10-K

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

þ	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the Fiscal Year Ended December 31, 2006
OR
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the transition period from          to

Commission File Number 000-23467

PENWEST PHARMACEUTICALS CO.

(Exact name of registrant as specified in its charter)

Washington	91-1513032
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
39 Old Ridgebury Road Suite 11 Danbury, Connecticut (Address of Principal Executive Offices)	06810-5120 (Zip Code)

Registrant’s telephone number, including area code:

(877) 736-9378

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

Common Stock, $.001 par value

(Including Associated Preferred Stock Purchase Rights)

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o     No þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Exchange Act of 1934. Yes o     No þ

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for at least the past 90 days. Yes þ     No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer o     Accelerated Filer þ     Non-Accelerated Filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o     No þ

The aggregate market value of the Registrant’s Common Stock held by non-affiliates as of June 30, 2006 was approximately $496,840,000 based on the last sale price of the Registrant’s Common Stock on the Nasdaq National Market on June 30, 2006. The number of shares of the Registrant’s Common Stock outstanding as of March 9, 2007 was 23,226,570.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of our definitive Proxy Statement relating to the 2007 Annual Meeting of Shareholders to be held on June 13, 2007 are incorporated by reference into Part III of this Form 10-K.

PENWEST PHARMACEUTICALS CO.

INDEX TO FORM 10-K

		Page
PART I
Item 1.	Business		1
Item 1A.	Risk Factors		13
Item 1B.	Unresolved Staff Comments		22
Item 2.	Properties		22
Item 3.	Legal Proceedings		22
Item 4.	Submission of Matters to a Vote of Security Holders		22
	Executive Officers of the Registrant		23
PART II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities		23
Item 6.	Selected Financial Data		24
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		25
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk		37
Item 8.	Financial Statements and Supplementary Data		37
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		37
Item 9A.	Controls and Procedures		37
Item 9B.	Other Information		40
PART III
Item 10.	Directors, Executive Officers and Corporate Governance		40
Item 11.	Executive Compensation		40
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		40
Item 13.	Certain Relationships and Related Transactions, and Director Independence		40
Item 14.	Principal Accounting Fees and Services		40
PART IV
Item 15.	Exhibits and Financial Statement Schedules		41
Signatures			42

Forward Looking Statements

This annual report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements, other than statements of historical facts, included or incorporated in this report regarding our strategy, future operations, financial position, future revenues, projected costs, prospects, plans and objectives of management are forward-looking statements. The words “believes,” “anticipates,” “estimates,” “plans,” “expects,” “intends,” “may,” “projects,” “will,” and “would” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We cannot guarantee that we actually will achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. There are a number of important factors that could cause our actual results to differ materially from those indicated or implied by forward-looking statements. These important factors include those set forth under “Risk Factors” in Item 1A. In addition, any forward-looking statements represent our estimates only as of the date this annual report is filed with the SEC and should not be relied upon as representing our estimates as of any subsequent date. We do not assume any obligation to update any forward-looking statements.

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PART I

ITEM 1.   BUSINESS

Overview

We develop pharmaceutical products based on innovative proprietary drug delivery technologies with a focus on products that address disorders of the nervous system. In June 2006, the United States Food and Drug Administration, or FDA, approved for marketing Opana^® ER, an extended release formulation of oxymorphone hydrochloride that we developed with Endo Pharmaceuticals Inc, or Endo, using our proprietary TIMERx^® drug delivery technology. We are currently developing product candidates designed for the treatment of pain, epilepsy, Parkinson’s disease and spasticity, as well as a product candidate for the treatment of edema resulting from congestive heart failure.

Opana ER.  Opana ER is an oral extended release opioid analgesic, which we developed with Endo using our proprietary TIMERx technology. Opana ER has been approved in the United States for twice-a-day dosing in patients with moderate to severe pain requiring continuous, around-the-clock opioid treatment for an extended period of time. Under the terms of our collaboration with Endo, Endo is responsible for marketing Opana ER in the United States. The product was launched by Endo in the United States in July 2006 in 5mg, 10mg, 20mg and 40mg tablets.

In January 2007, we signed an amendment to our strategic alliance agreement with Endo. Under the amendment, we and Endo agreed that royalties payable to us for U.S. sales of Opana ER would be calculated based on net sales of Opana ER rather than on operating profit and agreed to other related changes to the agreement. The amendment also resolved the parties’ dispute with regard to the sharing of marketing expenses during the period prior to when Opana ER reaches profitability.

Additional Product Candidates.  Of the products we are developing, we have two product candidates in clinical development.

•  Nalbuphine ER.  We are developing nalbuphine ER, a controlled release formulation of nalbuphine hydrochloride, for the treatment of pain. Nalbuphine ER, which we are developing using our TIMERx drug delivery technology, is designed to be taken as a tablet twice daily. We expect that nalbuphine ER, if approved, would compete in the moderate pain market with products such as Nubain^®, Tramadol^® ER, codeine and Demerol^®. We have completed a Phase I pharmacokinetic study of nalbuphine ER in which the formulation achieved the targeted blood levels, as well as a Phase IIa trial in which a single dose of nalbuphine ER positively reduced mean pain intensity in a dose-dependent manner over the 12-hour study period when compared to placebo. In January 2007, we commenced a Phase I dose escalation to steady state trial. The intent of this trial is to collect additional safety and pharmacokinetic data to assist us in designing a Phase IIa trial of the product candidate for chronic pain that we plan to commence in the third quarter of 2007.

•  Torsemide ER.  We are developing torsemide ER, a controlled release formulation of torsemide, a loop diuretic for the treatment of chronic edema, a condition involving excess fluid accumulation resulting from congestive heart failure, or CHF. Torsemide ER, which we are developing using our TIMERx drug delivery technology, is designed to be taken as a tablet once daily. We expect that torsemide ER, if approved, would compete with furosemide and other loop diuretics. We have completed several Phase I pharmacokinetic studies of torsemide ER and completed a Phase IIa study in which torsemide ER caused prolonged urinary sodium excretion in CHF patients. We intend to further refine our formulation and complete an additional Phase I pharmacokinetic study for torsemide ER in the first half of 2007. If the data from this Phase I study confirms the formulation and achieves the targeted blood level profiles, we intend to conduct a Phase II study comparing torsemide ER to Lasix, which we plan to commence in the second half of 2007.

We are also developing four other product candidates for the treatment of disorders of the nervous system. We are currently developing formulations and conducting pilot scale biostudies of these product candidates in either animals or humans to obtain pharmacokinetic data.

Our Strategies

Our business strategy is to build a specialty pharmaceutical company that develops and commercializes products that address disorders of the nervous system. The elements of our strategy include:

•  Focus on products that address disorders of the nervous system.  We are focusing on products that address disorders of the nervous system because we believe many of the currently approved products for the treatment of nervous system disorders can be enhanced by drug delivery technologies. In addition, we believe the market for treating nervous system disorders is an attractive market because many of these disorders are chronic in nature and are largely treated by specialist physicians that can be addressed with a relatively small sales force. If, however, we believe that we could develop a product that would address an unmet medical need and have a substantial market value, we may also selectively develop product candidates for diseases outside of the nervous system.

•  Reformulate existing drugs using drug delivery technologies.  We develop products by reformulating existing drugs utilizing proprietary drug delivery technologies. These drug delivery technologies include our own internally developed oral extended release technologies, as well as drug delivery technologies we may access through collaborations. When appropriate, we intend to utilize a “505(b)(2) regulatory strategy” to seek approval for our reformulations of existing drugs. Under this strategy, we will file a section 505(b)(2) New Drug Application, or a section 505(b)(2) NDA, which will rely on the FDA’s previous findings for the safety and effectiveness of the existing drug in addition to the data we generate regarding our reformulated drug. Because a section 505(b)(2) NDA may rely on the FDA’s previous findings, the trials that need to be conducted are generally more limited. Therefore, the development of a drug using the 505(b)(2) regulatory strategy is generally less costly and time consuming than the full NDA process.

•  Develop product candidates that have the potential for at least five years of exclusivity in the marketplace.  We intend to expand our portfolio to include product candidates for which we or our collaborators could obtain at least five years of exclusivity in the marketplace following marketing approval. This exclusivity could arise from meeting certain regulatory criteria for market exclusivity with the FDA, for example, in connection with the approval of new chemical entities or orphan drugs, or from intellectual property protection.

•  Continue to leverage and expand our proprietary drug delivery technologies.  We believe that we have significant expertise in drug formulation and in oral drug delivery technologies. Our proprietary drug delivery technologies, TIMERx controlled release, Geminex^® dual delivery, SyncroDose^® site-specific delivery and the gastroretentive system, are applicable to a wide range of drugs with different physical and chemical properties including water soluble and insoluble drugs, as well as high dose and low dose drugs. Using these technologies, we believe that we can formulate drugs with precise release profiles and improve the characteristics of existing drugs. In selecting product candidates for development, we intend to continue to focus on opportunities in which either our drug delivery technologies or other drug delivery technologies that we can access, can provide benefits to patients and result in branded, proprietary products. We intend to expand our proprietary drug delivery technologies by continuing to develop our core technologies, in-licensing or acquiring new technologies.

•  Commercialize product candidates independently and in collaboration with third parties.  We currently do not have any sales infrastructure. Opana ER is marketed by Endo; other of our marketed products are marketed by other collaborators. We expect that in the future, we will independently seek regulatory approval for most of our product candidates designed for the treatment of disorders of the nervous system. By retaining the rights to these products through approval, we believe that we can retain more value of such products if they are approved. In addition, we may retain marketing rights, or co-promotion rights, for our products that would be marketed to specialist physicians and build a relatively small specialty sales force to market these products. For those products that we selectively develop for the treatment of diseases outside of the nervous system, we plan to seek collaborators for the marketing of those products. The timing of seeking a collaborator will depend on a number of factors, including the costs of clinical development and our financing needs.

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Drug Delivery Technologies

We currently have four proprietary drug delivery technologies: TIMERx, a controlled-release technology; Geminex, a technology enabling drug release at two different rates; SyncroDose, a technology enabling controlled release at the appropriate site in the body; and our gastroretentive system, a technology enabling drug delivery to the upper gastrointestinal tract. Specifically, our TIMERx drug delivery platform is based on a hydrophilic matrix combining a heterodispersed mixture composed primarily of two polysaccharides, xanthan gum and locust bean gum, in the presence of dextrose. The physical interaction between these components works to form a strong, binding gel in the presence of water. We believe our drug delivery technologies have broad applicability across multiple therapeutic areas. To date, our technologies have been used in four products that have received regulatory approval, one in the United States and the others in countries in Europe or South America.

TIMERx

We developed our proprietary TIMERx delivery technology to address some limitations of other oral drug delivery technologies. We believe that the TIMERx technology has advantages over other oral drug delivery technologies because it is readily manufactured, adaptable to soluble and insoluble drugs and flexible for a variety of controlled release profiles. We continue to develop additional products in our pipeline using TIMERx and plan to seek to outlicense the technology to third parties for products outside of our strategic focus.

Under the TIMERx delivery system, drug release is controlled by the rate of water penetration from the gastrointestinal, or GI, tract into the TIMERx gum matrix, which expands to form a gel and subsequently releases the active drug substance. We can precisely control the release of the active drug substance in a tablet using the TIMERx technology by varying the proportion of the gums, together with the tablet coating and the tablet manufacturing process. Drugs using TIMERx technology are formulated by combining the active drug substance, the TIMERx matrix and additional excipients, and compressing the mixture into a tablet.

Geminex

Our patented Geminex dual release technology provides the independent release of one or more active ingredients in a single bi-layer tablet. The release of the active ingredients can be achieved at different rates involving two different controlled release profiles, or a controlled release and an immediate release profile. The technology is based on a bi-layer tablet that utilizes TIMERx matrix in the controlled release layer or layers.

SyncroDose

Our patented SyncroDose drug delivery system delivers the active drug sutbstance within a specific site in the GI tract or at the optimal time after ingestion, which is referred to as chronotherapeutic delivery. We believe that there are several disease states that can benefit from chronotherapeutic delivery including arthritis, cardiovascular disorders, asthma, neurological disorders and site-specific diseases such as GI cancers. SyncroDose is a technology based on our underlying TIMERx technology. The SyncroDose technology utilizes the TIMERx gum matrix in the coating of the tablet.

Gastroretentive

We developed our gastroretentive drug delivery system to provide controlled delivery of drugs in the upper GI tract. Drugs delivered orally are mostly absorbed in the stomach and the upper portions of the GI tract. By targeting delivery in the part of the stomach where a drug is absorbed, we believe we can increase the bioavailability of the drug, which could result in increased efficacy or a lower required dose of the drug.

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Products

Approved Products

Opana ER.  Opana ER is an oral extended release opioid analgesic that we developed with Endo using our proprietary TIMERx technology. In June 2006, Opana ER was approved in the United States for twice-a-day dosing in patients with moderate to severe pain requiring continuous, around-the-clock opioid treatment for an extended period of time. Under the terms of our collaboration with Endo, Endo is responsible for marketing Opana ER in the United States. The product was launched by Endo in the United States in July 2006 in 5mg, 10mg, 20mg and 40mg tablets.

Opana ER competes in the market for long acting, strong opioid analgesics with products such as Purdue Pharma’s OxyContin^® and MS Contin, Johnson and Johnson’s Duragesic^® patch, King Pharmaceuticals’ Avinza^® and Alpharma’s Kadian^®, as well as generic versions of some of these products. Products in the long acting, strong opioids market had aggregate sales in the United States in 2006 of approximately $3.0 billion.

To date, several other drug formulations utilizing our TIMERx technology have received regulatory approval in the United States, United Kingdom, Italy and Finland:

•  Nifedipine XL, a generic version of Pfizer, Inc.’s Procardia^® XL for the treatment of hypertension and angina that we developed with Mylan Pharmaceuticals Inc., is approved for sale in the United States. Mylan, which has the marketing rights for Nifedipine XL, is not marketing Nifedipine XL as a result of its acquisition from Pfizer of the right to market Pfizer’s generic versions of three strengths of Procardia XL under Pfizer’s NDA.

•  Cystrin CR, an extended release version of oxybutynin for the treatment of urge urinary incontinence, is approved for sale in Finland and has been licensed to Schering Oy.

•  Slofedipine XL, an extended release version of nifedipine for the treatment of angina, is approved for sale in the United Kingdom and Italy, and has been licensed to Sanofi-Aventis S.A. This product is no longer being marketed.

•  Cronodipin, an extended release version of nifedipine for the treatment of angina, is approved for sale in Brazil and has been licensed to Merck S.A. Industries Quimicas. We do not believe this product is being marketed any longer.

Products in Our Pipeline

We have a number of products in our development pipeline. The table below summarizes each of the products in this pipeline, including their respective intended therapeutic use. To date, we have retained all rights to these products.

Product	Therapeutic Category
Clinical Development
Nalbuphine ER (PW4142)	Moderate Chronic Pain
Torsemide ER (PW2132)	Edema/Congestive Heart Failure
Formulation and Phase 1 Biostudies
PW4110	Epilepsy
PW4153	Parkinson’s Disease
PW4158	Parkinson’s Disease
PW4159	Spasticity

Nalbuphine ER (PW4142)

We are developing nalbuphine ER, a controlled release formulation of nalbuphine hydrochloride, for the treatment of chronic pain. Nalbuphine ER, which we are developing using our TIMERx drug delivery

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technology, is designed to be taken as a tablet twice daily. Nalbuphine hydrochloride is a synthetic opioid agonist antagonist analgesic that blocks certain opioid receptors and potentially attenuates the development of tolerance and dependence. Nalbuphine hydrochloride is currently only available as a sterile solution suitable for subcutaneous, intramuscular or intravenous injection in a brand under the name Nubain and in a generic version. The annual sales of Nubain and its generic version were approximately $7.9 million in 2006, but we believe the market for this drug is limited by currently available formulations of the drug. We expect that nalbuphine ER, if approved, would compete in the moderate pain market against Nubain and oral drugs such as Tramadol ER, codeine and Demerol.

In December 2005, we completed a Phase IIa trial of nalbuphine ER designed to determine the degree and duration of pain relief of two different dose levels of nalbuphine ER in acute pain. The 165-patient Phase IIa trial was a pharmacokinetic-pharmacodynamic investigation of patients undergoing third molar extractions designed to correlate the level of analgesia in patients with the plasma level of the drug. Two different doses of nalbuphine ER were evaluated as single doses against placebo. Results from this Phase IIa study demonstrated that in the study nalbuphine ER reduced mean pain intensity in a dose-dependent manner over the twelve-hour period of the study. At both the higher and the lower dose level, we also observed in patients longer time to ingestion of rescue medication and lower proportion of patients requiring rescue analgesic therapy during the twelve-hour study period when compared to placebo. Finally, the percentage of patients experiencing at least a 50% reduction in pain intensity during the twelve-hour study period was higher for the both nalbuphine ER dose levels compared to placebo. No unusual side effects were reported during the twelve-hour dosing interval.

In 2006, we decided to develop this product for a chronic pain indication and conducted reformulation work and several Phase I studies to optimize the formulation for this purpose. In January 2007, we commenced a Phase I dose escalation to steady state trial. The intent of this trial is to collect additional safety and pharmacokinetic information which we can use to bridge the safety data from the acute pain trial we conducted in 2005 to a trial we intend to conduct in the second half of 2007. We expect data from this Phase I safety study in the second quarter of 2007. If the data from this trial supports a chronic pain trial, we intend to commence in the second half of 2007 a Phase IIa proof of concept trial in a chronic pain study comparing nalbuphine ER to placebo. We expect data from this Phase IIa trial by the end of 2007.

Torsemide ER (PW2132)

We are developing torsemide ER, a controlled release formulation of torsemide, a loop diuretic, for the treatment of edema related to CHF, which we are developing using our TIMERx drug delivery technology. CHF is a major cardiovascular disease affecting approximately 5 million patients in the United States according to the American Heart Association’s 2004 statistics on heart disease. The class of products to which torsemide belongs, loop diuretics, remains a key part of the clinical management of CHF. CHF patients are administered loop diuretics to facilitate the requirement that such patients excrete between 150mEq and 200mEq of sodium per day to prevent water retention related weight gain that can eventually lead to cardiac failure.

The current formulations of loop diuretics, which are all immediate release products, including Demadex, have short periods of action during which most of the sodium excretion caused by the drug occurs. These short periods of action can leave the patient unprotected for long periods of time during the day, when sodium retention can occur related to food intake. The short periods of action of existing loop diuretics can also create large urinary volume after drug ingestion, resulting in unpleasant side effects that can affect patient compliance.

We are developing torsemide ER to be taken as a tablet once-a-day, with the active drug ingredient designed to be released into the blood stream over a period of approximately 16 hours. We believe that this controlled release profile can provide more effective treatment of edema for patients with CHF by providing more measured diuresis over the course of the day. In particular, torsemide ER would provide release of torsemide during the waking hours when patients with CHF need protection from absorbing salt in connection with eating multiple meals over the course of the day.

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In 2004, we conducted a pharmacokinetic biostudy of torsemide ER outside the United States in approximately 20 healthy volunteers. In the study, torsemide ER achieved the plasma profiles we had targeted as endpoints of the study. Based on the results of the pilot biostudy, we filed an investigational new drug application, or IND, for torsemide ER in the United States. In the fourth quarter of 2005, we completed a Phase IIa study of torsemide ER in 37 patients. The study was an open-label, single-center study using a dose escalation trial design and studying the safety, pharmacokinetics and pharmacodynamics of single dose torsemide ER in patients with Class II or Class III CHF. Patients were placed on a sodium-restricted diet for three days prior to dosing. The study also included a comparator arm of Demadex 200 mg. The goal of the study was to investigate the total urinary sodium excretion in a 24-hour period, as well as the rate of sodium excretion over the 24-hour period. Administration of torsemide ER 100 mg resulted in a total urinary sodium excretion in a 24-hour period comparable to Demadex 200 mg. The study also showed that the total sodium excretion of torsemide ER was accomplished at a more sustained and slower rate over the course of the day using half the amount of drug that was in the Demadex formulation.

During 2006, we reformulated the product to address certain findings from our pervious studies and conducted two additional Phase I studies to optimize the formulation and the delivery of the drug. During the first half of 2007, we plan to conduct additional reformulation work on torsemide ER and conduct an additional Phase I study. If we are able to achieve the targeted blood levels in the Phase I study and are satisfied that the formulation has been optimized, then we intend to initiate a Phase II trial late in 2007. The Phase II study would be designed to compare the efficacy of torsemide ER to furosemide, a commonly prescribed generic loop diuretic. Following completion of these Phase II studies, we would seek to discuss further with the FDA the regulatory pathway for the approval of torsemide ER, including whether one Phase III pivotal safety and efficacy trial would be sufficient for approval if we seek approval under Section 505(b)(2) relying on the clinical data for Demadex, and the design of any required trials. We currently intend to seek a collaborator to market this product if approved. Our timing in seeking a collaborator will depend on a number of factors, including the results of our planned trials and our interactions with the FDA.

Additional Product Opportunities

We are developing formulations and conducting pilot scale Phase I biostudies on several product candidates primarily for the treatment of disorders of the nervous system. One of these product candidates is designed to treat epilepsy, two to treat Parkinson’s disease, and one to treat spasticity. Through our pilot scale Phase I biostudies, we are seeking to obtain pharmacokinetic data in either humans or animals. If the Phase I biostudies of any of these product candidates show the desired blood level profiles, we expect to advance the product candidate into further clinical trials, after considering a number of factors, such as our available resources, the size of the potential market, competitors in the potential market, the availability of intellectual property protection, the regulatory pathway and the development status of our other products. We will also determine how to advance the product, whether to develop the product, on our own and, if not, when to seek a collaborator.

Collaborative Agreements

We enter into collaborative agreements with pharmaceutical companies to develop, market or manufacture some of our products. We currently are parties to two types of collaborative agreements: joint development collaborative agreements and technology licensing collaborative agreements. In joint development collaborative agreements, such as our agreement with Endo, we jointly fund research and development with our collaborator. In these arrangements, we may receive up-front licensing fees or milestone payments. We may also receive royalties on the sales of the products by our collaborators. Technology licensing collaborative agreements involve the licensing of our TIMERx technology to a collaborator who is responsible for the development and marketing of a product using our technology. We may receive up-front licensing fees and milestone payments, and be entitled to receive royalties on our collaborators’ sales of the products covered by such collaborative arrangements and payments for the purchase of formulated TIMERx material by our collaborators.

In the future, we may enter into collaborative agreements involving the licensing of a product candidate after we complete some or all of the development work on the product candidate. Under this type of

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collaborative agreement, we anticipate that we would receive up-front licensing fees, milestone payments and royalties. For those product candidates which we seek to license prior to a regulatory filing, we would expect the collaborator to fund some of the development costs, as well as to market or co-promote the products upon approval. In determining whether and when to enter into such a collaborative agreement for a product, we will consider the complexity, the risk and cost of the development program, the level of marketing information required during development and the diseases for which the drug is intended.

Joint Development Collaborative Agreements

Endo Pharmaceuticals Inc.

In September 1997, we entered into a strategic alliance agreement with Endo with respect to the development of Opana ER, an extended release formulation of oxymorphone hydrochloride based on our TIMERx technology. This agreement was amended and restated in April 2002, and amended again in January 2007. Endo is a specialty pharmaceutical company with a market leadership position in pain management. Endo has a broad product line, including established brands such as Lidoderm^®, Percodan^®, Percocet^® and Frova^® as well as three newly launched products in 2006 including Opana ER, Opana^® and Synera^tm.

During the development of Opana ER, we formulated the product using our TIMERx technology and Endo conducted all clinical studies, and prepared and filed all regulatory applications. We have agreed to supply TIMERx material to Endo, and Endo has agreed to manufacture and market Opana ER in the United States. We also have agreed with Endo that any development and commercialization of Opana ER outside the United States would be accomplished through licensing to third parties approved by both Endo and us, and that we and Endo would divide equally any fees, royalties, payments or other revenue received by the parties in connection with such licensing activities. Endo is currently seeking collaborators for sales and marketing of Opana ER in Europe.

Prior to April 17, 2003, we shared with Endo the costs involved in the development of Opana ER. On April 17, 2003, we exercised our option under the terms of the Agreement and discontinued our participation in the funding of the development of Opana ER. We took this action because we believed that our strategic focus should be on funding other products in our development pipeline. As a result of this termination of funding, Endo completed the development of Opana ER and has the right to recoup the portion of development costs incurred by Endo that otherwise would have been funded by us.

We entered into an amendment in January 2007 as part of the resolution of a dispute between the parties with regard to the sharing of marketing expenses during the period prior to when Opana ER reaches profitability. Under the terms of the 2007 Amendment, we and Endo agreed that royalties payable to us for U.S. sales of Opana ER would be calculated based on net sales of the product rather than on operating profit. In connection with this change, we and Endo agreed:

•  Endo will pay us royalties on U.S. sales of Opana ER calculated based on a tiered royalty rate starting at 22% of annual net sales of the product up to $150 million of annual net sales, with the royalty rate increasing, based on agreed-upon levels of annual net sales achieved, from 25% up to a maximum of 30%.

•  No royalty payments will be due to us for the first $41 million of royalties that would otherwise have been payable beginning from the time of the product launch in July 2006.

•  Endo will pay us a percentage of any sublicense income it receives.

•  Endo will also pay us milestone payments up to $90 million based upon the achievement of agreed-upon annual sales thresholds.

•  Our share of the development costs for Opana ER that we opted out of funding in April 2003 is fixed at $28 million and will be recouped by Endo through a temporary 50% reduction in royalties. This temporary reduction in royalties will not apply until the threshold for the $41 million royalty holiday referred to above has been met.

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Technology Licensing Collaborative Agreements

Mylan Pharmaceuticals Inc.

In August 1994, we entered into product development and supply agreements with Mylan with respect to the development of Nifedipine XL, a generic version of Procardia^® XL, using our TIMERx technology. Procardia XL is a branded drug for the treatment of hypertension and angina that utilizes nifedipine as its active ingredient. Under the agreement, we were responsible for the formulation, manufacture and supply of TIMERx material for use in Nifedipine XL, and Mylan was responsible for conducting all bioequivalence studies, preparing all regulatory applications and submissions, and manufacturing and marketing Nifedipine XL in North America. In December 1999, the FDA approved Mylan’s Nifedipine XL 30 mg.

In March 2000, Mylan announced that it had signed a supply and distribution agreement with Pfizer to market an authorized generic version of all three strengths, 30 mg, 60 mg and 90 mg, of Procardia XL under Pfizer’s NDA. In connection with that agreement, Mylan decided not to market Nifedipine XL. As a result, Mylan entered a letter agreement with us under which Mylan agreed to pay us a royalty on all future net sales of Pfizer’s generic Procardia XL 30 mg. The royalty rate is comparable to that in our original agreement with Mylan for Nifedipine XL. Mylan has retained the marketing rights for Nifedipine XL 30mg. Mylan’s sales in the United States in 2006 of Pfizer’s generic Procardia XL 30 mg totaled approximately $25.9 million. The term of this letter agreement continues until such time as Mylan permanently ceases to market Pfizer’s generic Procardia XL. In 2006, 2005 and 2004, royalties from Mylan were approximately $3.1 million, $3.9 million and $4.8 million, respectively, or 89%, 63% and 94%, respectively, of our total revenue.

Research and Development

We conduct research and development activities on the development of product candidates utilizing our existing drug delivery technologies, as well as external drug delivery technologies we access through collaborators. Our research and development expenses in 2006, 2005 and 2004 were $22.9 million, $17.8 million and $20.2 million, respectively. These expenses do not include amounts incurred by our collaborators in connection with the development of products under our collaboration agreements, such as expenses for clinical trials performed by our collaborators or our collaborators’ share of funding.

Manufacturing

We currently have no internal commercial scale manufacturing capabilities. Under our existing collaboration agreements, our collaborators manufacture the pharmaceutical products and we supply bulk TIMERx materials to the collaborators. We have outsourced the commercial manufacture of bulk TIMERx materials to a third-party pharmaceutical company, Draxis Specialty Pharmaceuticals Inc., or Draxis. Under the manufacturing and supply agreement with Draxis, Draxis has agreed to exclusively manufacture TIMERx materials for us, and we have agreed to purchase from Draxis at least 50% of our annual requirements for these TIMERx materials. The agreement has an initial term that expires in November 2009, and will renew automatically for successive one-year periods unless either party gives notice of its intention not to renew 180 days prior to the then-current term. Either Draxis or we may terminate the agreement for the other’s bankruptcy, uncured breach, or for convenience on 18 months notice. We also agreed to purchase finished TIMERx materials and certain raw materials purchased by Draxis, under certain conditions, upon termination or expiration of the agreement. We have taken steps toward qualifying a second contract manufacturer as a second source of supply, including the completion of initial validation work. However, there is additional work required before the site is validated and we have decided that we will not complete this effort at the present time. We believe that there are a limited number of manufacturers that comply with current good manufacturing practices, or cGMP, regulations and are capable of manufacturing bulk TIMERx materials.

Our TIMERx technology is based on a hydrophilic matrix combining a heterodispersed mixture primarily composed of two polysaccharides, xanthan gums and locust bean gums, in the presence of dextrose. We

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purchase these gums from a primary supplier. We have also qualified alternate suppliers with respect to these gums. To date we have not experienced difficulty acquiring these materials.

Under our collaboration with Endo, we supply bulk TIMERx materials to Endo, and Endo is responsible for the manufacture of Opana ER. Endo has outsourced the commercial manufacture of Opana ER to a sole source third party manufacturer with which it has entered into a long-term manufacturing and development agreement.

Marketing and Distribution

We do not have a sales force for any products. We currently market our products through collaborators. Pursuant to our collaborative agreements, our collaborators have responsibility for the marketing and distribution of any pharmaceuticals developed based on our drug delivery technologies. In selecting a collaborator for a drug candidate, some of the factors we consider include the collaborator’s market presence in the therapeutic area targeted by the drug candidate, and the collaborator’s sales force and distribution network.

