduct (either ourselves orthrough third parties) all aspects of the formulation and manufacturing processes would have a material adverse effect on our ability todevelop and commercialize our products and product candidates.We do not have long-term agreements with any of these third parties, and if they are unable or unwilling to perform for any reason,we may not be able to locate alternative acceptable manufacturers or formulators or enter into favorable agreements with them. Anyinability to acquire sufficient quantities of our products or product candidates in a timely manner from these third parties could adverselyaffect sales of our products, delay clinical trials and prevent us from developing our products and product candidates in a cost-effectivemanner or on a timely basis. In addition, manufacturers of our products and product candidates are subject to cGMP and similar foreignstandards and we do not have control over compliance with these regulations by our manufacturers. If one of our contract manufacturersfails to maintain compliance, the production of our products or product candidates could be interrupted, resulting in delays andadditional costs. In addition, if the facilities of such manufacturers do not pass a pre-approval or post-approval plant inspection, the FDAwill not grant approval and may institute restrictions on the marketing or sale of our products or product candidates.27 Our manufacturing strategy presents the following additional risks: • because most of our third-party manufacturers and formulators are located outside of the U.S., there may be difficulties inimporting our products and product candidates or their components into the U.S. as a result of, among other things, FDA importinspections, incomplete or inaccurate import documentation or defective packaging • because of the complex nature of our products and product candidates, our manufacturers may not be able to successfullymanufacture our products and product candidates in a cost-effective and/or timely manner.Materials necessary to manufacture our compounds may not be available on commercially reasonable terms, or at all, whichmay delay the development, regulatory approval and commercialization of our compounds.We and our partners rely on manufacturers to purchase from third-party suppliers the materials necessary to produce ourcompounds for our clinical trials and commercialization. Suppliers may not sell these materials to such manufacturers at the times we orour partners need them or on commercially reasonable terms. We do not have any control over the process or timing of the acquisition ofthese materials by these manufacturers. Moreover, we currently do not have any agreements for the commercial production of thesematerials. If the manufacturers are unable to obtain these materials for our or our partners’ clinical trials, product testing, potentialregulatory approval of our compounds and commercial scale manufacturing could be delayed, significantly affecting our and ourpartners’ ability to further develop and commercialize our compounds. If we, our manufacturers or, in the case of our partnered products,our partners are unable to purchase these materials for our products or partnered products, as applicable, there would be a shortage insupply or the commercial launch of such products or partnered products would be delayed, which would materially affect our or ourpartners’ ability to generate revenues from the sale of such products or partnered products.We face substantial competition which may result in others developing or commercializing products before or moresuccessfully than we do.Our future success will depend on our or our partners’ ability to demonstrate and maintain a competitive advantage with respect toour compounds and our ability to identify and develop additional products or product candidates through the application of ourpharmacogenetics and pharmacogenomics expertise. Large, fully integrated pharmaceutical companies, either alone or together withcollaborative partners, have substantially greater financial resources and have significantly greater experience than we do in: • developing products and product candidates • undertaking pre-clinical testing and clinical trials • obtaining FDA and other regulatory approvals of products and product candidates and • manufacturing, marketing and selling productsThese companies may invest heavily and quickly to discover and develop novel products that could make our compounds obsolete.Accordingly, our competitors may succeed in obtaining patent protection, receiving FDA approval or commercializing superior productsor other competing products before we do. Technological developments or the FDA’s approval of new therapeutic indications for existingproducts may make our compounds obsolete or may make them more difficult to market successfully, any of which could have amaterial adverse effect on our business, results of operations and financial condition.Fanapt® (and our other compounds, if successfully developed and approved for commercial sale) will compete with a number ofdrugs and therapies currently manufactured and marketed by major pharmaceutical and other biotechnology companies. Our compoundsmay also compete with new products currently under development by others or with products which may cost less than our compounds.Physicians, patients, third party payors and the medical community may not accept or utilize any of our compounds that may beapproved. If Fanapt® (and our other compounds, if and when approved) do not achieve significant market28 acceptance, our business, results of operations and financial condition would be materially adversely affected. We believe the primarycompetitors for Fanapt® and tasimelteon are as follows: • For Fanapt® in the treatment of schizophrenia, the atypical antipsychotics Risperdal® (risperidone), including the depotformulation Risperdal® Consta®, and Invega® (paliperidone), including the depot formulation Invega® Sustennatm, each byOrtho-McNeil-Janssen Pharmaceuticals, Inc., Zyprexa® (olanzapine), including the depot formulation Zyprexa®, Relprevvtm byEli Lilly and Company, Seroquel® (quetiapine) by AstraZeneca PLC, Abilify® (aripiprazole) by BMS/Otsuka PharmaceuticalCo., Ltd., Geodon® (ziprasidone) by Pfizer Inc., Saphris® (asenapine) by Schering-Plough, Latuda® (lurasidone) by DainipponSumitomo Pharma, and generic clozapine, as well as the typical antipsychotics haloperidol, chlorpromazine, thioridazine, andsulpiride (all of which are generic). • For tasimelteon in the treatment of insomnia, Rozeremtm (ramelteon) by Takeda Pharmaceuticals Company Limited, hypnoticssuch as Ambien® (zolpidem) by sanofi-aventis (including Ambien CR®), Lunesta® (eszopiclone) by Sepracor Inc. , Sonata®(zaleplon) by King Pharmaceuticals, Inc., Silenor® (doxepin) by Somaxon Pharmaceuticals, Inc., generic compounds such aszolpidem, trazodone and doxepin, and over-the-counter remedies such as Benadryl® and Tylenol PM®. • For tasimelteon in the treatment of depression, antidepressants such as Paxil® (paroxetine) by GlaxoSmithKline (GSK), Zoloft®(sertraline) by Pfizer, Prozac® (fluoxetine) by Eli Lilly, Lexapro (escitalopram) by Lundbeck A/S /Forest Pharmaceuticals Inc.,Effexor® (venlafaxine) by Wyeth, Pristiq® (desvenlafaxine) by Pfizer, as well as other compounds such as Wellbutrin®(buproprion) by GSK, Cymbalta® (duloxetine) by Eli Lilly, Viibryd (vilazodone HCL) by Clinical Data Inc. and Valdoxan(agomelatine) by Novartis and Les Laboratories Servier.Additionally, our ability to compete may be affected because insurers and other third-party payors in some cases seek to encouragethe use of cheaper, generic products, which could make our compounds less attractive.We have no experience selling, marketing or distributing products and no internal capability to do so, which may makecommercializing our products and product candidates difficult.At present, we have no marketing experience or sales capabilities. Therefore, in order for us to commercialize Fanapt®, outside theU.S. and Canada, or our other compounds, we must either acquire or internally develop sales, marketing and distribution capabilities, orenter into collaborations with partners to perform these services for us. We may, in some instances, rely significantly on sales, marketingand distribution arrangements with our collaborative partners and other third parties. For example, we rely completely on Novartis tomarket, sell and distribute Fanapt® in the U.S. and Canada and our future revenues are materially dependent on the success of the effortsof Novartis.For the commercialization of Fanapt® outside the U.S. and Canada or our other compounds, we may not be able to establish salesand distribution partnerships on acceptable terms or at all, and if we do enter into a distribution arrangement, our success will bematerially dependent upon the performance of our partner. In the event that we attempt to acquire or develop our own in-house sales,marketing and distribution capabilities, factors that may inhibit our efforts to commercialize our products and product candidateswithout partners or licensees include: • our inability to recruit and retain adequate numbers of effective sales and marketing personnel • the inability of sales personnel to obtain access to or persuade adequate numbers of physicians to prescribe our products • the lack of complementary products to be offered by our sales personnel, which may put us at a competitive disadvantage againstcompanies with broader product lines and • unforeseen costs associated with creating our own sales and marketing team or with entering into a partnering agreement with anindependent sales and marketing organization29 The cost of establishing and maintaining a sales, marketing and distribution organization may exceed its cost effectiveness. If wefail to develop sales and marketing capabilities, if sales efforts are not effective or if costs of developing sales and marketing capabilitiesexceed their cost effectiveness, our business, results of operations and financial condition could be materially adversely affected.If we cannot identify, or enter into licensing arrangements for, new products or product candidates, our ability to develop adiverse product portfolio will be limited.A component of our business strategy is acquiring rights to develop and commercialize compounds discovered or developed by otherpharmaceutical and biotechnology companies for which we may find effective uses and markets through our unique pharmacogeneticsand pharmacogenomics expertise. Competition for the acquisition of these compounds is intense. If we are not able to identifyopportunities to acquire rights to commercialize additional products or product candidates, we may not be able to develop a diverseportfolio of products and product candidates and our business may be harmed. Additionally, it may take substantial human andfinancial resources to secure commercial rights to promising products or product candidates. Moreover, if other firms developpharmacogenetics and pharmacogenomics capabilities, we may face increased competition in identifying and acquiring additionalproducts or product candidates.We may not be successful in the development of products for our own account.In addition to our business strategy of acquiring rights to develop and commercialize products and product candidates, we maydevelop products and product candidates for our own account by applying our technologies to off-patent drugs as well as developing ourown proprietary molecules. Because we will be funding the development of such programs, there is a risk that we may not be able tocontinue to fund all such programs to completion or to provide the support necessary to perform the clinical trials, obtain regulatoryapprovals or market any approved products. We expect the development of products for our own account to consume substantialresources. If we are able to develop commercial products on our own, the risks associated with these programs may be greater than thoseassociated with our programs with collaborative partners.If we lose key scientists or management personnel, or if we fail to recruit additional highly skilled personnel, it will impairour ability to identify, develop and commercialize products.We are highly dependent on principal members of our management team and scientific staff, including our Chief Executive Officer,Mihael H. Polymeropoulos, M.D. These executives each have significant pharmaceutical industry experience. The loss of any suchexecutives, including Dr. Polymeropoulos, or any other principal member of our management team or scientific staff, would impair ourability to identify, develop and market new products. Our management and other employees may voluntarily terminate their employmentwith us at any time. The loss of the services of these or other key personnel, or the inability to attract and retain additional qualifiedpersonnel, could result in delays to development or approval, loss of sales and diversion of management resources. In addition, wedepend on our ability to attract and retain other highly skilled personnel, including research scientists. Competition for qualifiedpersonnel is intense, and the process of hiring and integrating such qualified personnel is often lengthy. We may be unable to recruit suchpersonnel on a timely basis, if at all, which would negatively impact our development and commercialization programs.Additionally, we do not currently maintain “key person” life insurance on the lives of our executives or any of our employees. Thislack of insurance means that we may not have adequate compensation for the loss of the services of these individuals.Product liability lawsuits could divert our resources, result in substantial liabilities and reduce the commercial potential ofour compounds.The risk that we may be sued on product liability claims is inherent in the development and sale of pharmaceutical products. Forexample, we face a risk of product liability exposure related to the testing of our products and product candidates in clinical trials and willface even greater risks upon commercialization by30 us or our partners of our compounds. We believe that we may be at a greater risk of product liability claims relative to otherpharmaceutical companies because our compounds are intended to treat behavioral disorders, and it is possible that we may be held liablefor the behavior and actions of patients who use our compounds. These lawsuits may divert our management from pursuing our businessstrategy and may be costly to defend. In addition, if we are held liable in any of these lawsuits, we may incur substantial liabilities andwe or our partners may be forced to limit or forego further commercialization of one or more of our compounds. Although we maintainproduct liability insurance, our aggregate coverage limit under this insurance is $10.0 million, and while we believe this amount ofinsurance is sufficient to cover our product liability exposure, these limits may not be high enough to fully cover potential liabilities. Asour development activities and commercialization efforts progress and we and our partners sell our compounds, this coverage may beinadequate, we may be unable to obtain adequate coverage at an acceptable cost or we may be unable to get adequate coverage at all or ourinsurer may disclaim coverage as to a future claim. This could prevent the commercialization or limit the commercial potential of ourcompounds. Even if we are able to maintain insurance that we believe is adequate, our results of operations and financial condition maybe materially adversely affected by a product liability claim. Uncertainties resulting from the initiation and continuation of productsliability litigation or other proceedings could have a material adverse effect on our ability to compete in the marketplace. Product liabilitylitigation and other related proceedings may also require significant management time.Legislative or regulatory reform of the healthcare system in the U.S. and foreign jurisdictions may affect our or ourpartners’ ability to sell our products or partnered products profitably.The continuing efforts of the U.S. and foreign governments, insurance companies, managed care organizations and other payors ofhealth care services to contain or reduce health care costs may adversely affect our or our partners’ ability to set prices for our products orpartnered products which we or our partners believe are fair, and our ability to generate revenues and achieve and maintain profitability.Specifically, in both the U.S. and some foreign jurisdictions there have been a number of legislative and regulatory proposals tochange the healthcare system in ways that could affect our or our partners’ ability to sell our products or partnered products profitably. Inthe U.S., the Medicare Prescription Drug Improvement and Modernization Act of 2003 reformed the way Medicare covered and providedreimbursement for pharmaceutical products. This legislation could decrease the coverage and price that we or our partners may receive forour products or partnered products. Other third-party payors are increasingly challenging the prices charged for medical products andservices. It will be time-consuming and expensive for us or our partners to go through the process of seeking reimbursement fromMedicare and private payors. Our products or partnered products may not be considered cost effective, and coverage and reimbursementmay not be available or sufficient to allow the sale of such products on a competitive and profitable basis. Further federal and stateproposals and healthcare reforms are likely which could limit the prices that can be charged for the drugs we develop and may furtherlimit our commercial opportunity. Our results of operations could be materially adversely affected by the Medicare prescription drugcoverage legislation, by the possible effect of this legislation on amounts that private insurers will pay and by other healthcare reformsthat may be enacted or adopted in the future.The Patient Protection and Affordable Care Act of 2010, as amended by the Health Care and Education Reconciliation Act of 2010,or PPACA, is a sweeping measure intended to expand healthcare coverage within the U.S., primarily through the imposition of healthinsurance mandates on employers and individuals and expansion of the Medicaid program, and the establishment of health careexchanges. Several provisions of the new law, which have varying effective dates, may affect us, and will likely increase certain of ourcosts. For example, an increase in the Medicaid rebate rate from 15.1% to 23.1% is effective as of January 1, 2010, and the volume ofrebated drugs has been expanded to include beneficiaries in Medicaid managed care organizations, effective as of March 23, 2010. ThePPACA also imposes an annual fee on pharmaceutical manufacturers beginning in 2011, based on the manufacturer’s sale of brandedpharmaceuticals and biologics (excluding orphan drugs); expands the 340B drug discount program (excluding orphan drugs) includingthe creation of new penalties for non-compliance; and includes a 50% discount on brand name drugs for Medicare31 Part D participants in the coverage gap, or “doughnut hole”. The law also revises the definition of “average manufacturer price” forreporting purposes (effective October 1, 2010), which could increase the amount of the Company’s Medicaid drug rebates to states, oncethe provision is effective. Substantial new provisions affecting compliance also have been added, which may require us to modify ourbusiness practices with health care practitioners.The reforms imposed by the new law will significantly impact the pharmaceutical industry; however, the full effects of the PPACAcannot be known until these provisions are implemented and the Centers for Medicare & Medicaid Services and other federal and stateagencies issue applicable regulations or guidance. Moreover, in the coming years, additional changes could be made to governmentalhealthcare programs that could significantly impact the success of our products or product candidates. We will continue to evaluate thePPACA, as amended, the implementation of regulations or guidance related to various provisions of the PPACA by federal agencies, aswell as trends and changes that may be encouraged by the legislation and that may potentially impact on our business over time. Thesedevelopments could, however, have a material adverse effect on our business, financial condition and results of operations.In some foreign countries, including major markets in the European Union and Japan, the pricing of prescription pharmaceuticals issubject to governmental control. In these countries, pricing negotiations with governmental authorities can take nine to twelve months orlonger after the receipt of regulatory marketing approval for a product. To obtain reimbursement or pricing approval in some countries, wemay be required to conduct a clinical trial that compares the cost-effectiveness of our product to other available therapies. Our businesscould be materially harmed if reimbursement of our products is unavailable or limited in scope or amount or if pricing is set atunsatisfactory levels.Our business is subject to extensive governmental regulation and oversight and changes in laws could adversely affect ourrevenues and profitability.Our business is subject to extensive government regulation and oversight. As a result, we may become subject to governmentalactions which could materially adversely affect our business, results of operations and financial condition, including: • new laws, regulations or judicial decisions, or new interpretations of existing laws, regulations or decisions, related to patentprotection and enforcement, health care availability, method of delivery and payment for health care products and services or ourbusiness operations generally • changes in the FDA and foreign regulatory approval processes that may delay or prevent the approval of new products and resultin lost market opportunity • new laws, regulations and judicial decisions affecting pricing or marketing and • changes in the tax laws relating to our operationsIn addition, the Food and Drug Administration Amendments Act of 2007 or the FDAAA included new authorization for the FDA torequire post-market safety monitoring, along with a clinical trials registry, and expanded authority for the FDA to impose civil monetarypenalties on companies that fail to meet certain commitments. The amendments among other things, require some new drug applicants tosubmit risk evaluation and minimization strategies to monitor and address potential safety issues for products upon approval, grant theFDA the authority to impose risk management measures for marketed products and to mandate labeling changes in certaincircumstances, and establish new requirements for disclosing the results of clinical trials. Companies that violate the law are subject tosubstantial civil monetary penalties. Additional measures have also been enacted to address the perceived shortcomings in the FDA’shandling of drug safety issues, and to limit pharmaceutical company sales and promotional practices. While we expect the FDAAA tohave a substantial effect on the pharmaceutical industry, the extent of that effect is not yet known. As the FDA issues regulations,guidance and interpretations relating to the new legislation, the impact on the industry as well as our business will become clearer. Therequirements and other changes that the FDAAA imposes may make it more difficult, and likely more costly, to obtain approval of newpharmaceutical products and to32 produce, market and distribute existing products. Our and our partners’ ability to commercialize approved products successfully may behindered, and our business may be harmed as a result.Failure to comply with government regulations regarding the sale and marketing of our products or partnered productscould harm our business.Our and our partners’ activities, including the sale and marketing of our products or partnered products, are subject to extensivegovernment regulation and oversight, including regulation under the federal Food, Drug and Cosmetic Act and other federal and statestatutes. We are also subject to the provisions of the Federal Anti-Kickback Statute and several similar state laws, which prohibitpayments intended to induce physicians or others either to purchase or arrange for or recommend the purchase of healthcare products orservices. While the federal law applies only to products or services for which payment may be made by a federal healthcare program,state laws may apply regardless of whether federal funds may be involved. These laws constrain the sales, marketing and otherpromotional activities of manufacturers of drugs and biologicals, such as us, by limiting the kinds of financial arrangements, includingsales programs, with hospitals, physicians, and other potential purchasers of drugs and biologicals. Other federal and state lawsgenerally prohibit individuals or entities from knowingly presenting, or causing to be presented, claims for payment from Medicare,Medicaid, or other third party payors that are false or fraudulent, or are for items or services that were not provided as claimed. Anti-kickback and false claims laws prescribe civil and criminal penalties for noncompliance that can be substantial, including thepossibility of exclusion from federal healthcare programs (including Medicare and Medicaid).Pharmaceutical and biotechnology companies have been the target of lawsuits and investigations alleging violations of governmentregulation, including claims asserting antitrust violations, violations of the Federal False Claim Act, the Anti-Kickback Statute, thePrescription Drug Marketing Act and other violations in connection with off-label promotion of products and Medicare and/or Medicaidreimbursement or related to environmental matters and claims under state laws, including state anti-kickback and fraud laws.While we continually strive to comply with these complex requirements, interpretations of the applicability of these laws tomarketing practices are ever evolving. If any such actions are instituted against us or our partners and we or they are not successful indefending such actions or asserting our rights, those actions could have a significant and material impact on our business, including theimposition of significant fines or other sanctions. Even an unsuccessful challenge could cause adverse publicity and be costly to respondto, and thus could have a material adverse effect on our business, results of operations and financial condition.Future transactions may harm our business or the market price of our stock.We regularly review potential transactions related to technologies, products or product rights and businesses complementary to ourbusiness. These transactions could include: • mergers • acquisitions • strategic alliances • licensing agreements and • co-promotion and similar agreementsWe may choose to enter into one or more of these transactions at any time, which may cause substantial fluctuations in the marketprice of our stock. Moreover, depending upon the nature of any transaction, we may experience a charge to earnings, which could alsomaterially adversely affect our results of operations and could harm the market price of our stock.33 We may undertake strategic acquisitions in the future, and difficulties integrating such acquisitions could damage our abilityto achieve or sustain profitability.Although we have no experience in acquiring businesses, we may acquire businesses that complement or augment our existingbusiness. If we acquire businesses with promising product candidates or technologies, we may not be able to realize the benefit ofacquiring such businesses if we are unable to move one or more products or product candidates through preclinical and/or clinicaldevelopment to regulatory approval and commercialization. Integrating any newly acquired businesses or technologies could be expensiveand time-consuming, resulting in the diversion of resources from our current business. We may not be able to integrate any acquiredbusiness successfully. We cannot assure you that, following an acquisition, we will achieve revenues, specific net income or loss levelsthat justify the acquisition or that the acquisition will result in increased earnings, or reduced losses, for the combined company in anyfuture period. Moreover, we may need to raise additional funds through public or private debt or equity financing to acquire anybusinesses, which would result in dilution for stockholders or the incurrence of indebtedness. We may not be able to operate acquiredbusinesses profitably or otherwise implement our growth strategy successfully.Our quarterly operating results may fluctuate significantly.Our operating results will continue to be subject to quarterly fluctuations. The revenues we generate, if any, and our operating resultswill be affected by numerous factors, including: • our addition or termination of development programs • variations in the level of expenses related to our products, product candidates or future development programs • our execution of collaborative, licensing or other arrangements, and the timing of payments we may make or receive under thesearrangements • the timing of royalties or milestone payments, if any, from the sales of Fanapt® • regulatory developments affecting our compounds or those of our competitors • product sales • cost of product sales • marketing and other expenses • manufacturing or supply issues and • any intellectual property infringement lawsuit in which we may become involvedIf our quarterly operating results fall below the expectations of investors or securities analysts, the price of our common stock coulddecline substantially. Furthermore, any quarterly fluctuations in our operating results may, in turn, cause the price of our stock tofluctuate substantially. We believe that quarterly comparisons of our financial results are not necessarily meaningful and should not berelied