If we successfully develop one or more of the products for disorders of the nervous system and determine to retain the rights to market or co-promote, we plan to build or acquire a relatively small specialty sales force of approximately 50 to 100 sales representatives which targets specialty physicians to market these products. We believe that high prescribers of products for the treatment of disorders of the nervous system can be effectively targeted with a sales force of this size.

Patents and Proprietary Rights

We believe that patent and trade secret protection of our drug delivery technology and our products is important to our business, and that our success will depend in part on our ability to maintain existing patent protection, obtain additional patents, maintain trade secret protection and operate without infringing the proprietary rights of others.

Patents and Protection of Proprietary Information

As of February 28, 2007, we owned a total of 34 U.S. and 207 foreign patents. The U.S. patents principally cover our TIMERx technology, and its modifications and improvements, including the combination of the xanthan and locust bean gums, the oral solid dosage form of TIMERx and the method of preparation. Our patents also cover the application of TIMERx technology to various active drug substances. These patents will expire between 2008 and 2020.

We own one issued U.S. patent listed in the Orange Book for Opana ER. This patent expires in September 2008, although the product was granted New Dosage Form exclusivity which expires in June 2009. Endo and we are each prosecuting several additional patent applications to cover Opana ER. These U.S. patent applications and corresponding foreign patent applications relate to sustained release formulations of Opana ER, and methods of making and using the same formulation. Should any of these U.S. patent applications issue as patents, which is not guaranteed, they are likely to have patent expiration dates beyond 2022.

We also rely on trade secrets and proprietary knowledge, which we generally seek to protect by confidentiality and non-disclosure agreements with employees, consultants, licensees and other companies we conduct business with.

There has been substantial litigation in the pharmaceutical industry with respect to the manufacture, use and sale of drug products that are the subject of conflicting patent rights. Under the Waxman-Hatch Act, when an applicant files a section 505(b)(2) NDA or an Abbreviated New Drug Application, or ANDA, with the FDA with respect to a product covered by an unexpired patent listed in the Orange Book, the application must contain a certification with respect to each such patent stating either final approval of the section 505(b)(2) NDA or ANDA will not be sought until the expiration of the patent, which is referred to as a Paragraph III certification, or that the patent will not be infringed by the applicant’s product, or is invalid or unenforceable, which is referred to as a Paragraph IV certification. If the applicant makes a Paragraph IV certification, the applicant must give notice to the patent owner or the sponsor of the NDA for the brand name product. If the

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patent owner or the sponsor files a patent infringement lawsuit within 45 days of the receipt of such notice, the FDA will not grant final marketing approval to the Section 505(b)(2) NDA or the ANDA applicant until the earlier of a final judgment on the patent suit in favor of the applicant or 30 months (or such longer or shorter period as a court may determine) from the date of the certification. Patent litigation can be complex and costly, and could take up to several years to complete. The outcomes of patent litigation are difficult to predict. We evaluate the risk of patent infringement litigation with respect to each product we determine to develop.

Trademarks

TIMERx, Geminex and SyncroDose are our registered trademarks. Other tradenames and trademarks appearing in this annual report on Form 10-K are the property of their respective owners.

Government Regulation

Government authorities in the United States and other countries extensively regulate, among other things, the research, development, testing, manufacture, labeling, promotion, advertising, distribution and marketing of drug products. In the United States, the FDA regulates drug products under the Federal Food, Drug, and Cosmetic Act, or FDCA, and implements regulations and other laws. Failure to comply with applicable U.S. requirements, both before and after approval, may subject us to administrative and judicial sanctions, such as rejection of pending applications or delay in approving, warning letters, product recalls, product seizures, total or partial suspension of production or distribution, injunctions, and/or criminal prosecutions.

Before a drug product may be marketed in the United States, it must be approved by the FDA. The approval process requires substantial time, effort and financial resources, and we cannot be sure that any approval will be granted or granted on a timely basis. There are several kinds of applications that may be submitted to obtain FDA approval of drug products, including NDAs, section 505(b)(2) NDAs, or ANDAs. An NDA is a New Drug Application in which the information required for approval, including investigations of safety and effectiveness, comes from studies conducted by or for the sponsor of the NDA, or for which the sponsor has obtained a right of reference. A section 505(b)(2) NDA is an NDA in which at least some of the information required for approval comes from studies not conducted by or for the sponsor, and for which the sponsor has not obtained a right of reference. An ANDA is an application that utilizes for proof of safety and effectiveness data demonstrating that the drug is “bioequivalent” to a drug which the FDA has previously approved.

NDAs:  The steps required for the approval of an NDA include pre-clinical laboratory and animal tests and formulation studies; submission to the FDA of an IND for human clinical testing, which must become effective before human clinical trials may begin; adequate and well-controlled clinical trials to establish the safety and effectiveness of the product candidate for each indication for which approval is sought; submission to the FDA of the application; satisfactory completion of an FDA inspection of the manufacturing facility or facilities at which the drug is produced to assess compliance with cGMP; and FDA review and approval of the NDA.

Pre-clinical tests include laboratory evaluations of product chemistry, toxicity and formulation, as well as animal studies. The results of the pre-clinical tests, together with manufacturing information and analytical data, must be submitted to the FDA as part of an IND, which must become effective before human clinical trials may begin. An IND will automatically become effective 30 days after receipt by the FDA, unless before that time the FDA raises concerns or questions. Any concerns or questions raised by the FDA must be resolved before clinical trials may begin.

Clinical trials involve the administration of the investigational drug to human subjects under the supervision of qualified physician-investigators and healthcare personnel. Clinical trials are conducted under protocols detailing, for example, the parameters to be used in monitoring patient safety, and the safety and effectiveness criteria, or end points, to be evaluated.

Clinical trials are typically conducted in three phases; however, these phases may overlap or be combined. Each trial must be reviewed and approved by an independent Institutional Review Board before it can begin. Phase I usually involves the initial introduction of the investigational drug candidate into people to evaluate its

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safety, dosage tolerance, pharmacodynamics and, if possible, to gain an early indication of its effectiveness. Phase II usually involves trials in a limited patient population to evaluate dosage tolerance and appropriate dosage; identify possible adverse side effects and safety risks; and preliminarily evaluate the effectiveness of the drug candidate for specific indications. Phase III trials usually further evaluate clinical effectiveness and test further for safety by administering the drug candidate in its final form in an expanded patient population. We, our collaborators, or the FDA may suspend clinical trials at any time on various grounds, including a finding that the patients are being exposed to an unacceptable health risk.

Assuming successful completion of the required clinical testing, the results of the preclinical studies and the clinical studies, together with other detailed information, including information on the manufacture and composition of the product, are submitted in an NDA requesting approval to market the product for one or more indications. Before approving an application, the FDA usually will inspect the facility or the facilities at which the product candidate is manufactured to ensure that cGMP compliance is satisfactory. The FDA will approve an NDA only if it satisfies all regulatory criteria for approval. If the FDA determines the NDA does not meet certain regulatory criteria, the FDA may reject the application as not approvalable or outline the deficiencies in the NDA and request additional information. If the submission of the requested additional testing or information does not sufficiently address the deficiencies, the FDA ultimately may reject the application as not approvable.

505(b)(2) NDAs:  Section 505(b)(2) NDAs may be submitted for drug products that represent a modification of an already approved drug (such as a new indication or new dosage form) and for which investigations, in addition to bioavailability or bioequivalence studies, are essential to the drug’s approval. A section 505(b)(2) NDA may rely on the FDA’s previous findings of safety and effectiveness of the approved drug as well as information obtained by the Section 505(b)(2) applicant needed to support the modification of the listed drug. Preparing a 505(b)(2) NDA is generally less costly and time-consuming than preparing a full NDA.

The FDCA provides that the final approval of 505(b)(2) NDAs will be subject to certain conditions in various circumstances. For example, the holder of the NDA for the already-approved drug may be entitled to a period of market exclusivity, during which the FDA cannot finally approve the 505(b)(2) NDA. Also, if the already-approved drug is covered by one or more unexpired patents that are listed in the Orange Book, the 505(b)(2) NDA must contain a Paragraph III or Paragraph IV certification. If the 505(b)(2) NDA contains a Paragraph IV certification, the FDA will not finally approve the 505(b)(2) NDA until the earlier of a court decision in favor of the 505(b)(2) applicant or the expiration of 30 months from the date of certification, a period that may be shortened or extended by the court. The regulations governing marketing exclusivity and patent protection are complex and often uncertain.

ANDA’s:  The FDA may approve an ANDA if the product is the same in important respects as an already approved drug, or if the FDA has declared the drug suitable for an ANDA submission. For example, the FDA approved the ANDA submitted by our collaborator, Mylan, for the 30 mg dosage strength of a generic version of Procardia XL that we developed with Mylan. An ANDA must contain the same manufacturing and composition information as the NDA for the listed drug, but applicants need not submit preclinical and clinical safety and effectiveness data. Instead, they must submit studies showing that the product is bioequivalent to the already approved drug. Drugs are bioequivalent if the rate and extent of absorption of the drug does not show a significant difference from the rate and extent of absorption of the already-approved drug. Conducting bioequivalence studies is generally less time-consuming and costly than conducting pre-clinical and clinical studies necessary to support an NDA.

Like 505(b)(2) NDAs, final approvals of ANDAs are subject to certain conditions in various circumstances such as marketing exclusivity and patent certification. The regulations governing marketing exclusivity and patent certification relating to ANDAs are complex and often uncertain.

Other FDA Requirements:

After the marketing approval of a product by the FDA, certain changes to the approved product, such as adding new indications, manufacturing changes or additional labeling claims are subject to further FDA review and approval.

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In addition, regardless whether approval is sought under an NDA, a section 505(b)(2) NDA or an ANDA, we and our collaborators are required to comply with a number of FDA requirements both before and after approval. For example, the owner of an approved product is required to report certain adverse reactions and production problems to the FDA, and to comply with certain requirements concerning advertising and promotion for the product. Also, quality control and manufacturing procedures must continue to conform with cGMP after approval, and the FDA periodically inspects manufacturing facilities to assess compliance with cGMP. Accordingly, manufacturers must continue to expend time, money and effort in all areas of regulatory compliance, including production and quality control to comply with cGMP. In addition, discovery of problems such as safety problems may result in changes in labeling, or restrictions on a product manufacturer or NDA holder, including removal of the product from the market.

Competition

The pharmaceutical industry is highly competitive and is affected by new technologies, governmental regulations, healthcare legislation, availability of financing, litigation and other factors. Many of our competitors have longer operating histories and greater financial, technical, marketing, legal and other resources than us and some of our collaborators. In addition, many of our competitors have significantly greater experience than we have in conducting clinical trials of pharmaceutical products, obtaining FDA and other regulatory approvals of products, and marketing and selling approved products. We expect that we will be subject to competition from numerous other entities that currently operate or intend to operate in the pharmaceutical and specialty pharmaceutical industry.

The key factors affecting the success of our products are likely to include, among other things:

•  the safety and efficacy of our products;

•  the relative speed with which we can develop products;

•  generic competition for any product that we develop;

•  our ability to protect the intellectual property surrounding our products;

•  our ability to differentiate our products from our competitors’ products; and

•  external factors affecting pricing and/or reimbursement.

Our products in development will face competition from products with the same indication as the products we are developing. For instance, Opana ER competes with OxyContin and MS Contin, Duragesic patch, Avinza, Kadian and the generic version of some of these drugs. Each of these products is a potential treatment option for a physician managing a patient with moderate to severe, chronic pain.

Employees

As of March 1, 2007, we employed approximately 75 people, of whom 54 were primarily involved in research and development activities, and 21 were primarily involved in selling, general and administrative activities. As of March 1, 2007, none of our employees were covered by collective bargaining agreements. We consider our employee relations to be good.

Information Available on the Internet

Our internet address is www.penwest.com. We make available, free of charge through our website, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports filed or furnished pursuant to Section 12(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file such materials with the Securities and Exchange Commission, or SEC.

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ITEM 1A. — RISK FACTORS

Investing in our common stock involves a high degree of risk, and you should carefully consider the risks and uncertainties described below in addition to the other information included or incorporated by reference in this annual report on Form 10-K. If any of the following risks actually occurs, our business, financial condition or results of operations would likely suffer, possibly materially. In that case, the trading price of our common stock could fall.

We have not been profitable and expect to continue to incur substantial losses

We have incurred net losses since 1994, including net losses of $31.3 million, $22.9 million and $23.8 million during 2006, 2005 and 2004, respectively. As of December 31, 2006, our accumulated deficit was approximately $172 million.

Our strategy includes a significant commitment to spending on research and development targeted at identifying and developing products for the treatment of disorders of the nervous system. As a result, we expect to continue to incur net losses in 2007 as we continue to conduct development of and seek regulatory approvals for our product candidates. These net losses have had and will continue to have an adverse effect on our shareholders’ equity, total assets and working capital.

Our future profitability will depend on several factors, including:

•  the commercial success of Opana ER, and the timing and amount of royalties from Endo’s sales of Opana ER;

•  the level of our investment in research and development activities;

•  the successful development and commercialization of product candidates in our portfolio;

•  the level of investment for acquisitions or in-licensing of technologies or compounds intended to support our growth; and

•  royalties from Mylan’s sales of Pfizer’s generic Procardia XL 30 mg.

We may require additional funding, which may be difficult to obtain

As of December 31, 2006, we had cash, cash equivalents and short-term investments of $40.6 million. On March 13, 2007, we entered into a $24.0 million senior secured credit facility with Merrill Lynch Capital, a divison of Merrill Lynch Business Financial Services Inc. The credit facility consists of: (i) a $12.0 million term loan issued upon the closing of the credit facility and (ii) a $12.0 million term loan that we may access until September 15, 2008, subject to conditions specified in the agreement. We anticipate that, based on our current operating plan, our existing capital resources, the credit facility noted above and anticipated internally generated funds from royalties from Mylan will be sufficient to fund our operations on an ongoing basis without requiring us to seek additional external financing until at least late 2008.

Our requirements for additional capital may be substantial and will depend on many factors, including:

•  the commercial success of Opana ER;

•  the timing and amount of payments received under collaborative agreements, including in particular our agreement with Endo with respect to Opana ER and our agreement with Mylan with respect to Pfizer’s generic Procardia XL 30 mg;

•  the progress of our collaborative and internal development projects, funding obligations with respect to the projects, and the related costs to us of clinical studies for our product candidates;

•  the level of investment for the acquisition or in-licensing of technologies or compounds intended to support our growth;

•  the structure and terms of any future collaborative agreements;

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•  the prosecution, defense and enforcement of our patents and other intellectual property rights; and

•  the level of our investments in capital expenditures for facilities and equipment.

Subject to these factors, we may need to sell additional equity or debt securities or seek additional financing through other arrangements to fund operations beyond late 2008. In addition, if we decide to increase development work in our own internal portfolio or to acquire additional products or technologies, we may need to seek additional funding for such actions through collaborative agreements, research and development arrangements, or public or private financing of equity or debt.

If we raise additional funds by issuing equity securities, it will result in further dilution to our then-existing shareholders. Debt financing, such as the credit facility noted above, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. Any debt or equity financing may also contain terms, such as liquidation and other preferences, that are not favorable to us or our shareholders. If we raise additional funds through collaboration and licensing arrangements with third parties, it may be necessary to relinquish valuable rights to our technologies, research programs, or potential products or grant licenses on terms that may not be favorable to us. Additional financing may not be available in amounts or on terms acceptable to us, if at all. If we are unable to obtain additional financing, we may be required to delay, reduce the scope of, or eliminate one or more of our planned research, development and commercialization activities, which could harm our financial condition and operating results.

We depend heavily on the success of Opana ER, which may not be widely accepted by physicians, patients, third-party payors, or the medical community in general

We have invested a significant portion of our financial resources in the development of Opana ER. In the near term, our ability to generate significant revenues will depend primarily on the growth of Opana ER sales by Endo. Opana ER, which was approved by the FDA in June 2006 and launched by Endo in July 2006, may not be accepted by customers in the pharmaceutical market. In 2006, sales of Opana ER were less than was generally expected. Opana ER competes with a number of approved drugs manufactured and marketed by major pharmaceutical companies and generic versions of some of these drugs. It may have to compete against new drugs that are not yet marketed. The degree of market success of Opana ER depends on a number of factors, including:

•  the safety and efficacy of Opana ER as compared to competitive products;

•  Endo’s ability to educate the medical community about the safety and effectiveness of Opana ER;

•  the effectiveness of Endo’s sales and marketing activities;

•  Endo’s ability to manufacture and maintain suitable inventory for sale on an ongoing basis;

• the reimbursement policies of government and third party payors with respect to Opana ER;

•  the pricing of Opana ER; and

•  the level of stocking of Opana ER by wholesalers and retail pharmacies.

If Opana ER sales do not grow steadily or substantially, it would have a material adverse effect on our business, financial condition and results of operations.

In the event that we are able to obtain regulatory approval of any of our other products candidates, the success of those products would also depend upon their acceptance by physicians, patients, third party payors or the medical community in general. There can be no assurance as to market acceptance of our drug products and our drug delivery technologies.

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We are dependent on our collaborator Endo to manufacture, market and sell Opana ER, and in the future expect to be dependent on other collaborators to manufacture, market, and sell our other products

Opana ER and some of our other products have been developed and commercialized in collaboration with other pharmaceutical companies. Under these collaborations, we have typically been dependent on our collaborators to fund some portion of development, conduct clinical trials, obtain regulatory approvals for, and/or manufacture, market and sell products utilizing our drug delivery technologies. In particular, we are dependent on Endo to manufacture, market and sell Opana ER in the United States and on Mylan to market and sell Pfizer’s generic Procardia XL 30 mg.

We have limited experience in manufacturing, marketing and selling pharmaceutical products. Accordingly, if we cannot maintain our existing collaborations or establish new collaborations with respect to our other products in development, we will have to establish our own capabilities or discontinue commercialization of the affected products. Developing our own capabilities may be expensive and time consuming and could delay the commercialization of the affected product. There can be no assurance that we will be successful in developing these capabilities.

Our existing collaborations may be subject to termination on short notice under certain circumstances such as upon a bankruptcy event or if we breach the agreement. If any of our collaborations are terminated, we may be required to devote additional internal resources to the product, seek a new collaborator on short notice or abandon the product. The terms of any additional collaborations or other arrangements that we establish may not be favorable to us.

We are also at risk that these collaborations or other arrangements may not be successful. Factors that may affect the success of our collaborations include:

•  Our collaborators may be pursuing alternative technologies or developing alternative products, either on their own or in collaboration with others, that may be competitive to the product on which we are collaborating, which could affect our collaborator’s commitment to our collaboration.

•  Our collaborators may reduce marketing or sales efforts, or discontinue marketing or sales of our products. This could reduce the revenues we receive on the products.

•  Our collaborators may terminate their collaborations with us under certain circumstances. As a result, we may have to terminate the development of some drug candidates. This could also adversely affect perception of us in the business and financial communities and make it difficult for us to attract new collaborators.

•  Our collaborators may pursue higher priority programs or change the focus of their development programs, which could affect the collaborator’s commitment to us. Pharmaceutical and biotechnology companies re-evaluate their priorities from time to time, including following mergers and consolidations, which have been common in recent years in these industries.

•  Disputes may arise between us and our collaborators from time to time regarding contractual or other matters. In 2006, we were engaged in a dispute with Endo with regard to the sharing of marketing expenses during the period prior to when Opana ER reaches profitability. In January 2007, we resolved our dispute as part of an amendment to the agreement. Any other such disputes with Endo or other collaborators could be time consuming and expensive, and could impact our anticipated rights under our agreements with those collaborators.

The Drug Enforcement Agency, or DEA, limits the availability of the active drug substances used in Opana ER. As a result, Endo’s procurement quota may not be sufficient to meet commercial demand

Under the Controlled Substances Act of 1970, the DEA regulates chemical compounds as Schedule I, II, III, IV or V substances, with Schedule I substances considered to present the highest risk of substance abuse and Schedule V substances the lowest risk. The active drug substances in Opana ER, oxymorphone, is listed by the DEA as a Schedule II substance. Consequently, the manufacture, shipment, storage, sale and use of Opana ER

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are subject to a higher degree of regulation. For example, all Schedule II drug prescriptions must be signed by a physician, physically presented to a pharmacist and may not be refilled without a new prescription.

Furthermore, the DEA limits the availability of the active drug substances used in Opana ER. As a result, Endo’s procurement quota of the active drug substances may not be sufficient to meet commercial demands. Endo must apply to the DEA annually for procurement quota in order to obtain the substance. Any delay or refusal by the DEA in establishing the procurement quota could cause trade inventory disruptions which could have a material adverse effect on our business, financial position and results of operations.

We face significant competition, which may result in others discovering, developing or commercializing products before us or more successfully than we do

The pharmaceutical industry is highly competitive and is affected by new technologies, governmental regulations, health care legislations, availability of financing and other factors. Many of our competitors have:

•  significantly greater financial, technical and human resources than we have and may be better equipped to develop, manufacture and commercialize drug products;

•  more extensive experience than we have in conducting preclinical studies and clinical trials, obtaining regulatory approvals, and manufacturing and marketing pharmaceutical products;

•  competing products that have already received regulatory approval or are in late-stage development; and

•  collaborative arrangements in our target markets with leading companies and research institutions.

We face competition based on the safety and effectiveness of our products, the timing and scope of regulatory approvals, the availability and cost of supply, marketing and sales capabilities, reimbursement coverage, pricing, patent position and other factors. Our competitors may develop or commercialize more effective, safer or more affordable products, or obtain more effective patent protections. Accordingly, our competitors may commercialize products more rapidly or effectively than we do, which would adversely affect our competitive position, the likelihood that our product will achieve initial market acceptance and our ability to generate meaningful revenues from our products. Even if our products achieve initial market acceptance, competitive products may render our products obsolete or noncompetitive. If our products are rendered obsolete, we may not be able to recover the expenses of developing and commercializing those products.

We face competition from numerous public and private companies and their extended release technologies, including the oral osmotic pump (OROS) technology marketed by Johnson & Johnson, multiparticulate systems marketed by Elan Corporation plc, Biovail Corporation and KV Pharmaceutical Company, and traditional matrix systems marketed by SkyePharma plc.

Opana ER faces, and our products in development will face, competition from products with the same indication. For instance, Opana ER competes in the moderate to severe long acting opioid market with products such as OxyContin and MS Contin, Duragesic patch, Avinza and Kadian and the generic versions of some of these drugs.

Some of the products we are developing are proprietary products that are based on active drug substances that are not protected by patents. These products will compete against other products developed using the same or a similar active drug substances, including branded products, as well as their generic versions, based primarily on price. In addition, our products may compete against other competitive products in the same therapeutic class.

If our clinical trials are not successful or take longer to complete than we expect, we may not be able to develop and commercialize our products

In order to obtain regulatory approvals for the commercial sale of our products, we or our collaborators will be required to complete clinical trials in humans to demonstrate the safety and efficacy of the products. However, we may not be able to commence or complete these clinical trials in any specified time period,

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either because the FDA or other regulatory agencies object or for other reasons. With respect to our approved products, including Opana ER, we have relied on our collaborators to conduct clinical trials and obtain regulatory approvals. We intend to develop a significant portion of our current product candidates independently, including controlling the clinical trials and regulatory submissions with the FDA. We have limited experience in conducting Phase II and Phase III clinical trials and to date have not independently sought or obtained approval for the marketing of a drug product.

Even if we complete a clinical trial of one of our potential products, the clinical trial may not prove that our product is safe or effective to the extent required by the FDA, the European Commission, or other regulatory agencies to approve the product. We or our collaborators may decide, or regulators may require us or our collaborators, to conduct additional clinical trials. For example, in the approvable letter for Opana ER, the FDA required Endo to conduct an additional clinical trial which significantly delayed the approval of Opana ER. In another example, we terminated the development of PW2101, a beta blocker that we were developing for the treatment of hypertension and angina, because additional trials would have been required in order to address the concerns expressed in the non-approvable letter we received from the FDA in 2005. In addition, regulators may require post marketing testing and surveillance to monitor the safety and efficacy of a product.

The results from preclinical testing of a product that is under development may not be predictive of results that will be obtained in human clinical trials. In addition, the results of early human clinical trials may not be predictive of results that will be obtained in larger scale advanced stage clinical trials. Furthermore, we, our collaborators or the FDA may suspend clinical trials at any time if the subjects or patients participating in such trials are being exposed to unacceptable health risks or for other reasons.

The rate of completion of clinical trials is dependent in part upon the rate of enrollment of patients. Patient accrual is a function of many factors including the size of the patient population, the proximity of patients to clinical sites, the eligibility criteria for the study and the existence of competitive clinical trials. Delays in planned patient enrollment may result in increased costs and program delays.

If clinical trials do not show any potential product to be safe or efficacious, if we are required to conduct additional clinical trials or other testing of our products in development beyond those that we currently contemplate or if we are unable to successfully complete our clinical trials or other testing, we may:

•  be delayed in obtaining marketing approval for our products;

•  not be able to obtain marketing approval for our products; or

•  not be able to obtain approval for indications that are as broad as intended.

Our product development costs may also increase if we experience delays in testing or approvals. In addition, significant delays in clinical trials could allow our competitors to bring products to market before we do and impair our ability to commercialize our products.

Our controlled release drug delivery technologies rely on the ability to control the release of the active drug substances and our business would be harmed if it was determined that there were circumstances under which the active drug substances from one of our extended release products would be released rapidly into the blood stream

Our controlled release products and product candidates rely on our ability to control the release of the active drug substance. Some of the active ingredients in our controlled release products, including Opana ER, contain levels of active drug substance that could be harmful, even fatal, if the full dose of active drug substance were to be released over a short period of time, which is referred to as dose-dumping.

In 2005, Purdue Pharma voluntarily withdrew from the market its product Palladone^® hydromorphone hydrochloride extended-release capsules, after acquiring new information that serious and potentially fatal adverse reactions can occur when the product is taken together with alcohol. The data, gathered from a study testing the potential effects on the drug of alcohol use, showed that when Palladone is taken with alcohol, the extended-release mechanism is harmed and may lead to dose-dumping. In anticipation of questions from the

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FDA with respect to the potential dose-dumping effect of Opana ER given the FDA’s experience with Palladone, Endo conducted both in vitro and human testing of the effect of alcohol on Opana ER. In the in vitro testing, Endo did not find any detectible effect alcohol has on the time release mechanism of the product. In the human testing in the presence of alcohol, Endo does not believe that there was evidence of dose-dumping or signs of degradation of the controlled-release mechanism. Endo did note in this human testing a transient effect on blood levels that Endo believes reflects a short-lived increase in the absorption rate of oxymorphone already released from the tablet.

We are subject to extensive government regulation including the requirement of approval before our products may be marketed. Even if we obtain marketing approval, our products will be subject to ongoing regulatory review

We, our collaborators, our products, and our product candidates are subject to extensive regulation by governmental authorities in the United States and other countries. Failure to comply with applicable requirements could result in warning letters, fines and other civil penalties, delays in approving or refusal to approve a product candidate, product recall or seizure, withdrawal of product approvals, interruption of manufacturing or clinical trials, operating restrictions, injunctions and criminal prosecution.

Our products cannot be marketed in the United States without FDA approval. Obtaining FDA approval requires substantial time, effort and financial resources, and there can be no assurance that any approval will be granted on a timely basis if at all. We have had only limited experience in preparing applications and obtaining regulatory approvals. If the FDA does not approve our product candidates or does not approve them in a timely fashion, our business and financial condition may be adversely affected. Furthermore, the terms of marketing approval of any application, including the labeling content, may be more restrictive than we desire and could affect the marketability of our products.

Certain products containing our controlled release technologies require the submission of a full NDA. A full NDA must include complete reports of preclinical, clinical and other studies to prove adequately that the product is safe and effective. These studies may involve, among other things, full clinical testing, which requires the expenditure of substantial resources. In certain cases when we seek to develop a controlled release formulation of a FDA-approved drug with the same active drug substance, we may be able to rely on previous FDA determinations of safety and efficacy of the approved drug to support a section 505(b)(2) NDA. We can provide no assurance, however, that the FDA will accept a submission of a section 505(b)(2) NDA for any particular product. Even if the FDA did accept such a submission, the FDA may not approve the application in a timely manner or at all.

In addition, both before and after regulatory approval, we, our collaborators, our products, and our product candidates are subject to numerous FDA regulations covering testing, manufacturing, quality control, cGMP, adverse event reporting, labeling, advertising, promotion, distribution and export. We and our collaborators are subject to surveillance and periodic inspections by the FDA to ascertain compliance with these regulations. The relevant law and regulations may also change in ways that could affect us, our collaborators, our products and our product candidates. Failure to comply with regulatory requirements could have a material adverse impact on our business.

Opana ER contains a narcotic ingredient. As a result of reported misuse and abuse of prescription narcotics, the sale of Opana ER is subject to additional regulations, including the compliance with risk management programs, which may prove difficult or expensive to comply with; and we and Endo may face lawsuits

Opana ER contains a narcotic ingredient. Misuse or abuse of drugs containing narcotic ingredients can lead to physical or other harm. In the past few years, for example, reporteded misuse and abuse of OxyContin, a product containing the narcotic oxycodone, resulted in the strengthening of warnings on its labeling. The sponsor of OxyContin also faced numerous lawsuits, including class action lawsuits, related to OxyContin misuse or abuse. Misuse or abuse of Opana ER could also lead to additional regulations of Opana ER and subject us and Endo to litigation.

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Our success depends on our ability to protect our patents and other intellectual property rights

Our success depends in significant part on our ability to obtain patent protection for our products, both in the United States and in other countries, and our ability to enforce these patents. Patent positions can be uncertain and may involve complex legal and factual questions. Patents may not be issued from any patent applications that we own or license. If patents are issued, the claims allowed may not be as broad as we have anticipated and may not sufficiently cover our drug products or our technologies. In addition, issued patents that we own or license may be challenged, invalidated or circumvented. There is currently only one patent listed in the Orange Book for Opana ER, which expires in September 2008. We are currently prosecuting several additional patent applications that may cover Opana ER. However, there can be no assurance any of or all of these patent applications may be isssued.