upon as an indication of our future performance.Risks related to intellectual property and other legal mattersOur rights to develop and commercialize our product and, product candidates are subject in part to the terms and conditionsof licenses or sublicenses granted to us by other pharmaceutical companies. With respect to tasimelteon, these terms andconditions include an option in favor of the licensor to reacquire rights to commercialize and develop this product in certaincircumstances.Fanapt® (iloperidone) is based in part on patents and other intellectual property owned by sanofi-aventis and Novartis. TitanPharmaceuticals, Inc. (Titan) holds an exclusive license from sanofi-aventis to the intellectual property owned by sanofi-aventis, andTitan has sublicensed its rights under such license on an exclusive basis to Novartis. We acquired exclusive rights to this and otherintellectual property through a34 further sublicense from Novartis. The sublicense with Novartis was amended and restated in October of 2009 to provide Novartis withexclusive rights to commercialize Fanapt® in the U.S. and Canada and further develop and commercialize a long-acting injectable or depotformulation of Fanapt® in the U.S. and Canada. We retained exclusive rights to Fanapt® outside the U.S. and Canada and we haveexclusive rights to use any of Novartis’ data for Fanapt® for developing and commercializing Fanapt® outside the U.S. and Canada. AtNovartis’ option, we will enter into good faith discussions with Novartis relating to the co-commercialization of Fanapt® outside of theU.S. and Canada or, alternatively, Novartis will receive a royalty on net sales of Fanapt® outside of the U.S. and Canada. We may loseour rights to develop and commercialize Fanapt® outside the U.S. and Canada if we fail to comply with certain requirements in theamended and restated sublicense agreement regarding our financial condition, or if we fail to comply with certain diligence obligationsregarding our development or commercialization activities or if we otherwise breach the amended and restated sublicense agreement andfail to cure such breach. Our rights to develop and commercialize Fanapt® outside the U.S. and Canada may be impaired if we do notcure breaches by Novartis of similar obligations contained in its sublicense agreement with Titan. We are not currently aware of any suchbreach by Novartis. Our loss of rights in Fanapt® to Novartis would have a material adverse effect on our business, financial conditionand results of operations. In addition, if Novartis breaches the amended and restated sublicense agreement with respect to itscommercialization activities in the U.S. or Canada, we may terminate Novartis’ commercialization rights in the applicable country. Wewould no longer receive royalty payments from Novartis in connection with such country in the event of such termination.Tasimelteon is based in part on patents that we have licensed on an exclusive basis and other intellectual property licensed fromBristol-Myers Squibb Company (BMS). BMS holds certain rights with respect to tasimelteon in the license agreement. If we have notagreed to one or more partnering arrangements to develop and commercialize tasimelteon in certain significant markets with one or morethird parties by a certain date, BMS has the option to exclusively develop and commercialize tasimelteon on its own on pre-determinedfinancial terms, including milestone and royalty payments. BMS may terminate our license if we fail to meet certain milestones or if weotherwise breach our royalty or other obligations in the agreement. In the event that we terminate our license, or if BMS terminates ourlicense due to our breach, all of our rights to tasimelteon (including any intellectual property we develop with respect to tasimelteon) willrevert back to BMS or otherwise be licensed back to BMS on an exclusive basis. Any termination or reversion of our rights to develop orcommercialize tasimelteon, including any reacquisition by BMS of our rights, may have a material adverse effect on our business.If our efforts to protect the proprietary nature of the intellectual property related to our compounds are not adequate, wemay not be able to compete effectively in our markets.In addition to the rights we have licensed from Novartis and BMS relating to our compounds, we rely upon intellectual property weown relating to these compounds, including patents, patent applications and trade secrets. As of December 31, 2010, we had one pendingprovisional patent applications in the U.S., fifteen U.S. national stage applications under U.S.C. 371 and seven pending PatentCooperation Treaty applications, which permit the pursuit of patents outside of the U.S., relating to our compounds in clinicaldevelopment. Our patent applications may be challenged or fail to result in issued patents and our existing or future patents may be toonarrow to prevent third parties from developing or designing around these patents. In addition, we generally rely on trade secret protectionand confidentiality agreements to protect certain proprietary know-how that is not patentable, for processes for which patents are difficultto enforce and for any other elements of our drug development processes that involve proprietary know-how, information and technologythat is not covered by patent applications. While we require all of our employees, consultants, advisors and any third parties who haveaccess to our proprietary know-how, information and technology to enter into confidentiality agreements, we cannot be certain that thisknow-how, information and technology will not be disclosed or that competitors will not otherwise gain access to our trade secrets orindependently develop substantially equivalent information and techniques. Further, the laws of some foreign countries do not protectproprietary rights to the same extent as the laws of the U.S. As a result, we may encounter significant problems in protecting anddefending our intellectual property both in the U.S. and abroad. If we are unable to35 protect or defend the intellectual property related to our technologies, we will not be able to establish or maintain a competitive advantage inour market.If we do not obtain protection under the Hatch-Waxman Act and similar foreign legislation to extend our patents and toobtain market exclusivity for our products and partnered products, our business will be materially harmed.The United States Drug Price Competition and Patent Term Restoration Act of 1984, more commonly known as the “Hatch-Waxman Act,” provides for an extension of patent term for drugs for a period of up to five years to compensate for time spent indevelopment. Assuming we gain a five-year patent term restoration for tasimelteon, and that we continue to have rights under our licenseagreement with respect to this product, we would have exclusive rights to tasimelteon’s U.S. “new chemical entity” patent (the primarypatent covering the compound as a new composition of matter) until 2022. During the second quarter of 2009, we submitted to the PTOour application to extend the term of our patent relating to Fanapt® under the Hatch-Waxman Act. On February 23, 2010, the PTO issueda notice of allowance for our patent application for the microsphere long-acting injectable (or depot) formulation of Fanapt®. On August 3,2010, the PTO informed us that the patent had been issued with a patent term adjustment of 605 days, extending the patent expirationdate to June 26, 2024. Subsequently, on October 28, 2010, the PTO informed us that it had granted an additional patent term adjustmentof 59 days, making the total extension 664 days and making the patent expiration date August 24, 2024. A directive in the EuropeanUnion provides that companies that receive regulatory approval for a new compound will have a 10-year period of market exclusivity forthat compound (with the possibility of a further one-year extension) in most countries in Europe, beginning on the date of such Europeanregulatory approval, regardless of when the European new chemical entity patent covering such compound expires. A generic version ofthe approved drug may not be marketed or sold in Europe during such market exclusivity period. This directive may be of particularimportance with respect to Fanapt®, since the European new chemical entity patent for Fanapt® will expire prior to the end of this 10-yearperiod of market exclusivity.However, there is no assurance that we will receive the extensions of our patents or other exclusive rights available under the Hatch-Waxman Act or similar foreign legislation. If we fail to receive such extensions and exclusive rights, our ability or our partners’ ability toprevent competitors from manufacturing, marketing and selling generic versions of our products or partnered products will be materiallyimpaired.Litigation or third-party claims of intellectual property infringement could require us to divert resources and may prevent ordelay our drug discovery and development efforts.Our commercial success depends in part on our not infringing the patents and proprietary rights of third parties. Third parties mayassert that we are employing their proprietary technology without authorization. In addition, third parties may obtain patents in the futureand claim that use of our technologies infringes upon these patents. Furthermore, parties making claims against us may obtain injunctiveor other equitable relief, which could effectively block our ability to develop and commercialize one or more of our products. Defense ofthese claims, regardless of their merit, would divert substantial financial and employee resources from our business. In the event of asuccessful claim of infringement against us, we may have to pay substantial damages, obtain one or more licenses from third parties orpay royalties. In addition, even in the absence of litigation, we may need to obtain additional licenses from third parties to advance ourresearch or allow commercialization of our products. We may fail to obtain any of these licenses at a reasonable cost or on reasonableterms, if at all. In that event, we would be unable to develop and commercialize further one or more of our products.In addition, in the future we could be required to initiate litigation to enforce our proprietary rights against infringement by thirdparties. Prosecution of these claims to enforce our rights against others could divert substantial financial and employee resources from ourbusiness. If we fail to enforce our proprietary rights against others, our business will be harmed.36 If we use hazardous and biological materials in a manner that causes injury or violates applicable law, we may be liable fordamages.Our research, development and commercialization activities involve the controlled use of potentially hazardous substances,including toxic chemical and biological materials. Although we believe that our safety procedures for handling and disposing of suchmaterials comply with state and federal standards, there will always be the risk of contamination, injury or other damages resulting fromthese hazardous substances. If we were to become liable for an accident, or if we or our partners were to suffer an extended facilityshutdown, we could incur significant costs, damages and penalties that could materially harm our business, results of operations andfinancial condition.In addition, our operations produce hazardous waste products. While third parties are responsible for disposal of our hazardouswaste, we could be liable under environmental laws for any required cleanup of sites at which our waste is disposed. Federal, state,foreign and local laws and regulations govern the use, manufacture, storage, handling and disposal of these hazardous materials. If wefail to comply with these laws and regulations at any time, or if they change, we may be subject to criminal sanctions and substantialcivil liabilities, which may adversely affect our business.Even if we continue to comply with all applicable laws and regulations regarding hazardous materials, we cannot eliminate the riskof accidental contamination or discharge and our resultant liability for any injuries or other damages caused by these accidents. Althoughwe maintain pollution liability insurance, our coverage limit under this insurance is $2.0 million, and while we believe this amount andtype of insurance is sufficient to cover risks typically associated with our handling of materials, the insurance may not cover allenvironmental liabilities, and these limits may not be high enough to cover potential liabilities for these damages fully. The amount ofuninsured liabilities may exceed our financial resources and materially harm our business.Risks related to our common stockOur stock price has been highly volatile and may be volatile in the future, and purchasers of our common stock could incursubstantial losses.The realization of any of the risks described in these risk factors or other unforeseen risks could have a dramatic and adverse effecton the market price of our common stock. Between December 31, 2009 and December 31, 2010, the high and low sale prices of ourcommon stock as reported on the NASDAQ Global Market varied between $12.62 and $6.04. Additionally, market prices for securitiesof biotechnology and pharmaceutical companies, including ours, have historically been very volatile. The market for these securities hasfrom time to time experienced significant price and volume fluctuations for reasons that were unrelated to the operating performance of anyone company.The following factors, in addition to the other risk factors described in this section, may also have a significant impact on themarket price of our common stock: • publicity regarding actual or potential testing or trial results relating to products under development by us or our competitors • the outcome of regulatory review relating to products under development by us or our competitors • regulatory developments in the U.S. and foreign countries • developments concerning any collaboration or other strategic transaction we may undertake • announcements of patent issuances or denials, technological innovations or new commercial products by us or our competitors • termination or delay of development or commercialization program(s) by our partners • safety issues with our products or those of our competitors • our partners’ ability to successfully commercialize our partnered products37 • our ability to successfully execute our commercialization strategies • announcements of technological innovations or new therapeutic products or methods by us or others • actual or anticipated variations in our quarterly operating results • changes in estimates of our financial results or recommendations by securities analysts or failure to meet such financialexpectations • changes in government regulations or policies or patent decisions • changes in patent legislation or adverse changes to patent law • additions or departures of key personnel or members of our board of directors • publicity regarding actual or potential transactions involving us or • economic and other external factors beyond our controlAs a result of these factors, holders of our common stock might be unable to sell their shares at or above the price they paid for suchshares.If there are substantial sales of our common stock, our stock price could decline.A small number of institutional investors and private equity funds hold a significant number of shares of our common stock. Salesby these stockholders of a substantial number of shares, or the expectation of such sales, could cause a significant reduction in themarket price of our common stock.In addition to our outstanding common stock, as of December 31, 2010, there were a total of 4,365,107 shares of common stockthat we have registered and that we are obligated to issue upon the exercise of currently outstanding options and vesting of restricted stockunit awards granted under our Second Amended and Restated Management Equity Plan and 2006 Equity Incentive Plan. Upon theexercise of these options or settlement of these restricted stock units, as the case may be, in accordance with their respective terms, theseshares may be resold freely, subject to restrictions imposed on our affiliates under Rule 144. If significant sales of these shares occur inshort periods of time, these sales could reduce the market price of our common stock. Any reduction in the trading price of our commonstock could impede our ability to raise capital on attractive terms.If securities or industry analysts do not publish research or reports or publish unfavorable research about our business,our stock price and trading volume could decline.The trading market for our common stock will depend in part on the research and reports that securities or industry analystspublish about us or our business. We currently have research coverage by securities and industry analysts. If one or more of the analystswho covers the Company downgrades our stock, our stock price would likely decline. If one or more of these analysts ceases coverage ofour Company or fails to regularly publish reports on us, interest in the purchase of our stock could decrease, which could cause ourstock price or trading volume to decline.Our business could be negatively affected as a result of the actions of activist stockholders.Proxy contests have been waged against many companies in the biopharmaceutical industry, including us, over the last few years. Iffaced with another proxy contest, we may not be able to respond successfully to the contest, which would be disruptive to our business.Even if we are successful, our business could be adversely affected by a proxy contest involving us or our partners because: • responding to proxy contests and other actions by activist stockholders can be costly and time-consuming, disrupting operationsand diverting the attention of management and employees38 • perceived uncertainties as to future direction may result in the loss of potential acquisitions, collaborations or in-licensingopportunities, and may make it more difficult to attract and retain qualified personnel and business partners and • if individuals are elected to a board of directors with a specific agenda, it may adversely affect our ability to effectively andtimely implement our strategic plan and create additional value for our stockholdersThese actions could cause our stock price to experience periods of volatility.Anti-takeover provisions in our charter and bylaws, and in Delaware law, and our rights plan could prevent or delay achange in control of our company.We are a Delaware corporation and the anti-takeover provisions of Section 203 of the Delaware General Corporation Law maydiscourage, delay or prevent a change in control by prohibiting us from engaging in a business combination with an interestedstockholder for a period of three years after the person becomes an interested stockholder, even if a change of control would be beneficialto our existing stockholders. In addition, our amended and restated certificate of incorporation and bylaws may discourage, delay orprevent a change in our management or control over us that stockholders may consider favorable. Our amended and restated certificate ofincorporation and bylaws: • authorize the issuance of “blank check” preferred stock that could be issued by our board of directors to thwart a takeoverattempt • do not provide for cumulative voting in the election of directors, which would allow holders of less than a majority of the stock toelect some directors • establish a classified board of directors, as a result of which the successors to the directors whose terms have expired will beelected to serve from the time of election and qualification until the third annual meeting following their election • require that directors only be removed from office for cause • provide that vacancies on the board of directors, including newly-created directorships, may be filled only by a majority vote ofdirectors then in office • limit who may call special meetings of stockholders • prohibit stockholder action by written consent, requiring all actions to be taken at a meeting of the stockholders • establish advance notice requirements for nominating candidates for election to the board of directors or for proposing matters thatcan be acted upon by stockholders at stockholder meetingsMoreover, on September 25, 2008, our board of directors adopted a rights agreement, the provisions of which could result insignificant dilution of the proportionate ownership of a potential acquirer and, accordingly, could discourage, delay or prevent a change inour management or control over us.Unstable market, credit and financial conditions may exacerbate certain risks affecting our business and have seriousadverse consequences on our business.The recent economic downturn and market instability has made the business climate more volatile and more costly. Our generalbusiness strategy may be adversely affected by unpredictable and unstable market conditions. If the current equity and credit marketsdeteriorate further, or do not improve, it may make any necessary debt or equity financing more difficult, more costly, and more dilutive.While we believe we have adequate capital resources to meet current working capital and capital expenditure requirements, a lingeringeconomic downturn or significant increase in our expenses could require additional financing on less than attractive rates or on terms thatare excessively dilutive to existing stockholders. Failure to secure any39 necessary financing in a timely manner and on favorable terms could have a material adverse effect on our stock price and could requireus to delay or abandon clinical development plans.Sales of our products and partnered products will be dependent, in large part, on reimbursement from government healthadministration authorities, private health insurers, distribution partners and other organizations. As a result of the current credit andfinancial market conditions, these organizations may be unable to satisfy their reimbursement obligations or may delay payment. Inaddition, federal and state health authorities may reduce Medicare and Medicaid reimbursements, and private insurers may increase theirscrutiny of claims. A reduction in the availability or extent of reimbursement could negatively affect our or our partners’ product salesand revenue. Customers may also reduce spending during times of economic uncertainty.In addition, we rely on third parties for several important aspects of our business. For example, we depend upon Novartis for bothroyalty revenue and the further clinical development of Fanapt®, we use third party contract research organizations for many of ourclinical trials, and we rely upon several single source providers of raw materials and contract manufacturers for the manufacture of ourproducts and product candidates. Due to the recent tightening of global credit and the continued deterioration in the financial markets,there may be a disruption or delay in the performance of our third party contractors, suppliers or partners. If such third parties are unableto satisfy their commitments to us, our business would be adversely affected.ITEM 1B. UNRESOLVED STAFF COMMENTSNot applicable.ITEM 2. PROPERTIESOur current headquarters are located in Rockville, Maryland, consisting of approximately 27,000 square feet of office andlaboratory space. Our lease for this facility expires in 2016.Management believes that the leased facility is suitable and adequate to meet the Company’s anticipated needs.ITEM 3. LEGAL PROCEEDINGSThe Company is not a party to any material pending legal proceedings, and management is not aware of any contemplatedproceedings by any governmental authority against the Company.ITEM 4. REMOVED AND RESERVEDPART IIITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIESOur common stock is quoted on The NASDAQ Global Market under the symbol “VNDA.” The following table sets forth, for theperiods indicated, the range of high and low sale prices of our common stock as reported on The NASDAQ Global Market.Year Ended December 31, 2009 High Low First quarter 2009 $0.99 $0.47 Second quarter 2009 $14.79 $0.82 Third quarter 2009 $16.65 $10.46 Fourth quarter 2009 $13.21 $9.45 40 Year Ended December 31, 2010 High Low First quarter 2010 $12.62 $9.97 Second quarter 2010 $11.80 $6.59 Third quarter 2010 $7.81 $6.04 Fourth quarter 2010 $10.32 $6.43 As of March 4, 2011, there were 12 holders of record of our common stock.Securities Authorized for Issuance Under Equity Compensation PlansThe following table provides certain information regarding our equity compensation plans in effect as of December 31, 2010:Equity Compensation Plan Information Number of Securities Remaining Available for Number of Securities to Weighted-Average Issuance Under Equity be Issued Upon Exercise Exercise Price of Compensation Plans of Outstanding Options, Outstanding Options, (Excluding Securities Plan Category Warrants and Rights Warrants and Rights Reflected in Column (a)) (a) (b) (c) Equity compensation plans approved by securityholders 4,365,107 $11.98 2,376,472 Equity compensation plans not approved by securityholders — — — Total 4,365,107 $11.98 2,376,472 (a)Includes 4,005,544 shares issuable upon exercise of outstanding options and 359,563 shares issuable upon settlement of RSUsunder the 2006 Equity Incentive Plan and Second Amended and Restated Management Equity Plan.(b)Does not take into account RSUs, which have no exercise price.(c)On January 1 of each year, the number of shares reserved under the Incentive Plan is automatically increased by 4% of the totalnumber of shares of Common Stock that are outstanding at that time, or, if less, by 1,500,000 shares (or such lesser number asmay be approved by the Company’s Board of Directors).DividendsThe Company has not paid dividends to its stockholders (other than a dividend of preferred share purchase rights which wasdeclared on September 25, 2008) since its inception and does not plan to pay dividends in the foreseeable future. The Company currentlyintends to retain earnings, if any, to finance the growth of the Company.41 Market Price of and Dividends on the Registrant’s Common Equity and Related Stockholder MattersThe following graph shows the cumulative total return, assuming the investment of $100 on April 12, 2006 (the date of the initialpublic offering) on an investment in each of the Company’s common stock, the NASDAQ Composite Index and the NASDAQBiotechnology Index (in either case, assuming reinvestment of dividends). The comparisons in the table are required by the SEC and arenot intended to forecast or be indicative of possible future performance of the Company’s common stock. We have not paid dividends toour stockholders since the inception (other than a dividend of preferred share purchase rights which was declared on September 25,2008) and do not plan to pay dividends in the foreseeable future. The following graph and related information is being furnished solely toaccompany this Form 10-K pursuant to Item 201(e) of Regulation S-K and shall not be deemed “soliciting materials” or to be “filed” withthe SEC (other than as provided in Item 201), nor shall such information be incorporated by reference into any of our filings under theSecurities Act of 1933 or the Securities Exchange Act of 1934, whether made before or after the date hereof, and irrespective of any generalincorporation language in any such filing.42 ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATAThe consolidated statements of operations data for the years ended December 31, 2010, 2009 and 2008 and the consolidated balancesheet data as of December 31, 2010 and 2009 are each derived from our audited consolidated financial statements included in this annualreport on Form 10-K. The consolidated statements of operations data for the years ended December 31, 2007 and 2006, and theconsolidated balance sheet data as of December 31, 2008, 2007 and 2006 are each derived from our audited consolidated financialstatements not included herein. Our historical results for any prior period are not necessarily indicative of results to be expected in anyfuture period.The following data should be read together with our consolidated financial statements and accompanying notes and the sectionentitled “Management’s discussion and analysis of financial condition and results of operations” included in this annual report onForm 10-K. Year Ended December 31, (In thousands, except for share and per share amounts) 2010 2009 2008 2007 2006 Statements of operations data Revenue $35,709 $4,548 $— $— $— Operating expenses: Cost of sales 2,891 1,915 — — — Research and development 12,338 13,874 23,936 47,235 52,071 General and administrative 10,147 23,724 28,909 32,803 13,637 Intangible asset amortization 1,495 983 — — — Total operating expenses 26,871 40,496 52,845 80,038 65,708 Income (loss) from operations 8,838 (35,948) (52,845) (80,038) (65,708)Interest income 431 89 1,781 5,978 2,197 Income (loss) before tax provision 9,269 (35,859) (51,064) (74,060) (63,511)Tax provision 2,077 — — 10 — Net income (loss) 7,192 (35,859) (51,064) (74,070) (63,511)Net income (loss) per share: Basic $0.26 $(1.33) $(1.92) $(2.81) $(3.97)Diluted $0.25 $(1.33) $(1.92) $(2.81) $(3.97)Shares used in calculation of net income (loss) pershares: Basic 27,916,388 27,015,271 26,650,126 26,360,177 16,001,815 Diluted 28,534,617 27,015,271 26,650,126 26,360,177 16,001,815 2010 2009 2008 2007 2006 Balance sheet data Cash and cash equivalents $42,559 $205,295 $39,079 $41,930 $30,929 Marketable securities 155,478 — 7,379 51,223 942 Working capital 169,546 181,417 44,335 74,178 24,714 Total assets 213,101 225,714 49,934 96,861 36,260 Total liabilities 175,370 202,683 3,914 13,132 9,503 Accumulated deficit (253,641) (260,833) (224,974) (173,910) (99,840)Total stockholders’ equity 37,731 23,031 46,020 83,729 26,757 43 ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONSYou should read the following discussion and analysis of our financial condition and results of operations together with“Selected Consolidated Financial Data” and our consolidated financial statements and related notes appearing at the end of thisannual report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in thisannual report on Form 10-K include historical information and other information with respect to our plans and strategy for ourbusiness and contain forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differmaterially from those anticipated in these forward-looking statements as a result of certain factors, including but not limited tothose set forth under the “Risk Factors” section of this report and elsewhere in this annual report on Form 10-K.OverviewWe are a biopharmaceutical company focused on the development and commercialization of products for central nervous systemdisorders. We believe that each of our products and partnered products will address a large market with significant unmet medical needsby offering advantages over currently available therapies. Our product portfolio includes: • Fanapt® (iloperidone), a compound for the treatment of schizophrenia. On October 12, 2009, we entered into an amended andrestated sublicense agreement with Novartis. We had originally entered into a sublicense agreement with Novartis on June 4, 2004pursuant to which we obtained certain worldwide exclusive licenses from Novartis relating to Fanapt®. Pursuant to the amendedand restated sublicense agreement, Novartis has exclusive commercialization rights to all formulations of Fanapt® in theU.S. and Canada. On January 11, 2010, Novartis launched Fanapt® in the U.S. Novartis is responsible for the further clinicaldevelopment activities in the U.S. and Canada, including the development of a long-acting injectable (or depot) formulation ofFanapt®. Pursuant to the amended and restated sublicense agreement, we received an upfront payment of $200.0 million and areeligible for additional payments totaling up to $265.0 million upon the achievement of certain commercial and developmentmilestones for Fanapt® in the U.S. and Canada. We also receive royalties, which, as a percentage of net sales, are in the lowdouble-digits, on net sales of Fanapt® in the U.S. and Canada. In addition, we are no longer required to make any futuremilestone payments with respect to sales of Fanapt® or any future royalty payments with respect to sales of Fanapt® in theU.S. and Canada. We retain exclusive rights to Fanapt® outside the U.S. and Canada and we have exclusive rights to use any ofNovartis’ data for Fanapt® for developing and commercializing Fanapt® outside the U.S. and Canada. At Novartis’ option, wewill enter into good faith discussions with Novartis relating to the co-commercialization of Fanapt® outside of the U.S. andCanada or, alternatively, Novartis will receive a royalty on net sales of Fanapt® outside of the U.S. and Canada. OnFebruary 23, 2010, the U.S. Patent and Trademark Office (PTO) issued a notice of allowance for our patent application for themicrosphere long -acting injectable (or depot) formulation of Fanapt®. On August 3, 2010, the PTO informed us that the patenthad been issued with a patent term adjustment of 605 days, extending the patent expiration date to June 26, 2024. Subsequently,on October 28, 2010, the PTO informed us that it had granted an additional patent term adjustment of 59 days, making the totalextension 664 days and making the patent expiration date August 24, 2024. We continue to explore the regulatory path andcommercial opportunity for Fanapt® oral formulation outside of the U.S. and Canada. On November 1, 2010, the TherapeuticGoods Administration of Australia’s Department of Health and Ageing, accepted for evaluation our application for marketingapproval of the Fanapt® oral formulation.For the year ended December 31, 2010 we incurred $2.7 million in research and development costs directly attributable to ourdevelopment of Fanapt®. As a result of the approval by the U.S. Food and Drug Administration (FDA) of the new drugapplication (NDA) for Fanapt® in May 2009, we met a milestone under the original sublicense agreement which required us tomake a milestone payment of $12.0 million to Novartis. The $12.0 million was capitalized and will be amortized over theremaining life of the U.S. patent for Fanapt®, which we expect to last until May 15, 2017. This includes the44 Hatch-Waxman extension that extends patent protection for drug compounds for a period of up to five years to compensate fortime spent in development and a six-month pediatric term extension. • Tasimelteon, a compound for the treatment of sleep and mood disorders, including Circadian Rhythm Sleep Disorders (CRSD).The compound binds selectively to the brain’s melatonin receptors, which are thought to govern the body’s natural sleep/wakecycle. Compounds that bind selectively to these receptors are thought to be able to help treat sleep disorders, and additionally arebelieved to offer potential benefits in mood disorders. We announced positive top-line results from our Phase III trial of tasimelteonin transient insomnia in November 2006. In June 2008, we announced positive top-line results from the Phase III trial oftasimelteon in chronic primary insomnia. The trial was a randomized, double-blind, and placebo-controlled study with324 patients. The trial measured time to fall asleep and sleep maintenance, as well as next-day performance. On January 19,2010, the FDA granted orphan designation status for tasimelteon in a specific CRSD, Non-24-Hour Sleep/Wake Disorder(N24HSWD) in blind individuals without light perception. The FDA grants orphan drug designation to drugs that may providesignificant therapeutic advantage over existing treatments and target conditions affecting 200,000 or fewer U.S. patients per year.Orphan drug designation provides potential financial and regulatory incentives including study design assistance, tax credits,waiver of FDA user fees, tax credits, and up to seven years of market exclusivity upon marketing approval. On February 23,2011, the European Commission (EC) designated tasimelteon as an orphan medicinal product for the same indication. Weinitiated two clinical trials to pursue FDA approval of tasimelteon for the treatment of N24HSWD in blind individuals withoutlight perception in the third quarter of 2010. The first trial is a randomized, double-blind, placebo-controlled study with aplanned enrollment of approximately 160 patients with N24HSWD. The trial has a six month treatment period and includesmeasures of both nighttime and daytime sleep, as well as laboratory measures of the synchronization between the internal bodyclock and the 24-hour environmental light/dark cycle. We also initiated a one-year safety study of tasimelteon for the treatment ofN24HSWD. This trial is an open-label safety study with a planned enrollment of approximately 140 patients with N24HSWD.We plan to conduct additional clinical trials over the next one to two years to support the use of tasimelteon as a circadianregulator and the submission of a NDA to the FDA and a marketing authorization application to the European Medicines Agency(EMA). On January 6, 2011, an end-of-Phase II meeting was held with the FDA to discuss the development plan for tasimelteonin the treatment of N24HSWD. Tasimelteon is also ready for the Phase II trials for the treatment of depression. Given the range ofpotential indications for tasimelteon, we may pursue one or more partnerships for the development and commercialization oftasimelteon worldwide. For the year ended December 31, 2010, we incurred $8.3 million in direct research and development costsdirectly attributable to our development of tasimelteon.Since we began our operations in March 2003, we have devoted substantially all of our resources to the in-licensing and clinicaldevelopment of our compounds. Our ability to generate additional revenues largely depends on Novartis’ ability to successfullycommercialize Fanapt® in the U.S. and to successfully develop and commercialize Fanapt® in Canada and upon our ability, alone orwith others, to complete the development of our products or product candidates, and to obtain the regulatory approvals for andmanufacture, market and sell our products and product candidates. The results of our operations will vary significantly fromyear-to-year and quarter-to- quarter and depend on a number of factors, including risks related to our business, risks related to ourindustry, and other risks which are detailed in Item 1A of Part I of this annual report on Form 10-K, entitled “Risk Factors”.Revenues. Our revenues are derived primarily from our amended and restated sublicense agreement with Novartis and include anup-front payment, product sales and future milestone and royalty payments. Revenue is considered both realizable and earned when eachone of the following four conditions is met: (1) persuasive evidence of an arrangement exists, (2) the arrangement fee is fixed ordeterminable, (3) delivery or performance has occurred and (4) collectability is reasonably assured. Revenue from the $200.0 millionupfront payment will be recognized ratably on a straight-line basis from the date the amended and restated sublicense agreement becameeffective (November 27, 2009) through the expected life of the U.S. patent for Fanapt®, which we expect to last until May 15, 2017. Thisincludes the Hatch-Waxman extension that extends45 patent protection for drug compounds for a period of up to five years to compensate for time spent in development and a six-monthpediatric term extension. We recognize revenue from Fanapt® royalties and commercial and development milestones from Novartis whenrealizable and product revenue upon delivery of our products to Novartis. Revenue also consists of $0.5 million of grant income forqualified research and development investments under the Internal Revenue Service’s Therapeutic Discovery Project Credit Programwhich was received in the fourth quarter of 2010.Research and development expenses. Our research and development expenses consist primarily of fees paid to third-partyprofessional service providers in connection with the services they provide for our clinical trials, costs of contract manufacturingservices, costs of materials used in clinical trials and research and development, costs for regulatory consultants and filings, depreciationof capital resources used to develop our products, all related facilities costs, and salaries, benefits and stock-based compensationexpenses related to our research and development personnel. We expense research and development costs as incurred for compounds in thedevelopment stage, including certain payments made under our license agreements prior to FDA approval. Prior to FDA approval , allFanapt® manufacturing-related and milestone costs were included in research and development expenses. Subsequent to FDA approval ofFanapt®, manufacturing and milestone costs related to this product are being capitalized. Costs related to the acquisition of intellectualproperty have been expensed as incurred since the underlying technology associated with these acquisitions were made in connection withthe Company’s research and development efforts and have no alternative future use. Milestone payments are accrued in accordance withthe FASB guidance on accounting for contingencies which states that milestone payments be accrued when it is deemed probable that themilestone event will be achieved. We believe that significant investment in product development is a competitive necessity and plan tocontinue these investments in order to realize the potential of our products and product candidates and pharmacogenetics andpharmacogenomics expertise. For the year ended December 31, 2010, we incurred research and development expenses in the aggregate of$12.3 million, including stock-based compensation expenses of $2.5 million. We expect our research and development expenses toincrease as we continue to develop our products and product candidates. We expect to incur licensing costs in the future that could besubstantial, as we continue our efforts to develop our products, product candidates and partnered products and to evaluate potential in-license product candidates or compounds.The following table summarizes our product development initiatives for the years ended December 31, 2010, 2009 and 2008.Included in this table are the research and development expenses recognized in connection with the clinical development of Fanapt® andtasimelteon. Included in “Other product candidates” are the costs directly related to research initiatives for all other product candidates. Year Ended Year Ended Year Ended December 31, December 31, December 31, (In thousands) 2010 2009 2008 Direct project costs(1) Fanapt® $2,708 $9,532 $8,485 Tasimelteon 8,329 2,548 11,344 Other product candidates — 120 2,180 Total direct product costs 11,037 12,200 22,009 Indirect project costs(1) Facility 609 620 683 Depreciation 184 234 330 Other indirect overhead costs 508 820 913 Total indirect expenses 1,301 1,674 1,926 Total research and development expenses $12,338 $13,874 $23,935 (1)Many of our research and development costs are not attributable to any individual project because we share resources across severaldevelopment projects. We record direct costs, including personnel costs and46 related benefits and stock-based compensation, on a project-by-project basis. We record indirect costs that support a number of ourresearch and development activities in the aggregate.General and administrative expenses. General and administrative expenses consist primarily of salaries, other related costs forpersonnel, including stock-based compensation, serving executive, finance, accounting, information technology, marketing, and humanresource functions. Other costs include facility costs not otherwise included in research and development expenses and fees for legal,accounting and other professional services. General and administrative expenses also include third party expenses incurred to supportbusiness development, marketing and other business activities related to Fanapt®. For the year ended December 31, 2010, we incurredgeneral and administrative expenses in the aggregate of $10.1 million, including stock-based compensation expenses of $2.3 million.Other income. Other income consists of interest income earned on our cash and cash equivalents, marketable securities andrestricted cash.Critical accounting policiesThe preparation of our consolidated financial statements requires us to make estimates and assumptions that affect the reportedamounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of our financial statements, as well as thereported revenues and expenses during the reported periods. We base our estimates on historical experience and on various other factorsthat we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carryingvalue of assets and liabilities that are not apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.Our significant accounting policies are described in the notes to our audited consolidated financial statements for the year endedDecember 31, 2010 included in this annual report on Form 10-K. However, we believe that the following accounting policies are importantto understanding and evaluating our reported financial results, and we have accordingly included them in this discussion.Intangible asset, net. Costs incurred for products or product candidates not yet approved by the FDA and for which no alternativefuture use exists are recorded as expense. In the event a product or product candidate has been approved by the FDA or an alternativefuture use exists for a product or product candidate, patent and license costs are capitalized and amortized over the expected patent life ofthe related product or product candidate. Milestone payments to our partners are recognized when it is deemed probable that the milestoneevent will occur.As a result of the FDA’s approval of the NDA for Fanapt® in May 2009, we met a milestone under our original sublicense agreementwith Novartis which required us to make a payment of $12.0 million to Novartis. The $12.0 million is being amortized on a straight linebasis over the remaining life of the U.S. patent for Fanapt®, which we expect to last until May 15, 2017. This includes the Hatch-Waxman extension that extends patent protection for drug compounds for a period of up to five years to compensate for time spent indevelopment and a six-month pediatric term extension. This term is our best estimate of the life of the patent; if, however, the Hatch-Waxman or pediatric extensions are not granted, the intangible asset will be amortized over a shorter period. Amortization of the intangibleasset is recorded as intangible asset amortization.The carrying values of intangible assets are periodically reviewed to determine if the facts and circumstances suggest that a potentialimpairment may have occurred. We had no impairments of our intangible assets for the year ended December 31, 2010.Accrued expenses. As part of the process of preparing financial statements we are required to estimate accrued expenses. Theestimation of accrued expenses involves identifying services that have been performed on our behalf, and then estimating the level ofservice performed and the associated cost incurred for such services as of each balance sheet date in the financial statements. Accruedexpenses include professional service fees, such as lawyers and accountants, contract service fees, such as those under contracts withclinical monitors, data management organizations and investigators in conjunction with clinical trials, fees to contract47 manufacturers in conjunction with the production of clinical materials, and fees for marketing and other commercialization activities.Pursuant to our assessment of the services that have been performed on clinical trials and other contracts, we recognize these expenses asthe services are provided. Our assessments include, but are not limited to: (1) an evaluation by the project manager of the work that hasbeen completed during the period, (2) measurement of progress prepared internally and/or provided by the third-party service provider,(3) analyses of data that justify the progress, and (4) management’s judgment. In the event that we do not identify certain costs that havebegun to be incurred or we under- or over-estimate the level of services performed or the costs of such services, our reported expenses forsuch period would be too low or too high.Revenue Recognition. Our revenues are derived primarily from our amended and restated sublicense agreement with Novartis andinclude an up-front payment, product revenue and future milestone and royalty revenues. Revenue will be recognized ratably from the datethe amended and restated sublicense agreement became effective (November 27, 2009) through the expected life of the U.S. patent forFanapt®, which we expect to last until May 15, 2017. This includes the Hatch-Waxman extension that extends patent protection for drugcompounds for a period of up to five years to compensate for time spent in development and a six-month pediatric term extension. Werecognize revenue related to Fanapt® royalties and commercial and development milestones as they are realizable and earned, and productrevenue upon delivery of our products to Novartis. Our revenues are also derived from grant income which is recognized when it isreceived.Stock-based compensation. We currently use the Black-Scholes-Merton option pricing model to determine the fair value of stockoptions. The determination of the fair value of stock options on the date of grant using an option pricing model is affected by our stockprice as well as assumptions regarding a number of complex and subjective variables. These variables include the expected stock pricevolatility over the expected term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate andexpected dividends. Expected volatility rates are based on historical volatility of the common stock of comparable entities and other factorsdue to the lack of historic information of our publicly traded common stock. The expected term of options granted is based on thetransition approach provided by FASB guidance as the options meet the “plain vanilla” criteria required by this method. The risk-freeinterest rates are based on the U.S. Treasury yield for a period consistent with the expected term of the option in effect at the time of thegrant. We have not paid dividends to our stockholders since our inception (other than a dividend of preferred share purchase rights whichwas declared on September 25, 2008) and do not plan to pay dividends in the foreseeable future. The stock-based compensation expensefor a period is also affected by expected forfeiture rate for the respective option grants. If our estimates of the fair value of these equityinstruments or expected forfeitures are too high or too low, it would have the effect of overstating or understating expenses.Total employee stock-based compensation expense, related to all of our stock-based awards for the years ended December 31, 2010,2009 and 2008, was comprised of the following: Year Ended December 31, (In thousands) 2010 2009 2008 Research and development $2,536 $2,028 $1,748 General and administrative 2,271 8,738 11,667 Total stock-based compensation expense $4,807 $10,766 $13,415 As of December 31, 2010, $2.9 million in incremental tax benefits were recognized from stock options exercised in 2010, 2009 and2008, which resulted in a reclassification to reduce net cash used in operating activities with an offsetting increase in net cash provided byfinancing activities.Income taxesOn a periodic basis, we evaluate the realizability of our deferred tax assets and liabilities and will adjust such amounts in light ofchanging facts and circumstances, including but not limited to future projections of taxable income, the reversal of deferred tax liabilities,tax legislation, rulings by relevant tax authorities and tax planning strategies. Settlement of filing positions that may be challenged by taxauthorities could impact our income taxes in the year of resolution.48 In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of thedeferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxableincome during the period in which those temporary differences becomes deductible or the NOLs and credit carryforwards can be utilized.When considering the reversal of the valuation allowance, we consider the level of past and future taxable income, the reversal of deferredtax liabilities, the utilization of the carryforwards and other factors. Revisions to the estimated net realizable value of the deferred tax assetcould cause our provision for income taxes to vary significantly from period to period.Recent Accounting PronouncementsIn September 2009, the FASB issued new accounting guidance related to the revenue recognition of multiple element arrangements.The new guidance states that if vendor-specific objective evidence or third party evidence for deliverables in an arrangement cannot bedetermined, companies will be required to develop a best estimate of the selling price to separate deliverables and allocate arrangementconsideration using the relative selling price method. The accounting guidance will be applied prospectively and became effective duringthe first quarter of 2011. We adopted this guidance beginning January 1, 2011 and we do not expect this accounting guidance tomaterially impact our financial statements.In January 2010, the FASB issued new accounting guidance related to the disclosure requirements for fair value measurements andprovides clarification for existing disclosures requirements. More specifically, this update will require (a) an entity to disclose separatelythe amounts of significant transfers in and out of Levels 1 and 2 fair value measurements and to describe the reasons for the transfers;and (b) information about purchases, sales, issuances and settlements to be presented separately (i.e. present the activity on a gross basisrather than net) in the reconciliation for fair value measurements using significant unobservable inputs (Level 3 inputs). This guidanceclarifies existing disclosure requirements for the level of disaggregation used for classes of assets and liabilities measured at fair value andrequires disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair valuemeasurements using Level 2 and Level 3 inputs. The new disclosures and clarifications of existing disclosure are effective for fiscal yearsbeginning after December 15, 2009, except for the disclosure requirements for related to the purchases, sales, issuances and settlementsin the rollforward activity of Level 3 fair value measurements. Those disclosure requirements are effective for fiscal years ending afterDecember 31, 2010. We do not believe the adoption of this guidance will have a material impact to our consolidated financial statements.Results of operationsWe have a limited history of operations. We anticipate that our results of operations will fluctuate for the foreseeable future due toseveral factors, including any possible payments made or received pursuant to licensing or collaboration agreements, progress of ourresearch and development efforts, the timing and outcome of clinical trials and related possible regulatory approvals and our and ourpartners’ ability to successfully commercialize our products, product candidates and partnered products. On October 12, 2009, weentered into an amended and restated sublicense agreement with Novartis relating to Fanapt®. Pursuant to the amended and restatedsublicense agreement, we received an upfront payment of $200.0 million of which we recognized $26.8 million in 2010. The remainingamounts will be recognized ratably over the U.S. patent life of Fanapt®, which we expect to last until May 15, 2017. This includes theHatch-Waxman extension that extends patent protection for drug compounds for a period of up to five years to compensate for time spentin development and a six-month pediatric term extension. In addition, we recognized $5.3 million of product revenue in 2010 for productsold to Novartis. We are eligible for additional payments totaling up to $265.0 million upon the achievement of certain commercial anddevelopment milestones for Fanapt® in the U.S. and Canada. We received royalties of $3.1 million in 2010, which, as a percentage of netsales, are in the low double-digits, on net sales of Fanapt® in the U.S. and Canada. We also received grant income of $0.5 million forqualified research and development investments under the Internal Revenue Service’s Therapeutic Discovery Project Credit Program in thefourth quarter of 2010.49 Year ended December 31, 2010 compared to year ended December 31, 2009Revenues. Revenues were $35.7 million for the year ended December 31, 2010 compared to revenues of $4.5 million for the yearended December 31, 2009. Revenues for the year ended December 31, 2010 included $26.8 million recognized from Novartis related tostraight-line recognition of up-front license fees, $5.3 million for Fanapt® product sales to Novartis, $3.1 million in royalty revenuebased on 2010 sales of Fanapt® and grant income of $0.5 million for qualified research and development investments under the InternalRevenue Service’s Therapeutic Discovery Project Credit Program which was received in the fourth quarter of 2010. Novartis launchedFanapt® in January 2010.Cost of sales. Cost of sales were $2.9 million for inventory sold to Novartis for the year ended December 31, 2010 compared tocost of sales of $1.9 million for the year ended December 31, 2009.Intangible asset amortization. Intangible asset amortization for the year ended December 31, 2010 was $1.5 million compared to$1.0 million for the year ended December 31, 2009. The amortization is the result of the capitalized intangible asset related to the$12.0 million milestone payment to Novartis in May 2009.Research and development expenses. Research and development expenses decreased by $1.5 million, or 11.1%, to $12.3 millionfor the year ended December 31, 2010 compared to $13.9 million for the year ended December 31, 2009.The following table discloses the components of research and development expenses reflecting all of our project expenses for the yearsended December 31, 2010 and 2009: Year EndedDecember 31, Research and Development Expenses (In thousands) 2010 2009 Direct project costs: Clinical trials $2,542 $42 Contract research and development manufacturing, consulting, materials and other direct costs 2,976 7,735 Salaries, benefits and related costs 2,983 2,395 Stock-based compensation 2,536 2,028 Total direct costs 11,037 12,200 Indirect project costs 1,301 1,674 Total $12,338 $13,874 Direct costs decreased by $1.2 million primarily as a result of lower manufacturing costs offset by higher clinical trial, salary andbenefit expenses and stock-based compensation expenses. Clinical trials expense increased by $2.5 million primarily due to the costsassociated with two Phase III clinical trials for tasimelteon in N24HSWD in blind individuals without light perception, which wereinitiated in the third quarter of 2010. Contract research and development manufacturing, consulting, materials and other direct costsdecreased by $4.8 million primarily as a result of lower regulatory consulting expenses for Fanapt® in 2010 offset by increasedmanufacturing costs for tasimelteon in 2010.General and administrative expenses. General and administrative expenses decreased by $13.6 million, or 57.2%, to$10.1 million for the year ended December 31, 2010 from $23.7 million for the year ended December 31, 2009.50 The following table discloses the components of our general and administrative expenses for the years ended December 31, 2010 and2009: Year EndedDecember 31, General and Administrative Expenses (In thousands) 2010 2009 Salaries, benefits and related costs $1,745 $2,686 Stock-based compensation 2,271 8,738 Marketing, legal, accounting and other professional services 3,611 9,951 Other expenses 2,520 2,349 Total $10,147 $23,724 Salaries, benefits