Our research, development and commercialization activities, or any products in development may infringe or be claimed to infringe patents of competitors or other third parties. In such event, we may be ordered to pay such third party lost profit or punitive damages. We may have to seek a license from a third party and pay license fees or royalties. Awards of patent damages can be substantial. Licenses may not be available or available on acceptable terms, or the licenses may be nonexclusive, which could result in our competitors gaining access to the same intellectual property. If we or our collaborators are not able to obtain a license, we could be prevented from commercializing a product, or be forced to cease some aspect of our business operations.

Our success also depends on our ability to maintain the confidentiality of our trade secrets. We seek to protect such information by entering into confidentiality agreements with employees, consultants, licensees and other companies. These agreements may be breached by such parties. We may not be able to obtain an adequate remedy to such a breach. In addition, our trade secrets may otherwise become publicly known or be independently developed by our competitors.

We may become involved in patent litigation or other proceedings relating to our products or processes, which could result in liability for damages or termination of our development and commercialization programs

The pharmaceutical industry has been characterized by significant litigation, interference and other proceedings regarding patents, patent applications and other intellectual property rights. The types of situations in which we may become parties to such litigation or proceedings include:

•  We or our collaborators may initiate litigation or other proceedings against third parties to enforce our intellectual property rights.

•  If our competitors may file patent applications that claim technology also claimed by us, we or our collaborators may participate in interference or opposition proceedings to determine the priority of invention.

•  If third parties initiate litigation claiming that our processes or products infringe their patent or other intellectual property rights, we and our collaborators will need to defend our rights in such proceedings.

An adverse outcome in any litigation or other proceeding could subject us to significant liabilities and/or require us to cease using the technology that is at issue or to license the technology from third parties. We may not be able to obtain any required licenses to obtain it on commercially acceptable terms.

The cost of any patent litigation or other proceeding, even if resolved in our favor, could be substantial. In the past, the legal costs of defending litigation relating to a patent infringement claim have generally be the contractual responsibility of our marketing collaborators, unless such claim relates to TIMERx in which case such costs are our responsibility. We could nonetheless incur significant unreimbursed costs in participating and assisting in the litigation. Some of our competitors may have substantially greater resources to sustain the cost of such litigation and proceedings more effectively than we can. Uncertainties resulting from the initiation and continuation of patent litigation or other proceedings could have a material adverse effect on our ability to

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compete in the marketplace. Patent litigation and other proceedings may also absorb significant management time.

We have only limited manufacturing capabilities and will be dependent on third party manufacturers

We lack commercial scale facilities to manufacture our TIMERx materials or other products we are developing. We currently rely on Draxis for the bulk manufacture of our TIMERx materials under a manufacturing and supply agreement with an initial term that expires in November 2009. The agreement automatically renews for successive one-year periods, unless either party gives notice of its intent not to renew the agreement at least 180 days prior to the end of the then-current term. We are not a party to any agreements with our third party manufacturers for the products that we are currently evaluating in clinical trials, except for purchase orders or similar arrangements.

We believe that there are a limited number of manufacturers that comply with cGMP regulations who are capable of manufacturing our TIMERx materials. Although we have qualified alternate suppliers with respect to the xanthan gum and locust bean gums used to manufacture our TIMERx materials, we currently do not have a second supplier of TIMERx. If Draxis is unable to manufacture the TIMERx materials in the required quantities or fails to do so on a timely basis, or if Draxis does not agree to renew our agreement when it expires or renew it on terms acceptable to us, we may not be able to obtain alternative contract manufacturing or obtain such manufacturing on commercially reasonable terms. In addition, if we are unable to enter into longer-term manufacturing arrangements for our products on acceptable terms, particularly as drug candidates advance through clinical development and move closer to regulatory approval, our business and the development and commercialization of our products could be materially adversely effected. There can be no assurance that Draxis or any other third parties we rely on for supply of our TIMERx materials or other products will perform. Any failures by third party manufacturers may delay the development of products or the submission for regulatory approval, impair our or our collaborators’ ability to commercialize products as planned and deliver products on a timely basis, require us or our collaborators to cease distribution or recall some or all batches of products or otherwise impair our competitive position, which could have a material adverse effect on our business, financial condition and results of operations.

If our third party manufacturers fail to perform their obligations, we may be adversely affected in a number of ways, including:

•  we or our collaborators may not be able to meet commercial demands for Opana ER or our other products;

•  we may not be able to initiate or continue clinical trials for products that are under development; and

•  we may be delayed in submitting applications for regulatory approvals of our products.

We may not be able to successfully develop our own manufacturing capabilities. If we decide to develop our own manufacturing capabilities, we will need to recruit qualified personnel and build or lease the requisite facilities and equipment we currently do not have. Moreover, it may be very costly and time consuming to develop such capabilities.

The manufacture of our products is subject to regulations by the FDA and similar agencies in foreign countries. Any delay in complying or failure to comply with such manufacturing regulations could materially adversely affect the marketing of our products and our business, financial condition and results of operations.

We are dependent upon a limited number of suppliers for the gums used in our TIMERx materials

Our TIMERx drug delivery systems are based on a hydrophilic matrix combining a heterodispersed mixture primarily composed of two polysaccharides, xanthan gum and locust bean gums, in the presence of dextrose. These gums are also used in our Geminex, gastroretentive and SyncroDose drug delivery systems. We purchase these gums from a primary supplier. We have qualified alternate suppliers with respect to such materials, but we can provide no assurance that interruptions in supplies will not occur in the future. Any

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interruption in these supplies could have a material adverse effect on our ability to manufacture bulk TIMERx materials for delivery to our collaborators.

If we or our collaborators fail to obtain an adequate level of reimbursement by governmental or third party payors for Opana ER or any other products we develop, we may not be able to successfully commercialize the affected product

The availability of reimbursement by governmental and other third party payors affects the market for any pharmaceutical products, including Opana ER. These third party payors continually attempt to contain or reduce the costs of health care by challenging the prices charged for pharmaceutical products. In certain foreign countries, particularly the countries of the European Union, the pricing of prescription pharmaceuticals is subject to governmental control.

In both the United States and certain foreign jurisdictions, there have been a number of legislative and regulatory proposals to change the health care system. Further proposals are likely. The finally adoption of these proposals may affect our or our collaborators’ ability to set prices which provide an adequate return on our investment.

We expect Endo to experience pricing pressure with respect to Opana ER. We may experience similar pressure for other products for which we obtain marketing approvals in the future due to the trend toward managed health care, the increasing influence of health maintenance organizations and additional legislative proposals. Neither we nor our collaborators may be able to sell products profitably if access to managed care or government formularies is restricted or denied, or if reimbursement is unavailable or limited in scope or amount.

We will be exposed to product liability claims and may not be able to obtain adequate product liability insurance

Our business exposes us to potential product liability risks that are inherent in the testing, manufacturing, marketing and sales of pharmaceutical products. Product liability claims might be made by consumers, health care providers, other pharmaceutical companies, or third parties that sell our products. These claims may be made even with respect to those products that are manufactured in regulated facilities or that otherwise possess regulatory approval for commercial sale.

We are currently covered by a primary product liability insurance in amounts of $15 million per occurrence and $15 million annually in the aggregate on a claims-made basis, and by excess product liability insurance in the amount of $25 million. This coverage may not be adequate to cover all product liability claims. Product liability coverage is expensive. In the future, we may not be able to maintain or obtain such product liability insurance at a reasonable cost or in sufficient amounts to protect us against potential liability claims. Claims that are not covered by product liability insurance could have a material adverse effect on our business, financial condition and results of operations.

If we are unable to retain our key personnel, and continue to attract additional professional staff, we may not be able to maintain or expand our business

Because of the scientific nature of our business, our ability to develop products and compete with our current and future competitors will remain highly dependent upon our ability to attract and retain qualified scientific, technical, commercial and managerial personnel. The loss of key scientific, technical, commercial or managerial personnel or the failure to recruit additional key scientific, technical, commercial or managerial personnel could have a material adverse effect on our business. We do not have employment agreements with our key executives and we cannot guarantee that we will succeed in retaining all of our key personnel. There is intense competition for qualified personnel in our industry, and there can be no assurance that we will be able to continue to attract and retain the qualified personnel necessary for the success of our business.

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The market price of our common stock may be volatile

The market price of our common stock, like the market prices for securities of other pharmaceutical, biopharmaceutical and biotechnology companies, has historically been highly volatile. The market from time to time experiences significant price and volume fluctuations that are unrelated to the operating performance of particular companies. The market price of our common stock may also fluctuate as a result of our operating results, sales of Opana ER, future sales of our common stock, announcements of technological innovations or new therapeutic products by us or our competitors, announcements regarding collaborative agreements, clinical trial results, government regulations, developments in patent or other proprietary rights, public concern as to the safety of drugs developed by us or others, changes in reimbursement policies, comments made by securities analysts and other general market conditions.

Specific provisions of our Shareholder Rights Plan, Certificate of Incorporation and Bylaws and law of Washington State make a takeover of Penwest or a change in control or management of Penwest more difficult

We have adopted a shareholder rights plan, often referred to as a poison pill. The rights issued under the plan will cause substantial dilution to a person or group that attempts to acquire us on terms that are not approved by our board of directors, unless the board first determines to redeem the rights. Various provisions of our Certificate of Incorporation, our Bylaws and Washington law may also have the effect of deterring hostile takeovers or delaying or preventing changes in control or management of our company, including transactions in which our shareholders might otherwise receive a premium for their shares over then current market prices. In addition, these provisions may limit the ability of shareholders to approve transactions that they may deem to be in their best interest.

ITEM 1B.   UNRESOLVED STAFF COMMENTS

Not Applicable.

ITEM 2.   PROPERTIES

Our corporate offices comprise approximately 21,500 square feet and are located in Danbury, Connecticut. We lease these offices under a lease that currently expires on December 30, 2007, although we may extend this lease through December 30, 2008 by giving written notice by March 31, 2007.

We also lease research facilities, comprising approximately 15,500 square feet, in Patterson, New York, which we owned prior to the sale of our excipient business to Josef Rettenmaier Holding GmbH & Co. KG. in 2003. In November 2006, we exercised the third of three one year renewal options, extending the lease term to February 26, 2008.

The space we currently lease in Danbury, Connecticut and Patterson, New York is adequate for our present needs. We are exploring alternatives for new or additional space to meet our anticipated future requirements.

ITEM 3.   LEGAL PROCEEDINGS

Not Applicable.

ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Not Applicable.

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EXECUTIVE OFFICERS OF THE REGISTRANT

The following table sets forth the names, ages and positions of our executive officers.

Name	Age		Title	Dates
Jennifer L. Good		42	President and Chief Executive Officer	2006 — current
			President, Chief Operating Officer and Chief Financial Officer	2005 — 2006
			Senior Vice President, Finance and Chief Financial Officer	1997 — 2005
Anand R. Baichwal, Ph.D.		52	Senior Vice President, Licensing and Chief Scientific Officer	2006 — current
			Senior Vice President, Research & New Technology Development and Chief Scientific Officer	1997 — 2006
Benjamin L. Palleiko		41	Senior Vice President, Corporate Development and Chief Financial Officer	2006 — current
			Director, Investment Banking, SunTrust Robinson Humphrey	2003 — 2006
			Vice President, Investment Banking, Robertson Stephens, Inc.	2000 — 2002
Thomas Sciascia, M.D.		53	Senior Vice President and Chief Medical Officer	2001 — current

PART II

ITEM 5.   MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock, $.001 par value, is listed with and trades on the Nasdaq Global Market under the symbol “PPCO.” The high and low sale prices of our common stock during 2006 and 2005 are set forth below. These prices reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not necessarily represent actual transactions.

	High		Low
PERIOD 2006
Quarter Ended March 31	$	23.70	$	19.00
Quarter Ended June 30	$	23.10	$	15.73
Quarter Ended September 30	$	22.74	$	16.20
Quarter Ended December 31	$	19.35	$	15.67
PERIOD 2005
Quarter Ended March 31	$	12.91	$	9.75
Quarter Ended June 30	$	13.80	$	10.29
Quarter Ended September 30	$	17.59	$	10.20
Quarter Ended December 31	$	20.00	$	15.02

On March 9, 2007, we had 655 shareholders of record.

We have never paid cash dividends on our common stock. We presently intend to retain earnings, if any, for use in the operation of our business, and are precluded from paying any cash dividends under the terms of the senior secured credit facility. See “Sources of Liquidity” under the caption “Liquidity and Capital Resources” in “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

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ITEM 6.   SELECTED FINANCIAL DATA

The following selected financial data are derived from our consolidated financial statements. The data should be read in conjunction with the financial statements, related notes, and other financial information included herein.

	Year Ended December 31,
	2006			2005			2004			2003			2002
	(In thousands, except for per share data)
STATEMENT OF OPERATIONS DATA:
Revenues	$	3,499		$	6,213		$	5,108		$	4,678		$	5,537
Cost of revenues		231			39			104			169			170
Gross profit		3,268			6,174			5,004			4,509			5,367
Selling, general and administrative		14,075			13,247			9,485			10,361			7,568
Research and product development		22,857			17,797			20,205			20,590			16,955
Loss from continuing operations before cumulative effect of change in accounting principle		(31,312	)		(22,898	)		(23,785	)		(26,006	)		(19,028	)
Earnings from discontinued operations, net of income tax expense		—			—			—			177			1,929
Gain on sale of discontinued operations		—			—			—			9,894			—
Total discontinued operations		—			—			—			10,071			1,929
Net loss	$	(31,312	)	$	(22,898	)	$	(23,785	)	$	(15,935	)	$	(17,099	)
Basic and diluted loss per share:
Continuing operations	$	(1.38	)	$	(1.05	)	$	(1.28	)	$	(1.56	)	$	(1.23	)
Discontinued operations		—			—			—			0.60			0.12
Net loss per share	$	(1.38	)	$	(1.05	)	$	(1.28	)	$	(0.96	)	$	(1.11	)
Weighted average shares of common stock outstanding		22,751			21,711			18,627			16,678			15,462

	December 31,
	2006			2005			2004			2003			2002
	(In thousands)
BALANCE SHEET DATA:
Cash and cash equivalents	$	16,182		$	15,917		$	14,249		$	8,241		$	1,629
Marketable securities		24,408			39,377			60,121			55,652			2,057
Working capital		38,254			53,912			71,946			60,697			26,355
Total assets		52,742			67,021			87,522			78,503			50,220
Long term obligations-deferred compensation		2,763			2,977			3,314			3,104			2,889
Accumulated deficit		(172,428	)		(141,116	)		(118,218	)		(94,433	)		(78,025	)
Shareholders’ equity		45,121			60,411			78,801			67,696			31,423

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ITEM 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

We develop pharmaceutical products based on innovative proprietary drug delivery technologies with a focus on products that address disorders of the nervous system. In June 2006, the FDA approved for marketing Opana^® ER, an extended release formulation of oxymorphone hydrochloride that we developed with Endo using our proprietary TIMERx drug delivery technology. We are currently developing product candidates designed for the treatment of pain, epilepsy, Parkinson’s disease and spasticity, as well as a product candidate for the treatment of edema resulting from congestive heart failure.

Opana ER is an oral extended release opioid analgesic, which we developed with Endo using our proprietary TIMERx technology. Opana ER has been approved in the United States for twice-a-day dosing in patients with moderate to severe pain requiring continuous, around-the-clock opioid treatment for an extended period of time. Under the terms of our collaboration with Endo, Endo is responsible for marketing Opana ER in the United States. The product was launched by Endo in the United States in July 2006 in 5mg, 10mg, 20mg and 40mg tablets.

We entered into an amendment in January 2007 as part of the resolution of a dispute between the parties with regard to the sharing of marketing expenses during the period prior to when Opana ER reaches profitability. Under the terms of the 2007 Amendment, we and Endo agreed that royalties payable to us for U.S. sales of Opana ER would be calculated based on net sales of the product rather than on operating profit.

We have incurred net losses since 1994. As of December 31, 2006, our accumulated deficit was approximately $172 million. We expect operating losses and negative cash flows to continue until substantial sales of Opana ER or other products developed using our drug delivery technologies occur. We currently generate revenues primarily from royalties received from Mylan. Our future profitability will depend on several factors, including:

•  the commercial success of Opana ER, and the timing and amount of royalties from Endo’s sales of Opana ER;

•  the level of our investment in research and development activities;

•  the successful development and commercialization of product candidates, other than Opana ER, in our portfolio;

•  the level of investment for acquisitions or in-licensing of technologies or compounds intended to support our growth; and

•  royalties from Mylan’s sales of Pfizer’s generic version of Procardia XL 30 mg.

Our strategy includes a significant commitment to spending on research and development targeted at identifying and developing products to treat disorders of the nervous system. We expect to leverage our expertise in drug formulation and drug delivery in the development of these products. We also expect to expend resources on the expansion of our own drug delivery technologies, as well as on new technologies obtained through in-licenses or acquisition. Our spending in the area of new technology however, is discretionary and is subject to identifying appropriate opportunities, as well as the availability of funds from our operations, cash resources, collaborative research and development arrangements, and external financing.

Our results of operations may fluctuate from quarter to quarter depending on the success of Opana ER, the amount and timing of royalties under our agreement with Endo, the amount and timing of royalties on Mylan’s sales of Pfizer’s generic version of Procardia XL 30 mg, the volume and timing of shipments of formulated bulk TIMERx, the variations in payments under our collaborative agreements, and the amount and timing of our investment in research and development activities.

Effective January 1, 2006, all share-based payments to employees and directors, including grants of stock options and grants under compensatory employee stock purchase plans, are being recognized as an expense in

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the statement of operations based on their fair values as they are earned by the employees and directors under the vesting terms, in accordance with Statement of Financial Accounting Standards, or SFAS, No. 123R, “Share-Based Payment”. The effect of our adoption of SFAS 123R was an additional $4.0 million of compensation expense, or approximately $.18 per share, basic and diluted, in the year ended December 31, 2006, substantially all related to employee and director stock options. Of such amount, $2.1 million and $1.9 million were recorded as selling, general and administrative, or SG&A, expense, and research and product development, or R&D, expense, respectively.

Total share-based compensation expense recognized in the years ended December 31, 2006 and 2005 was $5.0 million and $2.9 million, respectively.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. We base our estimates on historical experience and on various other factors that we believe to be reasonable under the circumstances. We regard an accounting estimate underlying our financial statements as a “critical accounting estimate” if the nature of the estimate or assumption is material due to the level of subjectivity and judgment involved or the susceptibility of such matter to change, and if the impact of the estimate or assumption on our financial condition or performance may be material. On an ongoing basis, we evaluate these estimates and judgments. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are fully described in Note 2 to our financial statements included in this annual report, we regard the following as critical accounting estimates.

Revenue Recognition

Royalties and Licensing Fees

We recognize revenues from non-refundable upfront licensing fees received under collaboration agreements ratably over the development period of the related collaboration agreement when this period involves development risk associated with the incomplete stage of a product’s development, or over the estimated or contractual licensing and supply term when there exists an obligation to supply inventory for manufacture. Non-refundable milestone fees received for the development funding of a product are partially recognized upon receipt based on our proportionate development efforts achieved to date relative to the total expected development efforts and the remainder is generally recognized ratably over the remaining expected development period. The proportionate development efforts achieved are measured by estimating the percentage of work completed that is required of us in the development effort for the product. This estimate is primarily derived from the underlying project plans and timelines, developed by qualified personnel who work closely on such projects. In particular, we review output measures such as job specifications and tasks completed, compared to all such job specifications and tasks outlined for a particular project. Job specifications vary with each project and primarily include development activities regarding initial formulation work, manufacturing scale-up, proof-of-principle biostudies, clinical development and regulatory matters.

Non-refundable contractual fees received in connection with a collaborator’s launch of a product are also recognized ratably over the estimated or contractual licensing and supply term. Upon termination of a collaboration agreement, any remaining non-refundable licensing fees we received which had been deferred, are generally recognized in full.

Product royalty fees are recognized when earned as reported by our collaborators, and are generally subject to our review or audit.

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Product Sales

We recognize revenues from product sales when title transfers and customer acceptance provisions have lapsed, provided that collections of the related accounts receivable are probable.

Research and Development Expenses

Research and development expenses consist of costs associated with products being developed internally as well as products being developed under collaboration agreements, and include related salaries, benefits and other personnel related expenses, clinical trial costs, and contract and other outside service fees. We expense research and development costs as incurred. A significant portion of our development activities are outsourced to third parties, including contract research organizations and contract manufacturers in connection with the production of clinical materials, or may be performed by our collaborators. These arrangements may require estimates to be made of related service fees or our share of development costs. These arrangements may also require us to pay termination costs to the third parties for reimbursement of costs and expenses incurred in the orderly termination of contractual services.

These estimates involve identifying services, which have been performed on our behalf, and estimating the level of service performed and associated cost incurred for such service as of each balance sheet date in our financial statements. In connection with such service fees, our estimates are most affected by our understanding of the status and timing of services provided relative to the actual levels of service incurred by such service providers. The date on which services commence, the level of services performed on or before a given date, and the cost of such services are subject to our judgment. We make these judgments based upon the facts and circumstances known to us in accordance with generally accepted accounting principles.

Deferred Taxes — Valuation Allowance

Valuation allowances are established against the recorded deferred income tax assets to the extent that we believe it is more likely than not that a portion of the deferred income tax assets are not realizable. While we may consider any potential future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. At December 31, 2006, we had recorded full valuation allowances totaling approximately $69.2 million against our net deferred tax assets, as we believe it more likely than not that our deferred income tax assets will not be realized due to our historical losses.

Impairment of Long-Lived Assets

For purposes of recognizing and measuring impairment of our long-lived assets, including intangible assets such as our patents, we assess the recoverability of the carrying amount of these assets whenever facts and circumstances indicate that the carrying amount may not be fully recoverable. We measure the impairment related to long-lived assets by the amount by which the carrying amount of the assets exceeds the fair value of the assets. In assessing the recoverability of our intangible assets, we must make assumptions and estimates regarding the amounts and timing of future cash flows and other factors to determine the fair value of the respective assets. Estimated cash flow assumptions include profitability and/or net sales projections provided by our marketing partners or developed internally, based upon historical revenues or projected market share for new products. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets.

Share-Based Compensation

Effective January 1, 2006, we adopted SFAS 123R, “Share-Based Payment” requiring the expense recognition of the estimated fair value of all share-based payments granted to employees and directors, including grants of stock options and grants under compensatory employee stock purchase plans. Prior to this, we did not record the estimated fair value associated with such awards as an expense, but rather, we disclosed

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the estimated fair value in the notes to our financial statements as was permitted prior to our adoption of SFAS 123R. For the year ended December 31, 2006, we recorded approximately $5.0 million of expense associated with share-based payments, with the majority of this expense, approximately $4.0 million, attributable to employee and director stock options, and $771,000 attributable to restricted stock awards. As of December 31, 2006, there was approximately $4.4 million and $79,000 of unrecognized compensation cost related to stock option awards and outstanding restricted stock awards, respectively, that we expect to recognize as expense over a weighted average period of 1.1 years and 2.2 years, respectively.

The valuation of employee stock options is an inherently subjective process, since market values are generally not available for long-term, non-transferable employee stock options. Accordingly, we utilize an option pricing model to derive an estimated fair value. In calculating the estimated fair value of our stock options, we used a Black-Scholes-Merton pricing model, which requires the consideration of the following variables for purposes of estimating fair value:

•  the stock option exercise price;

•  the expected term of the option;

•  the grant date price of our common stock, which is issuable upon exercise of the option;

•  the expected volatility of our common stock;

•  expected dividends on our common stock (we do not anticipate paying dividends for the foreseeable future); and

•  the risk free interest rate for the expected option term.

Of the variables above, we believe that the selection of an expected term and expected stock price volatility are the most subjective. We use historical employee exercise and option expiration data to estimate the expected term assumption for the Black-Scholes-Merton grant date valuation. We believe that this historical data is currently the best estimate of the expected term of a new option, and that generally, all groups of our employees exhibit similar exercise behavior. In general, the longer the expected term used in the Black-Scholes-Merton pricing model, the higher the grant-date fair value of the option. For options granted prior to 2006, we used historical volatility to estimate the grant-date fair value of stock options. Historical volatility is calculated based on a period equal to the expected term of stock option awards, and actual stock prices during this period. Following a review of alternative methods of estimating expected volatility, we changed our method of estimating expected volatility for all stock options granted after 2005 from exclusively relying on historical volatility to using an average of implied volatility and historical volatility. In accordance with SFAS 123R, we selected the average of implied volatility and historical volatility as we believe neither of these measures is better than the other in estimating the expected volatility of our common stock. We believe that our estimates, both expected term and stock price volatility, are reasonable in light of the historical data we analyzed.

The valuation assumptions selected upon our adoption of SFAS 123R were applied to stock options that we granted subsequent to our adoption of SFAS 123R on January 1, 2006; however, stock option expense recorded in the year ended December 31, 2006 also included amounts related to the continued vesting of stock options that were granted prior to January 1, 2006. In accordance with the transition provisions of SFAS 123R, the grant date estimates of fair value associated with prior awards, which were also calculated using a Black-Scholes-Merton option pricing model, have not been changed. The specific valuation assumptions that were utilized for purposes of deriving an estimate of fair value at the time that prior awards were issued are as disclosed in our prior annual reports on Form 10-K. We use the accelerated attribution method to recognize expense for all options granted.

Upon the adoption of SFAS 123R, we were also required to estimate the level of award forfeitures expected to occur, and record compensation cost only for those awards that are ultimately expected to vest. This requirement applies to all awards that are not yet vested, including awards granted prior to January 1, 2006. Accordingly, we performed a historical analysis of option awards that were forfeited (such as by

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employee separation) prior to vesting, and ultimately recorded stock option expense that reflected this estimated forfeiture rate.

Results of Operations for Years Ended December 31, 2006, 2005 and 2004

Revenues

			Percentage					Percentage
			Increase					Increase
			(Decrease) from					(Decrease) from
	2006		2005			2005		2004			2004
	(In thousands, except percentages)
Royalty and Licensing Fees	$	3,118		(50	)%	$	6,213		27	%	$	4,882
Product Sales		381		n/a			—		(100	)%		226
Total Revenues	$	3,499		(44	)%	$	6,213		22	%	$	5,108

Substantially all of the royalty and licensing fees for 2006 and 2004 were generated from royalties received from Mylan. In 2005, royalties and licensing fees included $2.25 million in revenue recognized under our license agreement with Prism, which was terminated in the third quarter of 2005, and $3.9 million of royalties from Mylan on its sales of Pfizer’s 30 mg generic version of Procardia XL. Royalties from Mylan decreased in 2006 as compared to 2005, and in 2005 as compared to 2004, as a result of a decrease in Mylan’s net sales of Pfizer’s 30 mg generic version of Procardia XL. We believe that the decrease from 2005 to 2006 was due to two of Mylan’s customers purchasing significantly less product in 2006 than in 2005, as well as lower pricing overall. We believe that the decrease from 2004 to 2005 was due primarily to a reduction in sales volume attributable to reduced purchases by a single customer.

Product sales in 2006 and 2004 consisted of sales of formulated TIMERx to collaborators, with no comparable product sales occurring in 2005. Product sales in 2006 exclude shipments of TIMERx to Endo for use in Opana ER that occurred prior to FDA approval. We recognize the sales price and related costs of these pre-commercial shipments as offsets to research and development expense in accordance with our policy for cost-sharing arrangements, such as with Endo in connection with Opana ER. Following the FDA approval of Opana ER in June 2006, we recognized TIMERx shipments to Endo for use in Opana ER as product sales. As a result, we expect product sales to increase modestly in future periods.

Selling, General and Administrative Expense

Selling , general and administrative, or SG&A, expenses increased by 6% in 2006 to $14.1 million as compared to $13.2 million in 2005. This increase was primarily due to increased compensation expense, primarily relating to the $2.1 million recorded for employee stock options resulting from our adoption of SFAS 123R effective January 1, 2006, as well as increased market research expenses associated with the review of several product candidates in our pipeline. In 2005, SG&A included a one-time charge of approximately $3.0 million that we recorded in connection with the agreement we entered into with Tod Hamachek, our former Chairman and Chief Executive Officer, upon his resignation in February 2005. This $3.0 million charge included a non-cash charge of approximately $2.4 million related to the accelerated vesting and extension of exercise periods of stock options held by Mr. Hamachek.

SG&A expenses increased by 40% in 2005 to $13.2 million as compared to $9.5 million in 2004. This increase was primarily due to the one-time charge of approximately $3.0 million in the first quarter of 2005 that we recorded in connection with the agreement with Mr. Hamachek noted above. The increase in SG&A expenses in 2005 was also due to increased professional fees of approximately $600,000, primarily related to market research activities, and increased directors’ fees of approximately $345,000, of which approximately $280,000 was non-cash and related to stock-based compensation.

Research and Product Development Expenses

Research and product development, or R&D, expenses increased by $5.1 million or 28% in 2006 as compared to 2005, primarily due to increased spending in 2006 on the development of nalbuphine ER and

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torsemide ER, as well as increased compensation expense of $1.9 million related to stock based compensation resulting from our adoption of SFAS 123R effective January 1, 2006. These increases were partially offset by expense reductions in 2006 attributable to the discontinuation in the second quarter of 2005 of the development of PW2101, a drug that we were developing in 2004 and 2005 for the treatment of hypertension and angina.

Total R&D expense decreased by $2.4 million or 12% in 2005 as compared to 2004, primarily due to a decrease in spending on PW2101 in 2005. The decrease was partially offset by increased spending on our products in clinical development and on the development of other Phase I compounds intended for the treatment of disorders of the nervous system, increased compensation costs of research and product development personnel and a write-off of inventory primarily related to a change in specifications for our TIMERx material.