and related costs decreased by $0.9 million for the year ended December 31, 2010 as a result of executivedepartures in 2010. Stock-based compensation expense decreased by $6.5 million as a result of the reversal of expense relating tounvested options forfeited as a result of executive departures in 2010 and the subsequent reduced expense for existing employees.Marketing, legal, accounting and other professional services decreased by $6.3 million for the year ended December 31, 2010 primarilydue to the legal, consulting and financial advisor fees incurred during the year ended December 31, 2009 related to the Company’sevaluation of potential strategic transactions, including the Novartis agreement.Interest Income. Interest income increased $0.3 million to $0.4 million for the year ended December 31, 2010 from $0.1 million forthe year ended December 31, 2009, due to a higher average cash and marketable securities balances for the year combined with a lowerrate of return on investments.Tax Provision. The provision for income taxes of $2.1 million in 2010 is a result of generating pre-tax income of $9.3 million in2010 compared to a pre-tax loss of $35.9 million in 2009. Our effective tax rate of 22.4% for 2010 was favorably impacted by theutilization of deferred tax assets, primarily net operating loss carryforwards, which were previously reduced by a valuation allowance. Inaddition, our tax rate was favorably impacted by the receipt of the orphan drug credit, offset by nondeductible stock option expense, anda higher effective state tax rate.We previously submitted a PLR request and a supplemental information letter to the IRS to clarify the application of certainsection 382 change of ownership rules. Section 382 of the Code imposes an annual limitation on the ability of a corporation that undergoesan “ownership change” to utilize its tax attributes, including net operating loss carryforwards and research and development credits, toreduce its tax liability. On November 15, 2010, we received a PLR from the IRS. The PLR is generally consistent with our previouslystated tax position that we are able to offset a portion of our 2010 taxable income with our full net operating loss carryforwards.See footnote 11, “Income Taxes”, of our consolidated financial statements for further details on our effective tax rate and relatedchange in our valuation allowance.Year ended December 31, 2009 compared to year ended December 31, 2008Research and development expenses. Research and development expenses decreased by $10.1 million, or 42.0%, to $13.9 millionfor the year ended December 31, 2009 compared to $23.9 million for the year ended December 31, 2008.51 The following table discloses the components of research and development expenses reflecting all of our project expenses for the yearsended December 31, 2009 and 2008: Year EndedDecember 31, Research and Development Expenses (In thousands) 2009 2008 Direct project costs: Clinical trials $42 $7,441 Contract research and development manufacturing, consulting, materials and other direct costs 7,735 8,731 Salaries, benefits and related costs 2,395 4,089 Stock-based compensation 2,028 1,748 Total direct costs 12,200 22,009 Indirect project costs 1,674 1,926 Total $13,874 $23,935 Direct costs decreased by $9.8 million primarily as a result of lower clinical trial and manufacturing expenses and lower salary andbenefit expenses due to a reduced workforce. Clinical trials expense decreased by $7.4 million primarily due to the Phase III clinical trialfor tasimelteon in chronic primary insomnia being completed in 2008. Contract research and development manufacturing, consulting,materials and other direct costs decreased by $1.0 million primarily as a result of lower manufacturing costs for tasimelteon, andFanapt® manufacturing expenses being capitalized post FDA approval.General and administrative expenses. General and administrative expenses decreased by $5.2 million, or 17.9%, to$23.7 million for the year ended December 31, 2009 from $28.9 million for the year ended December 31, 2008.The following table analyzes the components of our general and administrative expenses for the years ended December 31, 2009 and2008: Year Ended December 31, General and Administrative Expenses (In thousands) 2009 2008 Salaries, benefits and related costs $2,686 $4,946 Stock-based compensation 8,738 11,667 Marketing, legal, accounting and other professional services 9,951 9,450 Other expenses 2,349 2,847 Total $23,724 $28,910 Salaries, benefits and related costs decreased by $2.3 million for the year ended December 31, 2009 as a result of a workforcereduction that took place in December 2008. Stock-based compensation expense decreased by $2.9 million as a result of the full vestingof non-qualified options issued at a higher fair market value. Marketing, legal, accounting and other professional services increased by$0.5 million for the year ended December 31, 2009 as a result of higher legal, consulting and financial advisor fees related to the Novartisagreement, offset by lower marketing expenses relating to Fanapt®.Interest income. Interest income decreased by $1.7 million to $0.1 million for the year ended December 31, 2009 from $1.8 millionfor the year ended December 31, 2008 due to lower average cash and marketable securities balances for the year combined with a lowerrate of return on investments.52 Intangible Asset, NetThe intangible asset consisted of the following: Estimated December 31, 2010 Useful Gross Net Life Carrying Accumulated Carrying(In thousands) (years) Amount Amortization AmountFanapt® 8 years $12,000 $2,478 $9,522 $12,000 $2,478 $9,522 On May 6, 2009, we announced that the FDA had approved the NDA for Fanapt®. As a result of the FDA’s approval of the NDA,we met a milestone under our original sublicense agreement with Novartis which required us to make a payment of $12.0 million toNovartis. The $12.0 million was capitalized and will be amortized over the remaining life of the U.S. patent for Fanapt®, which weexpect to last until May 15, 2017. This includes the Hatch-Waxman extension that provides patent protection for drug compounds for aperiod of up to five years to compensate for time spent in development and a six-month pediatric term extension. This term is our bestestimate of the life of the patent; if, however, the Hatch-Waxman or pediatric extensions are not granted, the intangible asset will beamortized over a shorter period.Intangible assets are amortized over their estimated useful economic life using the straight line method. Amortization expense was$1.5 million for the year ended December 31, 2010. We capitalized and began amortizing the asset immediately following the FDAapproval of the NDA for Fanapt®.The following table summarizes our intangible asset amortization schedule as of December 31, 2010: Amortization Expense by Period(In thousands) Total 2011 2012 2013 2014 2015 After 2015Intangible asset $9,522 $1,495 $1,495 $1,495 $1,495 $1,495 $2,047 RevenueRevenue consisted of the following: December 31, 2009 Revenue December 31, 2010 (In thousands) Deferred Revenue Recognized Deferred Revenue Revenue: Licensing agreement $197,431 $26,789 $170,642 Royalty revenue — 3,141 — Product sales — 5,290 — Grant revenue — 489 — Total $197,431 $35,709 $170,642 We entered into an amended and restated sublicense agreement with Novartis on October 12, 2009, pursuant to which Novartis hasthe right to commercialize and develop Fanapt® in the U.S. and Canada. Under the amended and restated sublicense agreement, wereceived an upfront payment of $200.0 million in December of 2009. Revenue will be recognized ratably from the date the amended andrestated sublicense agreement became effective (November 27, 2009) through the expected life of the U.S. patent for Fanapt®, which weexpect to last until May 15, 2017. This includes the Hatch-Waxman extension that extends patent protection for drug compounds for aperiod of up to five years to compensate for time spent in development and a six-month pediatric term extension. For the year endedDecember 31, 2010, we recognized $26.8 million of revenue under the amended and restated sublicense agreement. We recognize royaltyrevenue when it is realizable and earned and product revenue upon delivery of our products to Novartis. Our revenues are also derivedfrom grant income which is recognized when it is received.53 Liquidity and capital resourcesAs of December 31, 2010, our total cash and cash equivalents and marketable securities were $198.0 million compared to$205.3 million at December 31, 2009. Our cash and cash equivalents are deposits in operating accounts and highly liquid investmentswith an original maturity of 90 days or less at date of purchase and consist of time deposits, investments in money market funds withcommercial banks and financial institutions, and commercial paper of high-quality corporate issuers. Our marketable securities consistof investments in government sponsored enterprises and commercial paper. As of December 31, 2010, we also held a non-current depositof $0.4 million that is used to collateralize a letter of credit issued for our current office lease in Rockville, Maryland which expires in2016.As of December 31, 2010 and 2009 our liquidity resources are summarized as follows: As of December 31, (In thousands) 2010 2009 Balance sheet data Cash and cash equivalents $42,559 $205,295 U.S. Treasury and government agencies 45,455 — U.S. corporate debt 110,023 — Marketable securities, short-term 155,478 — Total $198,037 $205,295 As of December 31, 2010, we maintained all of our cash and cash equivalents in three financial institutions. Deposits held withthese institutions may exceed the amount of insurance provided on such deposits, but we do not anticipate any losses with respect to suchdeposits.FASB guidance establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiersinclude: • Level 1 — defined as observable inputs such as quoted prices in active markets • Level 2 — defined as inputs other than quoted prices in active markets that are either directly or indirectly observable • Level 3 — defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its ownassumptionsAs of December 31, 2010, we held certain assets that are required to be measured at fair value on a recurring basis. Fair Value Measurements at Reporting Date Using Quoted Prices in Active Markets for Significant Other Significant Identical Assets Observable Inputs Unobservable Inputs (In thousands) December 31, 2010 (Level 1) (Level 2) (Level 3) Description: Available-for-sale securities $155,478 $45,455 $110,023 $— Total $155,478 $45,455 $110,023 $— As December 31, 2009, we did not hold any assets or liabilities that are required to be measured at fair value on a recurring basis.We believe that our current existing cash and cash equivalents and marketable securities are sufficient to meet our working capitaland capital expenditure needs to execute our current planned business plan. However, the amounts of expenditures that will be needed tocarry out our business plan are subject to numerous uncertainties, which may adversely affect our liquidity and capital resources. Wepreviously submitted a private letter ruling (PLR) request and a supplemental information letter to the IRS to clarify the54 application of certain section 382 change of ownership rules. Section 382 of the Code imposes an annual limitation on the ability of acorporation that undergoes an “ownership change” to utilize its tax attributes, including net operating loss carryforwards and research anddevelopment credits, to reduce its tax liability. On November 15, 2010, we received a PLR from the IRS. The PLR is generally consistentwith our previously stated tax position that we are able to offset a portion of our 2010 taxable income with the Company’s full netoperating loss carryforwards. Total net operating loss carryforwards were $123.7 million as of December 31, 2008. As of December 31,2009, total net operating loss carryforwards were $155.8 million. We believe that the PLR received from the IRS clarifies certain tax rulesregarding the use of these net operating loss carryforwards and will support our position that our December 31, 2009 net operating losscarryforwards can be fully utilized beginning in 2010.We entered into an amended and restated sublicense agreement in 2009 with Novartis to commercialize Fanapt® in the U.S. andCanada. Novartis is responsible for the further clinical development activities in the U.S. and Canada, including the development of along-acting injectable (or depot) formulation of Fanapt®. Pursuant to the amended and restated sublicense agreement, we received anupfront payment of $200.0 million, and are eligible for additional payments totaling up to $265.0 million upon the achievement of certaincommercial and development milestones for Fanapt® in the U.S. and Canada. We will recognize the $200.0 million upfront paymentratably from the date the amended and restated sublicense agreement became effective (November 27, 2009) through the expected life ofthe U.S. patent for Fanapt®, which we expect to last until May 15, 2017. This includes the Hatch-Waxman extension that provides patentprotection for drug compounds for a period of up to five years to compensate for time spent in development and a six-month pediatric termextension. We also receive royalties, which, as a percentage of net sales, are in the low double digits, on net sales of Fanapt® in theU.S. and Canada. During the year ended December 31, 2010, we recorded $26.8 million in licensing revenue, product revenue of$5.3 million from product sold to Novartis and $3.1 million in royalty revenue. We recognize product revenue on the sale of the existingFanapt® product to Novartis upon delivery to Novartis and royalty revenue when realizable and earned. Other than participation in theJoint Steering Committee (JSC) established following the effective date of the amended and restated sublicense agreement with Novartis,we have no control over the progress of Novartis’ commercial plans. We cannot forecast with any degree of certainty the achievement ofmilestones and royalties under this agreement.We expect to continue to incur substantial expenses relating to our research and development efforts, as we focus on clinical trialsand manufacturing required for the development of our active product candidates. We initiated two clinical trials to pursue FDA approvalof tasimelteon for the treatment of N24HSWD in blind individuals without light perception beginning in the third quarter of 2010. Thefirst trial is a randomized, double-blind, placebo-controlled study with a planned enrollment of approximately 160 patients withN24HSWD. The trial has a six month treatment period and includes measures of both nighttime and daytime sleep, as well as laboratorymeasures of the synchronization between the internal body clock and the 24-hour environmental light/dark cycle. The second trial is aone-year safety study of tasimelteon for the treatment of N24HSWD. This trial is an open-label safety study with a planned enrollment ofapproximately 140 patients with N24HSWD. The duration and cost of clinical trials are a function of numerous factors such as thenumber of patients to be enrolled in the trial, the amount of time it takes to enroll them, the length of time they must be treated andobserved, and the number of clinical sites and countries for the trial. In addition, orphan clinical trials create an additional challenge dueto the limited number of available patients afflicted with the disease.We must receive regulatory approval to launch any of our products commercially. In order to receive such approval, the appropriateregulatory agency must conclude that our clinical data establish safety and efficacy and that our products and the manufacturingfacilities meet all applicable regulatory requirements. We cannot be certain that we will establish sufficient safety and efficacy data toreceive regulatory approval for any of our drugs or that our drugs and the manufacturing facilities will meet all applicable regulatoryrequirements.Because of the uncertainties discussed above, the costs to advance our research and development projects are difficult to estimateand may vary significantly. We expect that our existing funds, primarily consisting of the upfront payment received under the Novartiscontract and investment income will be sufficient to fund our planned operations. Our future capital requirements and the adequacy ofour available funds will depend on many factors, primarily including the scope and costs of our clinical development programs, thescope and55 costs of our manufacturing and process development activities, the magnitude of our discovery and preclinical development programsand the level of our pre-commercial launch activities. There can be no assurance that any additional financing required in the future willbe available on acceptable terms, if at all.Cash flowThe following table summarizes our cash flows for the years ended December 31, 2010, 2009 and 2008. Year Ended December 31, (In thousands) 2010 2009 2008 Net cash provided by (used in) Operating activities $(10,898) $169,336 $(45,955)Investing activities (155,622) (4,739) 43,088 Financing activities 3,784 1,619 — Effect of foreign currency translation — — 16 Net change in cash and cash equivalents $(162,736) $166,216 $(2,851)Year ended December 31, 2010 compared to year ended December 31, 2009Net cash used in operations was $10.9 million for the year ended December 31, 2010 and $169.3 million was provided byoperations for the year ended December 31, 2009. Adjustments to reconcile net income to net cash used in operating activities includednon-cash charges for depreciation and amortization of $2.0 million, stock-based compensation of $5.0 million, increases in deferred taxbenefits of $1.8 million and increases in excess tax benefits from the exercise of stock options of $2.9 million, decreases in prepaidexpenses and other assets, accounts receivable, and inventory of $5.3 million, increases in accrued expenses and accounts payable of$2.8 million, increases in accrued taxes payable of $3.9 million and increases in deferred revenue of $26.8 million. Net cash used byinvesting activities for the year ended December 31, 2010 was $155.6 million and consisted of net maturities and purchases ofmarketable securities of $155.7 million and the proceeds from the sale of property and equipment of $0.1 million. Net cash providedfrom financing activities for the year ended December 31, 2010 was $3.8 million and consisted of $0.9 million from the exercise of stockoptions and $2.9 million in excess tax benefits related to stock based compensation.Year ended December 31, 2009 compared to year ended December 31, 2008Net cash provided by operations was $169.3 million for the year ended December 31, 2009 and $46.0 million was used inoperations for the year ended December 31, 2008. The net loss for the year ended December 31, 2009 of $35.9 million was offsetprimarily by non-cash charges for depreciation and amortization of $1.6 million, stock-based compensation of $11.2 million, increasesin prepaid expenses and other assets of $0.8 million, increases in accounts receivable of $3.2 million, increases in accrued expenses andaccounts payable of $1.3 million, increases in inventory of $2.4 million and increases in deferred revenue of $197.4 million and$0.1 million of changes in other working capital. Net cash used by investing activities for the year ended December 31, 2009 was$4.7 million and consisted of the acquisition of an intangible asset of $12.0 million and net maturities and sales of marketable securitiesof $7.3 million. Net cash provided from financing activities resulted from the exercise of employees stock options for the year endedDecember 31, 2009 was $1.6 million.Off-balance sheet arrangementsWe have no off-balance sheet arrangements, as defined in Item 303(a)(4) of the Securities and Exchange Commission’sRegulation S-K.Contractual obligations and commitmentsOperating leases. Our commitments under operating leases shown below consist of payments relating to our real estate leases forour current headquarters located in Rockville, Maryland, which expires in 2016.56 The following table summarizes our long-term contractual cash obligations as of December 31, 2010: Cash Payments Due by Period(In thousands) Total 2011 2012 2013 2014 2015 After 2015Operating leases $4,282 $727 $749 $771 $795 $818 $422 Other contracts. We have entered into agreements for tasimelteon with clinical supply manufacturing organizations and otheroutside contractors who will be responsible for additional services supporting our ongoing clinical development processes. Thesecontractual obligations are not reflected in the table above because we may terminate them on no more than 60 days notice withoutincurring additional charges (other than charges for work completed but not paid for through the effective date of termination and othercosts incurred by our contractors in closing out work in progress as of the effective date of termination).License agreements. In February 2004 and June 2004, we entered into separate licensing agreements with BMS and Novartis,respectively, for the exclusive rights to develop and commercialize tasimelteon and Fanapt®. On October 12, 2009, we entered into anamended and restated sublicense agreement with Novartis. We are obligated to make (in the case of tasimelteon and, in the case of Fanapt®in the U.S. and Canada, are entitled to receive) payments under the conditions in the agreements upon the achievement of specifiedclinical, regulatory and commercial milestones. If the products are successfully commercialized we will be required to pay certainroyalties (and in the case of Fanapt® in the U.S. and Canada, will be entitled to receive) based on net sales for each of the licensedproducts.As a result of the successful commencement of the Phase III clinical study of tasimelteon in March 2006, we met the first milestonespecified in our licensing agreement with BMS and subsequently paid a license fee of $1.0 million.As a result of the acceptance by the FDA of the NDA for Fanapt® in October 2007, we met a milestone under our original sublicenseagreement with Novartis and subsequently paid a $5.0 million milestone fee. As a result of the FDA’s approval of the NDA for Fanapt®in May 2009, we met an additional milestone under the original sublicense agreement with Novartis which required us to make amilestone payment of $12.0 million to Novartis. The $12.0 million was capitalized and will be amortized over the remaining life of theU.S. patent for Fanapt®, which we expect to last until May 15, 2017. This includes the Hatch-Waxman extension that provides patentprotection for drug compounds for a period of up to five years to compensate for time spent in development and a six-month pediatric termextension. This term is the Company’s best estimate of the life of the patent; if, however, the Hatch-Waxman or pediatric extensions arenot granted, the intangible asset will be amortized over a shorter period. No amounts were recorded as liabilities relating to the licenseagreements included in the consolidated financial statements as of December 31, 2010, since the amounts, timing and likelihood of thesepayments are unknown and will depend on the successful outcome of future clinical trials, regulatory filings, favorable regulatoryapprovals, growth in product sales and other factors.Pursuant to the amended and restated sublicense agreement, Novartis has exclusive commercialization rights to all formulations ofFanapt® in the U.S. and Canada. Novartis is responsible for the further clinical development activities in the U.S. and Canada,including the development of a long-acting injectable (or depot) formulation of Fanapt®. Pursuant to the amended and restated sublicenseagreement, we received an upfront payment of $200.0 million and are eligible for additional payments totaling up to $265.0 million uponthe achievement of certain commercial and development milestones for Fanapt® in the U.S. and Canada. We also receive royalties, which,as a percentage of net sales, are in the low double-digits, on net sales of Fanapt® in the U.S. and Canada. In addition, we are no longerrequired to make any future milestone payments with respect to sales of Fanapt® or any royalty payments with respect to sales ofFanapt® in the U.S. and Canada. We retain exclusive rights to Fanapt® outside the U.S. and Canada and have exclusive rights to use anyof Novartis’ data for Fanapt® for developing and commercializing Fanapt® outside the U.S. and Canada. At Novartis’ option, we willenter into good faith discussions with Novartis relating to the co-commercialization of Fanapt® outside of the U.S. and Canada or,alternatively, Novartis will receive a royalty on net sales of Fanapt® outside of the U.S. and Canada.57 ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISKInterest ratesOur exposure to market risk is currently confined to our cash and cash equivalents, marketable securities and restricted cash. Wecurrently do not hedge interest rate exposure. We have not used derivative financial instruments for speculation or trading purposes.Because of the short-term maturities of our cash and cash equivalents and marketable securities, we do not believe that an increase inmarket rates would have any significant impact on the realized value of our investments.Effects of inflationOur most liquid assets are cash and cash equivalents and marketable securities. Because of their liquidity, these assets are notdirectly affected by inflation. We also believe that we have intangible assets in the value of our intellectual property. In accordance withgenerally accepted accounting principles, we have not capitalized the value of this intellectual property on our balance sheet. Due to thenature of this intellectual property, we believe that these intangible assets are not affected by inflation. Because we intend to retain andcontinue to use our equipment, furniture and fixtures and leasehold improvements, we believe that the incremental inflation related toreplacement costs of such items will not materially affect our operations. However, the rate of inflation affects our expenses, such as thosefor employee compensation and contract services, which could increase our level of expenses and the rate at which we use our resources.Marketable securitiesWe deposit our cash with financial institutions that we consider to be of high credit quality and purchase marketable securitieswhich are generally investment grade, liquid, short-term fixed income securities and money-market instruments denominated inU.S. dollars.ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATAThe consolidated financial statements and related financial statement schedules required to be filed are indexed on page 62 and areincorporated herein.ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURENone.ITEM 9A. CONTROLS AND PROCEDURESConclusion Regarding the Effectiveness of Disclosure Controls and ProceduresUnder the supervision and with the participation of our management, including the Chief Executive Officer and Chief FinancialOfficer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined inRules 13a-15(e) and 15d-15(e) under the Exchange Act) as of December 31, 2010. Based upon that evaluation, our Chief ExecutiveOfficer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of December 31, 2010, the endof the period covered by this annual report, to ensure that the information required to be disclosed by us in the reports that we file orsubmit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules andforms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer andChief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.Management’s Report on Internal Control Over Financial ReportingThe Company’s management is responsible for establishing and maintaining an adequate system of internal control over financialreporting, as defined in the Exchange Act Rule 13a-15(f). Management58 conducted an assessment of the Company’s internal control over financial reporting based on the framework established by theCommittee of Sponsoring Organizations of the Treadway Commission in Internal Control — Integrated Framework. Based on theassessment, management concluded that, as of December 31, 2010, the Company’s internal control over financial reporting is effective.The effectiveness of the Company’s internal control over financial reporting as of December 31, 2010 has been audited byPricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears on page 63 of thisannual report on Form 10-K.Changes in Internal Control over Financial ReportingThere has been no change in our internal controls over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of theExchange Act) during the fourth quarter of 2010 that has materially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting. In the fourth quarter of 2010, the Company hired a new Chief Financial Officer.ITEM 9B. OTHER INFORMATIONNone.PART IIIITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCEInformation required under this item will be contained in the Company’s Proxy Statement for the Annual Meeting of Stockholders tobe filed with the SEC within 120 days after the end of the fiscal year ended December 31, 2010, under the captions “Election ofDirectors,” “Executive Officers,” “Corporate Governance”, and “Section 16(a) Beneficial Ownership Reporting Compliance” and isincorporated herein by reference pursuant to General Instruction G(3) to Form 10-K.ITEM 11. EXECUTIVE COMPENSATIONInformation required under this item will be contained in the Company’s Proxy Statement for the Annual Meeting of Stockholders tobe filed with the SEC within 120 days after the end of the fiscal year ended December 31, 2010, under the captions “CorporateGovernance” and “Executive Compensation,” and is incorporated herein by reference pursuant to General Instruction G(3) to Form 10-K,except that information required by Item 407(e)(5) of Regulation S-K will be deemed furnished in this Form 10-K and will not be deemedincorporated by reference into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent thatwe specifically incorporate it by reference into such filing.ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATEDSTOCKHOLDER MATTERSIn addition to the information set forth under the caption “Securities Authorized for Issuance Under Equity Compensation Plans” inPart II of this annual report on Form 10-K, the information required under this item will be contained in the Company’s Proxy Statementfor the Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of the fiscal year ended December 31,2010, under the caption “Security Ownership by Certain Beneficial Owners and Management” and is incorporated herein by referencepursuant to General Instruction G(3) to Form 10-K.ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCEInformation required under this item will be contained in the Company’s Proxy Statement for the Annual Meeting of Stockholders tobe filed with the SEC within 120 days after the end of the fiscal year ended59 December 31, 2010, under the caption “Corporate Governance” and is incorporated herein by reference pursuant to GeneralInstruction G(3) to Form 10-K.ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICESInformation required under this item will be contained in the Company’s Proxy Statement for the Annual Meeting of Stockholders tobe filed with the SEC within 120 days after the end of the fiscal year ended December 31, 2010, under the caption “Ratification ofSelection of Independent Registered Public Accounting Firm” and is incorporated herein by reference pursuant to General Instruction G(3)to Form 10-K.PART IVITEM 15. EXHIBITS AND FINANCIAL STATEMENTS SCHEDULESThe consolidated financial statements filed as part of this annual report on Form 10-K are listed and indexed at page 62. Certainschedules are omitted because they are not applicable, or not required, or because the required information is included in the consolidatedfinancial statements or notes thereto.The Exhibits listed in the Exhibit Index immediately preceding the Exhibits are filed as part of this annual report on Form 10-K.60 SignaturesPursuant to the requirements of Section 13 and 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused thisannual report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in Rockville, Maryland, onMarch 10, 2011.VANDA PHARMACEUTICALS INC. By: /s/ MIHAEL H. POLYMEROPOULOS, M.D.Mihael H. Polymeropoulos, M.D.Chief Executive OfficerPursuant to the requirements of the Securities Act of 1934, this annual report on Form 10-K has been signed below by the followingpersons on behalf of the registrant and in the capacities and on the dates indicated.Name Title Date /s/ MIHAEL H. POLYMEROPOULOS, M.D.Mihael H. Polymeropoulos, M.D. President and Chief Executive Officerand Director (principal executive officer) March 10, 2011 /s/ JAMES P. KELLYJames P. Kelly Chief Financial Officer and Treasurer(principal financial officer and principalaccounting officer) March 10, 2011 /s/ HOWARD PIENHoward Pien Chairman of the Board and Director March 10, 2011 /s/ RICHARD W. DUGANRichard W. Dugan Director March 10, 2011 /s/ STEVEN K. GALSON, M.D.Steven K. Galson, M.D. Director March 10, 2011 /s/ ARGERIS N. KARABELAS, Ph.D.Argeris N. Karabelas, Ph.D. Director March 10, 2011 /s/ VINCENT J. MILANOVincent J. Milano Director March 10, 2011 /s/ H. THOMAS WATKINSH. Thomas Watkins Director March 10, 201161 Vanda Pharmaceuticals Inc.Index to consolidated financial statements Page(s)Report of Independent Registered Public Accounting Firm 63 Consolidated financial statements 64 Balance sheets at December 31, 2010 and 2009 64 Statements of operations for the years ended December 31, 2010, 2009 and 2008 65 Statements of changes in stockholders’ equity for the years ended December 31, 2010, 2009 and 2008 66 Statements of cash flows for the years ended December 31, 2010, 2009 and 2008 67 Notes to the consolidated financial statements 68 62 Report of Independent Registered Public Accounting FirmTo the Board of Directors and Stockholdersof Vanda Pharmaceuticals Inc.In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of changes instockholders’ equity, and of cash flows present fairly, in all material respects, the financial position of Vanda Pharmaceuticals Inc. andSubsidiary (collectively, the Company) at December 31, 2010 and 2009, and the results of their operations and their cash flows for eachof the three years in the period ended December 31, 2010, in conformity with accounting principles generally accepted in the United Statesof America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as ofDecember 31, 2010, based on criteria established in Internal Control — Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, formaintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financialreporting, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A. Our responsibility isto express opinions on these financial statements and on the Company’s internal control over financial reporting based on our integratedaudits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements arefree of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Ouraudits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financialstatement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control overfinancial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness ofinternal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in thecircumstances. We believe that our audits provide a reasonable basis for our opinions.A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accountingprinciples. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenanceof records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;(ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordancewith generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timelydetection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financialstatements.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because ofchanges in conditions, or that the degree of compliance with the policies or procedures may deteriorate./s/ PricewaterhouseCoopers LLPBaltimore, MarylandMarch 10, 201163 Vanda Pharmaceuticals Inc.Consolidated Balance Sheets December 31, (In thousands, except for share amounts) 2010 2009 AssetsCurrent assets Cash and cash equivalents $42,559 $205,295 Marketable securities 155,478 — Accounts receivable 511 3,164 Inventory — 2,399 Prepaid expenses, deposits and other current assets 1,843 2,093 Deferred tax, current portion 182 — Total current assets 200,573 212,951 Property and equipment, net 937 1,316 Intangible asset, net 9,522 11,017 Deferred tax, noncurrent portion 1,639 — Restricted cash 430 430 Total assets $213,101 $225,714 Liabilities and stockholders’ equityCurrent liabilities Accounts payable $648 $2,424 Accrued liabilities 1,324 2,321 Accrued income taxes 2,266 — Deferred revenues, current portion 26,789 26,789 Total current liabilities 31,027 31,534 Deferred rent 490 507 Deferred revenues, noncurrent portion 143,853 170,642 Total liabilities 175,370 202,683 Commitments Stockholders’ equity Preferred stock, $0.001 par value; 20,000,000 shares authorized, and no shares issued or outstanding — — Common stock, $0.001 par value; 150,000,000 shares authorized, 28,041,379 and27,568,595 shares issued and outstanding at December 31, 2010 and 2009, respectively 28 28 Additional paid-in capital 291,342 283,836 Accumulated other comprehensive income 2 — Accumulated deficit (253,641) (260,833)Total stockholders’ equity 37,731 23,031 Total liabilities and stockholders’ equity $213,101 $225,714 The accompanying notes are an integral part of these consolidated financial statements.64 Vanda Pharmaceuticals Inc.Consolidated Statements of Operations Year Ended December 31, (In thousands, except for share amounts) 2010 2009 2008 Revenue: Licensing agreement $26,789 $2,569 $— Royalty revenue 3,141 — — Product sales 5,290 1,979 — Grant revenue 489 — — Total revenue 35,709 4,548 — Operating expenses: Cost of sales — product 2,891 1,915 — Research and development 12,338 13,874 23,935 General and administrative 10,147 23,724 28,910 Intangible asset amortization 1,495 983 — Total operating expenses 26,871 40,496 52,845 Income (loss) from operations 8,838 (35,948) (52,845)Interest income 431 89 1,781 Income (loss) before tax provision 9,269 (35,859) (51,064)Tax provision 2,077 — — Net income (loss) $7,192 $(35,859) $(51,064)Net income (loss) per share: Basic $0.26 $(1.33) $(1.92)Diluted $0.25 $(1.33) $(1.92)Shares used in calculation of net income (loss) per share: Basic 27,916,388 27,015,271 26,650,126 Diluted 28,534,617 27,015,271 26,650,126 The accompanying notes are an integral part of these consolidated financial statements.65 Vanda Pharmaceuticals Inc.Statements of Changes in Stockholders’ Equity Accumulated Additional Other Common Stock Paid-in Comprehensive Accumulated Comprehensive (In thousands, except for share amounts) Shares Par Value Capital Income (Loss) Deficit Income (Loss) Total Balances at December 31, 2007 26,652,728 $27 $257,600 $12 $(173,910) $83,729 Issuance of common stock from restricted stock units 750 — — — — — — Employee and non-employee stock-based compensation — — 13,388 — — — 13,388 Comprehensive loss: Net loss — — — — (51,064) (51,064) Cumulative translation adjustment — — — 16 — 16 Net unrealized loss on marketable securities — — — (49) — (49) Comprehensive loss $(51,097) (51,097)Balances at December 31, 2008 26,653,478 27 270,988 (21) (224,974) 46,020 Issuance of common stock from exercised stock options andrestricted stock units 915,117 1 1,618 — — — 1,619 Employee and non-employee stock-based compensation — — 11,230 — — — 11,230 Comprehensive loss: Net loss — — — — (35,859) (35,859) Net unrealized gain on marketable securities — — — 21 — 21 Comprehensive loss $(35,838) (35,838)Balances at December 31, 2009 27,568,595 28 283,836 — (260,833) 23,031 Issuance of common stock from exercised stock options andrestricted stock units 472,784 — 892 — — — 892 Employee and non-employee stock-based compensation — — 4,982 — — — 4,982 Excess tax benefits from exercise of stock options — — 1,632 — — — 1,632 Comprehensive income: Net income — — — — 7,192 7,192 Net unrealized gain on marketable securities — — — 2 — 2 Comprehensive income $7,194 7,194 Balances at December 31, 2010 28,041,379 $28 $291,342 $2 $(253,641) $37,731 The accompanying notes are an integral part of these consolidated financial statements.66 Vanda Pharmaceuticals Inc.Consolidated Statements of Cash Flows Year Ended December 31, (In thousands) 2010 2009 2008 Cash flows from operating activities Net income (loss) $7,192 $(35,859) $(51,064)Adjustments to reconcile net income (loss) to net cash provided by (used in) operatingactivities Depreciation 336 442 531 Employee and non-employee stock-based compensation 4,982 11,230 13,388 Loss on disposal of assets (23) — — Amortization of discounts and premiums on marketable securities 212 138 (235)Amortization of intangible asset 1,495 983 — Deferred tax benefit (1,821) — — Excess tax benefits from exercise of stock options (2,892) — — Changes in assets and liabilities: Prepaid expenses and other current assets 250 (805) 645 Accounts receivable 2,653 (3,164) — Inventory 2,399 (2,399) — Accounts payable (1,776) 1,911 (2,476)Accrued liabilities (997) (577) (6,893)Accrued income taxes 3,898 — — Other liabilities (17) 5 149 Deferred revenue (26,789) 197,431 — Net cash provided by (used in) operating activities (10,898) 169,336 (45,955)Cash flows from investing activities Acquisition of intangible asset — (12,000) — Purchases of property and equipment — — (944)Proceeds from sale of property and equipment 66 — — Purchases of marketable securities (202,438) (11,366) (14,786)Proceeds from sale of marketable securities — 127 11,258 Maturities of marketable securities 46,750 18,500 47,560 Net cash provided by (used in) investing activities (155,622) (4,739) 43,088 Cash flows from financing activities Excess tax benefits from stock-based compensation 2,892 — — Proceeds from exercise of stock options 892 1,619 — Net cash provided by financing activities 3,784 1,619 — Effect of foreign currency — — 16 Net change in cash and cash equivalents (162,736) 166,216 (2,851)Cash and cash equivalents Beginning of period 205,295 39,079 41,930 End of period $42,559 $205,295 $39,079 The accompanying notes are an integral part of these consolidated financial statements.67 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements1. Business Organization and PresentationBusiness organizationVanda Pharmaceuticals Inc. (Vanda or the Company) is a biopharmaceutical company focused on the development andcommercialization of products for central nervous system disorders. Vanda commenced its operations in 2003. The Company’s leadproduct, Fanapt® (iloperidone), which Novartis Pharma AG (Novartis) began marketing in the U.S. in the first quarter of 2010, is acompound for the treatment of schizophrenia. On May 6, 2009, the U.S. Food and Drug Administration (FDA) granted U.S. marketingapproval of Fanapt® for the acute treatment of schizophrenia in adults. On October 12, 2009, Vanda entered into an amended and restatedsublicense agreement with Novartis. Vanda had originally entered into a sublicense agreement with Novartis on June 4, 2004 pursuant towhich Vanda obtained certain worldwide exclusive licenses from Novartis relating to Fanapt®. Pursuant to the amended and restatedsublicense agreement, Novartis has exclusive commercialization rights to all formulations of Fanapt® in the U.S. and Canada. Novartisis responsible for the further clinical development activities in the U.S. and Canada, including the development of a long-acting injectable(or depot) formulation of Fanapt®. Pursuant to the amended and restated sublicense agreement, Vanda received an upfront payment of$200.0 million at the end of 2009 and is eligible for additional payments totaling up to $265.0 million upon the achievement of certaincommercial and development milestones for Fanapt® in the U.S. and Canada. Vanda also receives royalties, which, as a percentage of netsales, are in the low double-digits, on net sales of Fanapt® in the U.S. and Canada. In addition, Vanda is no longer required to make anyfuture milestone payments with respect to sales of Fanapt® or any future royalty payments with respect to sales of Fanapt® in theU.S. and Canada. Vanda retains exclusive rights to Fanapt® outside the U.S. and Canada and Vanda has exclusive rights to use any ofNovartis’ data for Fanapt® for developing and commercializing Fanapt® outside the U.S. and Canada. At Novartis’ option, Vanda willenter into good faith discussions with Novartis relating to the co-commercialization of Fanapt® outside of the U.S. and Canada or,alternatively, Novartis will receive a royalty on net sales of Fanapt® outside of the U.S. and Canada. On February 23, 2010, theU.S. Patent and Trademark Office (PTO) issued a notice of allowance for Vanda’s patent application for the microsphere long -actinginjectable (or depot) formulation of Fanapt®. On August 3, 2010, the PTO informed Vanda that the patent had been issued with a patentterm adjustment of 605 days, extending the patent expiration date to June 26, 2024. Subsequently, on October 28, 2010, the PTOinformed Vanda that it had granted an additional patent term adjustment of 59 days, making the total extension 664 days and makingthe patent expiration date August 24, 2024. Vanda continues to explore the regulatory path and commercial opportunity for Fanapt® oralformulation outside of the U.S. and Canada. On November 1, 2010, the Therapeutic Goods Administration of Australia’s Department ofHealth and Ageing, accepted for evaluation Vanda’s application for marketing approval for the Fanapt® oral formulation.Tasimelteon is an oral compound in development for the treatment of sleep and mood disorders including Circadian Rhythm SleepDisorders (CRSD). On January 19, 2010, the FDA granted orphan drug designation status for tasimelteon in a specific CRSD, Non-24Hour Sleep/Wake Disorder (N24HSWD) in blind individuals without light perception. The FDA grants orphan drug designation to drugsthat may provide significant therapeutic advantage over existing treatments and target conditions affecting 200,000 or fewer U.S. patientsper year. Orphan drug designation provides potential financial and regulatory incentives including study design assistance, waiver ofFDA user fees, tax credits, and up to seven years of market exclusivity upon marketing approval. On February 23, 2011, the EuropeanCommission (EC) designated tasimelteon as an orphan medicinal product for the same indication. Vanda initiated two clinical trials topursue FDA approval of tasimelteon for the treatment of N24HSWD in blind individuals without light perception in the third quarter of2010. The first trial is a randomized, double-blind, placebo-controlled study with a planned enrollment of approximately 160 patientswith N24HSWD. The trial has a six month treatment period and includes measures of both nighttime and daytime sleep, as well aslaboratory measures of the synchronization between the internal body clock and the 24-hour environmental light/dark cycle. Vanda also68 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued)initiated a one-year safety study of tasimelteon for the treatment of N24HSWD. This trial is an open-label safety study with a plannedenrollment of approximately 140 patients with N24HSWD. Vanda plans to conduct additional clinical trials over the next one to two yearsto support the use of tasimelteon as a circadian regulator and the submission of a new drug application (NDA) to the FDA and amarketing authorization application to the European Medicines Agency (EMA). On January 6, 2011, an end-of-Phase II meeting was heldwith the FDA to discuss the development plan for tasimelteon in the treatment of N24HSWD. Tasimelteon is also ready for Phase II trialsfor the treatment of depression. Given the range of potential indications for tasimelteon, Vanda may pursue one or more partnerships forthe development and commercialization of tasimelteon worldwide.Throughout this annual report on Form 10-K, Vanda refers to Fanapt® within the U.S. and Canada as its partnered product andVanda refers to Fanapt® outside the U.S. and Canada and tasimelteon as its products. All other compounds are referred to as Vanda’sproduct candidates. In addition, Vanda refers to its partnered products, products and product candidates collectively as its compounds.Moreover, Vanda refers to drug products generally as drugs or products.Basis of presentationThe accompanying consolidated financial statements have been prepared in accordance with accounting principles generallyaccepted in the United States of America. All intercompany accounts and transactions have been eliminated in consolidation.2. Summary of significant accounting policiesUse of estimatesThe preparation of financial statements in conformity with accounting principles generally accepted in the United States of Americarequires management to make estimates that affect the reported amounts of assets and liabilities at the date of the financial statements,disclosure of contingent assets and liabilities, and the reported amounts of revenue and expenses during the reporting period. Actualresults could differ from those estimates.Cash and cash equivalentsFor purposes of the consolidated balance sheets and consolidated statements of cash flows, cash equivalents represent highly-liquidinvestments with a maturity date of three months or less at the date of purchase.Marketable securitiesThe Company classifies all of its marketable securities as available-for-sale securities. The Company’s investment policy requiresthe selection of high-quality issuers, with bond ratings of AAA to A1+/P1. Available-for-sale securities are carried at fair market value,with unrealized gains and losses reported as a component of stockholders’ equity in accumulated other comprehensive income/loss.Interest and dividend income is recorded when earned and included in interest income. Premiums and discounts on marketable securitiesare amortized and accreted, respectively, to maturity and included in interest income. The Company uses the specific identificationmethod in computing realized gains and losses on the sale of investments, which would be included in the consolidated statements ofoperations when generated. Marketable securities with a maturity of more than one year as of the balance sheet date are classified as long-term securities.InventoryThe Company values inventories at the lower of cost or net realizable value. The Company analyzes its inventory levels quarterlyand writes down inventory that has become obsolete, or has a cost basis in excess of69 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued)its expected net realizable value and inventory quantities in excess of expected requirements. Expired inventory is disposed of and therelated costs are written off to cost of sales. Prior to FDA approval, all Fanapt® manufacturing-related costs were included in research anddevelopment expenses. Subsequent to FDA approval of Fanapt®, manufacturing costs related to this product are capitalized. Pursuant tothe amended and restated sublicense agreement with Novartis, the Company sold its entire stock of finished product and the remainder ofits raw materials to Novartis in the first six months of 2010.Intangible Asset, netCosts incurred for products or product candidates not yet approved by the FDA and for which no alternative future use exists arerecorded as expense. In the event a product or product candidate has been approved by the FDA or an alternative future use exists for aproduct or product candidate, patent and license costs are capitalized and amortized over the expected patent life of the related product orproduct candidate. Milestone payments to the Company’s partners are recognized when it is deemed probable that the milestone event willoccur.As a result of the FDA’s approval of the NDA for Fanapt® in May 2009, the Company met a milestone under its original sublicenseagreement with Novartis which required the Company to make a payment of $12.0 million to Novartis. The $12.0 million is beingamortized on a straight line basis over the remaining life of the U.S. patent for Fanapt®, which the Company expects to last untilMay 15, 2017. This includes the Hatch-Waxman extension that extends patent protection for drug compounds for a period of up to fiveyears to compensate for time spent in development and a six-month pediatric term extension. This term is the Company’s best estimate ofthe life of the patent; if, however, the Hatch-Waxman or pediatric extensions are not granted, the intangible asset will be amortized over ashorter period. Amortization of the intangible asset is recorded as intangible asset amortization.The carrying values of intangible assets are periodically reviewed to determine if the facts and circumstances suggest that a potentialimpairment may have occurred. The Company had no impairments of its intangible assets for the year ended December 31, 2010.Fair value of financial instrumentsThe carrying amounts of the Company’s financial instruments, which include cash and cash equivalents, marketable securities,restricted cash, and accounts payable, approximate their fair values due to their short maturities.Property and equipmentProperty and equipment are stated at cost less accumulated depreciation and amortization. Depreciation of property and equipment isprovided on a straight-line basis over the estimated useful lives of the assets. Amortization of leasehold improvements is provided on astraight-line basis over the shorter of their estimated useful life or the lease term. The costs of additions and improvements are capitalized,and repairs and maintenance costs are charged to operations in the period incurred. Upon retirement or disposition of property andequipment, the cost and accumulated depreciation and amortization are removed from the accounts and any resulting gain or loss isreflected in the statement of operations for that period.Revenue RecognitionThe Company’s revenues are derived primarily from the amended and restated sublicense agreement with Novartis and include anup-front payment, product sales and future milestone and royalty payments. Revenue is considered both realizable and earned when eachone of the following four conditions is met: (1) persuasive evidence of an arrangement exists, (2) the arrangement fee is fixed ordeterminable, (3) delivery or70 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued)performance has occurred and (4) collectability is reasonably assured. Pursuant to the amended and restated sublicense agreement,Novartis has the right to commercialize and develop Fanapt® in the U.S. and Canada. Under the amended and restated sublicenseagreement, the Company received an upfront payment of $200.0 million in December of 2009. Pursuant to the amended and restatedsublicense agreement, the Company and Novartis established a Joint Steering Committee (JSC) following the effective date of the amendedand restated sublicense agreement. The Company expects to have an active role on the JSC and concluded that the JSC constitutes adeliverable under the amended and restated sublicense agreement and that revenue related to the upfront payment will be recognized ratablyover the term of the JSC; however, the delivery or performance has no term as the exact length of the JSC is undefined. As a result, theCompany deems the performance period of the JSC to be the life of the U.S. patent of Fanapt®, which the Company expects to last untilMay 15, 2017. This includes the Hatch-Waxman extension that provides patent protection for drug compounds for a period of up to fiveyears to compensate for time spent in development and a six-month pediatric term extension. This term is the Company’s best estimate ofthe life of the patent. Revenue will be recognized ratably from the date the amended and restated sublicense agreement became effective(November 27, 2009) through the expected life of the U.S. patent for Fanapt® (May 15, 2017). Revenue related to product sales isrecognized upon delivery to Novartis. The Company will recognize revenue from Fanapt® royalties and commercial and developmentmilestones from Novartis when realizable and earned. Our revenues are also derived from grant income which is recognized when it isreceived.Concentrations of credit riskFinancial instruments which potentially subject the Company to significant concentrations of credit risk consist primarily of cash,cash equivalents and marketable securities. The Company places its cash, cash equivalents and marketable securities with what theCompany believes to be highly-rated financial institutions. At December 31, 2010, the Company maintained all of its cash, cashequivalents and marketable securities in three financial institutions. Deposits held with these institutions may exceed the amount ofinsurance provided on such deposits. Generally, these deposits may be redeemed upon demand, and the Company believes there isminimal risk of losses on such balances.Accrued expensesManagement is required to estimate accrued expenses as part of the process of preparing financial statements. The estimation ofaccrued expenses involves identifying services that have been performed on the Company’s behalf, and then estimating the level of serviceperformed and the associated cost incurred for such services as of each balance sheet date in the financial statements. Accrued expensesinclude professional service fees, such as lawyers and accountants, contract service fees, such as those under contracts with clinicalmonitors, data management organizations and investigators in conjunction with clinical trials, fees to contract manufacturers inconjunction with the production of clinical materials, fees for marketing and other commercialization activities, and severance relatedcosts due to the Company’s workforce reduction which occurred in the fourth quarter of 2008. Pursuant to management’s assessment ofthe services that have been performed on clinical trials and other contracts, the Company recognizes these expenses as the services areprovided. Such management assessments include, but are not limited to: (1) an evaluation by the project manager of the work that hasbeen completed during the period, (2) measurement of progress prepared internally and/or provided by the third-party service provider,(3) analyses of data that justify the progress, and (4) management’s judgment. In the event that the Company does not identify certaincosts that have begun to be incurred or the Company under- or over-estimates the level of services performed or the costs of such services,the Company’s reported expenses for such period would be too low or too high.71 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued)Research and development expensesThe Company’s research and development expenses consist primarily of fees for services provided by third parties in connectionwith the clinical trials, costs of contract manufacturing services, milestone license fees, costs of materials used in clinical trials andresearch and development, cost for regulatory consultants and filings, depreciation of capital resources used to develop products, relatedfacilities costs, and salaries, other employee related costs and stock-based compensation for the research and development personnel. TheCompany expenses research and development costs as they are incurred for compounds in the development stage, including certainpayments made under the license agreements. Prior to FDA approval, all Fanapt® manufacturing-related and milestone costs wereincluded in research and development expenses. Subsequent to FDA approval of Fanapt®, manufacturing and milestone costs related tothis product are being capitalized. Costs related to the acquisitions of intellectual property have been expensed as incurred since theunderlying technology associated with these acquisitions were made in connection with the Company’s research and development effortsand have no alternative future use. Milestone payments are accrued in accordance with the FASB guidance on accounting forcontingencies which states that milestones payments be accrued when it is deemed probable that the milestone event will be achieved.General and administrative expensesGeneral and administrative expenses consist primarily of salaries, other employee related costs and stock-based compensation forpersonnel serving executive, business development, marketing, finance, accounting, information technology and human resourcefunctions, facility costs not otherwise included in research and development expenses, insurance costs and professional fees for legal,accounting and other professional services. General and administrative expenses also include third party expenses incurred to supportbusiness development, marketing and other business activities related to Fanapt®.Employee stock-based compensationThe fair value of stock options granted is amortized using the accelerated attribution method. The fair value of restricted stock units(RSUs) awarded is amortized using the straight line method. As stock-based compensation expense recognized in the consolidatedstatements of operations is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Forfeitures arerequired to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from thoseestimates. Pre-vesting forfeitures on the options granted prior to 2009 were estimated to be approximately 2%. The forfeiture rate wasincreased to 4% in 2009 based on the Company’s historical experience.Total employee stock-based compensation expense recognized for the years ended December 31, 2010, 2009 and 2008, wascomprised of the following: Year Ended December 31, (In thousands, except for share amounts) 2010 2009 2008 Research and development $2,536 $2,028 $1,748 General and administrative 2,271 8,738 11,667 Total employee stock-based compensation expense $4,807 $10,766 $13,415 As of December 31, 2010, $9.6 million of total unrecognized compensation costs related to non-vested awards are expected to berecognized over a weighted average period of 1.51 years. The total excess income tax benefit related to options exercises and the vesting ofRSUs recognized in the consolidated statement of changes in stockholders’ equity for the stock-based compensation arrangements was$1.6 million and $0 for the year ended December 31, 2010 and 2009, respectively.72 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued)The fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option pricing model that usesthe assumptions noted in the following table. Expected volatility rates are based on historical volatility of the common stock of comparableentities and other factors due to the lack of historic information of the Company’s publicly traded common stock. The expected term ofoptions granted is based on the transition approach provided by FASB guidance as the options meet the “plain vanilla” criteria requiredby this guidance. The risk-free interest rates are based on the U.S. Treasury yield for a period consistent with the expected term of theoption in effect at the time of the grant. The Company has not paid dividends to its stockholders since its inception (other than a dividendof preferred share purchase rights which was declared on September 25, 2008) and does not plan to pay dividends in the foreseeablefuture.Assumptions used in the Black-Scholes-Merton option pricing model for employee and director stock options granted during theyears ended December 31, 2010, 2009 and 2008 were as follows: Year Ended December 31, 2010 2009 2008 Expected dividend yield 0% 0% 0%Weighted average expected volatility 68% 68% 68%Weighted average expected term (years) 6.03 6.03 6.18 Weighted average risk-free rate 2.32% 2.81% 3.27%Income taxesThe Company accounts for income taxes under the liability method in accordance with the FASB provisions on accounting forincome taxes, which requires companies to account for deferred income taxes using the asset and liability method. Under the asset andliability method, current income tax expense or benefit is the amount of income taxes expected to be payable or refundable for the currentyear. A deferred income tax asset or liability is recognized for future tax consequences attributable to differences between the financialstatement carrying amounts of existing assets and liabilities and their respective tax bases and tax credits and loss carryforwards.Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portionor all of the deferred tax assets will not be realized. Tax rate changes are reflected in income during the period such changes are enacted.Changes in ownership may limit the amount of net operating loss carryforwards that can be utilized in the future to offset taxable income.Segment informationManagement has determined that the Company operates in one business segment which is the development and commercialization ofpharmaceutical products.Recent accounting pronouncementsIn September 2009, the FASB issued new accounting guidance related to the revenue recognition of multiple element arrangements.The new guidance states that if vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot bedetermined, companies will be required to develop a best estimate of the selling price to separate deliverables and allocate arrangementconsideration using the relative selling price method. The accounting guidance will be applied prospectively and became effective duringthe first quarter of 2011. Early adoption was allowed. The Company adopted this guidance beginning January 1, 2011 and does notexpect this accounting guidance to materially impact its financial statements.73 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued)In January 2010, the FASB issued new accounting guidance related to the disclosure requirements for fair value measurements andprovides clarification for existing disclosures requirements. More specifically, this update will require (a) an entity to disclose separatelythe amounts of significant transfers in and out of Levels 1 and 2 fair value measurements and to describe the reasons for the transfers;and (b) information about purchases, sales, issuances and settlements to be presented separately (i.e. present the activity on a gross basisrather than net) in the reconciliation for fair value measurements using significant unobservable inputs (Level 3 inputs). This guidanceclarifies existing disclosure requirements for the level of disaggregation used for classes of assets and liabilities measured at fair value andrequires disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair valuemeasurements using Level 2 and Level 3 inputs. The new disclosures and clarifications of existing disclosure are effective for fiscal yearsbeginning after December 15, 2009, except for the disclosure requirements for related to the purchases, sales, issuances and settlementsin the rollforward activity of Level 3 fair value measurements. Those disclosure requirements are effective for fiscal years ending afterDecember 31, 2010. The Company does not believe the adoption of this guidance will have a material impact to its consolidated financialstatements.Certain risks and uncertaintiesThe Company’s products and product candidates under development require approval from the FDA or other internationalregulatory agencies prior to commercial sales. There can be no assurance the products will receive the necessary clearance. If the Companyis denied clearance or clearance is delayed, it may have a material adverse impact on the Company.The Company’s products are concentrated in rapidly-changing, highly-competitive markets, which are characterized by rapidtechnological advances, changes in customer requirements and evolving regulatory requirements and industry standards. Any failure bythe Company to anticipate or to respond adequately to technological developments in its industry, changes in customer requirements orchanges in regulatory requirements or industry standards or any significant delays in the development or introduction of products orservices could have a material adverse effect on the Company’s business, operating results and future cash flows.The Company depends on single source suppliers for critical raw materials for manufacturing, as well as other components requiredfor the administration of its products and product candidates. The loss of these suppliers could delay the clinical trials or prevent or delaycommercialization of the products and product candidates.3. Earnings per shareNet income (loss) is calculated in accordance with FASB guidance on earnings per share. Basic earnings per share (EPS) iscalculated by dividing the net income (loss) by the weighted average number of shares of common stock outstanding, reduced by theweighted average unvested shares of common stock subject to repurchase. Diluted EPS is computed by dividing the net income (loss) bythe weighted average number of other potential common stock outstanding for the period. Other potential common stock includes stockoptions, warrants and RSUs, but only to the extent that their inclusion is dilutive.74 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued)The following schedule presents the calculation of basic and diluted net income (loss) per share of common stock for the years endedDecember 31, 2010, 2009, and 2008: Year Ended December 31, (In thousands, except for share and per share amounts) 2010 2009 2008 Numerator: Net income (loss) $7,192 $(35,859) $(51,064)Denominator: Weighted average shares of common stock outstanding, basic 27,916,388 27,015,271 26,650,126 Stock options and restricted stock units related to the issuance of commonstock 618,229 — — Weighted average shares of common stock outstanding, diluted 28,534,617 27,015,271 26,650,126 Net income (loss) per share: Basic $0.26 $(1.33) $(1.92)Diluted $0.25 $(1.33) $(1.92)Anti-dilutive securities not included in diluted net income (loss) per sharecalculation: Options to purchase common stock and restricted stock units 3,017,096 4,516,739 4,408,629 The Company incurred a net loss for the years ended December 31, 2009 and 2008, causing inclusion of any potentially dilutivesecurities to have an anti-dilutive affect, resulting in dilutive loss per share and basic loss per share attributable to common stockholdersbeing equivalent.4. Marketable securitiesThe following is a summary of the Company’s available-for-sale marketable securities as of December 31, 2010: Gross Gross Amortized Unrealized Unrealized Fair Market (In thousands) Cost Gains Losses Value Short-term: U.S. Treasury and government agencies $45,466 $— $(11) $45,455 U.S. corporate debt 110,010 27 (14) 110,023 $155,476 $27 $(25) $155,478 As of December 31, 2009, the Company did not hold any available-for-sale marketable securities.75 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued)5. Prepaid expenses, deposits and other current assetsThe following is a summary of the Company’s prepaid expenses, deposits and other current assets: December 31, (In thousands) 2010 2009 Current deposits with vendors $— $150 Prepaid insurance 244 284 Other prepaid expenses and vendor advances 966 1,658 Accrued interest income 633 1 Total prepaid expenses, deposits and other current assets $1,843 $2,093 6. Property and equipmentProperty and equipment — at cost: Estimated Useful Life December 31, (In thousands) (Years) 2010 2009 Laboratory equipment 5 $1,282 $1,348 Computer equipment 3 764 764 Furniture and fixtures 7 706 706 Leasehold improvements 10 844 844 3,596 3,662 Less — accumulated depreciation and amortization (2,659) (2,346) $937 $1,316 Depreciation and amortization expense for the years ended December 31, 2010, 2009 and 2008 was $0.3 million, $0.4 million and$0.5 million, respectively.7. Intangible Asset, NetThe intangible asset consists of the following as of December 31, 2010: December 31, 2010 Estimated Gross Net Useful Carrying Accumulated Carrying Life (years) Amount Amortization Amount (In thousands) Fanapt® 8 years $12,000 $2,478 $9,522 $12,000 $2,478 $9,522 The intangible asset consists of the following as of December 31, 2009: December 31, 2009 Estimated Gross Net Useful Life Carrying Accumulated Carrying (In thousands) (years) Amount Amortization Amount Fanapt® 8 years $12,000 $983 $11,017 $12,000 $983 $11,017 On May 6, 2009, the Company announced that the FDA had approved the NDA for Fanapt®. As a result of the FDA’s approval ofthe NDA for Fanapt®, the Company met a milestone under its original sublicense76 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued)agreement with Novartis which required the Company to make a license payment of $12.0 million to Novartis. The $12.0 million isbeing amortized on a straight line basis over the remaining life of the U.S. patent for Fanapt®, which the Company expects to last untilMay 15, 2017. This includes the Hatch-Waxman extension that provides patent protection for drug compounds for a period of up to fiveyears to compensate for time spent in development and a six-month pediatric term extension. This term is the Company’s best estimate ofthe life of the patent; if, however, the Hatch-Waxman or pediatric extensions are not granted, the intangible asset will be amortized over ashorter period.Intangible assets are amortized over their estimated useful economic life using the straight line method. Amortization expense was$1.5 million and $1.0 million for the years ended December 31, 2010 and 2009, respectively. The Company capitalized and beganamortizing the asset immediately following the FDA approval of the NDA for Fanapt®.The following table summarizes our intangible asset amortization schedule as of December 31, 2010: Amortization Expense by Period (In thousands) Total 2011 2012 2013 2014 2015 After 2015 Intangible asset $9,522 $1,495 $1,495 $1,495 $1,495 $1,495 $2,047 8. Accrued LiabilitiesAccrued liabilities consist of the following: December 31, (In thousands) 2010 2009 Accrued research and development expenses $1,061 $1,033 Accrued consulting and other professional fees 201 1,076 Employee benefits 62 106 Other accrued expenses — 106 Total accrued liabilities $1,324 $2,321 9. Revenue RecognitionThe Company’s revenue consisted of the following: December 31, 2009 Revenue December 31, 2010 (In thousands) Deferred Revenue Recognized Deferred Revenue Revenue: Licensing agreement $197,431 $26,789 $170,642 Royalty revenue — 3,141 — Product sales — 5,290 — Grant revenue — 489 — Total $197,431 $35,709 $170,642 Vanda entered into an amended and restated sublicense agreement with Novartis on October 12, 2009, pursuant to which Novartishas the right to commercialize and develop Fanapt® in the U.S. and Canada. Under the amended and restated sublicense agreement,Vanda received an upfront payment of $200.0 million in December of 2009. Revenue will be recognized ratably from the date the amendedand restated sublicense agreement became effective (November 27, 2009) through the expected life of the U.S. patent for Fanapt®(May 15, 2017). This includes the Hatch-Waxman extension that provides patent protection for drug compounds for a period of up tofive years to compensate for time spent in development and a six-month77 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued)pediatric term extension. This term is the Company’s best estimate of the life of the patent. For the year ended December 31, 2010, theCompany recognized $26.8 million of revenue for the licensing agreement. Vanda recognized $5.3 million for product sold to Novartisfor the year ended December 31, 2010. Vanda recognizes product revenue upon delivery of its products to Novartis. Vanda recognizedroyalty revenue of $3.1 million for the year ended December 31, 2010. Royalty revenue is based on a percentage of the quarterly net salesof Fanapt® sold in the U.S. and Canada by Novartis and is recorded when reliably measurable and earned. Revenue also consists of$0.5 million of grant income for qualified research and development investments under the Internal Revenue Service’s TherapeuticDiscovery Project Credit Program which was received in the fourth quarter of 2010.10. Commitments and ContingenciesOperating leasesThe Company has commitments totaling $4.3 million under operating real estate leases for its headquarters located in Rockville,Maryland, which expires in 2016.(In thousands) 2011 $727 2012 749 2013 771 2014 795 2015 818 After 2015 422 $4,282 Rent expense under operating leases was $1.0 million in 2010, 2009 and 2008, respectively.Guarantees and indemnificationsThe Company has entered into a number of standard intellectual property indemnification agreements in the ordinary course of itsbusiness. Pursuant to these agreements, the Company indemnifies, holds harmless, and agrees to reimburse the indemnified party forlosses suffered or incurred by the indemnified party, generally the Company’s business partners or customers, in connection with anyU.S. patent or any copyright or other intellectual property infringement claim by any third party with respect to the Company’s products.The term of these indemnification agreements is generally perpetual from the date of execution of the agreement. The maximum potentialamount of future payments the Company could be required to make under these indemnification agreements is unlimited. Since inception,the Company has not incurred costs to defend lawsuits or settle claims related to these indemnification agreements. The Company alsoindemnifies its officers and directors for certain events or occurrences, subject to certain limits. The Company believes that the fair valueof the indemnification agreements is minimal, and accordingly the Company has not recognized any liabilities relating to these agreementsas of December 31, 2010 and 2009.License agreementsThe Company’s rights to develop and commercialize its products are subject to the terms and conditions of licenses granted to theCompany by other pharmaceutical companies.Fanapt®. The Company acquired exclusive worldwide rights to patents and patent applications for Fanapt®, previously known asiloperidone, in 2004 through a sublicense agreement with Novartis. A predecessor company of sanofi-aventis, Hoechst Marion Roussel,Inc. (HMRI), discovered Fanapt® and78 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued)completed early clinical work on the compound. In 1996, following a review of its product portfolio, HMRI licensed its rights to theFanapt® patents and patent applications to Titan Pharmaceuticals, Inc. (Titan) on an exclusive basis. In 1997, soon after it had acquiredits rights, Titan sublicensed its rights to Fanapt® on an exclusive basis to Novartis. In June 2004, the Company acquired exclusiveworldwide rights to these patents and patent applications as well as certain Novartis patents and patent applications to develop andcommercialize Fanapt® through a sublicense agreement with Novartis. In partial consideration for this sublicense, the Company paidNovartis an initial license fee of $0.5 million and was obligated to make future milestone payments to Novartis of less than$100.0 million in the aggregate (the majority of which were tied to sales milestones), as well as royalty payments to Novartis at a ratewhich, as a percentage of net sales, was in the mid-twenties. In November 2007, the Company met a milestone under this sublicenseagreement relating to the acceptance of its filing of the NDA for Fanapt® for the treatment of schizophrenia and made a correspondingpayment of $5.0 million to Novartis. As a result of the FDA’s approval of the NDA for Fanapt® in May 2009, the Company met anadditional milestone under this sublicense agreement which required the Company to make a milestone payment of $12.0 million toNovartis.On October 12, 2009, Vanda entered into an amended and restated sublicense agreement with Novartis which amended and restatedthe June 2004 sublicense agreement with Novartis. Pursuant to the amended and restated sublicense agreement, Novartis has exclusivecommercialization rights to all formulations of Fanapt® in the U.S. and Canada. Novartis began selling Fanapt® in the U.S. during thefirst quarter of 2010. Novartis is responsible for the further clinical development activities in the U.S. and Canada, including thedevelopment of a long-acting injectable (or depot) formulation of Fanapt®. Pursuant to the amended and restated sublicense agreement,Vanda received an upfront payment of $200.0 million and Vanda is eligible for additional payments totaling up to $265.0 million uponthe achievement of certain commercial and development milestones for Fanapt® in the U.S. and Canada. Vanda also receives royalties,which, as a percentage of net sales, are in the low double-digits, on net sales of Fanapt® in the U.S. and Canada. In addition, Vanda is nolonger required to make any future milestone payments with respect to sales of Fanapt® or any future royalty payments with respect tosales of Fanapt® in the U.S. and Canada. Vanda retains exclusive rights to Fanapt® outside the U.S. and Canada and Vanda hasexclusive rights to use any of Novartis’ data for Fanapt® for developing and commercializing Fanapt® outside the U.S. and Canada. AtNovartis’ option, Vanda will enter into good faith discussions with Novartis relating to the co-commercialization of Fanapt® outside of theU.S. and Canada or, alternatively, Novartis will receive a royalty on net sales of Fanapt® outside of the U.S. and Canada.Vanda may lose its rights to develop and commercialize Fanapt® outside the U.S. and Canada if it fails to comply with certainrequirements in the amended and restated sublicense agreement regarding its financial condition, or if Vanda fails to comply with certaindiligence obligations regarding its development or commercialization activities or if Vanda otherwise breaches the amended and restatedsublicense agreement and fails to cure such breach. Vanda’s rights to develop and commercialize Fanapt® outside the U.S. and Canadamay be impaired if it does not cure breaches by Novartis of similar obligations contained its sublicense agreement with Titan forFanapt®. Vanda is not aware of any such breach by Novartis. In addition, if Novartis breaches the amended and restated sublicenseagreement with respect to its commercialization activities in the U.S. or Canada, Vanda may terminate Novartis’ commercialization rightsin the applicable country and Vanda would no longer receive royalty payments from Novartis in connection with such country in theevent of such termination.Tasimelteon. In February 2004, the Company entered into a license agreement with Bristol-Myers Squibb (BMS) under which theCompany received an exclusive worldwide license under certain patents and patent applications, and other licenses to intellectual property,to develop and commercialize tasimelteon. In partial consideration for the license, the Company paid BMS an initial license fee of$0.5 million. The Company is also obligated to make future milestone payments to BMS of less than $40.0 million in the aggregate (themajority of which are tied to sales milestones) as well as royalty payments based on the net sales of tasimelteon at a rate79 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued)which, as a percentage of net sales, is in the low teens. The Company made a milestone payment to BMS of $1.0 million under thislicense agreement in 2006 relating to the initiation of its first Phase III clinical trial for tasimelteon. The Company is also obligated underthis agreement to pay BMS a percentage of any sublicense fees, upfront payments and milestone and other payments (excluding royalties)that the Company receives from a third party in connection with any sublicensing arrangement, at a rate which is in the mid-twenties.The Company has agreed with BMS in the license agreement for tasimelteon to use commercially reasonable efforts to develop andcommercialize tasimelteon and to meet certain milestones in initiating and completing certain clinical work. The license agreement withBMS was amended on April 15, 2010 to, among other things, extend the deadline by which the Company must enter into a developmentand commercialization agreement with a third party for tasimelteon until the earliest of: (i) the date mutually agreed upon by the Companyand BMS following the provision by the Company to BMS of a full written report of the Phase III clinical studies on which the Companyintends to rely for filing for marketing authorization for tasimelteon in its first major market country (Phase III report); (ii) the date of theacceptance by a regulatory authority of the filing by the Company for marketing authorization for tasimelteon in a major market countryfollowing the provision by the Company to BMS of the Phase III report; or (iii) May 31, 2013.If the Company has not entered into such a development and commercialization agreement with respect to certain major marketcountries by the foregoing deadline, then BMS will have the option to exclusively develop and commercialize tasimelteon on its own inthose countries not covered by such an agreement on pre-determined financial terms, including milestone and royalty payments. Inaddition to the foregoing, pursuant to the April 15, 2010 amendment, Vanda’s deadline for filing a NDA for tasimelteon was extendeduntil June 1, 2013.Either party may terminate the tasimelteon license agreement under certain circumstances, including a material breach of theagreement by the other. In the event that BMS has not exercised its option to reacquire the rights to tasimelteon and the Companyterminates the license, or if BMS terminates the license due to the Company’s breach, all rights licensed and developed by the Companyunder this agreement will revert or otherwise be licensed back to BMS on an exclusive basis.Future license payments. No amounts were recorded as liabilities nor were any contractual obligations relating to the licenseagreements included in the consolidated financial statements as of December 31, 2010, since the amounts, timing and likelihood of thesefuture payments are unknown and will depend on the successful outcome of future clinical trials, regulatory filings, favorable FDAregulatory approvals, growth in product sales and other factors.Research and development and marketing agreementsIn the course of its business the Company regularly enters into agreements with clinical organizations to provide services relating toclinical development and clinical manufacturing activities under fee service arrangements. The Company’s current agreements for clinicalservices may be terminated on no more than 60 days notice without incurring additional charges, other than charges for work completedbut not paid for through the effective date of termination and other costs incurred by the Company’s contractors in closing out work inprogress as of the effective date of termination. The Company has transitioned all outstanding manufacturing purchase orders for the rawmaterial supply of Fanapt® to Novartis.80 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued)11. Income taxesThe provision (benefit) for income taxes consists of the following: Year Ended December 31, (In thousands) 2010 2009 2008 Current income tax expense (benefit): Federal $2,413 $— $— State 1,485 — — Foreign — — — Deferred income tax expense (benefit): Federal (1,821) — — State — — — Foreign — — — Total tax expense $2,077 $— $— Deferred tax assets, net, consist of the following: December 31, (In thousands) 2010 2009 Deferred tax asset (liability) Net operating loss carryforwards $— $60,818 Start-up costs 19,683 21,343 Stock-based compensation 13,987 14,854 Licensing agreements (1,481) 2,879 Research and development and orphan drug credits 5,594 5,707 Depreciation and amortization 49 23 Deferred revenue 67,310 — Accrued and deferred expenses 140 153 Net deferred tax assets 105,282 105,777 Deferred tax asset valuation allowance (103,461) (105,777) $1,821 $— The net deferred tax asset as of December 31, 2010 represents the amount the Company believes is more likely than not to be realizedin the foreseeable future.A reconciliation between the Company’s statutory tax rate and effective tax rate is as follows: December 31, 2010 2009 2008 Federal tax at statutory rate 35.0% (34.0)% (34.0)%State taxes 11.0% (4.4)% (5.4)%Change in valuation allowance (25.0)% 32.9% 41.1%Research and development credit (2.7)% (0.7)% (1.9)%Stock options 22.7% 3.2% — Orphan drug credit (21.1)% — — Section 162(m) limitation 2.5% 0.7% — Meals, entertainment and other non-deductible items — 2.3% 0.2%Effective tax rate 22.4% 0.0% 0.0%81 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued)The Company previously submitted a private letter ruling (PLR) request and a supplemental information letter to the IRS to clarifythe application of certain section 382 change of ownership rules. Section 382 of the Code imposes an annual limitation on the ability of acorporation that undergoes an “ownership change” to utilize its tax attributes, including net operating loss carryforwards and research anddevelopment credits, to reduce its tax liability. On November 15, 2010, the Company received a PLR from the IRS. The PLR is generallyconsistent with the Company’s previously stated tax position that the Company is able to offset a portion of our 2010 taxable income withthe Company’s full net operating loss carryforwards. Total net operating loss carryforwards were $123.7 million as of December 31,2008. As of December 31, 2009, total net operating loss carryforwards were $155.8 million. The Company believes that the PLR receivedfrom the IRS clarifies certain tax rules regarding the use of these net operating loss carryforwards and will support the Company’sposition that its December 31, 2009 net operating loss carryforwards can be fully utilized beginning in 2010.As of December 31, 2009, the Company had $155.8 million and $5.7 million of federal and state net operating losses and researchand development credits, respectively. During the year ended December 31, 2010, the Company utilized all of its federal and state netoperating losses and a portion of its research and