			Percentage					Percentage
			Increase					Increase
			(Decrease) from					(Decrease) from
	2006		2005			2005		2004			2004
	(In thousands, except percentages)
Nalbuphine ER	$	4,211		256	%	$	1,184		451	%	$	215
Torsemide ER		2,196		111	%		1,043		181	%		371
Venlafaxine ER		639		(31	)%		921		232	%		277
PW2101		—		(100	)%		1,817		(80	)%		9,228
Phase I Products, Internal Costs and Other		13,596		22	%		11,154		53	%		7,296
Research and New Technology Development		2,215		32	%		1,678		(40	)%		2,818
Total Research and Product Development Expense	$	22,857		28	%	$	17,797		(12	)%	$	20,205

In the preceding table, R&D expenses are set forth in the following six categories:

•  Nalbuphine ER — These expenses reflect our direct external expenses relating to the development of nalbuphine ER. These expenses approximated 18% of our R&D expenses in 2006, and consisted primarily of payments to third parties in connection with clinical trials of nalbuphine ER, including payments for drug active. The expenses for this compound increased in 2006 as compared to 2005 as we advanced the drug from Phase I through Phase IIa clinical trials and completed additional preparation for further clinical trials in 2007. We expect our R&D expenses on nalbuphine ER to increase in 2007 as we commence additional clinical trials, including a Phase I safety trial and Phase II chronic efficacy trial.

•  Torsemide ER — These expenses reflect our direct external expenses relating to the development of torsemide ER. These expenses consisted primarily of payments to third parties in connection with clinical trials of torsemide ER, including payments for drug active, and approximated 10% of our R&D expenses in 2006. The expenses for this compound increased in 2006 as compared to 2005 as we conducted reformulation work and two additional Phase I studies to optimize the formulation and the delivery of the drug. We expect our expenses on torsemide ER to increase in 2007 if the Phase I study we conduct in the first half of 2007 confirms the targeted blood level profile and we commence a planned Phase II comparative trial.

•  Venlafaxine ER — These expenses reflect our direct external expenses related to the development of venlafaxine ER. These expenses consisted primarily of payments to third parties in connection with the manufacture of venlafaxine ER, including payments for the drug active, and approximated 3% of our R&D expenses in 2006. During the second quarter of 2006, we ceased development work on this compound based on an assessment of the market opportunity and our estimated financial returns. We do not expect to incur additional R&D expenses with respect to venlafaxine ER in future periods.

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•  PW2101 — These expenses reflect our direct external expenses relating to the development of PW2101. These expenses consisted primarily of payments to third parties in connection with clinical trials of PW2101, the manufacturing of PW2101, including our development work related to the qualification of an alternative manufacturing site, and the preparation of an NDA for PW2101. We received a nonapprovable letter on this drug in 2005, and we discontinued development work on PW2101 in the second quarter of 2005. We do not expect to incur additional R&D expenses with respect to PW2101 in future periods.

•  Phase I Products, Internal Costs and Other — These expenses primarily reflect expenses such as salaries and benefits for our product development personnel, including our formulation, clinical and regulatory groups, and other costs primarily related to our laboratory facilities that are not allocated to specific programs. These expenses also reflect both our direct external expenses and our allocated internal expenses relating to the development of Phase I product candidates, and expenses incurred to support the approval of Opana ER of approximately $866,000 in 2006, which included expenses related to manufacturing process characterization of TIMERx for FDA compliance and in connection with our obligations under our agreement with Endo. Our direct external expenses primarily reflect payments to third parties for the drug active and proof-of-principle biostudies conducted on our Phase I products. These costs increased in 2006 as compared to 2005, primarily as a result of the recording of compensation expense related to employee stock options resulting from our adoption of SFAS 123R effective January  1, 2006. The increase was partially offset by a write-off of TIMERx inventory in the second quarter of 2005, primarily related to a change in specifications for TIMERx. We continually evaluate the Phase I product candidates we are developing, and may terminate or accelerate development of product candidates based on study results, product development risk, commercial opportunity, perceived time to market and other factors.

•  Research and New Technology Development — These expenses reflect both our direct external expenses and our allocated internal expenses relating to research on new or existing technologies within the Company that support the product pipeline. These direct external expenses consist primarily of payments to third parties in connection with consulting and outside laboratory fees. Our internal expenses primarily include salaries and benefits of our research and new technology development group, and other costs such as depreciation on purchased equipment, and the amortization or any write-downs of patent costs, other than product patent write-offs charged directly to a product development project or amortization of patent costs relating to commercialized products which are included in cost of revenues. These expenses increased in 2006 as compared to 2005, primarily due to increased professional fees and amortization of patents associated with development programs.

There can be no assurance that any of our product candidates will advance through the clinical development process and be successfully developed, will receive regulatory approval, or will be successfully commercialized. Completion of clinical trials and commercialization of these product candidates may take several years, and the length of time can vary substantially according to the type, complexity and novelty of a product candidate. Due to the variability in the length of time necessary to develop a product, the uncertainties related to the estimated cost of the development process and the uncertainties involved in obtaining governmental approval for commercialization, accurate and meaningful estimates of the ultimate cost to bring our product candidates to market are not available.

Tax Rates

The effective tax rates for 2006, 2005 and 2004 were essentially zero. The effective tax rates are higher than the federal statutory rate of a 34% benefit due primarily to valuation allowances recorded to offset net deferred tax assets relating to our net operating losses, and foreign income taxes.

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Liquidity and Capital Resources

Sources of Liquidity

Since 1998, when we became an independent, publicly-owned company, we have funded our operations and capital expenditures from the proceeds of the sale and issuance of shares of common stock, the sale of our excipient business, sales of excipients, sales of formulated bulk TIMERx, royalties and milestone payments from Mylan and other collaborators, and advances under credit facilities. As of December 31, 2006, we had cash, cash equivalents and short-term investments of $40.6 million.

On March 13, 2007, we entered into a $24.0 million senior secured credit facility with Merrill Lynch Capital, a divison of Merrill Lynch Business Financial Services Inc. The credit facility consists of: (i) a $12.0 million term loan advanced upon the closing of the credit facility and (ii) a $12.0 million term loan that we may access until September 15, 2008, subject to conditions specified in the agreement. Under the agreement, we may not access this second amount unless our market capitalization at the time of the advance request is greater than $250 million. In connection with this credit facility, we granted the lender a perfected first priority security interest in all existing and after-acquired assets, excluding our intellectual property which is subject to a negative pledge; royalty payments from Mylan on their sales of Pfizer’s generic version of Procardia XL 30mg, if we pledge such royalty payments to another lender; and up to $3,000,000 of equipment which we may, at our election, pledge to another lender in connection with an equipment financing facility separate from this credit facility. In addition, we are precluded from paying cash dividends to our shareholders during the term of the agreement. Each loan has a term of 42 months from the date of advance with interest-only payments for the first nine months, but in any event, not beyond September 30, 2008; interest plus monthly principal payments equal to 1.67% of the loan amount for the period from the end of the interest-only period through December 2008; and interest plus straight line amortization payments with respect to the remaining principal balance for the remainder of the term.

Amounts outstanding under the credit facility bear interest at an annual rate of one month LIBOR at the time of the advance plus 5%, which rate will be fixed for the term of the applicable loan. At the time of final payment of each loan under the credit facility, we will pay an exit fee of 3.0% of the original principal loan amount. We are also required to pay prepayment penalties of 3.0% of any prepaid amount in the first year, 2.0% of any prepaid amount in the second year and 1% of any prepaid amount thereafter. As of March 13, 2007, the interest rate on the credit facility was 10.32% and $12.0 million was outstanding.

Cash Flows

In 2006, we had negative cash flow from operations of $23.6 million, primarily due to our net loss of $31.3 million for the year which included depreciation and amortization of $1.6 million and a non-cash charge of $5.0 million for stock-based compensation. In 2005, we had negative cash flow from operations of $20.1 million, primarily due to the net loss of $22.9 million we had for the year which included depreciation and amortization of $1.5 million, inventory and patent write-offs of $634,000 and a non-cash charge of $2.4 million relating to the accelerated vesting and extension of exercise periods of stock options held by Mr. Hamachek in connection with his resignation in February 2005. Operating cash flows in 2005 also included approximately $2.7 million in the net pay-down of accounts payable and accrued expenses.

In 2006, net cash provided by investing activities totaled $13.1 million, primarily reflecting sales and maturities of marketable securities, net of purchases, of $15.1 million. Net cash provided by investing activities also reflected $1.8 million expended for the acquisition of laboratory equipment for drug development activities and $619,000 expended to secure patents on technology we have developed, as well as proceeds from the withdrawal of $446,000 from the cash surrender value of a life insurance policy to reimburse us for retirement and deferred compensation benefits we directly paid to Mr. Hamachek. In 2005, net cash provided by investing activities totaled $20.3 million primarily reflecting sales and maturities of marketable securities, net of purchases, of $21.0 million. In addition, investing activities in 2005 reflected $276,000 in capital expenditures for the acquisitions of fixed assets primarily related to laboratory equipment for drug development activities as well as costs incurred for information technology. Funds expended for patents in 2005 totaled $479,000 and included costs to secure patents on technology and products developed by us.

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In 2006 and 2005, financing activities provided $10.8 million and $1.5 million, respectively, in cash, substantially all due to net cash proceeds from stock option exercises.

On February 1, 2007, we entered into a termination agreement with Anand Baichwal, our Senior Vice President, Licensing and Chief Scientific Officer, terminating certain provisions of the recognition and incentive agreement dated as of May 14, 1990, as amended, between Penwest and Dr. Baichwal. Under the recognition and incentive agreement, we were obligated to pay Dr. Baichwal on an annual basis in arrears (i) one-half of one percent of our net sales of TIMERx material to third parties, (ii) one-half of one percent of royalties received by us under licenses, collaborations or other exploitation agreements with third parties with respect to the sale, license, use or exploitation by such third parties of products based on or incorporating the TIMERx material, and (iii) one-half of one percent of payments made in lieu of the net sales or royalties as described above and received by us. Under the terms of the termination agreement, Penwest and Dr. Baichwal terminated this payment obligation and agreed that we would have no further obligation to make any payments to Dr. Baichwal under the recognition and incentive agreement except for amounts owed with respect to 2006. We agreed to pay Dr. Baichwal $770,000 in cash and to issue to him 19,696 shares of our common stock with a fair market value of approximately $287,000, for total consideration of $1,057,000. Dr. Baichwal remains an officer of Penwest.

On February 1, 2007, we entered into a termination agreement with John Staniforth, a director of and consultant to Penwest, terminating the royalty agreement dated as of September 25, 1992, as amended, between Penwest and Dr. Staniforth. Under the royalty agreement, we were obligated to pay Dr. Staniforth on an annual basis in arrears one-half of one percent of our net revenue generated from the sales or licenses of products covered by the TIMERx patents. Under the terms of the termination agreement, Penwest and Dr. Staniforth terminated this payment obligation and agreed that we would have no further obligation to make any payments to Dr. Staniforth under the royalty agreement except for amounts owed with respect to 2006. We agreed to pay Dr. Staniforth $770,000 in cash and to issue to him 19,696 shares of our common stock with a fair market value of approximately $287,000, for total consideration of $1,057,000. Dr. Staniforth remains on the Board of Penwest.

Our Board of Directors approved the termination agreements entered into with Drs. Baichwal and Staniforth.

Funding Requirements

We anticipate that, based on our current operating plan and excluding any potential revenues from Opana ER, our existing capital resources, the credit facility noted above and anticipated internally generated funds from royalties from Mylan will be sufficient to fund our operations on an ongoing basis without requiring us to seek external financing until at least late 2008. We expect to invest approximately $750,000 for capital expenditures in 2007, primarily for laboratory equipment for our drug development activities.

Our requirements for capital in our business are substantial and will depend on many factors, including:

•  the commercial success of Opana ER and royalties received from Endo on sales of Opana ER;

•  the timing and amount of payments received under collaborative agreements, including in particular our agreement with Endo with respect to Opana ER and our agreement with Mylan with respect to Pfizer’s generic Procardia XL 30 mg;

•  the progress of our collaborative and independent development projects, funding obligations with respect to the projects, and the related costs to us of clinical studies for our products;

•  the level of investment for the acquisition or in-licensing of technologies or compounds intended to support our growth;

•  the structure and terms of any future collaborative agreements;

•  the prosecution, defense and enforcement of our patents and other intellectual property rights; and

•  the level of our investment in capital expenditures for facilities or equipment.

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If we determine to acquire additional product candidates or technologies, we may need to seek additional funding through collaborative agreements or public or private financings of equity or debt securities.

We plan to meet our long-term cash requirements through our existing cash balance, the credit facility noted above, revenues from collaborative agreements, as well as through equity or debt financings. In July 2005, we filed a registration statement on Form S-3 with the SEC, which became effective on August 17, 2005. This shelf registration statement covers the issuance and sale by us, of any combination of common stock, preferred stock, debt securities and warrants having an aggregate purchase price of up to $75 million.

If we raise additional funds by issuing equity securities, further dilution to our then-existing shareholders may result. Additional debt financing, such as the credit facility noted above, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. Any debt or equity financing may contain terms, such as liquidation and other preferences, that are not favorable to us or our shareholders. If we raise additional funds through collaboration and licensing arrangements with third parties, it may be necessary to relinquish valuable rights to our technologies, research programs or potential product, or grant licenses on terms that may not be favorable to us. We cannot be certain that additional financing will be available in amounts or on terms acceptable to us, if at all. If we are unable to obtain this additional financing, we may be required to delay, reduce the scope of, or eliminate one or more of our planned research, development and commercialization activities, which could harm our financial condition and operating results.

Contractual Obligations

Our outstanding contractual cash obligations include obligations under our operating leases primarily for facilities, purchase obligations primarily relating to clinical development and obligations under deferred compensation plans as discussed below. Following is a table summarizing our contractual obligations as of December 31, 2006 (in thousands).

			Less than						After
	Total		One Year		1-3 Years		4-5 Years		5 Years
Operating Leases	$	797	$	765	$	32	$	—	$	—
Purchase Obligations		3,645		3,645		—		—		—
Deferred Compensation, including current portion		3,053		294		588		588		1,583
Total	$	7,495	$	4,704	$	620	$	588	$	1,583

Deferred compensation, including current portion, reflects the commitments described below:

•  We have a Supplemental Executive Retirement Plan, or SERP, a nonqualified plan which covers our former Chairman and Chief Executive Officer, Tod R. Hamachek. Under the SERP, effective in May 2005, we became obligated to pay Mr. Hamachek approximately $12,600 per month over the lives of Mr. Hamachek and his spouse.

•  We also have a Deferred Compensation Plan, or DCP, a nonqualified plan which covers Mr. Hamachek. Under the DCP, effective in May 2005, we became obligated to pay Mr. Hamachek approximately $140,000 per year, including interest, in ten annual installments. However, these installments are recalculated annually based on market interest rates as provided for under the DCP.

We do not fund these liabilities, and no assets are held by the plans. However, we have two whole-life insurance policies in a rabbi trust, the cash surrender value or death benefits of which are held in trust for the SERP and DCP liabilities. In April 2006, we withdrew from the trust approximately $446,000 as reimbursement for all SERP and DCP benefit payments we previously made to Mr. Hamachek. Effective in June 2006, Mr. Hamachek’s SERP and DCP benefit payments are being made directly from the assets in the trust. As of December 31, 2006, trust assets comprised of the cash surrender value of these life insurance polices totaling $2.7 million and $2,000 held in a money market account.

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Net Operating Loss Carryforwards

As of December 31, 2006, we had federal net operating loss, or NOL, carryforwards of approximately $161.3 million for income tax purposes, of which approximately $6.2 million, $8.4 million, $9.1 million, $17.7 million, $19.4 million, $13.5 million, $22.8 million, $21.8 million and $42.4 million expire in 2018, 2019, 2020, 2021, 2022, 2023, 2024, 2025 and 2026, respectively. In addition, we had research and development tax credit carryforwards of approximately $5.3 million of which $67,000, $359,000, $341,000, $777,000, $828,000, $858,000, $760,000, $669,000 and $650,000 expire in 2018, 2019, 2020, 2021, 2022, 2023, 2024, 2025 and 2026, respectively. The use of the NOLs and research and development tax credit carryforwards are limited to our future taxable earnings. For financial reporting purposes, as of December 31, 2006, a valuation allowance of $62.7 million has been recognized to offset net deferred tax assets, primarily attributable to the NOL carryforward. The change in the valuation allowance in 2006 was an increase of $14.3 million. Utilization of the operating losses is subject to a limitation due to the ownership change provisions of the Internal Revenue Code.

Market Risk and Risk Management Policies

Market risk is the risk of loss to future earnings, to fair values or to future cash flows that may result from changes in the price of a financial instrument. The value of a financial instrument may change as a result of changes in interest rates, foreign currency exchange rates and other market changes. Market risk is attributed to all market sensitive financial instruments, including debt instruments. Our operations are exposed to financial market risks, primarily changes in interest rates. Our interest rate risk primarily relates to our investments in marketable securities.

The primary objectives for our investment portfolio are liquidity and safety of principal. Investments are made to achieve the highest rate of return, consistent with these two objectives. Our investment policy limits investments to specific types of instruments issued by institutions with investment grade credit ratings and places certain restrictions on maturities and concentration by issuer.

As of December 31, 2006, our marketable securities consisted primarily of corporate debt and U.S. Government-agency backed discounted notes, and approximated $24.4 million. These marketable securities had maturity dates of up to six months. Due to the relatively short-term maturities of these securities, management believes there is no significant market risk. As of December 31, 2006, market values approximated carrying values. As of December 31, 2006, we had approximately $40.6 million in cash, cash equivalents and short-term investments, and accordingly, a sustained decrease in the rate of interest earned of 1% would have caused a decrease in the annual amount of interest earned of up to approximately $406,000.

As of December 31, 2005, our marketable securities consisted primarily of corporate debt and U.S. Government-agency backed discounted notes and approximated $39.4 million.

Recent Accounting Pronouncements

In February 2007, the FASB issued SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities — Including an Amendment of FASB Statement No. 115.” SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company is in the process of evaluating the impact this pronouncement may have on its results of operations and financial position.

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R).” SFAS No. 158 requires employers to recognize the funded status (i.e. the difference between the fair value of plan assets and the projected benefit obligations) of defined benefit pension and other postretirement benefit plans as an asset or liability in its statement of financial position and to recognize changes in the funded status in the year in which the changes occur as a component of comprehensive income. In addition, SFAS No. 158 requires employers to measure the funded status of its plans as of the date of its year-end statement of financial position and also requires additional disclosures regarding amounts included in accumulated other

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comprehensive income. SFAS No. 158 is effective as of the end of fiscal years ending after December 15, 2006; therefore, the Company adopted the recognition and disclosure provisions of SFAS No. 158 on December 31, 2006. The effect of adopting SFAS No. 158 on the Company’s financial position was to decrease the liability under its SERP and to increase accumulated other comprehensive income by $110,000. SFAS No. 158 had no effect on the Company’s financial position as of December 31, 2005 (see Note 12).

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 provides a common definition of fair value to be applied to existing GAAP requiring the use of fair value measures, establishes a framework for measuring fair value and enhances disclosure about fair value measures under other accounting pronouncements. However, SFAS No. 157 does not change existing guidance as to whether or not an asset or liability is carried at fair value. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and, as such, the Company plans to adopt the provisions of SFAS No. 157 on January 1, 2008. The Company is in the process of evaluating the effect the adoption of this pronouncement will have on its results of operations, financial position and cash flows.

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”, an interpretation of FASB Statement No. 109, “Accounting for Income Taxes” (“FIN 48”), to create a single model to address accounting for uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold that a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company will adopt FIN 48 as of January 1, 2007, as required. The Company is in the process of evaluating the effect the adoption of this interpretation will have on its results of operations, financial position and cash flows.

In June 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections-a replacement of APB Opinion No. 20 and FASB Statement No. 3”. SFAS No. 154 replaces APB Opinion No. 20, “Accounting Changes”, and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements”, and changes the requirements for the accounting and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in accounting principle and to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. SFAS No. 154 also requires that a change in depreciation, amortization, or depletion method for long-lived, nonfinancial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. SFAS No. 154 requires that the change in accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings for that period, rather than being reported in an income statement. Such a change would require a company to restate its previously issued financial statements to reflect the change in accounting principle to prior periods presented. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Our adoption of SFAS No. 154 on January 1, 2006 had no effect on the Company’s results of operations, financial position and cash flows.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs — an amendment of ARB No. 43, Chapter 4”. This Statement amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4, previously stated that “. . .under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges. . .” This Statement requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this Statement shall be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Our adoption of SFAS No. 151 on January 1, 2006 had no effect on the Company’s results of operations, financial position and cash flows.

36

Other pronouncements issued by the FASB or other authoritative accounting standards groups with future effective dates are either not applicable or not significant to our financial statements.

ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Reference is made to the disclosure under the caption “Market Risk and Risk Management Policies” in “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

All financial statements required to be filed hereunder are filed as Appendix A hereto and are listed under Item 15(a) included herein.

ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

ITEM 9A.   CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures.  Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2006. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of December 31, 2006, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

(b) Changes in Internal Control Over Financial Reporting.  No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act) occurred during the fiscal quarter ended December 31, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

(c) Reports on Internal Control Over Financial Reporting

Management’s Annual Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) and 15d-15(f) promulgated under the Securities Exchange Act of 1934 as a process designed by, or under the supervision of, our principal executive and principal financial officers and effected by our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:

•  Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;

37

•  Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and

•  Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2006. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on this assessment, management believes that, as of December 31, 2006, our internal control over financial reporting is effective based on those criteria.

Management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which appears below.

38

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

Penwest Pharmaceuticals Co.

We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting that Penwest Pharmaceuticals Co. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Penwest Pharmaceuticals Co.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

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 of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that Penwest Pharmaceuticals Co. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Penwest Pharmaceuticals Co. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the balance sheets of Penwest Pharmaceuticals Co. as of December 31, 2006 and 2005, and the related statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006 and our report dated March  13, 2007 expressed an unqualified opinion thereon.

/s/  Ernst & Young LLP

Stamford, Connecticut

March 13, 2007

39

ITEM 9B.   OTHER INFORMATION

On March 13, 2007, we entered into a credit and security agreement with Merrill Lynch Capital, a division of Merrill Lynch Business Financial Services Inc., as Lender and Administrative Agent. A description of the terms of the agreement is included under “Sources of Liquidity” under the caption “Liquidity and Capital Resources” in “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

PART III

ITEM 10.   DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The information required by this item will be contained in our definitive proxy statement for the 2007 annual meeting of shareholders under the captions “Discussion of Proposals,” “Information About Corporate Governance,” “Information About Our Executive Officers” and “Other Information” and is incorporated herein by this reference.

We have adopted a code of business conduct and ethics applicable to all of our directors and employees. The code of business conduct and ethics is available on the corporate governance section of “Investor Relations” of our website, www.penwest.com.

Any waiver of the code of business conduct and ethics for directors or executive officers, or any amendment to the code that applies to directors or executive officers, may only be made by the board of directors. We intend to satisfy the disclosure requirement under Item 5.05 of Form 8-K regarding an amendment to, or waiver from, a provision of this code of ethics by posting such information on its website, at the address and location specified above. To date, no such waivers have been requested or granted.

Information regarding our executive officers is set forth in Part I of this annual report on Form 10-K under the caption “Executive Officers of the Registrant.”

ITEM 11.   EXECUTIVE COMPENSATION

The information required by this item will be contained in our 2007 proxy statement under the captions “Corporate Governance,” “Information About Our Executive Officers” and “Other Information” and is incorporated herein by this reference.

ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information required by this item will be contained in our 2007 proxy statement under the captions “Information About Our Executive Officers” and “Other Information” and is incorporated herein by this reference.

ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information required by this item will be contained in our 2007 proxy statement under the caption “Information About Our Executive Officers” and is incorporated herein by this reference.

ITEM 14.   PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by this item will be contained in our 2007 proxy statement under the caption “Discussion of Proposals” and is incorporated herein by this reference.

40

PART IV

ITEM 15.   EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a) (1), (2) Financial Statements and Financial Statement Schedule

The following documents are filed as Appendix A hereto and are included as part of this Annual Report on Form 10-K:

The balance sheets as of December 31, 2006 and 2005 and the related statements of operations, cash flows and shareholders’ equity for each of the three years in the period ended December 31, 2006.

Schedule II — Valuation and Qualifying Accounts

All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are omitted because they are not applicable or because the information is presented in the financial statements or notes thereto.

(3) Exhibits

The list of Exhibits filed as part of this Annual Report on Form 10-K are set forth on the Exhibit Index immediately preceding such exhibits, and is incorporated herein by this reference. This list includes a subset containing each management contract, compensatory plan, or arrangement required to be filed as an exhibit to this report.

41

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Penwest Pharmaceuticals Co.

/s/  Jennifer L. Good

Jennifer L. Good,

President and Chief Executive Officer

Date: March 13, 2007

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

/s/  Jennifer L. Good Jennifer L. Good	President and Chief Executive Officer, Director (principle executive officer)	Date: March 13, 2007
/s/  Benjamin L. Palleiko Benjamin L. Palleiko	Senior Vice President, Corporate Development and Chief Financial Officer (principal financial and accounting officer)	Date: March 13, 2007
/s/  Paul E. Freiman Paul E. Freiman	Chairman of the Board	Date: March 13, 2007
/s/  Peter F. Drake Peter F. Drake, Ph.D.	Director	Date: March 13, 2007
/s/  Rolf H. Henel Rolf H. Henel	Director	Date: March 13, 2007
/s/  Robert J. Hennessey Robert J. Hennessey	Director	Date: March 13, 2007
/s/  David P. Meeker David P. Meeker, M.D.	Director	Date: March 13, 2007
/s/  John N. Staniforth John N. Staniforth, Ph.D.	Director	Date: March 13, 2007
/s/  Anne M. VanLent Anne M. VanLent	Director	Date: March 13, 2007

42

APPENDIX A

PENWEST PHARMACEUTICALS CO.

INDEX TO FINANCIAL STATEMENTS AND

FINANCIAL STATEMENT SCHEDULE

	Page
Financial Statements
Report of Independent Registered Public Accounting Firm		F-2
Balance Sheets		F-3
Statements of Operations		F-4
Statements of Shareholders’ Equity		F-5
Statements of Cash Flows		F-6
Notes to Financial Statements		F-7
Schedule II — Valuation and Qualifying Accounts		S-1

F-1

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

Penwest Pharmaceuticals Co.

We have audited the accompanying balance sheets of Penwest Pharmaceuticals Co. as of December 31, 2006 and 2005, and the related statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

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 audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Penwest Pharmaceuticals Co. at December 31, 2006 and 2005, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

As discussed in Notes 2 and 3 to the financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R) (revised 2004), “Share-Based Payment” and Statement of Financial Accounting Standards No. 158, “Employee Accounting for Defined Benefit Pension and Other Postretirement Plans” in 2006.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Penwest Pharmaceuticals Co.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 13, 2007 expressed an unqualified opinion thereon.

/s/  Ernst & Young LLP

Stamford, Connecticut

March 13, 2007

F-2

PENWEST PHARMACEUTICALS CO.

BALANCE SHEETS

	December 31,
	2006			2005
	(In thousands,
	except share amounts)
ASSETS
Current assets:
Cash and cash equivalents	$	16,182		$	15,917
Marketable securities		24,408			39,377
Trade accounts receivable		683			942
Inventories		201			140
Prepaid expenses and other current assets		1,595			1,112
Total current assets		43,069			57,488
Fixed assets, net		3,787			2,990
Patents, net		3,184			3,383
Other assets		2,702			3,160
Total assets	$	52,742		$	67,021
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	1,324		$	1,064
Accrued expenses		2,096			1,722
Accrued development costs		1,105			499
Deferred compensation — current portion		290			291
Total current liabilities		4,815			3,576
Deferred revenue		43			57
Deferred compensation		2,763			2,977
Total liabilities		7,621			6,610
Shareholders’ equity:
Preferred stock, par value $.001, authorized 1,000,000 shares, none outstanding		—			—
Common stock, par value $.001, authorized 60,000,000 shares, issued and outstanding 23,132,815 shares at December 31, 2006 and 21,889,940 shares at December 31, 2005		23			22
Additional paid in capital		217,427			201,659
Accumulated deficit		(172,428	)		(141,116	)
Accumulated other comprehensive income (loss)		99			(154	)
Total shareholders’ equity		45,121			60,411
Total liabilities and shareholders’ equity	$	52,742		$	67,021

See accompanying notes

F-3

PENWEST PHARMACEUTICALS CO.

STATEMENTS OF OPERATIONS

	Year Ended December 31,
	2006			2005			2004
	(In thousands, except per share data)
Revenues:
Royalties and licensing fees	$	3,118		$	6,213		$	4,882
Product sales		381			—			226
Total revenues		3,499			6,213			5,108
Cost of revenues		231			39			104
Gross profit		3,268			6,174			5,004
Operating expenses:
Selling, general and administrative		14,075			13,247			9,485
Research and product development		22,857			17,797			20,205
Total operating expenses		36,932			31,044			29,690
Loss from operations		(33,664	)		(24,870	)		(24,686	)
Investment income		2,352			1,974			906
Loss before income tax expense		(31,312	)		(22,896	)		(23,780	)
Income tax expense		—			2			5
Net loss	$	(31,312	)	$	(22,898	)	$	(23,785	)
Basic and diluted net loss per common share	$	(1.38	)	$	(1.05	)	$	(1.28	)
Weighted average shares of common stock outstanding		22,751			21,711			18,627

See accompanying notes

F-4

PENWEST PHARMACEUTICALS CO.

STATEMENTS OF SHAREHOLDERS’ EQUITY

										Accumulated
					Additional					Other
	Common Stock				Paid-In		Accumulated			Comprehensive
	Shares		Amount		Capital		Deficit			(Loss) Income			Total
	(In thousands)
Balances, December 31, 2003		18,423	$	18	$	162,068	$	(94,433	)	$	43		$	67,696
Net loss		—		—		—		(23,785	)		—			(23,785	)
Changes in unrealized gain/loss on marketable securities		—		—		—		—			(143	)		(143	)
Comprehensive loss		—		—		—		—			—			(23,928	)
Issuance of common stock pursuant to an equity financing, net		3,125		4		32,795		—			—			32,799
Issuance of common stock pursuant to stock compensation plans		130		—		2,081		—			—			2,081
Issuance of common stock pursuant to Stock Purchase Plan		15		—		153		—			—			153
Balances, December 31, 2004		21,693		22		197,097		(118,218	)		(100	)		78,801
Net loss		—		—		—		(22,898	)		—			(22,898	)
Changes in unrealized loss on marketable securities		—		—		—		—			(54	)		(54	)
Comprehensive loss		—		—		—		—			—			(22,952	)
Issuance of common stock pursuant to stock compensation plans		183		—		2,027		—			—			2,027
Stock compensation charge in connection with modification of stock options		—		—		2,398		—			—			2,398
Issuance of common stock pursuant to Stock Purchase Plan		14		—		137		—			—			137
Balances, December 31, 2005		21,890		22		201,659		(141,116	)		(154	)		60,411
Net loss		—		—		—		(31,312	)		—			(31,312	)
Changes in unrealized loss on marketable securities		—		—		—		—			143			143
Comprehensive loss		—		—		—		—			—			(31,169	)
Transition adjustment for funded status of post retirement plan		—		—		—		—			110			110
Issuance of common stock pursuant to stock compensation plans		1,233		1		11,511		—			—			11,512
Stock compensation charges in connection with stock options and Stock Purchase Plan		—		—		4,098		—			—			4,098
Issuance of common stock pursuant to Stock Purchase Plan		10		—		159		—			—			159
Balances, December 31, 2006		23,133	$	23	$	217,427	$	(172,428	)	$	99		$	45,121

See accompanying notes

F-5

PENWEST PHARMACEUTICALS CO.

STATEMENTS OF CASH FLOWS

	Year Ended December 31,
	2006			2005			2004
	(In thousands)
Operating activities:
Net loss	$	(31,312	)	$	(22,898	)	$	(23,785	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation		1,001			987			1,042
Amortization of patents		565			464			410
Inventory reserves		—			497			75
Patent impairment losses		254			137			417
Deferred revenue		(14	)		(14	)		(14	)
Deferred compensation		190			194			211
Stock compensation		4,978			3,083			297
Changes in operating assets and liabilities:
Trade accounts receivable		259			184			27
Inventories		(61	)		5			(62	)
Accounts payable, accrued expenses and other		497			(2,700	)		(1,505	)
Net cash used in operating activities		(23,643	)		(20,061	)		(22,887	)
Investing activities:
Proceeds from sale of discontinued operations		—			—			1,250
Acquisitions of fixed assets, net		(1,818	)		(276	)		(1,226	)
Patent costs		(619	)		(479	)		(643	)
Purchases of marketable securities		(27,739	)		(51,499	)		(57,681	)
Proceeds from maturities of marketable securities		41,248			47,054			17,795
Proceeds from sales of marketable securities		1,600			25,450			35,150
Proceeds from cash surrender value of life insurance policy withdrawal		446			—			—
Net cash provided by (used in) investing activities		13,118			20,250			(5,355	)
Financing activities:
Issuance of common stock, net		10,790			1,479			34,250
Net cash provided by financing activities		10,790			1,479			34,250
Net increase in cash and cash equivalents		265			1,668			6,008
Cash and cash equivalents at beginning of year		15,917			14,249			8,241
Cash and cash equivalents at end of year	$	16,182		$	15,917		$	14,249

See accompanying notes

F-6

PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS

1.   BUSINESS

Penwest Pharmaceuticals Co. (the “Company” or “Penwest”) develops pharmaceutical products based on innovative proprietary drug delivery technologies with a focus on products that address disorders of the nervous system. On June 22, 2006, the United States Food and Drug Administration (the “FDA”), approved Opana^® ER, which the Company previously referred to as oxymorphone ER. Opana ER is an extended release formulation of oxymorphone that the Company developed with Endo Pharmaceuticals Inc. (“Endo”) using the Company’s proprietary TIMERx drug delivery technology. Opana ER is approved for twice-a-day dosing in patients with moderate to severe pain requiring continuous, around-the-clock opioid therapy for an extended period of time. The Company is also developing additional product candidates designed for the treatment of pain, epilepsy, Parkinson’s disease and spasticity, as well as a product candidate designed for the treatment of edema resulting from congestive heart failure. The Company conducts its business primarily in North America.

The Company has incurred net losses since 1994. As of December 31, 2006, the Company’s accumulated deficit was approximately $172 million. The Company expects operating losses and negative cash flows to continue until substantial sales of Opana ER or other products commercialized utilizing TIMERx technology or other technologies occur. The Company’s revenues for 2004, 2005 and 2006 were generated primarily from royalties received from Mylan Pharmaceuticals Inc (“Mylan”). The Company’s future profitability will depend on several factors, including: the commercial success of Opana ER, and the timing and amount of royalties from Endo’s sales of Opana ER; the level of our investment in research and development activities; the successful development and commercialization of product candidates other than Opana ER in our portfolio; the level of investment for acquisitions or in-licensing of technologies or compounds intended to support our growth; and royalties from Mylan’s sales of Pfizer, Inc’s. (“Pfizer”) 30 mg. generic version of Procardia XL.

The Company is subject to the risks and uncertainties associated with drug development. These risks and uncertainties include, but are not limited to, a history of net losses, technological changes, dependence on collaborators and key personnel, the successful completion of development efforts and obtaining regulatory approval, the successful commercialization of products compliant with government regulations, patent infringement litigation, competition from current and potential competitors, dependence on third party manufacturers and a requirement for additional funding.

2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Cash and Cash Equivalents

All highly liquid investments with maturities of 90 days or less when purchased are considered cash equivalents.

Marketable Securities

The Company accounts for marketable securities in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The Company classifies its marketable securities as available-for-sale securities. Such securities are stated at fair value and primarily consist of corporate bonds, commercial paper and discounted notes backed by U.S. government agencies. Unrealized holding gains or losses are included in shareholders’ equity as a separate component

F-7

PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

of accumulated other comprehensive income (loss). The specific identification method is used to compute the realized gains and losses, if any, on marketable securities.

Credit Risk and Fair Value of Financial Instruments

The Company performs ongoing credit evaluations of its customers and generally does not require collateral. Revenues from product sales and licensing fees are primarily derived from major pharmaceutical companies that generally have significant cash resources. Allowances for doubtful accounts receivable are maintained based on historical payment patterns, aging of accounts receivable and actual write-off history. As of December 31, 2006 and December 31, 2005, no allowances for doubtful accounts were recorded by the Company. One customer of the Company accounted for approximately 89%, 63% and 94% of total revenues in 2006, 2005 and 2004, respectively. Another customer of the Company accounted for approximately 36% of total revenues for 2005.

The primary objectives for the Company’s investment portfolio are liquidity and safety of principal. Investments are made to achieve the highest rate of return to the Company, consistent with these two objectives. The Company’s investment policy limits investments to certain types of instruments issued by institutions with investment grade credit ratings, and places certain restrictions on maturities and concentration by issuer.

The carrying value of financial instruments, which includes cash, cash equivalents, marketable securities, receivables and accounts payable, approximates fair value due to the short term nature of these instruments.

Inventories

Inventories, which consist of raw materials and manufactured bulk TIMERx finished products, are stated at the lower of cost (first-in, first-out) or market. The costs of any such raw materials and finished products acquired for research and development activities that also have alternative future uses are capitalized when acquired. The Company periodically reviews and quality tests its inventory to identify obsolete, slow moving or otherwise unsaleable inventories and establishes allowances for situations in which the cost of the inventory is not expected to be recovered. Inventory allowances or write-offs associated with development projects are charged to research and product development expense prior to regulatory approval. The Company records pre-commercial sales of its bulk TIMERx to its development project collaborators as an offset to research and product development expense in situations where cost-sharing arrangements exist. These sales were not material in 2006, 2005 or 2004.

Long-Lived Assets

Fixed assets are recorded at cost and depreciated using the straight-line method over their estimated useful lives or over the lease term, if shorter, for leasehold improvements. Estimated useful lives by class of assets are substantially as follows:

Machinery and equipment	5-10 years
Office furniture, equipment and software	3-10 years
Leasehold improvements	1-3 years

The Company reviews the recoverability of its long-lived assets, including definite-lived intangible assets, whenever facts and circumstances indicate that the carrying amount may not be fully recoverable. For purposes of recognizing and measuring impairment, the Company evaluates long-lived assets based upon the lowest level of independent cash flows ascertainable to evaluate impairment. If the sum of the undiscounted future cash flows expected over the remaining asset life is less than the carrying value of the assets, the Company may recognize an impairment loss. The impairment related to long-lived assets is measured as the amount by

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PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

which the carrying amount of the assets exceeds the fair value of the asset. When fair values are not readily available, the Company estimates fair values using expected discounted future cash flows.

Foreign Currencies

Realized gains and losses from foreign currency transactions are reflected in the statements of operations and were not significant in each year in the three year period ended December 31, 2006.

Accumulated Other Comprehensive Income (Loss)

Accumulated other comprehensive income (loss) at December 31, 2006 consisted of the transition adjustment for the funded status of the Company’s Supplemental Executive Retirement Plan (“SERP”) recorded in connection with the adoption of SFAS 158 (see Note 3) and unrealized losses on marketable securities. Accumulated other comprehensive income (loss) at December 31, 2005 and 2004 consisted of unrealized losses on marketable securities.

Income Taxes

The liability method, prescribed by SFAS No. 109, “Accounting for Income Taxes,” is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities. The Company recorded no income tax benefits relating to the net operating losses generated during 2006, 2005 and 2004, as such losses were fully offset by valuation allowances. Valuation allowances are established against the recorded deferred income tax assets to the extent that the Company believes it is more likely than not that a portion of the deferred income tax assets are not realizable.

Revenue Recognition

Royalties and licensing fees — The Company recognizes revenues from non-refundable upfront licensing fees received under collaboration agreements ratably over the development period of the related collaboration agreement when this period involves development risk associated with the incomplete stage of a product’s development, or over the estimated or contractual licensing and supply term when there exists an obligation to supply inventory for manufacture. Non-refundable milestone fees received for the development funding of a product are partially recognized upon receipt based on the Company’s proportionate development efforts achieved to date relative to the total expected development efforts and the remainder is generally recognized ratably over the remaining expected development period. The proportionate development efforts achieved are measured by estimating the percentage of work completed that is required of the Company in the development effort for the product. This estimate is primarily derived from the underlying project plans and timelines, developed by qualified personnel who work closely on such projects. In particular, the Company reviews output measures such as job specifications and tasks completed, compared to all such job specifications and tasks outlined for a particular project. Job specifications vary with each project and primarily include development activities regarding initial formulation work, manufacturing scale-up, proof-of-principle biostudies, clinical development and regulatory matters. Non-refundable contractual fees received in connection with a collaborator’s launch of a product are also recognized ratably over the estimated or contractual licensing and supply term. Upon termination of a collaboration agreement, any remaining non-refundable licensing fees received by the Company, which had been deferred, are generally recognized in full. Product royalty fees are recognized when earned, as reported by our collaborators, and are generally subject to review or audit by the Company.

Product sales — The Company recognizes revenues from product sales when title transfers and customer acceptance provisions have lapsed, provided that collections of the related accounts receivable are probable. Shipping and handling costs are included in cost of revenues.

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PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

Research and Development Expenses

Research and development expenses consist of costs associated with products being developed internally as well as products being developed under collaboration agreements and include related salaries, benefits and other personnel related expenses, clinical trial costs, and contract and other outside service fees. Research and development costs are expensed as incurred. A significant portion of the Company’s development activities are outsourced to third parties, including contract research organizations and to contract manufacturers in connection with the production of clinical materials. These activities may also be performed by the Company’s collaborators. These arrangements may require estimates to be made of related service fees or the Company’s share of development costs, in which actual results could materially differ from the estimates and affect the reported amounts in the Company’s financial statements. These arrangements with third parties may also require the Company to pay termination costs to the third parties for reimbursement of costs and expenses incurred in the orderly termination of contractual services.

Per Share Data

Loss per common share is computed based on the weighted average number of shares of common stock outstanding during the period. For all years reported, diluted loss per share was the equivalent of basic loss per share due to the respective net losses. No dilution for common stock equivalents is included in 2006, 2005 and 2004 as the effects would be antidilutive. Such securities, excluded due to their antidilutive effect, are as follows:

	December 31,
	2006		2005		2004
	(In thousands of shares)
Stock options outstanding		2,267		3,016		2,647
Restricted stock outstanding (unvested)		52		68		50
		2,319		3,084		2,697

Share-Based Compensation

Effective January 1, 2006, the Company adopted SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”) using the modified prospective transition method. SFAS 123R requires all share-based payments to employees, including grants of employee stock options as well as grants under compensatory employee stock purchase plans, to be recognized as an expense in the statement of operations based on their fair values as they are earned by the employees under the vesting terms. Pro forma disclosure of stock-based compensation expense, as was the Company’s practice under SFAS 123, “Accounting for Stock-Based Compensation”, is no longer permitted (see Note 8).

The valuation of employee stock options is an inherently subjective process, since market values are generally not available for long-term, non-transferable employee stock options. Accordingly, an option pricing model is utilized to derive an estimated fair value. In calculating the estimated fair value of stock options granted, a Black-Scholes-Merton pricing model is used which requires the consideration of the following variables for purposes of estimating fair value:

•  the stock option exercise price;

•  the expected term of the option;

•  the grant date price of the Company’s common stock, which is issuable upon exercise of the option;

•  the expected volatility of the Company’s common stock;

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PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

•  expected dividends on the Company’s common stock (the Company does not anticipate paying dividends for the foreseeable future); and

•  the risk free interest rate for the expected option term.

Of the variables above, the Company believes that the selection of an expected term and expected stock price volatility are the most subjective. The Company uses historical employee exercise and option expiration data to estimate the expected term assumption for the Black-Scholes-Merton grant date valuation. The Company believes that this historical data is currently the best estimate of the expected term of a new option, and that generally, all groups of its employees exhibit similar exercise behavior. In general, the longer the expected term used in the Black-Scholes-Merton pricing model, the higher the grant-date fair value of the option. For options granted prior to 2006, the Company used historical volatility to estimate the grant-date fair value of stock options. Historical volatility is calculated based on a period equal to the expected term of stock option awards, and actual stock prices during this period. Following a review of alternative methods of estimating expected volatility, the Company changed its method of estimating expected volatility for all stock options granted after 2005 from exclusively relying on historical volatility to using an average of implied volatility and historical volatility. In accordance with SFAS 123R, the Company selected the average of implied volatility and historical volatility as it believes neither of these measures is better than the other in estimating the expected volatility of the Company’s common stock. The Company believes that its estimates, both expected term and stock price volatility, are reasonable in light of the historical data analyzed.

The valuation assumptions selected upon the adoption of SFAS 123R were applied to stock options that the Company granted subsequent to its adoption of SFAS 123R; however, stock option expense recorded in the year ended December 31, 2006, also included amounts related to the continued vesting of stock options that were granted prior to January 1, 2006. In accordance with the transition provisions of SFAS 123R, the grant date estimates of fair value associated with prior awards, which were also calculated using a Black-Scholes-Merton option pricing model, have not been changed. The Company uses the accelerated attribution method to recognize expense for all options granted.

Upon the adoption of SFAS 123R, the Company was also required to estimate the level of award forfeitures expected to occur, and record compensation cost only for those awards that are ultimately expected to vest. This requirement applies to all awards that are not yet vested, including awards granted prior to January 1, 2006. Accordingly, the Company performed a historical analysis of option awards that were forfeited (such as by employee separation) prior to vesting, and ultimately recorded stock option expense that reflected the estimated forfeiture rate.

3.   RECENT ACCOUNTING PRONOUNCEMENTS

In February 2007, the FASB issued SFAS 159 “The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115”. SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company is in the process of evaluating the impact this pronouncement may have on its results of operations and financial position.

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R)”. SFAS No. 158 requires employers to recognize the funded status (i.e. the difference between the fair value of plan assets and the projected benefit obligations) of defined benefit pension and other postretirement benefit plans as an asset or liability in its statement of financial position and to recognize changes in the funded status in the year in which the changes occur as a component of comprehensive income. In addition, SFAS No. 158 requires employers to measure the funded status of its plans as of the date of its year-end statement of financial position and also requires additional disclosures regarding amounts included in accumulated other

F-11

PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

comprehensive income. SFAS No. 158 is effective as of the end of fiscal years ending after December 15, 2006; therefore, the Company adopted the recognition and disclosure provisions of SFAS No. 158 at December 31, 2006. The effect of adopting SFAS No. 158 on the Company’s financial position was to decrease the liability under its SERP and to increase accumulated other comprehensive income by $110,000. SFAS No. 158 had no effect on the Company’s financial position as of December 31, 2005 (see Note 12).

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”. SFAS No. 157 provides a common definition of fair value to be applied to existing GAAP requiring the use of fair value measures, establishes a framework for measuring fair value and enhances disclosure about fair value measures under other accounting pronouncements, but does not change existing guidance as to whether or not an asset or liability is carried at fair value. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and, as such, the Company plans to adopt the provisions of SFAS No. 157 on January 1, 2008. The Company is in the process of evaluating the effect the adoption of this pronouncement will have on its results of operations, financial position and cash flows.

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”, an interpretation of FASB Statement No. 109, “Accounting for Income Taxes” (“FIN 48”), to create a single model to address accounting for uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes, by prescribing a minimum recognition threshold that a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company will adopt FIN 48 as of January  1, 2007, as required. The Company is in the process of evaluating the effect the adoption of this interpretation will have on its results of operations, financial position and cash flows.

In June 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections-a replacement of APB Opinion No. 20 and FASB Statement No. 3”. This standard replaces APB Opinion No. 20, “Accounting Changes”, and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements”, and changes the requirements for the accounting and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in accounting principle and to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. SFAS No. 154 also requires that a change in depreciation, amortization, or depletion method for long-lived, nonfinancial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. SFAS No. 154 requires that the change in accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings for that period, rather than being reported in an income statement. Such a change would require a company to restate its previously issued financial statements to reflect the change in accounting principle to prior periods presented. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS No. 154 had no effect on the Company’s results of operations, financial position and cash flows.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs — an amendment of ARB No. 43, Chapter 4”. This Statement amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4, previously stated that “. . .under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges. . .” This Statement requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this Statement shall be effective for inventory

F-12

PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

costs incurred during fiscal years beginning after June 15, 2005. The adoption of SFAS No. 151 had no effect on the Company’s results of operations, financial position and cash flows.

Other pronouncements issued by the FASB or other authoritative accounting standards groups with future effective dates are either not applicable or not significant to the financial statements of the Company.

4.   MARKETABLE SECURITIES

The amortized costs and estimated fair values of marketable securities are as follows:

			Gross		Gross		Estimated
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
	(In thousands)
December 31, 2006:
Corporate debt securities	$	21,381	$	3	$	10	$	21,374
U.S. government agency-backed discounted notes		3,038		—		4		3,034
Total marketable securities	$	24,419	$	3	$	14	$	24,408
December 31, 2005:
Corporate debt securities	$	32,472	$	—	$	113	$	32,359
U.S. government agency-backed discounted notes		7,059		—		41		7,018
Total marketable securities	$	39,531	$	—	$	154	$	39,377

Maturities of marketable securities at fair value as of December 31, 2006, are as follows (in thousands):

Contractual maturity — maturing in one year or less $ 24,408

The primary objectives for the Company’s investment portfolio are liquidity and safety of principal. Investments are made to achieve the highest rate of return to the Company, consistent with these two objectives. The Company’s investment policy limits investments to certain types of instruments issued by institutions with investment grade credit ratings and places certain restrictions on maturities, and concentration by issuer (see Note 2, “Credit Risk and Fair Value of Financial Instruments”).

A decline in the market value of any security below cost that is deemed to be other than temporary results in a reduction in carrying amount to fair value. Such impairments are charged to the results of operations and a new cost basis for the security is established. Unrealized losses on marketable securities held at December 31, 2006 and 2005 were not deemed other than temporary, as all such securities are investment grade, and management believes the impairments are attributable to increased market rates.

5.   INVENTORIES

Inventories are summarized as follows:

	December 31,
	2006		2005
	(In thousands)
Raw materials	$	64	$	44
Finished products		137		96
Total inventories	$	201	$	140

As of December 31, 2006, there were no inventory allowances. Inventories at December 31, 2005 are net of allowances of $208,000. During 2005, the Company recorded write-offs of inventory totaling approximately

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PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

$497,000 relating primarily to a change in specifications for TIMERx. Such write-offs are reflected in research and product development expense in the statements of operations.

The Company currently has no internal commercial scale manufacturing capabilities. Generally, the Company’s collaborators manufacture the pharmaceutical products, and the Company is responsible for supplying them with bulk TIMERx. The Company outsources the commercial manufacture of its bulk TIMERx to a third-party pharmaceutical company, Draxis Specialty Pharmaceuticals Inc. (“Draxis”), under a manufacturing and supply agreement with an initial term that expires in November 2009. The agreement automatically renews for successive one-year periods, unless either party gives notice of its intent not to renew the agreement at least 180 days prior to the end of the then-current term. Under the terms of the agreement, the Company may be obligated, under certain conditions, to purchase finished bulk TIMERx and certain raw materials used in manufacturing TIMERx, upon termination or expiration of the agreement.

The Company’s TIMERx technology is based on a hydrophilic matrix combining a heterodispersed mixture primarily composed of two polysaccharides, xanthan and locust bean gums, in the presence of dextrose. The Company purchases these gums from a primary supplier. Although the Company has qualified alternate suppliers with respect to these gums and to date has not experienced difficulty acquiring these materials, there can be no assurance that interruptions in supplies will not occur in the future or that the Company will not have to obtain substitute suppliers.

6.   FIXED ASSETS

Fixed assets at cost, summarized by major categories, consist of the following:

	December 31,
	2006		2005
	(In thousands)
Equipment and leasehold improvements	$	6,382	$	5,092
Software		1,998		1,834
Projects in progress		308		76
		8,688		7,002
Less: accumulated depreciation and amortization		4,901		4,012
	$	3,787	$	2,990

The Company capitalizes certain costs associated with developing or obtaining internal-use software. These costs include external direct costs of materials and services used in developing or obtaining the software, and payroll and payroll-related costs for employees directly associated with the software development project. The Company did not capitalize any software development costs in 2006, 2005 or 2004. The Company includes software development costs within equipment and software, and generally amortizes the software development costs over a period of five years, once the systems are placed in service. Amortization expense related to software development costs totaled $323,000, $323,000 and $313,000 for 2006, 2005 and 2004, respectively. Unamortized software development costs totaled $507,000 and $830,000 as of December 31, 2006 and 2005, respectively.

7.   PATENTS

	December 31,
	2006		2005
	(In thousands)
Patents, net of accumulated amortization of $2,101 and $1,625:	$	3,184	$	3,383

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PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

Patents include costs to secure patents on technology and products developed by the Company. Patents are amortized on a straight-line basis over their estimated useful lives of 17 to 20 years. Amortization expense of approximately $565,000, $464,000 and $410,000 was recorded in the years ended December 31, 2006, 2005, and 2004, respectively.

The approximate amortization expense expected to be recognized related to existing patent costs is as follows (in thousands):

Year	Amount
2007	$	379
2008		376
2009		363
2010		330
2011		284
Thereafter		1,452
Total	$	3,184

Patents are evaluated for potential impairment whenever events or circumstances indicate that future undiscounted cash flows may not be sufficient to recover their carrying amounts. An impairment loss is recorded to the extent the asset’s carrying value is in excess of the fair value of the asset. When fair values are not readily available, the Company estimates fair values using expected discounted future cash flows. During the years ended December 31, 2006, 2005 and 2004, the Company recorded impairment losses of approximately $254,000, $137,000 and $417,000, respectively, relating to its patents. The impairment losses recorded in 2006 related to the write-off of patent costs primarily in connection with early stage development programs discontinued by the Company, and that the Company determined no longer had value. The impairment losses recorded in 2005 primarily related to the write-off of patents in connection with the termination of the PW2101 development program, which patents the Company determined no longer had value. The impairment losses recorded in 2004 primarily related to the write-off of patents covering inhalation technology which patents the Company determined no longer had value. Such impairment losses are reflected in research and product development expense in the statements of operations.

8.   SHAREHOLDERS’ EQUITY

On July 27, 2005, the Company filed a registration statement on Form S-3 with the Securities and Exchange Commission (the “SEC”), which became effective on August 17, 2005. This shelf registration statement covers the issuance and sale by the Company of any combination of common stock, preferred stock, debt securities and warrants having an aggregate purchase price of up to $75 million.

On December 14, 2004, the Company completed the sale of a total of 3,125,000 shares of common stock through a private placement to selected institutional investors, resulting in net proceeds to the Company, after fees and expenses, of approximately $32.8 million, to fund the research, development, marketing and commercialization of the Company’s products and technologies, and for general corporate purposes.

Share-Based Compensation

In December 2004, the FASB issued SFAS 123R, which is a revision of SFAS 123. SFAS 123R supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, and amends SFAS No. 95, “Statement of Cash Flows”. The approach to quantifying stock-based compensation expense in SFAS 123R is similar to SFAS 123. However, the revised statement requires all share-based payments to employees, including grants of employee stock options as well as grants under compensatory employee stock purchase plans, to be recognized as an expense in the statement of operations based on their

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PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

fair values as they are earned by the employees under the vesting terms. Pro forma disclosure of stock-based compensation expense, as was the Company’s practice under SFAS 123, is no longer permitted. The Company adopted SFAS 123R effective beginning January 1, 2006 using the modified prospective transition method. The effect of the adoption was an additional $4.0 million in compensation expense, or approximately $0.18 per share, basic and diluted, substantially all related to employee stock options, for the year ended December 31, 2006. Of such amounts, $2.1 million was recorded to selling, general and administrative expense, and $1.9 million was recorded to research and product development expense, for the year ended December 31, 2006. Total share-based compensation expense recognized in 2006 and 2005 was $5.0 million and $2.9 million, respectively (see Note 11).

Under the modified prospective transition method, prior periods are not restated for the effect of SFAS 123R. Had the Company accounted for stock-based compensation plans using the fair value based accounting method proscribed by SFAS 123R for the periods prior to 2006, the Company’s net loss and net loss per share would have approximated the pro forma amounts indicated below:

	Year Ended December 31
	2005			2004
	(In thousands,
	except per share data)
Net loss — as reported	$	(22,898	)	$	(23,785	)
Stock-based compensation expense included in reported net loss		2,939			296
Stock-based compensation under fair value method		(3,652	)		(3,575	)
Net loss — pro forma after stock-based compensation under fair value method	$	(23,611	)	$	(27,064	)
Net loss per share, basic and diluted — as reported	$	(1.05	)	$	(1.28	)
Net loss per share, basic and diluted — pro forma after stock-based compensation under fair value method	$	(1.09	)	$	(1.45	)

Penwest Stock Option Plans

As of December 31, 2006, the Company had three stock option plans: the 2005 Stock Incentive Plan (the “2005 Plan”), the 1998 Spin-off Option Plan (the “Spin-off Plan”) and the 1997 Equity Incentive Plan (the “1997 Plan”). The 2005 Plan and the 1997 Plan provide for the grants of incentive stock options, nonstatutory stock options, restricted and unrestricted stock awards, and other stock-based awards, including the grant of securities convertible into common stock and the grant of stock appreciation rights (collectively “Awards”). Since the 2005 Plan was approved, the Company has granted options and issued other securities to employees, directors and consultants under the 2005 Plan. No additional awards have been made under the Spin-off Plan or the 1997 Plan. A total of 1,650,000 shares of common stock may be issued pursuant to Awards granted under the 2005 Plan. Such awards generally may not be granted at an exercise price that is less than the fair market value of the common stock on the date of grant, as determined by the Company’s Board of Directors. Stock option awards generally vest over a one to four year period and expire no later than ten years from the date of grant. Restricted stock awards entitle recipients to acquire shares of common stock, subject to the right of the Company to purchase all or part of such shares from the recipient in the event that the conditions specified in the applicable award are not satisfied prior to the end of the applicable restriction period established for such award. Restricted stock awards currently vest over a one to four year period and are recorded at fair value, which is based on the fair market value of the common stock on the date of grant.

On June 21, 2004, the Company granted nonstatutory stock options outside of any equity compensation plan pursuant to a Nonstatutory Stock Option Agreement entered into with one of its former officers in connection with such officer’s commencement of employement, providing for the purchase of 100,000 shares of its common stock at an exercise price equal to the fair market value of the common stock on the date of

F-16

PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

grant. These options vest over a four year period, and are subject to acceleration upon the occurrence of a change in control of the Company.

On August 31, 1998, Penford Corporation (“Penford”), the Company’s former parent corporation, distributed to the holders of Penford common stock all of the outstanding shares of the Company’s common stock (the “Distribution”). In connection with such transaction, the Company’s 1998 Spin-off Option Plan was adopted in June 1998 to provide for the grant of stock options to employees of Penwest and non-employee directors of Penford who held options to purchase Penford common stock as of the date of the Distribution and who ceased to be employees of Penford under the terms of Penford’s stock option plans. As of December 31, 2006, options to purchase 1,999 shares remain outstanding under the Spin-off Plan. The Company may not grant any additional options under the Spin-off Plan.

Under the terms of executive retention agreements entered into with each executive officer, if, within 12 months following a change in control of the Company, the executive’s employment is terminated by the Company other than for cause, death or disability, or by the executive for good reason, as such terms are defined, the vesting of all stock options and restricted stock held by the executive will be accelerated in full, to the extent not already vested, and all shares of stock underlying stock options and all shares of restricted stock will be free of any right of repurchase by the Company. The retention agreements terminate if a change in control of the Company does not occur prior to December 31, 2008.