development credits. At December 31, 2010, the Company had research anddevelopment credits and orphan drug credits remaining of $2.6 million and $3.0 million, respectively. These credits have variousexpiration dates, the oldest of which will begin to expire in 2024.The Company’s income tax returns have not been under examination by any federal or state tax jurisdictions. Since the Companyhas generated net operating losses from inception through December 31, 2009, all income tax returns filed by the Company are subject toexamination by the taxing jurisdictions.The Company adopted ASC 740-10 on December 31, 2008. As of December 31, 2009 and 2010, the Company has no knownuncertain tax positions.The valuation allowance activity on deferred tax assets was as follows: Balance At Additions Charged Reductions Credited Beginning of To Income Tax To Income Tax Balance At End (In thousands) Period Expense Expense Of Period Calendar year ended: December 31, 2008 $71,623 $22,364 $— $93,987 December 31, 2009 $93,987 $11,790 $— $105,777 December 31, 2010 $105,777 $67,336 $69,652 $103,461 12. Fair Value MeasurementsFASB guidance establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiersinclude: • Level 1 — defined as observable inputs such as quoted prices in active markets • Level 2 — defined as inputs other than quoted prices in active markets that are either directly or indirectly observable • Level 3 — defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its ownassumptionsAs of December 31, 2010, the Company held certain assets that are required to be measured at fair value on a recurring basis.82 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued) Fair Value Measurements at Reporting Date Using Quoted Prices in Active Markets Significant Other Significant for Identical Observable Unobservable December 31, Assets Inputs Inputs (In thousands) 2010 (Level 1) (Level 2) (Level 3) Description: Available-for-sale securities $155,478 $45,455 $110,023 $— Total $155,478 $45,455 $110,023 $— As of December 31, 2009, the Company did not hold any assets or liabilities that are required to be measured at fair value on arecurring basis.13. Restricted cashDuring 2005, in conjunction with the lease of the office and laboratory space building in Rockville, MD, the Company provided thelandlord with a letter of credit, which was collateralized with a restricted cash deposit in the amount of $0.4 million. The deposit isrecorded as non-current restricted cash at December 31, 2010 since the letter of credit is required until the lease expires in 2016.14. Equity incentive plansAs of December 31, 2010 the Company had two equity incentive plans, the Second Amended and Restated Management Equity Planadopted in December 2004 (the 2004 Plan) and the 2006 Equity Incentive Plan adopted in April 2006 (the 2006 Plan). An aggregate of680,754 shares were subject to outstanding options granted under the 2004 Plan as of December 31, 2010, and no additional options willbe granted under this plan. Reserved under the 2006 Plan as of December 31, 2010 are 5,619,924 shares of the Company’s commonstock of which 3,743,915 shares were subject to outstanding options and RSUs as of December 31, 2010. On January 1 of each year,the number of shares reserved under the 2006 Plan is automatically increased by 4% of the total number of shares of common stock thatare outstanding at that time, or, if less, by 1,500,000 shares (or such lesser number as may be approved by the Company’s board ofdirectors). As of January 1, 2011, the number of shares of common stock that may be issued under the 2006 Plan was automaticallyincreased by 1,121,655 shares, representing 4% of the total number of shares of common stock outstanding on January 1, 2010,increasing the total number of shares of common stock available for issuance under the Plan to 6,741,579 shares.Options are subject to terms and conditions established by the compensation committee of the board of directors. None of the stock-based awards are classified as a liability as of December 31, 2010. Option awards have 10-year contractual terms and all options grantedprior to December 31, 2006, options granted to new employees, and certain options granted to existing employees vest and becomeexercisable on the first anniversary of the grant date with respect to the 25% of the shares subject to option awards. The remaining 75% ofthe shares subject to the option awards vest and become exercisable monthly in equal installments thereafter over three years. Certainoption awards granted to existing employees after December 31, 2006 vest and become exercisable monthly in equal installments over fouryears. The initial stock options granted to directors upon their election vest and become exercisable in equal monthly installments over aperiod of four years, while the subsequent annual stock option grants to directors vest and become exercisable in equal monthlyinstallments over a period of one year. Certain option awards to executives and directors provide for accelerated vesting if there is a changein control of the Company. Certain option awards to employees and executives provide for accelerated vesting if the respective employee’sor executive’s service is terminated by the Company for any reason other than cause or permanent disability. When an option is exercised,the Company issues a new share of common stock.83 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued)A summary of option activity for the 2004 Plan is presented below: Weighted Average Weighted Average Number of Exercise Price at Remaining Term Aggregate (In thousands, except for share amounts) Shares Grant Date (Years) Intrinsic Value Outstanding at December 31, 2007 1,169,975 $1.77 7.75 $5,988 Forfeited (4,849) 5.27 Cancelled (10,878) 5.84 Outstanding at December 31, 2008 1,154,248 $1.72 6.72 $129 Cancelled (26,793) 3.30 Exercised (394,561) 1.17 Outstanding at December 31, 2009 732,894 $1.97 5.79 $6,798 Forfeited (4) 4.73 Exercised (52,136) 4.58 $137 Outstanding at December 31, 2010 680,754 $1.77 4.77 $5,232 Exercisable at December 31, 2010 680,754 $1.77 4.77 $5,232 A summary of option activity for the 2006 Plan is presented below: Weighted Average Weighted Average Number of Exercise Price at Remaining Term Aggregate (In thousands, except for share amounts) Shares Grant Date (Years) Intrinsic Value Outstanding at December 31, 2007 1,765,635 $26.08 9.14 $— Granted 1,412,250 4.75 Forfeited (19,903) 20.28 Cancelled (526,601) 9.89 Outstanding at December 31, 2008 2,631,381 $17.79 8.53 $— Granted 1,567,000 11.96 Forfeited (220,998) 24.17 Cancelled (308,443) 11.94 Exercised (184,095) 6.29 Outstanding at December 31, 2009 3,484,845 $15.91 8.45 $5,347 Granted 787,125 8.54 Forfeited (343,575) 24.99 Cancelled (471,957) 13.03 Exercised (131,648) 4.96 $364 Outstanding at December 31, 2010 3,324,790 $14.07 8.01 $3,426 Exercisable at December 31, 2010 1,696,957 $18.31 7.04 $1,781 The Company received a total of $0.9 million and $1.6 million in cash from the exercises of options during the year endedDecember 31, 2010 and December 31, 2009, respectively.A RSU is a stock award that entitles the holder to receive shares of the Company’s common stock as the award vests. The fair valueof each RSU was based on the closing price of the Company’s stock on the date of grant which equals the RSUs intrinsic value. EachDecember, the Compensation Committee approves RSUs for each of the Company’s employees to be awarded the following January.These awards vest in equal annual84 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued)installments over four years beginning January of the following year, provided that the employee remains employed with the Company. Asof December 31, 2010, there was $3.5 million of total unrecognized compensation cost related to unvested RSU awards granted under theCompany’s stock incentive plans.A summary of RSU activity for the 2006 Plan is presented below: Number of Weighted Average Aggregate (in thousands, except for share amounts) Shares Price/Share Fair Value Outstanding at January 1, 2007 — $— $— Granted 3,000 16.24 Unvested at December 31, 2007 3,000 $16.24 $21 Granted 623,000 0.57 Vested (750) 16.24 Cancelled (2,250) 16.24 Unvested at December 31, 2008 623,000 $0.57 $312 Granted 54,000 5.70 Vested (336,461) 1.11 Vested and unissued (286,500) 0.57 Cancelled (41,539) 2.81 Unvested at December 31, 2009 12,500 $0.80 $141 Granted 479,625 10.27 Vested (2,500) 0.80 Vested and unissued (59,562) 10.31 Cancelled (70,500) 11.67 Unvested at December 31, 2010 359,563 $9.75 $3,401 15. Employee benefit planThe Company has a defined contribution plan under the Internal Revenue Code Section 401(k). This plan covers substantially allemployees who meet minimum age and service requirements and allows participants to defer a portion of their annual compensation on apre-tax basis. Currently, the Company matches 50 percent up to the first six percent of employee contributions. All matchingcontributions have been paid by the Company. The employer match vests over a 4 year period. The total employer match was$0.1 million for the years ended December 31, 2010, 2009 and 2008, respectively.85 Vanda Pharmaceuticals Inc.Notes to the Consolidated Financial Statements — (Continued)16. Quarterly financial data (unaudited) First Second Third Fourth 2010 (in thousands, except for per share amounts) Quarter Quarter Quarter Quarter Revenue $12,421 $8,290 $7,246 $7,752 Income from operations 6,147 1,156 744 791 Net income 529 1,279 3,184 2,200 Net income per share Basic $0.02 $0.05 $0.11 $0.08 Diluted $0.02 $0.04 $0.11 $0.08 2009 Revenue $— $— $— $4,548 Loss from operations (6,557) (12,413) (7,735) (9,242)Net loss (6,504) (12,392) (7,725) (9,237)Basic and diluted net loss per share $(0.24) $(0.46) $(0.28) $(0.34)86 VANDA PHARMACEUTICALS INC.EXHIBIT INDEXExhibit No. Description 3.8 Form of Amended and Restated Certificate of Incorporation of the registrant (filed as Exhibit 3.8 to Amendment No. 2 tothe registrant’s Registration Statement on Form S-1 (File No. 333-130759), as filed on March 17, 2006, and incorporatedherein by reference) 3.10 Form of Certificate of Designation of Series A Junior Participating Preferred Stock (filed as Exhibit 3.10 to the registrant’scurrent report on Form 8-K (File No. 001-34186) as filed on September 25, 2008 and incorporated herein by reference) 3.11 Second Amended and Restated Bylaws of the registrant, as amended and restated on December 16, 2008 (filed as Exhibit3.11 to the registrant’s current report on Form 8-K (File No. 001-34186) as filed on December 17, 2008 and incorporatedherein by reference) 4.1 2004 Securityholder Agreement (as amended) (filed as Exhibit 4.1 to the registrant’s Registration Statement on Form S-1(File No. 333-130759), as originally filed on December 29, 2005, and incorporated herein by reference) 4.4 Specimen certificate representing the common stock of the registrant (filed as Exhibit 4.4 to Amendment No. 2 to theregistrant’s Registration Statement on Form S-1 (File No. 333-130759), as filed on March 17, 2006, and incorporatedherein by reference) 4.5 Rights Agreement, dated as of September 25, 2008, between the registrant and American Stock Transfer & TrustCompany, LLC, as Rights Agent (filed as Exhibit 4.5 to the registrant’s current report on Form 8-K (File No. 001-34186)as filed on September 25, 2008 and incorporated herein by reference) 4.6 Amendment to Rights Agreement, dated as of December 22, 2009, between the registrant and American Stock Transfer& Trust Company, LLC, as Rights Agent (filed as Exhibit 4.6 to the registrant’s current report on Form 8-K (File No.001-34186) as filed on December 22, 2009 and incorporated herein by reference) 10.1 Registrant’s Second Amended and Restated Management Equity Plan (filed as Exhibit 10.1 to the registrant’s RegistrationStatement on Form S-1 (File No. 333-130759), as originally filed on December 29, 2005, and incorporated herein byreference) 10.2# Sublicense Agreement between the registrant and Novartis Pharma AG dated June 4, 2004 (as amended) (relating toFanapt®) (filed as Exhibit 10.2 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1 (File No. 333-130759), as filed on February 16, 2006, and incorporated herein by reference) 10.3# Amended and Restated License, Development and Commercialization Agreement by and between Bristol-Myers SquibbCompany and the registrant dated July 24, 2005 (relating to tasimelteon) (filed as Exhibit 10.3 to Amendment No. 1 to theregistrant’s Registration Statement on Form S-1 (File No. 333-130759), as filed on February 16, 2006, and incorporatedherein by reference) 10.7 Lease Agreement between the registrant and Red Gate III LLC dated June 25, 2003 (lease of Rockville, MD office space)(filed as Exhibit 10.7 to the registrant’s Registration Statement on Form S-1 (File No. 333-130759), as originally filed onDecember 29, 2005, and incorporated herein by reference) 10.8 Amendment to Lease Agreement between the registrant and Red Gate III LLC dated September 27, 2003 (filed as Exhibit10.8 to the registrant’s Registration Statement on Form S-1 (File No. 333-130759), as originally filed on December 29,2005, and incorporated herein by reference) 10.9 Lease Agreement between the registrant and MCC3 LLC (by Spaulding and Slye LLC) dated August 4, 2005 (filed asExhibit 10.9 to the registrant’s Registration Statement on Form S-1 (File No. 333-130759), as originally filed onDecember 29, 2005, and incorporated herein by reference) 10.10 Summary Plan Description provided for the registrant’s 401(k) Profit Sharing Plan & Trust (filed as Exhibit 10.10 to theregistrant’s Registration Statement on Form S-1 (File No. 333-130759), as originally filed on December 29, 2005, andincorporated herein by reference) 10.11 Form of Indemnification Agreement entered into by directors (filed as Exhibit 10.11 to the registrant’s RegistrationStatement on Form S-1 (File No. 333-130759), as originally filed on December 29, 2005, and incorporated herein byreference)87 Exhibit No. Description 10.17 2006 Equity Incentive Plan (filed as Exhibit 10.17 to Amendment No. 2 to the registrant’s Registration Statement on FormS-1 (File No. 333-130759), as filed on March 17, 2006, and incorporated herein by reference) 10.19 Amendment to Lease Agreement between the registrant and MCC3 LLC (by Spaulding and Slye LLC) dated November15, 2006 (filed as Exhibit 10.19 to the registrant’s annual report on Form 10-K (File No. 000-51863) for the year endingDecember 31, 2006 and incorporated herein by reference) 10.20 Form of Tax Indemnity Agreement (filed as Exhibit 10.20 to the registrant’s quarterly report on Form 10-Q (File No. 000-51863) for the period ending September 30, 2007 and incorporated herein by reference) 10.22 Second Amendment to Lease Agreement between the registrant and MCC3 LLC (by Spaulding and Slye MCC3 LLC)dated September 14, 2007 (filed as Exhibit 10.22 to the registrant’s annual report on Form 10-K (File No. 000-51863) forthe year ending December 31, 2007 and incorporated herein by reference) 10.33 Amended and Restated Employment Agreement for William D. Clark dated December 16, 2008 (filed as Exhibit 10.33 tothe registrant’s quarterly report on Form 10-Q (File No. 001-34186) for the quarter ending June 30, 2009 and incorporatedherein by reference) 10.34 Amended and Restated Employment Agreement for Mihael H. Polymeropoulos dated December 16, 2008 (filed as Exhibit10.34 to the registrant’s quarterly report on Form 10-Q (File No. 001-34186) for the quarter ending June 30, 2009 andincorporated herein by reference) 10.35 Employment Agreement for Stephanie R. Irish dated May 22, 2009 (filed as Exhibit 10.35 to the registrant’s quarterlyreport on Form 10-Q (File No. 001-34186) for the quarter ending June 30, 2009 and incorporated herein by reference) 10.36 Employment Agreement for John Feeney dated May 22, 2009 (filed as Exhibit 10.36 to the registrant’s quarterly report onForm 10-Q (File No. 001-34186) for the quarter ending June 30, 2009 and incorporated herein by reference) 10.37# Amended and Restated Sublicense Agreement between the registrant and Novartis Pharma AG dated October 12, 2009(relating to Fanapt®) (filed as Exhibit 10.37 to the registrant’s annual report on Form 10-K for the year endingDecember 31, 2009 and incorporated herein by reference) 10.38 Employment Agreement for James Kelly dated December 13, 2010. 10.39 Amendment dated December 16, 2010 to Amended and Restated Employment Agreement for Mihael H. Polymeropoulosdated December 16, 2008 10.40 Amendment dated December 16, 2010 to Employment Agreement for John Feeney dated May 22, 2009 10.41 Amended and Restated Tax Indemnity Agreement dated December 16, 2010 by and between the Registrant and Mihael H.Polymeropoulos 23.1 Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm 31.1 Certification of the Chief Executive Officer, as required by Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification of the Chief Financial Officer as required by Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Certifications of the Chief Executive Officer and Chief Financial Officer as required by 18 U.S.C. 1350 32.2 Certifications of the Chief Executive Officer and Chief Financial Officer as required by 18 U.S.C. 1350#Confidential treatment has been granted with respect to certain provisions of this exhibit.88Exhibit 10.38VANDA PHARMACEUTICALS INC.EMPLOYMENT AGREEMENT This Employment Agreement (this “Agreement”) was entered into as of December 13, 2010, by and between James Kelly (the “Executive”) and VandaPharmaceuticals Inc., a Delaware corporation (the “Company”). 1. Duties and Scope of Employment. (a) Position. For the term of his employment under this Agreement (“Employment”), the Company agrees to employ the Executive in the position ofSenior Vice President, Chief Financial Officer, Treasurer and Secretary. The Executive shall be subject to the supervision of, and shall have such authority asis delegated to him by, the Company’s Chief Executive Officer. The Executive hereby accepts such employment and agrees to undertake the duties andresponsibilities normally inherent in such position and such other duties and responsibilities as the Company’s Board of Directors (the “Board”) shall fromtime to time reasonably assign to him. (b) Obligations to the Company. During the term of his Employment, the Executive shall devote his full business efforts and time to the Company.During the term of his Employment, without the prior written approval of the Board, the Executive shall not render services in any capacity to any otherperson or entity and shall not act as a sole proprietor or partner of any other person or entity or as a shareholder owning more than five percent of the stock ofany other corporation. The Executive shall comply with the Company’s policies and rules, as they may be in effect from time to time during the term of hisEmployment. (c) No Conflicting Obligations. The Executive represents and warrants to the Company that he is under no obligations or commitments, whethercontractual or otherwise, that are inconsistent with his obligations under this Agreement. The Executive represents and warrants that he will not use ordisclose, in connection with his Employment, any trade secrets or other proprietary information or intellectual property in which the Executive or any otherperson has any right, title or interest and that his Employment as contemplated by this Agreement will not infringe or violate the rights of any other person orentity. The Executive represents and warrants to the Company that he has returned all property and confidential information belonging to any prior employers. 2. Cash and Incentive Compensation. (a) Salary. The Company shall pay the Executive as compensation for his services a base salary at a gross annual rate of not less than $285,000. Suchsalary shall be payable in accordance with the Company’s standard payroll procedures. (The annual compensation specified in this Subsection (a), togetherwith any increases in such compensation that the Company may grant from time to time, is referred to in this Agreement as “Base Compensation.”)  (b) Incentive Bonuses. The Executive shall be eligible for an annual incentive bonus with a target amount equal to 40% of his Base Compensation (the“Annual Target Bonus”). Such bonus (if any) shall be awarded based on objective or subjective criteria established in advance by the Board. Any bonus forthe fiscal year in which Executive’s employment begins shall be prorated, based on the number of days Executive is employed by the Company during thatfiscal year. Any incentive bonus for a fiscal year shall in no event be paid later than 21/2 months after the close of such fiscal year. Except as provided inSection 6, such bonus shall be paid only if Executive is employed by the Company at the time of payment. The determinations of the Board with respect tosuch bonus shall be final and binding. (c) Stock Options. On the date of this Agreement, the Company shall grant the Executive a nonstatutory stock option to purchase 150,000 shares of theCompany’s Common Stock (the “Option”). The per-share exercise price of the Option shall be equal to the fair market value of one share of the Company’sCommon Stock on the date of grant. The maximum term of the Option shall be 10 years, subject to earlier expiration in the event of the termination of theExecutive’s service with the Company. The grant of the Option shall be subject to the terms and conditions set forth in the Vanda Pharmaceuticals Inc. 2006Equity Incentive Plan and in the Company’s standard form of Stock Option Agreement. The Option will become exercisable with respect to 25% of the shareson the first anniversary of the date of this Agreement and with respect to the remaining 75% of the shares in equal monthly installments over the next 3 years ofcontinuous service thereafter. The Option shall become exercisable in full if (i) the Company is subject to a Change in Control before the Executive’s servicewith the Company terminates and (ii) the Executive is subject to an Involuntary Termination within 24 months after such Change in Control. In addition, Section 6(d) shall apply to the Option. (d) Restricted Stock Units. On the date of this Agreement, the Company shall grant the Executive restricted stock units covering 50,000 shares of theCompany’s Common Stock (the “RSU Award”). The grant of the RSU Award shall be subject to the terms and conditions set form in the VandaPharmaceuticals Inc. 2006 Equity Incentive Plan and in the Company’s standard form of Restricted Stock Unit Award Agreement. The RSU Award will vestwith respect to 25% of the shares on January 1, 2012, an additional 25% of the shares on January 1, 2013, an additional 25% of the shares on January 1,2014, and the final 25% of the shares on January 1, 2015, provided that Executive’s remains in continuous service with the Company on each applicablevesting date. The RSU Award shall vest in full if (i) the Company is subject to a Change in Control before the Executive’s service with the Companyterminates and (ii)the Executive is subject to an Involuntary Termination within 24 months after such Change in Control. 3. Vacation and Employee Benefits. During the term of his Employment, the Executive shall be eligible for 20 paid vacation days each year inaccordance with the Company’s standard policy for similarly situated employees, as it may be amended from time to time. During the term of hisEmployment, the Executive shall be eligible to participate in any employee benefit plans maintained by the Company for similarly situated employees, subjectin each case to the generally applicable terms and conditions of the plan in question and to the determinations of any person or committee administering suchplan.2 4. Business Expenses. During the term of his Employment, the Executive shall be authorized to incur necessary and reasonable travel, entertainment andother business expenses in connection with his duties hereunder. The Company shall reimburse the Executive for such expenses upon presentation of anitemized account and appropriate supporting documentation, all in accordance with the Company’s generally applicable policies. Any reimbursement shall(a) be paid promptly but not later than the last day of the calendar year following the year in which the expense was incurred, (b) not be affected by any otherexpenses that are eligible for reimbursement in any calendar year and (c) not be subject to liquidation or exchange for another benefit. 5. Term of Employment. (a) Basic Rule. The Company agrees to continue the Executive’s Employment, and the Executive agrees to remain in Employment with the Company,from the date of this Agreement until the date when the Executive’s Employment terminates pursuant to Subsection (b) below. The Executive’s Employmentwith the Company shall be “at will,” meaning that either the Executive or the Company may terminate the Executive’s Employment at any time, with orwithout Cause. Any contrary representations which may have been made to the Executive shall be superseded by this Agreement. This Agreement shallconstitute the full and complete agreement between the Executive and the Company on the “at will” nature of the Executive’s Employment, which may only bechanged in an express written agreement signed by the Executive and a duly authorized officer of the Company (other than the Executive). (b) Termination. The Company may terminate the Executive’s Employment at any time and for any reason (or no reason), and with or without Cause,by giving the Executive notice in writing. The Executive may terminate his Employment by giving the Company 14 days’ advance notice in writing. TheExecutive’s Employment shall terminate automatically in the event of his death. (c) Rights Upon Termination. Except as expressly provided in Section 6, upon the termination of the Executive’s Employment pursuant to thisSection 5, the Executive shall only be entitled to the compensation, benefits and reimbursements described in Sections 2, 3 and 4 for the period preceding theeffective date of the termination. The payments under this Agreement shall fully discharge all responsibilities of the Company to the Executive. (d) Termination of Agreement. This Agreement shall terminate when all obligations of the parties hereunder have been satisfied. The termination ofthis Agreement shall not limit or otherwise affect any of the Executive’s obligations under Section 7. 6. Termination Benefits. (a) General Release. Any other provision of this Agreement notwithstanding, Subsections (b), (c) and (d) below shall not apply unless a generalrelease of all known and unknown claims that the Executive may then have against the Company or persons affiliated with the Company becomes effective bythe Release Deadline (as defined below), (ii) has agreed not to prosecute any legal action or other proceeding based upon any of such3 claims and (iii) has returned all property of the Company in the Executive’s possession. The release shall be in a form prescribed by the Company, withoutalterations, and must become effective on or before the 60th day following the Executive’s Separation (the “Release Deadline”). (b) Severance Pay. If, during the term of this Agreement, a Separation occurs because the Company terminates the Executive’s Employment for anyreason other than Cause or Permanent Disability, or because the Executive terminates his Employment within six months after a condition constituting GoodReason arises, then the Company shall pay the Executive both of the following: (i) Base Compensation. His Base Compensation for a period of 12 months following the Separation (the “Continuation Period”). Such BaseCompensation shall be paid at the rate in effect at the time of the Separation and in accordance with the Company’s standard payroll procedures. Thesalary continuation payments shall commence on the Company’s next regularly scheduled payroll that occurs following the Release Deadline, and thefirst payment will include amounts that would have been paid between the Separation date and the first payment date but for the obligation to deliveran effective release of claims. (ii) Target Bonus. An amount equal to his Annual Target Bonus at the rate in effect at the time of the Separation. Such amount shall be payablein a lump sum on the Company’s next regularly scheduled payroll that occurs following the Release Deadline. (c) Health Insurance. If Subsection (b) above applies, and if the Executive elects to continue his health insurance coverage under the ConsolidatedOmnibus Budget Reconciliation Act (“COBRA”) following the Separation, then the Company shall pay the Executive’s monthly premium under COBRAuntil the earliest of (i) the close of the Continuation Period, (ii) the expiration of the Executive’s continuation coverage under COBRA and (iii) the date when theExecutive is offered substantially equivalent health insurance coverage in connection with new employment or self-employment. (d) Options. If, during the term of this Agreement, a Separation occurs because the Company terminates the Executive’s Employment for any reasonother than Cause or Permanent Disability, then (i) the vested portion of the shares of the Company’s Common Stock subject to all options held by theExecutive at the time of his Separation shall be determined by adding three months to the actual period of service that he has completed with the Company and(ii) such options shall be exercisable for six months after the Executive’s Separation. 7. Non-Solicitation, Non-Disclosure and Non-Competition. The Executive has entered into a Proprietary Information and Inventions Agreement with theCompany, which agreement is incorporated herein by reference.4 8. Successors. (a) Company’s Successors. This Agreement shall be binding upon any successor (whether direct or indirect and whether by purchase, lease, merger,consolidation, liquidation or otherwise) to all or substantially all of the Company’s business and/or assets. For all purposes under this Agreement, the term“Company” shall include any successor to the Company’s business and/or assets which becomes bound by this Agreement. (b) Executive’s Successors. This Agreement and all rights of the Executive hereunder shall inure to the benefit of, and be enforceable by, theExecutive’s personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. 