The following table presents a summary of the Company’s stock option activity and related information for the year ended December 31, 2006:

						Weighted-Average
				Weighted		Remaining		Aggregate
				Average		Contractual Terms		Intrinsic
	Shares			Exercise Price		in Years		Value
Balance at December 31, 2005		3,015,563		$	10.88
Options Exercisable		2,120,947		$	9.99
Granted		622,250		$	20.03
Exercised		(1,202,792	)	$	8.84
Forfeited		(167,286	)	$	14.10
Expired		(1,075	)	$	15.93
Balance at December 31, 2006		2,266,660		$	14.23		6.5	$	7,809,424
Options Exercisable		1,274,381		$	11.98		4.7	$	6,219,428

The weighted average fair values of options granted during 2006, 2005 and 2004 were $11.18, $6.82 and $8.12, respectively. Total cash received by the Company from the exercise of stock options during 2006 was approximately $10.6 million. The total intrinsic values of options exercised during 2006, 2005 and 2004 were approximately $14.8 million, $827,000 and $634,000, respectively. The total fair value of options which vested during 2006, 2005 and 2004 were approximately $2.7 million, $3.8 million and $2.3 million, respectively. As of December 31, 2006, there was approximately $4.4 million of unrecognized compensation cost related to stock option awards that is expected to be recognized as expense over a weighted average period of 1.1 years.

F-17

PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

The fair values of each option grant in 2006, 2005 and 2004 were estimated using the Black-Scholes-Merton option pricing model with the following weighted average assumptions:

	2006			2005			2004
Expected dividend yield		None			None			None
Risk free interest rate		4.7	%		4.1	%		3.7	%
Expected volatility		58	%		48	%		46	%
Expected life of options		5.6 years			7.5 years			7.5 years

The following table presents a summary of restricted stock activity for 2006:

				Weighted-Average		Aggregate
				Grant-Date		Intrinsic
	Shares			Fair Value		Value
Restricted stock outstanding at December 31, 2005		68,000		$	11.37	$	1,308,660
Granted		24,000		$	19.41
Vested		(40,500	)	$	11.17
Restricted stock outstanding at December 31, 2006		51,500		$	15.24	$	853,355

The total fair value of restricted stock which vested and the total compensation cost recognized for restricted stock awards during 2006 were approximately $452,000 and $771,000, respectively. As of December 31, 2006, there was approximately $79,000 of unrecognized compensation cost related to outstanding restricted stock awards that the Company expects to recognize as expense over a weighted average period of approximately 2.2 years.

Employee Stock Purchase Plan

The Employee Stock Purchase Plan was approved in October 1997 and enables all employees to subscribe “during specified offering periods” to purchase shares of common stock at the lower of 85% of the fair market value of the shares on the first or last day of such offering period. A maximum of 228,000 shares are authorized for issuance under the Plan. There were 10,404 shares, 13,779 shares and 14,612 shares issued under the Plan during 2006, 2005 and 2004, respectively.

Rights Agreement

On June 25, 1998, the Company’s Board of Directors declared a dividend of one right for each outstanding share of the Company’s Common Stock (the “Right”) to shareholders of record at the close of business on July 28, 1998. Each Right entitles the registered holder to purchase from the Company one one-thousandth of a share of the Series A Preferred Stock, at a purchase price of $60 in cash, subject to adjustment.

The Rights are not currently exercisable and will not be exercisable until the earlier of (i) 10 business days (or such later date as may be determined by the Board) following the later of (a) a public announcement that a person or group of affiliated or associated persons (a “Rights Acquiring Person”) has acquired, or obtained the right to acquire, beneficial ownership of 15% or more of the outstanding shares of Common Stock or (b) the first date on which an executive officer of the Company has actual knowledge that a Rights Acquiring Person has become such, or (ii) 10 business days (or such later date as may be determined by the Board) following the commencement of a tender offer or exchange offer that would result in a person or group beneficially owning 15% or more of such outstanding shares of Common Stock. The Rights will expire upon the close of business on July 27, 2008 unless earlier redeemed or exchanged.

F-18

PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

9.   COMMITMENTS

Leases

Under a lease agreement signed with Joseph Rettenmaier Holding GmbH & Co. KG on February 27, 2003 (see Note 13), the Company obtained the right to occupy approximately 14,000 square feet of office and research and development space in the Patterson, New York facility until February 2008. The lease was initially rent-free (plus operating expenses) until February 27, 2005, and since that time, the Company has leased the property pursuant to three successive one-year options at monthly rent payments approximating $14,000, plus operating expenses. On March 7, 2005, the Company signed an amendment to the lease, effective February 27, 2005, increasing its leased space to approximately 15,000 square feet and bringing its monthly rent payments to approximately $15,000, plus operating expenses. On September 1, 2006, the Company signed an additional amendment to the lease, increasing its leased space to approximately 15,500 square feet and bringing its monthly rent payments to approximately $15,500, plus operating expenses. In November 2006, Penwest exercised the third of its one year renewal options, extending the current term to February 26, 2008.

In 2004, the Company signed a lease amendment to its corporate office lease in Danbury, Connecticut for approximately 21,500 square feet of office space, replacing the office space included in its lease signed in February 2003. This lease, as amended, had an initial term expiring December 30, 2006; however, in 2006, the Company exercised its first of two one year renewal options extending this lease through December 30, 2007. Monthly rent payments, including utilities, will approximate $47,000 for 2007.

As of December 31, 2006, certain of the Company’s property and equipment are leased under operating leases ranging from one to two years. Rental expense under operating leases was $873,000, $848,000 and $739,000, for the years ended December 31, 2006, 2005 and 2004, respectively. Of such amounts, approximately $171,000, $198,000 and $129,000 in 2006, 2005 and 2004, respectively, related to contingent rents including allocated operating expenses of the Company’s leased facility in Patterson, New York.

Future minimum lease payments as of December 31, 2006 for noncancellable operating leases having initial lease terms of more than one year are as follows:

	Operating
	Leases
	(In thousands)
2007	$	765
2008		32
2009		—
2010		—
2011		—
Thereafter		—
Total minimum lease payments	$	797

10.   INCOME TAXES

There was no provision for income taxes for 2006. The provision for income taxes for 2005 and 2004 consisted of current foreign income taxes and totaled $2,000 and $5,000, respectively.

F-19

PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

The reconciliation between the statutory tax rate and those reflected in the Company’s income tax provision is as follows:

	2006			2005			2004
Statutory tax rate		(34	)%		(34	)%		(34	)%
Valuation allowance		34			34			34
		—	%		—	%		—	%

The components of deferred income tax (assets) and liabilities at December 31 are as follows:

	2006			2005
	(In thousands)
Inventory allowance and basis differences	$	(13	)	$	(163	)
Deferred compensation and SERP liability		(1,266	)		(1,307	)
Deferred revenue		(17	)		(23	)
Stock-based compensation		(1,830	)		—
Tax credit carryforwards		(5,363	)		(4,497	)
Net operating loss carryforwards		(56,156	)		(44,413	)
Total deferred tax assets		(64,645	)		(50,403	)
Depreciation and amortization		1,608			1,708
Other		337			284
Total deferred tax liabilities		1,945			1,992
Net deferred tax asset before valuation allowance		(62,700	)		(48,411	)
Valuation allowance		62,700			48,411
Net deferred tax liability	$	—		$	—

The Company made no income tax payments in 2006. The Company’s income tax payments for 2005 and 2004 consisting solely of foreign income taxes, approximated $2,000 and $5,000 for 2005 and 2004, respectively.

At December 31, 2006, the Company had federal net operating loss (“NOL”) carryforwards of approximately $161.3 million for income tax purposes, of which approximately $6.2 million, $8.4 million, $9.1 million, $17.7 million, $19.4 million, $13.5 million, $22.8 million, $21.8 million and $42.4 million expire in 2018, 2019, 2020, 2021, 2022, 2023, 2024, 2025 and 2026, respectively. In addition, the Company had research and development tax credit carryforwards of approximately $5.3 million of which $67,000, $359,000, $341,000, $777,000, $828,000, $858,000, $760,000, $669,000 and $650,000 expire in 2018, 2019, 2020, 2021, 2022, 2023, 2024, 2025 and 2026, respectively. The use of the NOLs, and research and development tax credit carryforwards are limited to future taxable earnings of the Company.

The exercise of non-qualified stock options and the vesting of restricted stock give rise to compensation that is included in the taxable income of the applicable employees and directors, and deducted by the Company for federal and state income tax purposes. As a result of the exercise of non-qualified stock options and the vesting of restricted stock, the Company’s net operating loss carryforwards include approximately $20.8 million attributable to excess tax benefits from stock compensation deductions, which can be used to offset future taxable income, if any. If and when realized, the related tax benefits of these net operating loss carryforwards will be credited directly to paid-in capital.

F-20

PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

For financial reporting purposes, at December 31, 2006 a valuation allowance of $62.7 million has been recognized to offset net deferred tax assets, primarily attributable to the NOL carryforward. The change in the valuation allowance in 2006 was an increase of $14.3 million. Utilization of the operating losses are subject to a limitation in the event of an ownership change under provisions of the Internal Revenue Code.

11.   COMPENSATION CHARGE

On February 14, 2005, Tod R. Hamachek resigned from his positions as the Company’s Chief Executive Officer and Chairman of the Board of Directors, and as a member of the Board, and entered into a Severance and Settlement Agreement and Release with the Company (the “Agreement”). Under the Agreement, the Company agreed that, in consideration of Mr. Hamachek’s release and other agreements under the Agreement, it would pay Mr. Hamachek eighteen months base salary ($594,000) as severance pay, pay all premium costs relating to medical insurance continuation coverage for eighteen months and provide certain other benefits. The Company also agreed to accelerate in full the vesting of all unvested stock options (146,000 shares) held by Mr. Hamachek, and to extend the period during which he could exercise his stock options to the earlier of two years or their original expiration date. In connection with the Agreement, the Company recorded a charge to its statement of operations totaling approximately $3.0 million in 2005. This charge, included in selling, general and administrative expense in 2005, includes a non-cash charge of approximately $2.4 million relating to the stock options noted above.

12.   RETIREMENT PLANS AND OTHER EMPLOYEE BENEFITS

Savings Plan

Company employees participate in the Penwest Pharmaceuticals Co. Savings Plan, a defined contribution plan generally covering all of its employees. Under the Plan, the Company may make quarterly employer matching contributions as defined in the Plan agreement, in an amount equal to a percentage of each participant’s pre-tax contributions to the Plan up to 6% of earnings. Participants are immediately vested in their contributions, as well as any earnings thereon. Vesting in the employer contribution portion of their accounts, as well as any earnings thereon is based on years of credited service, and vest over a four-year period. The Company’s expense under the Plan was $244,000, $229,000 and $206,000 for 2006, 2005 and 2004, respectively.

The Plan also includes a discretionary annual profit-sharing component that is awarded by Penwest’s Board of Directors, generally based on achievement of predetermined corporate goals. This feature is available to all employees who meet the eligibility requirements of the Plan. There was no profit sharing expense in 2006, 2005, or 2004.

Supplemental Executive Retirement Plan

The Company has a Supplemental Executive Retirement Plan (“SERP” or the “Plan”), a nonqualified plan, which covers the former Chairman and Chief Executive Officer of Penwest, Mr. Hamachek. For 2006, 2005 and 2004, the net expense for the SERP was $122,000, $124,000 and $135,000, respectively. The Plan is unfunded and has no assets. The Company uses a measurement date of December 31 for its SERP.

On December 31, 2006, the Company adopted the recognition and disclosure provisions of SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R)”. SFAS No. 158 requires employers to recognize the funded status (i.e. the difference between the fair value of plan assets and the projected benefit obligations) of defined benefit pension and other postretirement benefit plans as an asset or liability in its statement of financial position and to recognize changes in the funded status in the year in which the changes occur as a component of comprehensive income. In addition, SFAS No. 158 requires employers to measure the funded status of its

F-21

PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

plans as of the date of its year-end statement of financial position and also requires additional disclosures regarding amounts included in accumulated other comprehensive income. The adjustment to accumulated other comprehensive income (loss) at adoption represents the net unrecognized actuarial gains remaining from the initial adoption of SFAS No. 87, “Employers’ Accounting for Pensions”, all of which were previously netted against the plan’s funded status in our statement of financial position pursuant to the provisions of SFAS No. 87. These amounts will be subsequently recognized as net periodic pension cost pursuant to our historical accounting policy for amortizing such amounts. Further, actuarial gains and losses that arise in subsequent periods, and are not recognized as net periodic pension cost in the same periods, will be recognized as a component of accumulated other comprehensive income (loss). Those amounts will be subsequently recognized as a component of net periodic pension cost on the same basis as the amounts recognized in accumulated other comprehensive income (loss) at the adoption of SFAS No. 158.

The incremental effects of adopting the provisions of SFAS No. 158 for the Plan on the Company’s statement of financial position at December 31, 2006 are presented in the following table. The adoption of SFAS No. 158 had no effect on the Company’s statements of operations for the year ended December 31, 2006, or for any prior period presented, and it will have no effect on the Company’s future operating results. Had the Company not been required to adopt SFAS No. 158 at December 31, 2006, it would have recognized a minimum pension liability pursuant to the provisions of SFAS No. 87 of $2,297,000.

The effect of recognizing the funded status and adjusting the liability of the Plan is included in the table below under the column labeled “Effect of adopting SFAS No. 158” (in thousands):

	December 31, 2006
	Prior to Adopting		Effect of Adopting			As Reported at
	SFAS No. 158		SFAS No. 158			December 31, 2006
Intangible asset (retirement plan)	$	—	$	—		$	—
Liability for plan benefits	$	2,297	$	(110	)	$	2,187
Accumulated other comprehensive income	$	—	$	110		$	110

The following disclosures summarize information relating to the Plan:

Change in benefit obligation:

	2006			2005
	(In thousands)
Benefit obligation at beginning of period	$	2,168		$	2,168
Interest cost		120			122
Actuarial (gain) loss		50			(21	)
Benefits paid		(151	)		(101	)
Benefit obligation at December 31,	$	2,187		$	2,168
Change in plan assets:

	2006			2005
	(In thousands)
Fair value of plan assets at beginning of year	$	—		$	—
Employer contributions		151			101
Benefit payments		(151	)		(101	)
Fair value of plan assets at end of year	$	—		$	—

F-22

PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

Amounts recognized in the statement of financial position consist of:

	2006
	(In thousands)
Current liabilities	$	(147	)
Noncurrent liabilities		(2,040	)
Net amount recognized at December 31, (included in deferred compensation)	$	(2,187	)

Amounts recognized in accumulated other comprehensive income consist of:

	2006
	(In thousands)
Net gain	$	(122	)
Prior service cost		12
Total	$	(110	)

Information for plans with an accumulated benefit obligation in excess of plan assets, December 31:

	2006		2005
	(In thousands)
Projected benefit obligation	$	2,187	$	2,168
Accumulated benefit obligation	$	2,187	$	2,168
Plan assets at fair value	$	—	$	—

Components of net periodic benefit cost:

	2006		2005
	(In thousands)
Interest cost	$	120	$	123
Amortization of prior service cost		2		2
Amortization of gains		—		(1	)
Net periodic benefit cost	$	122	$	124

The amortization of prior service cost is determined using straight-line amortization of the cost over the average remaining service period of the employee expected to receive benefits under the Plan. The estimated prior service costs that will be amortized from accumulated other comprehensive income into net periodic benefit cost during 2007 is approximately $2,000.

Weighted-average assumptions used to determine benefit obligations as of December 31:

	2006			2005
Discount rate		5.60	%		5.75	%
Rate of compensation increase		N/A			N/A

Weighted-average assumptions used to determine net periodic benefit cost for years ended December 31:

	2006			2005
Discount rate		5.75	%		6.00	%
Rate of compensation increase		N/A			N/A

Plan contributions are equal to benefits paid to the Plan participant during the year. The Company expects to make contributions to the Plan of approximately $151,000 in 2007. Effective February 14, 2005, Mr. Hamachek resigned from his positions as Chairman and Chief Executive Officer (see Note 11). Under the

F-23

PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

SERP, effective in May 2005, the Company became obligated to pay Mr. Hamachek approximately $12,600 per month over the lives of Mr. Hamachek and his spouse. The following benefit payments are expected to be paid over the next ten years (in thousands):

2007	$	151
2008		151
2009		151
2010		151
2011		151
Years 2012-2016		752

Deferred Compensation Plan

The Company has a Deferred Compensation Plan (“DCP”), a nonqualified plan which covers Mr. Hamachek. No amounts were contributed to the DCP during 2006, 2005 and 2004. Under the DCP, the Company recognized interest expense of $68,000, $70,000 and $76,000 for 2006, 2005 and 2004, respectively. The liability for the DCP was approximately $867,000 and $942,000 as of December 31, 2006 and 2005, respectively, and is included in deferred compensation on the Company’s balance sheets, including the current portion of approximately $143,000 at December 31, 2006. The Company does not fund this liability and no assets are held by the DCP. In connection with the resignation and retirement of Mr. Hamachek in February 2005 (see Note 11) under the DCP, effective in May 2005, the Company became obligated to pay Mr. Hamachek approximately $140,000 per year, including interest, in ten annual installments. These installments are recalculated annually based on market interest rates as provided for under the DCP. The following benefit payments, including interest, are expected to be paid under the DCP over the eight remaining annual installments (in thousands):

2007	$	143
2008		143
2009		143
2010		143
2011		143
Years 2012-2014		429

The Company has two whole-life insurance policies held in a rabbi trust (the “Trust”), the cash surrender value or death benefits of which are held in trust for the SERP and DCP liabilities. The Company is entitled to borrow against or withdraw from these policies to fund the liabilities under the SERP and the DCP as provided by the terms of the Trust. In April 2006, the Company withdrew from the Trust approximately $446,000 as reimbursement for all SERP and DCP benefit payments previously made by the Company to Mr. Hamachek. In addition, effective in June 2006, Mr. Hamachek’s SERP and DCP benefit payments are being made directly from the assets in the Trust. The cash surrender value of these life insurance polices totaled $2,700,000 and $3,160,000 as of December 31, 2006 and 2005, respectively. Trust assets, including $2,000 held in a money market account at December 31, 2006, are included in Other Assets in the Company’s balance sheets.

Health Care and Life Insurance Benefits

The Company offers health care and life insurance benefits to its active employees. Costs incurred for these benefits were $685,000, $603,000 and $643,000 in 2006, 2005 and 2004, respectively.

F-24

PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

13.   DISCONTINUED OPERATIONS

On February 27, 2003, Penwest sold substantially all of the assets (the “Assets”) used in the Company’s former excipient business to subsidiaries and affiliates of Josef Rettenmaier Holding GmbH & Co. KG for $41.75 million, plus the assumption of specified liabilities. The purchase price included $39.5 million in cash and a non-interest bearing promissory note of $2.25 million, with $1.0 million paid to Penwest in April 2003 and $1.25 million paid to Penwest in May 2004.

14.   LICENSING AGREEMENTS

The Company enters into collaborative arrangements with pharmaceutical companies to develop, manufacture or market products formulated with proprietary drug delivery technologies.

Endo Pharmaceuticals Inc.

In September 1997, the Company entered into a strategic alliance agreement with Endo with respect to the development of Opana ER, an extended release formulation of oxymorphone based on the Company’s TIMERx technology. This agreement was amended and restated in April 2002, and amended in January 2007. Endo is a specialty pharmaceutical company with a market leadership position in pain management. Endo has a broad product line, including established brands such as Lidoderm^®, Percodan^®, Percocet^® and Frova^® as well as three newly launched products in 2006 including Opana ER, Opana^®, and Synera^tm.

During the development of the product, the Company formulated Opana ER, and Endo conducted all clinical studies and prepared and filed all regulatory applications. The Company agreed to supply TIMERx material to Endo, and Endo agreed to manufacture and market Opana ER in the United States. The Company also agreed with Endo that any development and commercialization of Opana ER outside the United States would be accomplished through licensing to third parties approved by both Endo and the Company, and that the Company and Endo would divide equally any fees, royalties, payments or other revenue received by the parties in connection with such licensing activities. Endo is currently seeking a collaborator for Europe.

Prior to April 17, 2003, the Company shared with Endo the costs involved in the development of Opana ER. On April 17, 2003, the Company exercised its option under the terms of the Agreement and discontinued its participation in the funding of the development of Opana ER. The Company took this action because it believed that the Company’s strategic focus should be on funding other products in its development pipeline. As a result of this termination of funding, Endo completed the development of Opana ER and has the right to recoup the portion of development costs incurred by Endo that otherwise would have been funded by the Company.

The Company entered into the January 2007 amendment as part of the resolution of a dispute between the parties with regard to the sharing of marketing expenses during the period prior to when Opana ER reaches profitability. Under the terms of the 2007 Amendment, the Company and Endo agreed that royalties payable to the Company for U.S. sales of Opana ER would be calculated based on net sales of the product rather than on operating profit. In connection with this change, the Company and Endo agreed:

•  Endo will pay the Company royalties on U.S. sales of Opana ER calculated based on a royalty rate starting at 22% of annual net sales of the product up to $150 million of annual net sales, with the royalty rate increasing, based on agreed-upon levels of annual net sales achieved, from 25% up to a maximum of 30%.

•  No royalty payments will be due to the Company for the first $41 million of royalties that would otherwise have been payable beginning from the time of the product launch in July 2006.

•  Endo will pay the Company a percentage of any sublicense income it receives and milestone payments of up to $90 million based upon the achievement of agreed-upon annual sales thresholds.

F-25

PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

•  The Company’s share of the development costs for Opana ER that it opted out of funding in April 2003 will be fixed at $28 million and will be recouped by Endo through a temporary 50% reduction in royalties. This temporary reduction in royalties will not apply until the threshold for the $41 million royalty holiday referred to above has been met.

Mylan Pharmaceuticals Inc.

On March 2, 2000, Mylan announced that it had signed a supply and distribution agreement with Pfizer to market a generic version of all three strengths (30 mg, 60 mg, 90 mg) of Pfizer’s generic Procardia XL. In connection with that agreement, Mylan decided not to market Nifedipine XL, a generic version of Procardia XL that the Company had developed in collaboration with Mylan. As a result, Mylan entered into a letter agreement with the Company whereby Mylan agreed to pay us a royalty on all future net sales of Pfizer’s generic Procardia XL 30 mg. The royalty percentage was comparable to the percentage called for in Penwest’s original agreement with Mylan for Nifedipine XL 30 mg. Mylan has retained the marketing rights to the Nifedipine XL 30 mg. Mylan’s sales in the United States in 2006 of Pfizer’s generic Procardia XL 30 mg totaled approximately $25.9 million. The term of the letter agreement continues until such time as Mylan permanently ceases to market generic Procardia XL. In 2006, 2005 and 2004, royalties from Mylan were approximately $3.1 million, $3.9 million and $4.8 million, respectively, or 89%, 63% and 94%, respectively, of the Company’s total revenue.

Prism Pharmaceuticals, Inc.

On April 26, 2005, the Company entered into a licensing agreement (the “License Agreement”) with Prism Pharmaceuticals, Inc. (“Prism”) granting Prism exclusive rights to market Penwest’s PW2101 product in the United States and Canada. Under the terms of the License Agreement, the Company granted Prism an exclusive license under certain Penwest intellectual property to develop, make, use and commercialize PW2101 in the United States and Canada for all indications except the treatment and/or prophylaxis of migraine. Prism made a non-refundable $4.0 million payment to the Company upon signing the License Agreement and had agreed to pay the Company milestone payments upon achievement of milestones related to FDA approval and launch of PW2101, and royalties on net sales. Upon receipt, the Company deferred the $4.0 million received from Prism.

In June 2005, the FDA issued a non approvable letter for the Company’s NDA for PW2101. Given the FDA’s concerns expressed in the non approvable letter, the time and resources the Company expected it would take to address them, and the commercial window for this product opportunity, the Company decided not to undertake the additional activities on PW2101 that it believed would be required to address the FDA’s concerns. On July 7, 2005, the Company was notified by Prism that Prism also did not intend to proceed with development activities on PW2101 under the License Agreement. As a result, the License Agreement terminated effective July 20, 2005. In connection with the termination, the Company and Prism signed a settlement agreement in September 2005, and Penwest repaid Prism $1.75 million of the $4.0 million payment the Company received from Prism, and recognized the remaining $2.25 million as licensing fee revenue in the third quarter of 2005.

15.   CONTINGENCIES

The Company is a party to certain claims and proceedings in the ordinary course of business. The Company does not believe any of these matters will result, individually or in the aggregate, in a material adverse effect upon its financial condition or future results of operations.

16.   RELATED PARTY TRANSACTIONS

Under a Recognition and Incentive Agreement with Anand Baichwal, (as amended, the “Baichwal Agreement”) the Company’s Senior Vice President of Licensing and Chief Scientific Officer, the Company was obligated to pay to Dr. Baichwal on an annual basis in arrears, royalties for (i) one-half of one percent of

F-26

PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

the Company’s Net Sales (as defined in the Baichwal Agreement) of TIMERx^® material (as defined in the Baichwal Agreement) to third parties, (ii) one-half of one percent of royalties received by the Company under licenses, collaborations or other exploitation agreements with third parties with respect to the sale, license, use or exploitation by such third parties of products based on or incorporating the TIMERx^® material, and (iii) one-half of one percent of payments made in lieu of such Net Sales or royalties and received by the Company. The Baichwal Agreement also contains non-competition and non-solicitation provisions that expire two years after the termination of Dr. Baichwal’s employment. These royalties for Dr. Baichwal totaled approximately $16,000, $20,000, and $25,000 for 2006, 2005 and 2004, respectively. Specified provisions of the Baichwal Agreement were terminated on February 1, 2007 (see Note 17).

Under a Royalty Agreement with John N. Staniforth (the “Staniforth Agreement”), a member of the Company’s Board of Directors, the Company was obligated to pay Dr. Staniforth on an annual basis in arrears one-half of one percent of the Company’s Net Sales (as defined in the Staniforth Agreement) of TIMERx^® material (as defined in the Staniforth Agreement) related to the products covered by the TIMERx^® patents. These royalties for Dr. Staniforth totaled approximately $16,000, $20,000 and $25,000 for 2006, 2005 and 2004, respectively. The Staniforth Agreement was terminated on February 1, 2007 (See Note 17).

Dr. Staniforth also had a consulting agreement with the Company under which he was paid $80,000 per year, payable in quarterly payments. The consulting agreement was terminated by the Company in 2006.

17.   SUBSEQUENT EVENTS

Royalty Termination Agreements

On February 1, 2007, the Company entered in a termination agreement with Dr. Baichwal terminating specified provisions of the Baichwal Agreement (“Termination Agreement”). Pursuant to the Termination Agreement, the Company and Dr. Baichwal agreed that the Company would have no further obligation to make any payments to Dr. Baichwal under the Recognition and Incentive Agreement except for amounts owed with respect to 2006. In consideration for such agreement, the Company agreed to pay Dr. Baichwal $770,000 in cash and to issue to him 19,696 shares of the Company’s common stock with a fair market value of approximately $287,000, for total consideration of $1,057,000. Dr. Baichwal is still an employee of Penwest.

On February 1, 2007, the Company entered in a termination agreement with Dr. Staniforth terminating the Staniforth Agreement (“Termination Agreement”). Pursuant to the Termination Agreement, the Company and Dr. Staniforth agreed that the Company would have no further obligation to make any payments to Dr. Staniforth under the Royalty Agreement except for amounts owed with respect to 2006. In consideration for such agreement, the Company agreed to pay Dr. Staniforth $770,000 in cash and to issue to him 19,696 shares of the Company’s common stock with a fair market value of approximately $287,000, for total consideration of $1,057,000. Dr. Staniforth remains on the Board of Penwest.

The Termination Agreements entered into with Drs. Baichwal and Staniforth were approved by the Company’s Board of Directors.

Credit Facility

On March 13, 2007, the Company entered into a $24.0 million senior secured credit facility (“Credit Facility”) with Merrill Lynch Capital, a division of Merrill Lynch Business Financial Services Inc. The Credit Facility consists of: (i) a $12.0 million term loan advanced upon the closing of the Credit Facility and (ii) a $12.0 million term loan that the Company may access until September 15, 2008, subject to conditions specified in the agreement. Under the agreement, the Company may not access this second amount unless the Company’s market capitalization at the time of the advance request is greater than $250 million. In connection with this Credit Facility, the Company granted the lender a perfected first priority security interest in all existing and after-acquired assets of the Company, excluding its intellectual property which is subject to a negative pledge; royalty payments from Mylan on their sales of Pfizer’s generic version of Procardia XL 30mg, if the Company pledges such royalty payments to another lender; and up to $3,000,000 of equipment

F-27

PENWEST PHARMACEUTICALS CO

NOTES TO FINANCIAL STATEMENTS — (Continued)

which the Company may, at its election, pledge to another lender in connection with an equipment financing facility separate from this credit facility. In addition, the Company is precluded from paying cash dividends to its shareholders during the term of the agreement. Each loan has a term of 42 months from the date of advance with interest-only payments for the first nine months, but in any event, not beyond September 30, 2008; interest plus monthly principal payments equal to 1.67% of the loan amount for the period from the end of the interest-only period through December 2008; and interest plus straight line amortization payments with respect to the remaining principal balance for the remainder of the term.

Amounts outstanding under the Credit Facility bear interest at an annual rate of one month LIBOR at the time of the advance, plus 5%, which rate will be fixed for the term of the applicable loan. At the time of final payment of each loan under the Credit Facility, the Company will pay an exit fee of 3.0% of the original principal loan amount. The Company is also required to pay prepayment penalties of 3.0% of any prepaid amount in the first year, 2.0% of any prepaid amount in the second year and 1% of any prepaid amount thereafter. As of March 13, 2007, the interest rate on the Credit Facility was 10.32% and $12.0 million was outstanding.