9. Definitions. For all purposes under this Agreement: “Cause” shall mean: (a) An unauthorized use or disclosure by the Executive of the Company’s confidential information or trade secrets, which use or disclosure causesmaterial harm to the Company; (b) A material breach by the Executive of any agreement between the Executive and the Company; (c) A material failure by the Executive to comply with the Company’s written policies or rules; (d) The Executive’s conviction of, or plea of “guilty” or “no contest” to, a felony under the laws of the United States or any State thereof; (e) The Executive’s gross negligence or willful misconduct; (f) A continuing failure by the Executive to perform assigned duties after receiving written notification of such failure from the Board; or (g) A failure by the Executive to cooperate in good faith with a governmental or internal investigation of the Company or its directors, officers oremployees, if the Company has requested the Executive’s cooperation. “Change in Control” shall mean: (a) The consummation of a merger or consolidation of the Company with or into another entity or any other corporate reorganization, if persons whowere not stockholders of the Company immediately prior to such merger, consolidation or other reorganization own immediately after such merger,consolidation or other reorganization 50% or more of the voting power of the outstanding securities of each of (i) the continuing or surviving entity and (ii) anydirect or indirect parent corporation of such continuing or surviving entity;5 (b) The sale, transfer or other disposition of all or substantially all of the Company’s assets; (c) A change in the composition of the Board, as a result of which fewer than 50% of the incumbent directors are directors who either: (i) Had been directors of the Company on the date 24 months prior to the date of such change in the composition of the Board (the “OriginalDirectors”); or (ii) Were appointed to the Board, or nominated for election to the Board, with the affirmative votes of at least a majority of the aggregate of (A) theOriginal Directors who were in office at the time of their appointment or nomination and (B) the directors whose appointment or nomination waspreviously approved in a manner consistent with this Paragraph (ii); or (d) Any transaction as a result of which any person is the “beneficial owner” (as defined in Rule 13d-3 under the Securities Exchange Act of 1934, asamended (the “Exchange Act”)), directly or indirectly, of securities of the Company representing at least 50% of the total voting power represented by theCompany’s then outstanding voting securities. For purposes of this Subsection (d), the term “person” shall have the same meaning as when used in Sections13(d) and 14(d) of the Exchange Act but shall exclude (i) a trustee or other fiduciary holding securities under an employee benefit plan of the Company or of aparent or subsidiary of the Company and (ii) a corporation owned directly or indirectly by the stockholders of the Company in substantially the sameproportions as their ownership of the Common Stock of the Company. A transaction shall not constitute a Change in Control if its sole purpose is to change the State of the Company’s incorporation or to create a holdingcompany that will be owned in substantially the same proportions by the persons who held the Company’s securities immediately before such transaction. “Code” shall mean the Internal Revenue Code of 1986, as amended. “Good Reason” shall mean (i) a change in the Executive’s position with the Company that materially reduces his level of authority or responsibility,(ii) a material reduction in his Base Compensation or (iii) receipt of notice that his principal workplace will be relocated by more than 30 miles. A conditionshall not be considered “Good Reason” unless the Executive gives the Company written notice of such condition within 90 days after the initial existence ofsuch condition and the Company fails to remedy such condition within 30 days after receiving the Executive’s written notice. “Involuntary Termination” shall mean a Separation resulting from either (i) the Executive’s involuntary discharge by the Company for reasons otherthan Cause or (ii) the Executive’s voluntary resignation for Good Reason.6 “Permanent Disability” shall mean the Executive’s inability to perform the essential functions of the Executive’s position, with or without reasonableaccommodation, for a period of at least 120 consecutive days because of a physical or mental impairment. “Separation” shall mean a “separation from service,” as defined in the regulations under Section 409A of the Code, 10. Miscellaneous Provisions. (a) Notice. Notices and all other communications contemplated by this Agreement shall be in writing and shall be deemed to have been duly given whenpersonally delivered or when mailed by overnight courier, U.S. registered or certified mail, return receipt requested and postage prepaid. In the case of theExecutive, mailed notices shall be addressed to him at the home address that he most recently communicated to the Company in writing. In the case of theCompany, mailed notices shall be addressed to its corporate headquarters, and all notices shall be directed to the attention of its Secretary. (b) Modifications and Waivers. No provision of this Agreement shall be modified, waived or discharged unless the modification, waiver or dischargeis agreed to in writing and signed by the Executive and by an authorized officer of the Company (other than the Executive). No waiver by either party of anybreach of, or of compliance with, any condition or provision of this Agreement by the other party shall be considered a waiver of any other condition orprovision or of the same condition or provision at another time. (c) Whole Agreement. No other agreements, representations or understandings (whether oral or written and whether express or implied) which are notexpressly set forth in this Agreement have been made or entered into by either party with respect to the subject matter hereof. This Agreement and theProprietary Information and Inventions Agreement contain the entire understanding of the parties with respect to the subject matter hereof. (d) Tax Matters. All payments made under this Agreement shall be subject to reduction to reflect taxes or other charges required to be withheld by law.For purposes of Section 409A of the Code, each periodic salary continuation payment under Section 6(b)(i) is hereby designated as a separate payment. If theCompany determines that the Executive is a “specified employee” within the meaning of Section 409A(a)(2)(B)(i) of the Code and the regulations thereunder atthe time of his Separation, then: (i) Any salary continuation payments under Section 6(b)(i), to the extent not exempt from Section 409A of the Code, shall commence with theCompany’s first regularly scheduled payroll that occurs during the seventh month after the Executive’s Separation and, once such paymentscommence, any amounts accrued from the Separation date shall be paid in a lump sum on the first payment date; and7 (ii) Any lump-sum payment under Section 6(b)(ii), to the extent not exempt from Section 409A of the Code, shall be made with the Company’sfirst regularly scheduled payroll that occurs during the seventh month after the Executive’s Separation.The Company shall not have a duty to design its compensation policies in a manner that minimizes the Executive’s tax liabilities, and the Executive shall notmake any claim against the Company or the Board related to tax liabilities arising from the Executive’s compensation. (e) Choice of Law. The validity, interpretation, construction and performance of this Agreement shall be governed by the laws of the State of Maryland(except its provisions governing the choice of law). (f) Severability. The invalidity or unenforceability of any provision or provisions of this Agreement shall not affect the validity or enforceability ofany other provision hereof, which shall remain in full force and effect. (g) No Assignment. This Agreement and all rights and obligations of the Executive hereunder are personal to the Executive and may not be transferredor assigned by the Executive at any time. The Company may assign its rights under this Agreement to any entity that assumes the Company’s obligationshereunder in connection with any sale or transfer of all or a substantial portion of the Company’s assets to such entity. (h) Counterparts. This Agreement may be executed in two or more counterparts, each of which shall be deemed an original, but all of which togethershall constitute one and the same instrument.[REMAINDER OF PAGE LEFT BLANK INTENTIONALLY]8 IN WITNESS WHEREOF, each of the parties has executed this Agreement, in the case of the Company by its duly authorized officer, as of the date firstwritten above. /s/ James Kelly James Kelly Vanda Pharmaceuticals Inc. By Title: 9Exhibit 10.39VANDA PHARMACEUTICALS INC.December 16, 2010Mihael H. Polymeropoulos, M.D.c/o Vanda Pharmaceuticals Inc.9605 Medical Center DriveRockville, MD 20850Dear Mihael: You and Vanda Pharmaceuticals, Inc. (the “Company”) entered into an employment agreement as of February 10, 2005, as amended and restated as ofNovember 4, 2008 and further amended and restated as of December 16, 2009 (the “Employment Agreement”). To avoid potential adverse tax consequencesimposed by Section 409A of the Internal Revenue Code of 1986, as amended, the Employment Agreement is hereby further amended as follows: Section 6(a) of the Employment Agreement is hereby amended and restated as follows: (a) General Release. Any other provision of this Agreement notwithstanding, Subsections (b), (c) and (d) below shall not apply unless theEmployee (i) has executed a general release (in a form prescribed by the Company) of all known and unknown claims that he may then have against theCompany or persons affiliated with the Company and (ii) has agreed not to prosecute any legal action or other proceeding based upon any of such claims.The Company shall deliver the form of release to the Employee within 5 days after his Separation. The Employee shall execute the release within the periodset forth in the form, which shall be no later than 50 days after the Employee’s Separation. Section 6(b)(i) of the Employment Agreement is hereby amended and restated as follows: (b) Base Compensation. His Base Compensation for a period of 12 months following the Separation (the “Continuation Period”). Such BaseCompensation shall be paid at the rate in effect at the time of the Separation and in accordance with the Company’s standard payroll procedures. Thesalary continuation payments shall commence on the Company’s first payroll that occurs on or following the 61st day after the Employee’s Separation,provided that the release of claims described in Section 6(a) has become effective on or prior to the 60th day after the Employee’s Separation. Once suchsalary continuation payments commence, the first installment thereof will include all amounts that would have been paid had such payments commencedon the Separation date.  Mihael H. Polymeropoulos, M.D.December 16, 2010Page 2 The last sentence of Section 6(b)(ii) of the Employment Agreement is hereby amended and restated as follows: The Severance Bonus shall be payable on the Company’s first payroll that occurs on or following the 61st day after the Employee’s Separation,provided that the release of claims described in Section 6(a) has become effective on or prior to the 60th day after the Employee’s Separation. You may indicate your agreement with this amendment of the Employment Agreement by signing and dating the enclosed duplicate original of this letteragreement and returning it to me. This letter agreement may be executed in two counterparts, each of which will be deemed an original, but both of whichtogether will constitute one and the same instrument. Very truly yours,Vanda Pharmaceuticals Inc. By: /s/ James P. Kelly 12/16/10 Title: SVP & CFO I have read and accept this amendment: /s/ Mihael H. PolymeropoulosMihael H. Polymeropoulos, M.D. Dated: 12/16/2010 Exhibit 10.40VANDA PHARMACEUTICALS INC.December 16, 2010John Feeney, M.D.c/o Vanda Pharmaceuticals Inc.9605 Medical Center DriveRockville, MD 20850Dear John: You and Vanda Pharmaceuticals, Inc. (the “Company”) entered into an employment agreement as of May 22, 2009, (the “Employment Agreement”). Toavoid potential adverse tax consequences imposed by Section 409A of the Internal Revenue Code of 1986, as amended, the Employment Agreement is herebyfurther amended as follows: Section 6(b)(i) of the Employment Agreement is hereby amended and restated as follows: (i) Base Compensation. His Base Compensation for a period of 12 months following the Separation (the “Continuation Period”). Such BaseCompensation shall be paid at the rate in effect at the time of the Separation and in accordance with the Company’s standard payroll procedures. Thesalary continuation payments shall commence on the Company’s first payroll that occurs on or following the 61st day after the Employee’s Separation,provided that the release of claims described in Section 6(a) has become effective on or prior to the 60th day after the Employee’s Separation. Once suchsalary continuation payments commence, the first installment thereof will include all amounts that would have been paid had such payments commencedon the Separation date. Section 6(b)(ii) of the Employment Agreement is hereby amended and restated as follows: (ii) Target Bonus. An amount equal to his Annual Target Bonus at the rate in effect at the time of the Separation. Such amount shall be payable in alump sum on the Company’s first payroll that occurs on or following the 61st day after the Employee’s Separation, provided that the release of claimsdescribed in Section 6(a) has become effective on or prior to the 60th day after the Employee’s Separation.  John Feeney, M.D.December 16, 2010Page 2 You may indicate your agreement with this amendment of the Employment Agreement by signing and dating the enclosed duplicate original of this letteragreement and returning it to me. This letter agreement may be executed in two counterparts, each of which will be deemed an original, but both of whichtogether will constitute one and the same instrument. Very truly yours,Vanda Pharmaceuticals Inc. By: /s/ James P. Kelly 12/16/10 Title: SVP & CFO I have read and accept this amendment: /s/ John Feeney, M.D.John Feeney, M.D. Dated: 16 Dec 2010 Exhibit 10.41TAX INDEMNITY AGREEMENT This Amended and Restated Tax Indemnity Agreement (this “Agreement"') is made as of this 16th day of December 2010 by and between VandaPharmaceuticals Inc. (the “Company”) and Mihael H. Polymeropoulos (the “Executive"'). WHEREAS, the Compensation Committee of the Company’s Board of Directors has determined that the Company should enter into amended andrestated tax indemnity agreements with certain of its executives to reimburse certain excise taxes, interest and penalties they may be obligated to pay inconnection with a change of control of the Company, so that the Company may preserve the financial incentives the Company created by granting stockoptions to those executives, and so that the Company may also continue to provide motivation for those executives to stay with the Company and act in its bestinterests. NOW, THEREFORE, in consideration of the foregoing, and for other good and valuable consideration, the receipt and sufficiency of which is herebyacknowledged and agreed to, the parties hereto agree as follows: 1. Gross-Up Payment. If it is determined that any payment or distribution of any type to the Executive or for his benefit by the Company, any of itsaffiliates, any person who acquires ownership or effective control of the Company or ownership of a substantial portion of the Company’s assets (within themeaning of section 280G of the Internal Revenue Code of 1986, as amended (the “Code”), and the regulations thereunder) or any affiliate of such person,whether paid or payable or distributed or distributable pursuant to the terms of this Agreement or otherwise (the “Total Payments”), would be subject to theexcise tax imposed by section 4999 of the Code or any interest or penalties with respect to such excise tax (such excise tax and any such interest or penalties arecollectively referred to as the “Excise Tax”), then the Executive shall be entitled to receive an additional payment (a “Gross-Up Payment”) in an amountcalculated to ensure that after the Executive pays all taxes (and any interest or penalties imposed with respect to such taxes), including any Excise Tax,imposed upon the Gross-Up Payment, the Executive retains an amount of the Gross-Up Payment equal to the Excise Tax imposed upon the Total Payments. 2. Determination by Accountant. All determinations and calculations required to be made under this Agreement shall be made by an independentaccounting firm selected by the Executive from among the largest five accounting firms in the United States (the “Accounting Firm”). For purposes of makingthe calculations required by this Agreement, the Accounting Firm may make reasonable assumptions and approximations concerning applicable taxes and mayrely on reasonable, good-faith interpretations concerning the application of sections 280G and 4999 of the Code. The Company and the Executive shallfurnish to the Accounting Firm such information and documents as the Accounting Firm may reasonably request in order to make a determination under thisAgreement. The Accounting Firm shall provide its determination (the “Determination”), together with detailed supporting calculations regarding the amount ofany Gross-Up Payment and any other relevant matter, to the Executive and the Company within five days after the Executive or the Company made a request(if the Executive reasonably believes that any of the Total Payments may be subject to the Excise Tax). If the Accounting Firm determines that no Excise Tax ispayable by the Executive, it shall furnish the  Executive with a written statement that it has concluded that no Excise Tax is payable (including the reasons therefor) and that the Executive has substantialauthority not to report any Excise Tax on his federal income tax return. If a Gross-Up Payment is determined to be payable, it shall be paid to the Executivewithin five days after the Determination has been delivered to him or the Company, but in any event prior to the close of the calendar year next following thecalendar year in which the Excise tax was paid. Any determination by the Accounting Firm shall be binding upon the Company and the Executive, absentmanifest error. 3. Over- and Underpayments. As a result of uncertainty in the application of section 4999 of the Code at the time of the initial determination by theAccounting Firm hereunder, it is possible that Gross-Up Payments not made by the Company should have been made (''Underpayment”) or that Gross-UpPayments will have been made by the Company that should not have been made (“Overpayment”). In either event, the Accounting Firm shall determine theamount of the Underpayment or Overpayment that has occurred. In the case of an Underpayment, the Company shall promptly pay the amount of suchUnderpayment to the Executive or for his benefit, hi the case of an Overpayment, the Executive shall, at the direction and expense of the Company, take suchsteps as are reasonably necessary (including the filing of returns and claims for refund), follow reasonable instructions from, and procedures established by,the Company, and otherwise reasonably cooperate with the Company to correct such Overpayment, provided, however, that (i) the Executive shall in no eventbe obligated to return to the Company an amount greater than the net after-tax portion of the Overpayment that the Executive has retained or has recovered as arefund from the applicable taxing authorities and (ii) this provision shall be interpreted in a manner consistent with the intent of paragraph 1 above, which isto make the Executive whole, on an after-tax basis, from the application of the Excise Tax, it being understood that the correction of an Overpayment mayresult in the Executive’s repaying to the Company an amount that is less than the Overpayment. 4. Limitation on Parachute Payments. Any other provision of this Agreement notwithstanding, if the Excise Tax could be avoided by reducing the TotalPayments by $25,000 or less, then the Total Payments shall be reduced to the extent necessary to avoid the Excise Tax and no Gross-Up Payment shall bemade. If the Accounting Firm determines that the Total Payments are to be reduced under the preceding sentence, then the Company shall promptly give theExecutive notice to that effect and a copy of the detailed calculation thereof. If none of the Total Payments are subject to section 409A of the Code, then thereduction will occur in the manner elected by the Executive prior to the date of any such payment; provided, however, that if the manner elected by theExecutive pursuant to this sentence could in the opinion of the Company result in any of the Total Payments becoming subject to section 409A of the Code,then the following sentence will instead apply. If any of the Total Payments is subject to section 409A of the Code, or the Executive fails to elect an order underthe preceding sentence, then the reduction will occur in the following order: (i) cancellation of acceleration of vesting of any equity or equity-based awards(including options to purchase shares of the Company’s stock) for which the exercise price (if any) exceeds the then-fair market value of the underlying stockor other equity; (ii) reduction of cash payments (with such reduction being applied to the payments in the reverse order in which they would otherwise be made(that is, later payments will be reduced before earlier payments); and (iii) cancellation of acceleration of vesting of equity or equity-based awards not coveredunder (i) above; provided, however, that in the event that acceleration of vesting of equity or equity-based awards is to be cancelled, such acceleration of  vesting will be cancelled in the reverse order of the date of grant of such awards (that is, later awards will be canceled before earlier awards). 5. Whole Agreement. No other agreements, representations or understandings (whether oral or written and whether express or implied) which are notexpressly set forth in this Agreement have been made or entered into by either party with respect to the subject matter hereof. This Agreement contains the entireunderstanding of the parties with respect to the subject matter hereof. The Tax Indemnity Agreement entered into as of November 7, 2007, between theExecutive and the Company is hereby superseded.[The rest of this page has been intentionally left blank.]  IN WITNESS WHEREOF, the Company and the Executive have duly executed this Agreement as of the date first written above. VANDA PHARMACEUTICALS INC. /s/ James P Kelly 12/16/10 By: James P Kelly Its: SVP & CFO EXECUTIVE /s/ Mihael H. Polymeropoulos 12/16/10Mihael H. Polymeropoulos Exhibit 23.1CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (No. 333-133368, No. 333-138070, No. 333-141571,No. 333-148924, No. 333-156995, No. 333-164567 and No. 333-171962) and on Form S-3 (No. 333-171963) of Vanda Pharmaceuticals Inc. of our reportdated March 10, 2011 relating to the financial statements and the effectiveness of internal control over financial reporting, which appears in this Form 10-K./s/ PricewaterhouseCoopers LLPBaltimore, MarylandMarch 10, 2011EXHIBIT 31.1CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICERPURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Mihael H. Polymeropoulos, certify that: 1. I have reviewed this annual report on Form 10-K of Vanda Pharmaceuticals Inc.; 2. Based on my knowledge, this report does not contain any untrue statements of a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the consolidated financial statements, and other financial information included in this report, fairly present in all materialrespects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) forthe registrant and have: a. designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensurethat material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities,particularly during the period in which this report is being prepared; b. designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision,to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles; c. evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectivenessof the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d. disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s fourth fiscal quarterthat has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting.5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to theregistrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): a. all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likelyto adversely affect the registrant’s ability to record, process, summarize and report financial information; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control overfinancial reporting. Date: March 10, 2011 /s/ Mihael H. Polymeropoulos Mihael H. Polymeropoulos President and Chief Executive Officer(Principal Executive Officer) EXHIBIT 31.2CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICERPURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, James P. Kelly, certify that: 1. I have reviewed this annual report on Form 10-K of Vanda Pharmaceuticals Inc.; 2. Based on my knowledge, this report does not contain any untrue statements of a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the consolidated financial statements, and other financial information included in this report, fairly present in all materialrespects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) forthe registrant and have: a. designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensurethat material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities,particularly during the period in which this report is being prepared; b. designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision,to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles; c. evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectivenessof the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d. disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s fourth fiscal quarterthat has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting.5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to theregistrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): a. all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likelyto adversely affect the registrant’s ability to record, process, summarize and report financial information; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control overfinancial reporting. Date: March 10, 2011 /s/ James P. Kelly James P. Kelly Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) EXHIBIT 32.1CERTIFICATIONPURSUANT TO RULE 13A – 14(B) OF THE OF THE SECURITIES EXCHANGE ACT OF 1934AND 18 U.S.C. SECTION 1350In connection with the Annual Report of Vanda Pharmaceuticals Inc. (the “Registrant”) on Form 10-K for the annual period ended December 31, 2010 as filedwith the Securities and Exchange Commission on the date hereof (the “Report”), I, Mihael H. Polymeropoulos, certify, in accordance with Rule 13a-14(b) of theSecurities Exchange Act of 1934 and 18 U.S.C. Section 1350, that to the best of my knowledge: (1) The Report fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Registrant. Date: March 10, 2011 /s/ Mihael H. Polymeropoulos Mihael H. Polymeropoulos President and Chief Executive Officer(Principal Executive Officer) A signed original of this written statement required by Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350 has beenprovided to the Registrant and will be retained by the Registrant and furnished to the Securities and Exchange Commission or its staff upon request.This certification accompanies the Form 10-K to which it relates, is not deemed filed with the Securities and Exchange Commission and is not to beincorporated by reference into any filing of the Registrant under the Securities Act of 1933 or the Securities Exchange Act of 1934 (whether madebefore or after the date of the Form 10-K), irrespective of any general incorporation language contained in such filing. EXHIBIT 32.2CERTIFICATIONPURSUANT TO RULE 13A – 14(B) OF THE OF THE SECURITIES EXCHANGE ACT OF 1934AND 18 U.S.C. SECTION 1350In connection with the Annual Report of Vanda Pharmaceuticals Inc. (the “Registrant”) on Form 10-K for the annual period ended December 31, 2010 as filedwith the Securities and Exchange Commission on the date hereof (the “Report”), I, James P. Kelly, certify, in accordance with Rule 13a-14(b) of the SecuritiesExchange Act of 1934 and 18 U.S.C. Section 1350, that to the best of my knowledge: (1) The Report fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Registrant. Date: March 10, 2011 /s/ James P. Kelly James P. Kelly Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) A signed original of this written statement required by Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350 has beenprovided to the Registrant and will be retained by the Registrant and furnished to the Securities and Exchange Commission or its staff upon request.This certification accompanies the Form 10-K to which it relates, is not deemed filed with the Securities and Exchange Commission and is not to beincorporated by reference into any filing of the Registrant under the Securities Act of 1933 or the Securities Exchange Act of 1934 (whether madebefore or after the date of the Form 10-K), irrespective of any general incorporation language contained in such filing. 

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