18.   QUARTERLY FINANCIAL DATA (UNAUDITED)

Summarized quarterly financial data for the years ended December 31, 2006 and 2005 is as follows:

	Quarter Ended
	Mar. 31, 2006			June 30, 2006			Sept. 30, 2006			Dec. 31, 2006
	(Unaudited)			(Unaudited)			(Unaudited)			(Unaudited)
Total revenues	$	965		$	1,075		$	720		$	739
Gross profit		943			1,042			671			612
Net loss	$	6,303		$	(7,416	)	$	(8,741	)	$	(8,852	)
Net loss per share	$	(0.28	)	$	(0.33	)	$	(0.38	)	$	(0.38	)

	Quarter Ended
	Mar. 31, 2005			June 30, 2005			Sept. 30, 2005			Dec. 31, 2005
	(a)			(b)			(c)
	(Unaudited)			(Unaudited)			(Unaudited)			(Unaudited)
	(In thousands, except per share data)
Total revenues	$	982		$	1,296		$	3,004		$	931
Gross profit		974			1,282			2,996			922
Net loss	$	(8,947	)	$	(5,686	)	$	(2,986	)	$	(5,279	)
Net loss per share	$	(0.41	)	$	(0.26	)	$	(0.14	)	$	(0.24	)

(a)	During the first quarter of 2005, the Company recorded a $3.0 million compensation charge in connection with a Severance and Settlement Agreement and Release it entered into with Tod Hamachek, Penwest’s former Chairman and Chief Executive Officer, upon his resignation in February 2005. Such charge is reflected in selling, general and administrative expense.
(b)	During the second quarter of 2005, the Company recorded a write-off of inventory of approximately $395,000 relating primarily to a change in specifications for TIMERx. The Company also recognized impairment losses of $118,000 related to patents covering PW2101, a beta blocker intended for the treatment of hypertension and angina, which the Company determined no longer had value. Such charges are reflected in research and product development expense.
(c)	During the third quarter of 2005, the Company recognized $2.25 million of licensing revenue under its agreement with Prism, which was terminated in July 2005. Such revenue is reflected in royalties and licensing fees.

F-28

SCHEDULE II — VALUATION AND QUALIFYING ACCOUNTS

PENWEST PHARMACEUTICALS CO.
DECEMBER 31, 2006

			Additions
					Charged to
	Balance at		Charged to		Other					Balance at
	Beginning		Costs and		Accounts-		Deductions-			End of
	of Period		Expenses		Describe		Describe			Period
	(In thousands)
Year ended December 31, 2006
Inventory Allowances	$	208	$	—	$	—	$	208	(a)	$	—
Year ended December 31, 2005
Inventory Allowances	$	85	$	497	$	—	$	374	(a)	$	208
Year ended December 31, 2004
Inventory Allowances	$	82	$	75	$	—	$	72	(a)	$	85

(a) Disposals of unrecoverable inventory costs.

S-1

Exhibit Index

		Filed with
Exhibit		this Form	Form or		Filing Date	SEC File
Number	Description	10-K	Schedule		with SEC	Number
2.1	Purchase Agreement by and between Penwest Pharmaceuticals Co. and Josef Rettenmaier Holding GmBh & Co. KG, dated November 1, 2002.		Schedule 14A		1/31/2003	000-23467
2.2	Amendment to Purchase Agreement made as of February 26, 2003, by and among Penwest Pharmaceuticals Co., Josef Rettenmaier Holding GmbH & Co. KG, and the other parties named therein.			8-K	2/28/2003	000-23467
3.1	Amended and Restated Articles of Incorporation			10-Q	8/3/2004	000-23467
3.2	Amended and Restated Bylaws of the Company.			S-1	10/21/1997	333-38389
3.3	Designation of Rights and Preference of Series A Junior Participating Preferred Stock of the Company filed on July 17, 1998.			10/A	7/17/1998	000-23467
4.1	Specimen certificate representing the Common Stock.			S-1/A	12/17/1997	333-38389
4.2	Form of Rights Agreement dated as of July 27, 1998 between the Company and the Rights Agent.			10/A	7/17/1998	000-23467
10.1†	Product Development and Supply Agreement dated August 17, 1994 by and between the Registrant and Mylan Pharmaceuticals Inc.			S-1	10/21/1997	333-38389
10.2†	Sales and Distribution Agreement dated January 3, 1997 by and between the Registrant and Mylan Pharmaceuticals Inc.			S-1	10/21/1997	333-38389
10.3†	Letter Agreement dated February 25, 2000 by and between the Registrant Mylan Pharmaceuticals Inc.			10-Q	8/14/2000	000-23467
10.4†	Amended and Restated Strategic Alliance Agreement, dated as of April 2, 2002, by and between Endo Pharmaceuticals Holdings Inc. and the Company			10-Q	8/14/2002	000-23467
10.5††	1997 Equity Incentive Plan.			S-1	10/21/1997	333-38389
10.6††	1997 Employee Stock Purchase Plan.			S-1	10/21/1997	333-38389
10.7††	1998 Spinoff Option Plan.			10/A	7/7/1998	000-23467
10.8	Form of Tax Allocation Agreement entered into between the Registrant and Penford Corporation.			10	6/22/1998	000-23467
10.9††	Recognition and Incentive Agreement dated as of May 14, 1990 between the Registrant and Anand Baichwal, as amended.			S-1/A	11/10/1997	333-38389

		Filed with
Exhibit		this Form	Form or		Filing Date	SEC File
Number	Description	10-K	Schedule		with SEC	Number
10.10††	Royalty Agreement dated September 25, 1992 between the Company and John N. Staniforth.			10-Q	5/15/2002	000-23467
10.11††	Confidentiality, Consulting and Noncompetition Agreement dated September 25, 1992 between the Company and John N. Staniforth.			10-Q	5/15/2002	000-23467
10.12	Lease Agreement dated as of February 3, 2003 by and between Union Carbide Corporation and the Registrant.			10-Q	5/15/2003	000-23467
10.13	Lease Amendment and Attornment Agreement, dated March 15, 2004, by and between Union Carbide Corporation and the Registrant.			10-Q	8/3/2004	000-23467
10.14††	Form of Option Agreement for 1997 Incentive Plan			10-K	3/16/05	000-23467
10.15††	Nonstatutory Stock Option Agreement dated June 21, 2004 by and between the Registrant and Alan F. Joslyn, Ph.D.			S-8	7/26/2005	333-126897
10.16††	Severance and Settlement Agreement and Release dated February 14, 2005 by and between the Registrant and Tod R. Hamachek			10-Q	5/9/2005	000-23467
10.17††	Offer Letter dated February 15, 2005 by and between the Registrant and Robert J. Hennessey			10-Q	5/9/2005	000-23467
10.18††	2005 Stock Incentive Plan			8-K	6/7/2005	000-23467
10.19††	Amendment No. 1 to 2005 Stock Incentive Plan			10-Q	11/9/06	000-23467
10.20††	Form of Incentive Stock Option Agreement for grants under 2005 Stock Incentive Plan			8-K	6/7/2005	000-23467
10.21††	Form of Employee Nonstatutory Stock Option Agreement for grants under 2005 Stock Incentive Plan			8-K	6/7/2005	000-23467
10.22††	Form of Nonstatutory Stock Option Agreement (Consultants and Directors) for grants under 2005 Stock Incentive Plan			8-K	6/7/2005	000-23467
10.23††	Form of Director Restricted Stock Agreement for grants under 2005 Stock Incentive Plan			8-K	6/7/2005	000-23467
10.24††	Form of Executive Retention Agreement entered into by the Registrant and each of the Executive Officers			10-K	3/16/2006	000-23467
10.25††	Summary of Executive Officer Bonus Program	X
10.26††	Summary of the Director Compensation Program	X
10.27††	Offer Letter between the Company and Benjamin L. Palleiko, effective June 19, 2006			10-Q	8/9/06	00-23467

		Filed with
Exhibit		this Form	Form or	Filing Date	SEC File
Number	Description	10-K	Schedule	with SEC	Number
10.28†††	Manufacture and Supply Agreement dated November 6, 2006 between the Company and Draxis Specialty Pharmaceuticals Inc.	X
23	Consent of Ernst & Young LLP	X
31.1	Certification of Principal Executive Officer pursuant to Exchange Act Rules 13a-14 or 15d-14, as adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002.	X
31.2	Certification of Principal Financial Officer pursuant to Exchange Act Rules 13a-14 or 15d-14, as adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002.	X
32.1	Certification of Principal Executive Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002	X
32.2	Certification of Principal Financial Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002	X

†	Confidential treatment granted as to certain portions, which portions are omitted and filed separately with the Commission.
††	Management contract or compensatory plan or arrangement required to be filed as an Exhibit to the Annual Report on Form 10-K.
†††	Confidential treatment requested as to certain portions, which portions are omitted and filed separately with the Commission.

EX-10.25

                                                                   EXHIBIT 10.25

                   Summary of Executive Officer Bonus Program


         Penwest Pharmaceuticals Co. ("the Company") maintains a bonus program
for its executive officers that is administered by the Compensation Committee
(the "Committee") of the Board of Directors of the Company. This program
provides for an annual cash payout dependent on achievement by both the
executive and the Company of predetermined short-term operating goals and
longer-term strategic objectives. These goals also include Company goals and
individual goals. Our President's target bonus is based 100% upon achieving
Company goals. Individual incentive compensation target awards are set annually
by the Compensation Committee. These target awards are determined by salary
grade and are subject to an adjustment based on individual performance, and
typically range from 25%-40% of the executive's salary.

EX-10.26

                                                                   EXHIBIT 10.26

                  Summary of the Director Compensation Program


         Penwest Pharmaceuticals Co. ("the Company") maintains a director
compensation program for its directors that is administered by the Compensation
Committee of the Board of Directors of the Company. Under this program:

     -   Each of the Company's non-employee directors receives an annual
         retainer of $20,000 per year, payable in quarterly installments on the
         first business day of each calendar quarter. Each non-employee director
         may elect to receive this annual retainer in cash, shares of the
         Company's common stock, or both.

     -   Each non-employee director also receives, in cash or shares of the
         Company's common stock pursuant to the director's elections, fees of
         $1,500 for each board meeting attended in person and fees of between
         $500 and $1,000 for each board meeting attended telephonically.

     -   All non-employee directors receive reimbursement for all reasonable
         expenses incurred in attending meetings of the Board and committees of
         the Board.

     -   On the first business day of each calendar year, the Company issues to
         each non-employee director either options to purchase 12,000 shares of
         the Company's common stock or a grant of 6,000 shares of restricted
         common stock, as elected by the director. The exercise price of these
         options equals the fair market value of one share of the Company's
         common stock on the date of grant. Options granted pursuant to the
         director compensation program vest on the first anniversary of the date
         of grant. Restricted common stock granted pursuant to the director
         compensation program is granted without requiring payment of additional
         consideration by the director and vests on the first anniversary of the
         grant date. The vesting of options and of the restricted common stock
         is subject to acceleration in full upon the occurrence of a change in
         control of the Company.

     -   Upon the date of the initial election of any non-employee director to
         the Board, the Company grants such non-employee director 20,000 shares
         of restricted common stock and grants an additional 12,000 shares of
         restricted common stock generally every four years thereafter. These
         shares vest in four equal annual installments commencing upon the first
         anniversary of the date of grant. The vesting of the restricted common
         stock is subject to acceleration in full upon the occurrence of a
         change in control of the Company.

EX-10.28

                                                                   Exhibit 10.28

          Confidential Materials omitted and filed separately with the
         Securities and Exchange Commission. Asterisks denote omissions.

                        MANUFACTURE AND SUPPLY AGREEMENT
                                     BETWEEN

                      DRAXIS SPECIALTY PHARMACEUTICALS INC.

                         AND PENWEST PHARMACEUTICALS CO.

                             AS OF NOVEMBER 6, 2006



                                TABLE OF CONTENTS

                                                                              
ARTICLE I - INTERPRETATION..................................................      2

ARTICLE II - FORMULATION....................................................      7

ARTICLE III - CONSIDERATION.................................................      9

ARTICLE V- DELIVERY, TITLE AND ACCEPTANCE...................................     15

ARTICLE VII - REGULATORY MATTERS............................................     20

ARTICLE VIII - REPRESENTATIONS AND WARRANTIES...............................     21

ARTICLE IX - INTELLECTUAL PROPERTY..........................................     25

ARTICLE X - INDEMNITIES AND LIMITATION OF LIABILITIES.......................     29

ARTICLE XI - TERM AND TERMINATION...........................................     31

ARTICLE XII - MISCELLANEOUS.................................................     33



                                      - i -



                        MANUFACTURE AND SUPPLY AGREEMENT

THIS AGREEMENT is effective from the 6th day of November 2006 (the "EFFECTIVE
DATE")

BETWEEN:                      PENWEST PHARMACEUTICALS CO. a corporation
                              incorporated under the laws of Washington, having
                              offices at 39 Old Ridgebury Road, Suite #11,
                              Danbury, Connecticut, U.S.A. 06810 and at 2981
                              Route 22, Patterson, New York, U.S.A. 12563;

                              ("PURCHASER")

AND:                          DRAXIS SPECIALTY PHARMACEUTICALS INC., a
                              corporation amalgamated under the laws of Canada
                              having its principal office at 16751 Trans Canada
                              Highway, Kirkland, Quebec H9H 4J4;

                              ("SUPPLIER")

WHEREAS Purchaser and DRAXIS Pharma Inc. are parties to a Custom Manufacturing
Agreement dated as of September 27, 1999 (the "Prior Agreement");

AND WHEREAS Supplier is the successor in interest to DRAXIS Pharma, Inc.;

AND WHEREAS the Parties are willing to amend and restate the Prior Agreement as
provided herein;

AND WHEREAS Purchaser desires to have Supplier manufacture and supply certain
ingredients for Purchaser's tablet products;

AND WHEREAS Supplier desires to manufacture and supply Purchaser with certain
ingredients for the manufacture of Purchaser's tablet products;

AND WHEREAS the Parties are willing to carry out the foregoing pursuant to the
terms and conditions set forth in this Agreement.

NOW THEREFORE in consideration of the mutual covenants and agreements in this
Agreement, Purchaser and Supplier agree with each other as follows:

                                     - 1 -


                           ARTICLE I - INTERPRETATION

1.1   DEFINED TERMS.

As used in this Agreement and in the Quality Agreement (as defined below), the
following terms have the following meanings unless the context clearly requires
otherwise:

"ACCEPTED PURCHASE ORDER(s)" shall have the meaning ascribed hereto in Section
4.3(b) of this Agreement.

"AFFILIATE" means, with respect to a Party, any legal entity (such as a
corporation, partnership or limited liability company) that controls, is
controlled by or under common control with such Party. For the purposes of this
definition, the term "control" means (i) beneficial ownership of at least fifty
percent (50%) of the voting securities of a corporation or other business
organization with voting securities or (ii) a fifty percent (50%) or greater
interest in the net assets or profits of a partnership or other business
organization without voting securities.

"AGREEMENT" means this Manufacture and Supply Agreement and all schedules listed
in Section 1.2 supplemental thereto and any amendments to the foregoing.

"BATCH" means a production batch of Products as specified in Schedule C attached
hereto.

"BUSINESS DAY" or "BUSINESS DAYS" means any day other than Saturday, Sunday or a
holiday generally recognized in Canada or the United States.

"CALENDAR YEAR(s)" means January 1 to December 31 of any given year or years, as
the case may be.

"CFR" means the U.S. Code of Federal Regulations.

"CONSUMER PRICE INDEX" means the Consumer Price Index for Canada (P119500) as
published by Statistics Canada, or a successor agency. In the event that
Statistics Canada stops publishing the Consumer Price Index or substantially
changes its content or format, the Parties will substitute another comparable
index published monthly by a mutually agreeable source. If Statistics Canada
redefines the base year for the Consumer Price Index from 1986 to another year,
the Parties will continue to use the Consumer Price Index but will convert to
the new base year using an appropriate, mutually agreeable conversion formula.

                                     - 2 -


"CURRENT GOOD MANUFACTURING PRACTICES" or "CGMP" or "GMP" means, as applicable
in accordance with the country(ies) in which the Products will be manufactured
or distributed, the practices set out in the guidelines (i) published as the
Good Manufacturing Practices for Drug Manufacturers and Importers by the HPFBI,
as amended from time to time, with respect to the Products manufactured or
distributed in Canada, (ii) for the manufacture of pharmaceutical products and
the Current Good Manufacturing Practices as defined in United States 21 CFR 210,
et seq., as amended from time to time, with respect to the Products manufactured
or distributed in the United States, and (iii) the EU Guidelines to Good
Manufacturing Practice for Medical Products for Human and Veterinary Use, as
amended from time to time, with respect to the Products manufactured or
distributed in the European Union, and, in any event, (iv) such other relevant
good manufacturing practices as required by applicable Law.

"DESIGNATED SUPPLIER" shall have the meaning ascribed to it in the Quality
Agreement.

"DESIGNATED SUPPLIER'S AUDIT" shall have the meaning ascribed to it in the
Quality Agreement.

"FACILITY" means those sections of Supplier's facility located at 16751 Trans
Canada Highway, Kirkland, Quebec, Canada used in the Formulation of the Products
hereunder and, subject to Purchaser's prior written approval, such other
facilities used by Supplier in the Formulation of Products hereunder.

"FDA" means the United States Food and Drug Administration, or any successor to
it.

"FORMULATE" or "FORMULATED" means to effect the operation required in the
manufacture, processing, filling, testing, packaging, labelling or storage, as
the case may be, of the Products by Supplier.

"FORMULATION" means any operation required in the manufacture, processing,
filling, testing, packaging, labelling or storage, as the case may be, of the
Products by Supplier.

"FORMULATION RECORDS" shall have the meaning ascribed to it in Section 6.5.

"GOVERNMENTAL AUTHORITY" or "REGULATORY AUTHORITY" means any court, tribunal,
arbitrator, agency, commission, official or other instrumentality of Canada, any
relevant foreign country or territory, or any domestic or foreign state,
province, country, city or other political subdivision thereof.

"HPFBI" means the Health Products and Food Branch Inspectorate of Health Canada,
or any successor to it.

"INCOTERMS 2000" means the International Commercial Terms published by the
International Chamber of Commerce, as amended from time to time, codifying the
contractual rules for the interpretation of standardized commercial terms for
transactions. Where referenced, the relevant provisions of Incoterms 2000 shall
be deemed to have

                                     - 3 -


been incorporated by reference in this Agreement except in so far as they may
conflict with any other provision of this Agreement, in which case the Agreement
provision shall prevail.

"INDEMNITEES" means a Party seeking indemnification hereunder, and that Party's
shareholders, directors, officers, employees, agents and representatives.

"INDEMNITOR" means a Party providing indemnification hereunder.

"INTELLECTUAL PROPERTY" means all domestic or foreign (i) trademarks, service
marks, trade names, trade dress, logos and slogans and all goodwill associated
therewith; (ii) patent, patent rights, industrial and other designs, including
any and all applications, applications for registration, registrations,
divisions, continuations, continuations-in-part, extensions, substitutions,
renewals, revalidations, re-examinations, reissues or additions, including
supplementary certificates of protection, or of to any of the foregoing items;
(iii) copyright, any original work or authorship fixed in any tangible medium of
expression, including literary works, all forms and types of computer software,
all source code, object code, firmware, development tools, files, records and
data, and all documentation related to any of the foregoing, all musical,
dramatic, pictorial, graphic and artistic works; (iv) trade secrets, technology,
discoveries and improvements, know-how, proprietary rights, formulae,
confidential and proprietary information, technical information, techniques,
inventions, designs, drawings, procedures, processes, models, formulations,
manuals and systems, whether or not patentable or copyrightable, including all
biological, chemical, biochemical, toxicological, pharmacological and metabolic
material and information and data relating thereto and formulation, clinical,
analytical and stability information and data which have actual or potential
commercial value and are not available in the public domain; and (v) all other
intellectual property or proprietary rights, in each case whether or not subject
to statutory registration or protection.

"INVENTORY CARRYING FEE(s)" shall have the meaning ascribed thereto in Section
4.2(f).

"LAW(s)" means any law, statute, rule, regulation, guideline (including Current
Good Manufacturing Practices), ordinance or other pronouncement of any
Governmental Authority having the effect of law in Canada, any relevant foreign
country or any territory or any domestic or foreign state, province, county,
city or other political subdivision.

"LICENSED TECHNOLOGY" shall have the meaning ascribed thereto in Section
8.2(a)(iii).

"LICENCES" means the licences, permits, certificates, authorizations or
approvals issued to Supplier by the relevant Governmental Authorities in respect
of its Facility, the conducting of Supplier's business and Supplier's
Formulation activities.

"LONG LEAD TIME MATERIALS" means those Materials listed in Schedule E hereto
held by Supplier beyond requirements necessary for (a) the supply of the
Products required under

                                     - 4 -


Firm Orders and (b) any pre-approved safety stock, including the safety stock
described in Section 4.2(e).

"LOSSES" mean any and all damages, fines, fees, settlements, payments,
obligations, penalties, deficiencies, losses, costs and expenses (including
without limitation, interest, court costs, reasonable fees of attorneys,
accountants and other experts and other reasonable expenses of litigation or
other Proceedings or of any claim, default or assessment) but shall exclude any
and all indirect, incidental, special or consequential damages or losses,
including loss of profits or revenue.

"MATERIALS" mean all materials and ingredients used in the Formulation of
Products by Supplier, including the raw materials and packaging, shipping or
labelling materials, as well as freight and duty services, if applicable;
Materials shall include the raw materials listed in the Specifications.

"ONGOING FORECAST" has the meaning ascribed thereto in Section 4.1(a) of this
Agreement.

"PARTY" means either Purchaser or Supplier, individually; "PARTIES" means
Purchaser and Supplier collectively.

"PERSON" means any natural person, entity, corporation, general partnership,
limited partnership, proprietorship, other business organization, trust, union,
association or Governmental Authority.

"PRICES" or "PRICE" means the total aggregate cost of each Product, as set out
in Schedule "C" for 2006 and as adjusted in subsequent years of the Term of the
Agreement in accordance with the provisions of Section 3.1.

"PROCEEDING" means applicable action, claim, suit, proceeding, arbitration or
Governmental Authority action, notification, investigation or audit.

"PRODUCT(s)" means the product(s) to be Formulated by Supplier for Purchaser, as
set out in Schedule C and such other product(s) as may be mutually agreed
between the Parties in the form of a Product Amendment and in accordance with
this Agreement.

"PRODUCT DEVELOPMENTS" shall have the meaning ascribed hereto in Section 9.1(c)
of this Agreement.

"PURCHASE ORDER(s)" shall have the meaning ascribed hereto in Section 4.3(a) of
this Agreement.

"PURCHASER INTELLECTUAL PROPERTY" means any and all Intellectual Property
relating to the Products or their Formulation by Supplier that is (i) owned by
Purchaser at the Effective Date or (ii) developed or acquired by Purchaser after
the Effective Date provided that such Intellectual Property does not utilize nor
is based on any Supplier Intellectual Property. "Purchaser Intellectual
Property" excludes Product Developments.

                                     - 5 -


"QUALITY AGREEMENT" means the agreement executed by the Parties as of the
Effective Date which sets out the details of the allocation of certain tasks
between the Parties as related to the Formulation of the Product needed to
satisfy quality control considerations, including responsibilities for quality
assurance and control of Materials, packaging components, and bulk Product, a
copy of which is attached hereto as Schedule "B".

"SPECIFICATIONS" means, with respect to any Products, all specifications for
Materials, manufacturing procedures, sampling plans for the Products as well as
the procedures, requirements (regulatory or otherwise), standards and other
items necessary to Formulate the Products, as approved by the Parties and
attached as Schedule "A".

"SUPPLIER INTELLECTUAL PROPERTY" means (i) all Intellectual Property owned by
Supplier as of the Effective Date; (ii) all Intellectual Property developed or
acquired by Supplier after the Effective Date independent of the performance of
its obligations under this Agreement, provided that such Intellectual Property
does not utilize nor is based on any Purchaser Intellectual Property or Product
Developments; or (iii) all Intellectual Property conceived, reduced to practice,
authored or otherwise generated or developed in the performance of its
obligations under this Agreement, provided that such Intellectual Property has
general applicability to the manufacture of pharmaceutical products other than
the Products (unless such Intellectual Property relates to and/or is an
improvement, modification, alteration or enhancement to any of Purchaser
Intellectual Property, in which case it shall be a Product Development).

"TERM" means, collectively, the Initial Term (as defined in Section 11.1(a)) and
any Renewal Term (as defined in Section 11.1(b)), as the case may be.

"THIRD PARTY" means any Person other than the Parties or their Affiliates.

1.2   INCORPORATION OF SCHEDULES.

The terms of the Schedules attached or referred to herein are an integral part
of this Agreement. The following Schedules are attached hereto:

      -     Schedule "A" - Product Specifications

      -     Schedule "B" - Quality Agreement

      -     Schedule "C" - Product Prices

      -     Schedule "D" - Confidential Disclosure Agreement

      -     Schedule "E" - Long Lead Time Materials

1.3   CURRENCY.

Except as otherwise expressly stated, all dollar amounts referred to in this
Agreement are in CANADIAN dollars.

1.4   GENERAL.

                                     - 6 -


Article headings in this Agreement are for convenience only and shall not be
used in interpreting this Agreement. The Agreement shall be read with such
changes in gender or number as the context requires. The definitions in Article
1 shall apply equally to both the singular and plural forms of the terms
defined. The words "include", "includes" and "including" shall be deemed to be
followed by the phrase "without limitation". All references herein to Articles,
Sections, paragraphs, clauses and Schedules shall be deemed references to
Articles, Sections, paragraphs and clauses of this Agreement and Schedules to
this Agreement unless the context shall otherwise require.

                            ARTICLE II - FORMULATION

2.1   AGREEMENT TO FORMULATE PRODUCTS.

For the Term of this Agreement, Supplier agrees to Formulate the Products for
Purchaser in the Facility in accordance with the terms set out in this Agreement
and Supplier shall exclusively Formulate the Products for Purchaser subject to
Supplier being the principal supplier for the Formulation of the Products,
Formulating at a minimum 50% of the aggregate volume Product in kilograms
purchased by Purchaser in each Calendar Year of the Term or any renewal thereof.
The Parties agree that, in the event that Supplier fails to supply a Product
within sixty (60) days after the delivery date described in Section 4.1 for the
Firm Zone for any reason (including Force Majeure) not caused by Purchaser or a
Designated Supplier, Purchaser shall be relieved of this annual minimum purchase
requirement for the longer of the remainder of the relevant Calendar Year or
three (3) months after Supplier is again able to supply such Products (in the
latter case the annual minimum purchase requirement for any other periods in the
relevant Calendar Year(s) shall be measured as 50% of the aggregate volume
Product in kilograms purchased by Purchaser during such periods).

2.2   CONFORMANCE WITH SPECIFICATIONS.

Supplier shall Formulate the Products in accordance with the Specifications.
Either of the Parties shall have the right to request changes to any of the
Specifications in accordance with this Agreement and Section 13 of the Quality
Agreement. Recommendations to change any of the Specifications shall be in
writing. Supplier shall not implement any change to the Specifications unless
and until both Parties have agreed to such changes in writing. Supplier shall
not unreasonably withhold its consent to any change to the Specifications (a)
requested by Purchaser, (b) required by any Governmental Authority or (c)
necessary to ensure that the Products are Formulated in accordance with
applicable cGMP. A change in the Specifications by Purchaser shall be validated
by Supplier through the performance of [**] consecutive successful validation
batches of Product. Such validation shall be performed at Purchaser's costs and
expenses.

                                     - 7 -


2.3   CONFORMANCE WITH CGMP.

Supplier shall Formulate the Products in accordance with applicable Current Good
Manufacturing Practices. Each Party shall promptly notify the other of knowledge
of any new instructions or specifications required in order to comply with
Current Good Manufacturing Practices, and shall reasonably cooperate in agreeing
on the best means to comply with any new requirements.

2.4   SUPPLY OF MATERIALS.

Supplier shall supply all Materials necessary for the Formulation of the Product
as indicated in the Specifications.

2.5   QUALITY AGREEMENT.

The Parties will, on the Effective Date, execute the Quality Agreement. The
Parties agree that, if any provisions of the Quality Agreement are inconsistent
with this Agreement, the provisions of this Agreement shall govern to the extent
of such inconsistency.

2.6   THIRD PARTY SUPPLIERS AND DESIGNATED SUPPLIERS.

Third Party suppliers and Designated Suppliers of Materials must be agreed upon
between the Parties, including any changes thereto during the Term of this
Agreement.

2.7   COSTS AND EXPENSES.

Supplier shall bear all of its own costs and expenses incurred in Formulating
the Product unless otherwise specifically provided herein. Notwithstanding the
above, all artwork expenses will be charged back to Purchaser and payable in
accordance with Sections 3.3 and 4.2(h).

2.8   ADDITION OF PRODUCTS.

The Parties may add a Product to this Agreement from time to time by entering
into an amendment to this Agreement (individually referred to as a "Product
Amendment"). Each Product Amendment shall form a part of this Agreement and
shall contain a description of the Product to be Formulated pursuant to the
terms of that Product Amendment and of this Agreement, the Specifications for
such Product, the Price payable by Purchaser to Supplier for the Product,
territory(ies) in which Purchaser proposes to distribute same and any additional
provisions relating to such Product as the Parties may agree to. For greater
certainty, neither Party shall have an obligation to add a Product to the
Agreement. Each Party shall have the sole discretion as to whether or not it
agrees to add a Product to this Agreement.

                                     - 8 -


2.9   ASSISTANCE FROM PURCHASER.

Purchaser shall use commercially reasonable efforts to provide all information
necessary for Supplier to Formulate the Products in accordance with the
Specifications and all applicable Laws, including cGMP, and shall make its
employees reasonably available on a timely basis to respond to questions
concerning such information.

                          ARTICLE III - CONSIDERATION

3.1   PRICE OF PRODUCTS AND ADJUSTMENT.

On January 1st of 2007 and each subsequent year of the Term, the Price shall be
subject to an adjustment, which adjustment shall be equal to [**]. Supplier
shall provide Purchaser with a written notice no later than December 15th of
each year of the Term setting forth the Price for the Products for the following
Calendar Year. [**]. In the event there is a significant increase or decrease in
Material costs either party may initiate discussions in order to address such
impact on the Price.

The Price shall also be payable for all samples of Products required to be
maintained by Supplier under the terms of this Agreement or any applicable Law
as well as any additional samples which the Purchaser requires.

3.2   MINIMUM BATCH SIZE.

Minimum Batch sizes shall be based on the minimum Formulation Batch size as
agreed by the Parties and set forth in Schedule "C" or the relevant Product
Amendment, as applicable.

3.3   PAYMENT.

Purchaser shall pay Supplier for all Products Formulated under the terms of this
Agreement, within thirty (30) days of the date of the invoice. Supplier shall
send the corresponding Product with the relevant Formulation Records and the
applicable release documents in accordance with Section 6.3 hereof. Supplier
shall issue invoices in respect of the Products upon shipment of such Products,
with interest at the rate of one percent (1%) per month (twelve percent (12%)
per annum) or the highest rate permitted by applicable Law (if lower) payable on
all overdue accounts.

3.4   TAXES.

In addition to the amounts paid by Purchaser pursuant to Section 3.1, Purchaser
shall pay to Supplier all applicable use, consumption, sales or excise taxes of
any taxing authority with respect to the purchase of the Products (but in no
event any tax on the net income of

                                     - 9 -


Supplier). The amount of such taxes will be added to the Price in effect at the
time of shipment thereof and will be reflected in the invoices submitted to
Purchaser by Supplier pursuant to Section 3.3 hereof. Purchaser shall pay the
amount of such taxes to Supplier in accordance with the payment provisions set
forth in Section 3.3 hereof. Supplier hereby agrees to indemnify Purchaser
against, and shall reimburse Purchaser for, any expenditures, including taxes
and penalties levied by the applicable Governmental Authority in connection
therewith, that Purchaser is required to make on account of Supplier's failure
to pay such taxes or other related governmental charges to the relevant taxing
authorities.

3.5   CAPITAL EXPENDITURES.

Any capital expenditures that Purchaser requests Supplier to purchase in order
to Formulate the Products will be payable by Purchaser upon the terms and
conditions agreed upon between the Parties and are not included in the Price. To
be reimbursable, all arrangements for capital expenditures must be in writing
and signed by both Parties.

3.6   ADDITIONAL COSTS.

In addition to the Price, Purchaser shall pay any fees for additional services,
including stability testing fees, which may be performed by Supplier for
Purchaser in accordance with the provisions of this Agreement to the extent
mutually agreed by the Parties in writing. Such fees will be payable by
Purchaser within thirty (30) days of receipt of invoice and are not included in
the Price. Invoices for such additional fees will be issued upon completion of
the relevant service. Supplier shall perform stability testing on the Product in
accordance with the terms and Price set forth in Schedule "C" hereto.

3.7   COST OF CHANGES TO SPECIFICATIONS.

(a)   CHANGES REQUESTED BY PURCHASER. Purchaser shall be responsible for all
      costs related to Materials purchased or ordered by Supplier for the
      Formulation of the Products which are unusable as a result of changes made
      in the Specifications, including without limitation, changes to the
      graphics used on packaging, films, dies, proofs, provided that such
      changes were made at Purchaser's request. Supplier agrees to use
      reasonable efforts to minimize these costs to Purchaser.

(b)   CHANGES TO COMPLY WITH cGMP. Purchaser shall be responsible for all costs,
      except direct Facility costs, associated with changes required in the
      Specifications of the Products in order to comply with changes to cGMP
      occurring after the date of this Agreement; provided that Purchaser
      pre-approves such costs in writing. Such approval shall not be
      unreasonably withheld or delayed.

                                     - 10 -


                           ARTICLE IV - PRODUCT SUPPLY

4.1   FORECASTS.

(a)   ONGOING FORECASTS. On or before the Friday of the third (3rd) week of each
      month of every year of the Agreement, Purchaser shall provide Supplier
      with a copy of its forecast of its anticipated Product Formulation
      requirements for the [**] month period commencing the following month (the
      "Ongoing Forecast"). Each Ongoing Forecast shall provide delivery dates
      for each Firm Zone (as defined in Section 4.2(a) hereof), in addition to
      quantity and purchase order specifics for the Firm Zone, the Material Zone
      and the Open Zone. In the event that an Ongoing Forecast is not delivered
      on the Friday of the third (3rd) week of a given calendar month in
      accordance with this provision, the prior month's Ongoing Forecast will
      constitute that month's Ongoing Forecast.

4.2   ORDER PROCEDURES.

(a)   FIRM ZONE. Product quantities forecasted for the first [**] months of an
      Ongoing Forecast (the "Firm Zone"), are deemed to be firm orders, and as
      such Purchaser is committed to same. The Parties shall use reasonable best
      efforts to negotiate any change in the delivery date of any firm order;
      provided, however, that:

            (i) if Purchaser reduces its requirements for Products to be
            Formulated in the Firm Zone of an Ongoing Forecast, Purchaser shall
            [**]; and

            (ii) if Supplier agrees to Formulate additional quantities of the
            Products in the Firm Zone of an Ongoing Forecast, Purchaser, in
            addition to the Price, shall [**]. Supplier shall [**].

(b)   MATERIAL ZONE. Product quantities forecasted for the next [**] months of
      an Ongoing Forecast following the Firm Zone (the "Material Zone") are
      deemed to be firm as they relate to the quantities of Products to be
      ordered. Changes of timing for delivery of Products within the Material
      Zone may be made by Purchaser, at Purchaser's reasonable discretion;
      provided, however, that if any order made by Purchaser for Products to be
      delivered during the Material Zone of an Ongoing Forecast is cancelled,
      deferred or reduced, so as to result in lesser quantity Products ordered
      by Purchaser than indicated in the corresponding month of such Material
      Zone, Purchaser shall be responsible for the cost of obsolete or unused
      Materials reasonably procured by Supplier for the purpose of meeting the
      requirements specified in the Firm Zone (if applicable) and in the
      corresponding months of the Material Zone of that Ongoing Forecast and in
      accordance with any minimum order quantities of Materials by Third Party
      suppliers.

                                     - 11 -


(c)   OPEN ZONE. Product quantities forecasted for the last [**] months of an
      Ongoing Forecast (the "Open Zone") are deemed to be open as they relate to
      the quantities of Products to be ordered and Purchaser is not committed to
      same. The Parties acknowledge and agree that the requirements specified in
      the Open Zone of an Ongoing Forecast are for the purposes of Supplier's
      internal scheduling and planning only and Purchaser shall not be
      responsible for any costs of Materials procured or other expenses incurred
      by Supplier for the purpose of meeting the requirements specified in the
      Open Zone, unless related to Long Lead Time Materials as referenced in
      Section 4.2(d) or agreed to by both Parties in writing.

(d)   LONG LEAD TIME MATERIALS. The Parties shall agree on the purchase or
      entering into of commitments to purchase any Long Lead Time Materials
      described in Schedule E hereto as amended from time to time by the Parties
      in writing based on the Ongoing Forecast for a specified month. Purchaser
      shall pay Supplier for those Long Lead Time Materials that cannot be used
      by Supplier for the Formulation of the Products within [**] months of the
      specified months for which those Long Lead Time Materials were purchased.
      The Long Lead Time Materials paid for by the Purchaser shall be the sole
      property of the Purchaser.

(e)   SAFETY STOCK. Supplier will carry the necessary safety stock of Materials
      to support [**] Batches of Product to ensure timely delivery of orders of
      Products (the "Safety Stock"). Any safety stock of Materials with
      unusually long re-order lead times may be carried by Supplier, but only if
      approved in writing by Purchaser. Purchaser shall be invoiced on a monthly
      basis for the storage fees for such Safety Stock. The rate to be charged
      in 2006 is $[**] (USD) per skid per month. The fee is in addition to the
      Price. The Supplier shall advise Purchaser on a yearly basis by January
      30th if there is an increase in Supplier's standard monthly inventory
      carrying fee for each skid. Purchaser shall be liable to purchase said
      Safety Stock in the event of termination or expiration of this Agreement
      and/or in the event of the expiration of the shelf-life of such Safety
      Stock. Supplier shall use the Materials for the Formulation of the
      Products, including the Safety Stock, on a first-in/first-out basis.
      Supplier shall promptly replenish the Safety Stock upon the use thereof in
      accordance with the Terms of this Agreement.

(f)   DELAYS IN DELIVERY OF MATERIALS BY THIRD PARTY SUPPLIER. Delivery dates
      specified in Purchase Orders are subject to Supplier's receipt of
      Materials from the Third-Party supplier thereof (as the case may be) not
      less than [**] weeks prior to the specified delivery date; provided,
      however, that Supplier shall use all commercially reasonable efforts to
      obtain Materials from said Third Party supplier. Supplier agrees to use
      commercial reasonable efforts to Formulate the Product as soon as possible
      in the event that the supplier of the Materials fails to deliver the
      Materials in accordance with this schedule.

(g)   GRAPHIC CHANGES. If there is to be change to any artwork for any Product,
      at least [**] weeks prior to the intended first delivery date of such
      Product

                                     - 12 -


      with such changed artwork, Purchaser shall provide to Supplier, at no
      cost, digital artwork in a format acceptable to Supplier and in compliance
      with the packaging specifications (if any) for such Product. All one time
      costs and expenses associated with any such artwork changes shall be the
      responsibility of Purchaser and shall be charged directly to the Purchaser
      and are not included in the Price.

(h)   DELIVERY PERFORMANCE. Subject to Sections 4.2(g) and 4.3(a) hereof,
      Supplier will use all commercially reasonable efforts to deliver (A) [**]
      percent [**] of all Purchase Orders included in the volumes in each Firm
      Zone on, or within [**] Business Days of, the delivery dates specified in
      the Accepted Purchase Orders corresponding to such Purchase Orders, and
      (B) [**] percent [**] of the [**] for the quantity of Product ordered by
      Purchaser pursuant to such Accepted Purchase Orders; provided that
      Purchaser's payment obligations pursuant to Section 3 of the Agreement
      shall apply only to those quantities of Product actually delivered to
      Purchaser. For purposes of this Section 4.2(i), subject to Section 5.2 of
      the Agreement, Supplier shall be deemed to have delivered Product to
      Purchaser when such Product has been accepted by Purchaser's carrier in
      accordance with Section 5.1 of the Agreement.

4.3   PURCHASE ORDERS

(a)   GENERAL. Purchaser shall deliver to Supplier purchase orders (each a
      "Purchase Order") for the aggregate Product volumes in each Firm Zone.
      Supplier shall receive Purchaser's Purchase Orders at least [**] months
      before the delivery date of each Product. Each Purchase Order shall
      specify the volumes of Products ordered, the Price, the delivery date, the
      destination of delivery of the Products and Purchaser's instructions for
      such delivery, in accordance with the provisions of Section 5.1(b) of this
      Agreement.

(b)   DELIVERY. The Purchase Orders may be delivered electronically or by other
      means in such location as Supplier shall designate from time to time.
      Supplier shall promptly acknowledge acceptance of each Purchase Order by
      sending to Purchaser electronic (email and/or fax) written notice of
      acknowledgement and acceptance for each Purchase Order promptly after its
      receipt (an "Accepted Purchase Order"). Failure by Supplier to deliver to
      Purchaser a written notice of acceptance of a Purchase Order within [**]
      Business Days after receipt of said Purchase Order shall constitute
      Supplier's deemed acceptance of said Purchase Order.

(c)   REJECTION AND DEEMED ACCEPTANCE. Notwithstanding anything in this
      Agreement to the contrary, Supplier reserves the right at its sole
      discretion to reject without liability any Purchase Order solely to the
      extent that the Purchase Orders request Products greater than the volumes
      in each Firm Zone or Material Zone, as applicable; provided, however, that
      failure by Supplier to deliver to Purchaser a written notice so objecting
      to a Purchase Order within [**]

                                     - 13 -


      Business Days after receipt of the Purchase Order shall constitute
      Supplier's deemed acceptance of said Purchase Order and such Purchase
      Order shall be deemed an Accepted Purchase Order.

(d)   FAILURE TO SUPPLY.

            (i)   Save in the event of a Force Majeure in accordance with
                  Section 12.2 hereof, Supplier shall be obliged to Formulate
                  and deliver Products which are subject to an Accepted Purchase
                  Order within [**] Business Days of the specified delivery
                  date referenced therein. In the event that Supplier is not
                  able to fulfil an Accepted Purchase Order by the specified
                  delivery date:

                  A.    [**]; and

                  B.    [**].

            (ii)  In the event that Supplier fails to supply a Product within
                  [**] days after the delivery date specified in an Accepted
                  Purchase Order within a Firm Zone as described in Section 4.1
                  for any reason (including Force Majeure) not caused by
                  Purchaser or a Designated Supplier, Purchaser may, at its sole
                  discretion, purchase or have manufactured from any other
                  source the quantity of Products necessary to meet its
                  requirements for such Firm Zone and the annual minimum
                  purchase requirements set forth in Section 2.1 hereof shall
                  not apply for the longer of the remainder of the relevant
                  Calendar Year or [**] months after Supplier is again able to
                  supply such Products (in the latter case the annual minimum
                  purchase requirement for any other periods in the relevant
                  Calendar Year(s) shall be measured as 50% of the aggregate
                  volume Product in kilograms purchased by Purchaser during such
                  periods).

(e)   CONFLICT. In the event of any conflict between the terms and conditions of
      this Agreement and the terms and conditions of any Purchase Order or any
      other related document, the terms and conditions of this Agreement shall
      prevail to the extent of such conflict.

4.4   STANDARD FORMS.

                                     - 14 -


In ordering and delivering the Products pursuant hereto, Supplier and Purchaser
may employ their standard forms, but nothing in those forms shall be construed
to modify, amend or supplement the terms of this Agreement and, in the case of
any conflict herewith, the terms of this Agreement shall prevail.

                   ARTICLE V - DELIVERY, TITLE AND ACCEPTANCE

5.1   PRODUCT STORAGE AND SHIPMENT.

(a)   STORAGE CONDITIONS. The Materials and Products manufactured by Supplier
      are to be stored and packaged by Supplier in accordance with the
      conditions agreed between Purchaser and Supplier and in accordance with
      the Specifications and applicable Law.

(b)   SHIPPING RESPONSIBILITIES. The Products ordered by Purchaser pursuant to
      this Agreement shall be deemed delivered by Supplier to Purchaser once
      delivered onto the Purchaser's carrier truck, FCA (Incoterms 2000) the
      Facility's loading dock. Shipment of the Products shall be at Purchaser's
      sole cost and expenses. Purchaser shall be liable for any and all
      transportation charges, including without limitation freight, duties and
      taxes levied in connection with the supply of Products and shipment of
      same. Supplier shall arrange for the shipment of the Products in
      accordance with Purchaser's instructions. Purchaser shall retain the
      carrier and insurance company for shipping of the Products in accordance
      with the terms of this Agreement. Purchaser shall provide Supplier with a
      listing of carriers and Purchaser's account number and its insurance
      company contact information. Supplier will schedule freight pick up with
      one of such specified carriers and complete the documentation on behalf of
      Purchaser for each shipment of Product by using Purchaser's account
      number. All costs and invoices related to the shipment of the Products
      shall be charged by Purchaser's selected carrier directly to Purchaser for
      all Third Party costs related to same. If Purchaser wishes the delivery of
      the Products to be on any unique pallets, Purchaser shall, at its own cost
      and expense, make such pallets available to Supplier. Supplier shall be
      responsible for the packaging of the Products in accordance with the
      Product packaging Specifications, if provided by Purchaser to Supplier,
      or, if no such Product packaging Specifications are provided by Purchaser
      to Supplier, in a commercially reasonable manner. Such packaging
      Specifications, if provided, shall include packaging and carrier
      instructions.

(c)   TRANSFER OF TITLE. Notwithstanding anything to the contrary contained
      herein, title to and risk of loss for the Products supplied to Purchaser
      under this Agreement shall pass to Purchaser at the time the Products are
      delivered onto the Purchaser's carrier truck at the Facility's loading
      dock, not cleared for export. Except as otherwise provided herein,
      Supplier shall not be liable to Purchaser for the costs of loss of any
      kind arising out of or in relation to damage to or loss of the Products
      which occurs after title to and risk for the Products passes to

                                     - 15 -


      Purchaser. For greater certainty, Purchaser shall be liable for all costs
      and risks of loss while Products are in transit.

5.2   PURCHASER ACCEPTANCE.

(a)   QUANTITATIVE DEFECTS. Purchaser shall inform Supplier in writing of any
      claim relating to quantitative defects in shipments of Products within
      [**] days from the receipt of such shipment by Purchaser or within [**]
      days from the receipt of such shipment of Products by Purchaser's designee
      in the event that the Products are shipped by Supplier to Purchaser's
      designee and Purchaser shall provide to Supplier copies of any appropriate
      documents relating to such defects. Supplier shall [**] provide Purchaser
      with any missing quantities of such Products as soon as reasonably
      possible after receipt of notice from Purchaser. Any claim for a
      quantitative defect which is not made within such [**] day or [**] day
      period, as applicable, shall be deemed to have been waived by Purchaser.

(b)   QUALITATIVE DEFECTS. Purchaser shall have [**] days from the receipt of
      each shipment of Products or within [**] days from the receipt of the
      Products by Purchaser's Third Party designee in the event that the
      Products are shipped by Supplier to Purchaser's Third Party designee, in
      which to determine by appropriate validated tests and assays whether or
      not each Batch delivered conforms to the Specifications. To assist such
      testing, Supplier shall deliver to Purchaser, with respect to each Batch
      Formulated and delivered to Purchaser or Purchaser's Third Party designee,
      at least [**] kilograms of Product samples from such Batch, which samples
      shall be delivered to Purchaser at the same time as such Batch is shipped
      to Purchaser or its Third Party designee. Such samples shall be charged to
      Purchaser in accordance with the Price set forth in this Agreement. If
      Purchaser deems that a Batch does not conform to the Specifications
      ("Rejected Batch"), unless such non-conformance with the Specifications is
      the result of or arises from a defect in any of the Materials or services
      supplied by Purchaser or by a Designated Supplier, the result of a defect
      in Purchaser's formula for the Formulation of the Products or a defect in
      the Specifications, Purchaser may reject such Batch by giving written
      notice to Supplier within such [**] day or [**] day period, as applicable,
      after receipt of such Batch by Purchaser or its authorized Affiliate or
      Third Party ("Rejection Notice"). Purchaser must specify in reasonable
      detail the manner in which such Batch fails to meet the Specifications.
      Save and except that Purchaser shall be liable for any Rejected Batch
      resulting from or arising from defects in any of the Materials or services
      supplied by Purchaser or by a Designated Supplier (unless such Designated
      Supplier has been audited by Supplier at Purchaser's expense as set forth
      in the Quality Agreement) or as a result of a defect in Purchaser's
      formula for the Formulation of the Products. Notwithstanding the above,
      Purchaser shall be deemed to have accepted any Batch with respect to which
      it fails to notify Supplier as provided above.

                                     - 16 -


(c)   DISPOSITION OF REJECTED BATCH. Supplier shall have [**] days from the
      receipt of the Rejection Notice to accept or reject Purchaser's claims and
      submit a report on the Rejected Batch indicating the investigation and
      testing done and the recommended disposition to Purchaser, as the case may
      be. Purchaser shall review such report and notify Supplier that Purchaser
      either requests additional data, approves the recommended disposition of
      the Rejected Batch or will otherwise direct Supplier as to how Purchaser
      wishes the Rejected Batch to be disposed of.

(d)   DISPUTE OF TEST RESULTS. If the Parties fail to agree on whether a Batch
      of Products fails in whole or part to meet the Specifications and on the
      disposition of such Rejected Batch, such dispute shall be resolved
      promptly by an independent testing organization of recognized repute
      within the pharmaceutical industry of the United States or the country in
      which such Batch is to be distributed, mutually agreed upon by the
      Parties. The appointment of such organization shall not be unreasonably
      delayed by either Party. The decision of such testing organization shall
      be binding on both Parties. The fees and costs of the testing
      organization, and storage and handling of the Products during the resolve
      of the dispute shall be borne by the Party whose position is not sustained
      by the testing organization.

(e)   REWORK AND REPLACEMENT OF REJECTED BATCH.

            (i) If the Parties agree that a Rejected Batch fails in whole or in
            part to conform to the Specifications, or if a dispute between the
            Parties in this regard has been resolved pursuant to Section 5.2(d)
            in favour of Purchaser, Supplier shall [**] (1) accept return of the
            Rejected Batch (which shall be returned to Supplier forthwith) or
            otherwise dispose of the Rejected Batch, as so agreed, and (2) :

                  A. if possible, rework or reclaim the Rejected Batch, or
                  destroy the Rejected Batch;

                  B. and deliver a replacement shipment for the Rejected Batch
                  ("Replacement Batch") which shall conform with the
                  Specifications

               as promptly as possible, but in no event later than [**] days
               after the date Supplier accepts Purchaser's written Rejection
               Notice or the date of the final resolution of the dispute,
               whichever is earlier provided that Purchaser has not prevented
               Supplier from maintaining the Safety Stock. The Parties agree
               that Supplier shall be entitled to use the Materials contained in
               the Safety Stock to fulfill its obligations under this Section
               5.2 (e).

            (ii) Notwithstanding the existence of a dispute concerning Products
            rejected by Purchaser, pending resolution of such dispute, Supplier
            shall, as

                                     - 17 -

            promptly as possible, but in no event later than [**] days after
            issue by Purchaser of a Purchase Order for additional Products of
            the type and quantity claimed to be rejected as contemplated by
            Section 5.2(b) hereof, deliver such additional Products, and
            Purchaser shall be obligated to pay for such Products in accordance
            with Section 3.3 hereof even if such Replacement Batch fails to meet
            the Specifications, provided that such failure is not the result of
            Supplier's performance of the Material qualifications in accordance
            with this Agreement, equipment failure or Supplier not following the
            Purchaser's formula for the Formulation of the Products. In the
            event that it is ultimately determined that the Rejected Batch was
            properly rejected by Purchaser, then Purchaser shall not be liable
            for the payment of the Rejected Batch and shall be credited
            accordingly for the payment of same. If it is ultimately determined
            that the Rejected Batch was not properly rejected by Purchaser, then
            Purchaser shall promptly pay Supplier for such Rejected Batch.

5.3   RECALLS.

As between Supplier and Purchaser, Purchaser shall be responsible for recalls of
the Products. Supplier shall cooperate with Purchaser in the event of any recall
and provide such reasonable assistance in connection therewith as Purchaser may
reasonably request. Subject to the limitations set forth in Section 10 hereof,
the costs of any recall shall be borne by the Party responsible; provided,
however, that Supplier shall be responsible only if the recall directly results
from its negligence, wilful misconduct or breach of this Agreement. For greater
certainty and notwithstanding the above, Supplier shall not be responsible if it
Formulated the Products in accordance with the Specifications and the formula
provided by Purchaser for the Formulation of the Product and applicable cGMP.

                   ARTICLE VI - QUALITY ASSURANCE AND CONTROL

6.1   FORM OF QUALITY AGREEMENT.

On the Effective Date, the Parties are executing the Quality Agreement. The
Parties agree that to the extent of an inconsistency with the terms of the
Quality Agreement and the Agreement, the terms of this Agreement shall prevail
to the extent of such conflict.

6.2   TESTING.

Supplier shall perform, with respect to the Materials and the Products, the
quality control tests and assays identified in (a) the Specifications and (b)
the Quality Agreement and in accordance therewith. Supplier shall provide
Purchaser with the Certificate of Analysis for the Materials used in the
Formulation of the Product. Purchaser agrees to pay Supplier an additional
charge for such service. Such Certificates of Analysis shall be delivered by
Supplier to Purchaser with the delivery of each Batch of Product.

6.3   PRODUCT BATCH RELEASE.

                                     - 18 -


Supplier shall be responsible for the release of each production Batch of
Products, except to the extent that applicable Law requires that Purchaser be so
responsible, in which event (and to such extent), Purchaser shall assume such
responsibility. To the extent necessary in relation to the release of any
Product by Purchaser or otherwise requested by Purchaser, each Batch of Product
delivered by Supplier to Purchaser shall be accompanied by a copy of the
relevant Formulation Record for such Batch of Product, a "Certificate of
Compliance" which certifies the date of Formulation, expiration date of the
Product and that the Batch was Formulated in conformance with the Specifications
and cGMP, and a "Certificate of Analysis" for in-process testing which lists the
in-process tests performed by Supplier and sets forth the results of those
tests. Supplier shall not ship any Batch of a Product that based on Supplier's
tests fails to meet the Specifications for the Products, contains any Materials
that failed to meet the Specifications for the Materials, or for which the
packaging failed to meet the Specifications for the packaging, unless directed
to so ship by Purchaser in writing. Purchaser agrees that an additional fee will
be charged to Purchaser for the supply of the Formulation Records with each
shipment of Product.

6.4   RETENTION SAMPLES.

Sampling details and schedules must be agreed to by the Parties prior to
implementation and incorporated into the Quality Agreement (and shall include
the requirements provided in Section 8.2 thereof). For greater certainty, and
without limitation, samples of Product and raw materials must be retained in
sufficient quantities and must be stored under controlled conditions and
retained by Supplier or, if agreed to by the Parties, by Purchaser, for a period
equal to [**], or longer if required by applicable Law. The costs of the samples
requested by Purchaser shall be [**]. Supplier shall have the right to use the
retained samples to conduct testing either for investigation purposes in
accordance with applicable Laws or following a claim or potential claim by
Purchaser or any Third Party regarding the raw materials and/or Formulation and
in-process testing of the Products and/or for audit purposes.

6.5   FORMULATION RECORDS.

Supplier shall maintain true, accurate and complete records regarding the
Formulation of the Products as required by applicable Law ("Formulation
Records") including, without limitation, the information required to be
maintained pursuant to the Quality Agreement.

6.6   DESIGNATED SUPPLIERS AUDIT.

If Purchaser and Supplier agree that Supplier shall be responsible for the
performance of a Designated Supplier's Audit, Purchaser agrees that such
Designated Supplier's Audit shall be performed at Purchaser's sole cost and
expense and Purchaser shall reimburse Supplier within [**] days of receipt of
the invoice for any such costs and expenses incurred as a result of such
Designated Supplier's Audit. The rate to be charged to

                                     - 19 -


Purchaser for the performance of such Designated Supplier's Audit shall be
Supplier's applicable standard rate. Such standard rate is established at
CDN$[**] per hour for Calendar Year 2006.

                        ARTICLE VII - REGULATORY MATTERS

7.1   AUDIT AND INSPECTION.

(a)   PURCHASER AUDIT. Supplier grants Purchaser the right to audit or to
      appoint Third Parties to audit once per Calendar Year (or as provided
      below), at any reasonable time during normal business hours, (i) the
      Formulation processes and work practices relating to the Product and
      inventory of Materials and Products, (ii) all Licenses necessary to
      conduct Supplier's business and Formulate each of the Products, (iii) the
      Facility, and (iv) the documentation demonstrating Supplier's satisfactory
      performance of its obligations under this Agreement and the Quality
      Agreement. Purchaser will notify Supplier at least [**] Business Days in
      advance of such an audit. Purchaser may exercise such right once annually
      in any Calendar Year save and except for situations where a single audit
      reveals significant concerns from the perspective of Purchaser, acting
      reasonably, that require appropriate additional audit follow-up. Any such
      audit shall not exceed a [**] Business Day period. Purchaser shall have
      the right to perform [**] audits in any Calendar Year (or additional
      audits if Purchaser, acting reasonably, determines there are significant
      concerns that require appropriate additional audits) subject to (i) a [**]
      Business Days prior written notice, (ii) [**]. Any Third Party appointed
      by Purchaser to perform such an audit and any Third Party accompanying or
      assisting Purchaser in the performance of any such audit performed herein
      shall at all times be bound by the obligations of confidentiality and
      non-disclosure of Supplier's confidential information consistent with
      those provided herein and agree to disclose to Purchaser only such
      information as is necessary to determine if Supplier is performing its
      obligations under this Agreement and the Quality Agreement. Such Third
      Party shall also agree to disclose to Supplier the results of its review.
      It is furthermore agreed that the on-site availability of Purchaser or
      such Third Party shall have no bearing on Supplier's production schedule
      as Supplier shall be authorized and entitled to proceed with same in the
      absence of Purchaser's representative.

(b)   INSPECTION BY GOVERNMENTAL AUTHORITIES. Supplier shall permit inspections
      of the Facility by Governmental Authorities of all relevant territories
      (such as the FDA, HPFBI or equivalent foreign regulatory authorities) with
      respect to the fulfillment of any requirement for any License during the
      Term of this Agreement and, if necessary, thereafter.

(c)   INSPECTION NOTIFICATION. Supplier agrees to promptly notify Purchaser of
      any inspection by any Governmental Authority pending as of the date hereof
      or as

                                     - 20 -


      notice of same may arise, and of any communications to or from any
      Governmental Authority (including the reporting of adverse drug
      experiences or field alerts) which might adversely affect Supplier's
      ability to perform its obligations under this Agreement or which directly
      relates to the Products. Supplier shall keep Purchaser informed of the
      resolution of the matter with the relevant Governmental Authority.
      Supplier shall promptly provide to Purchaser a summary of findings with
      respect thereto; provided that Supplier shall have the right to redact all
      confidential information contained in any Facility inspection reports
      which are not related to Purchaser or the Products.

7.2   REGULATORY SUBMISSIONS AND ANNUAL PRODUCT REVIEWS.

Supplier shall provide reasonable support for any submissions required to the
HPFBI, FDA and other applicable Governmental Authority to support contract
manufacturing of Purchaser's Products by Supplier at the Facility. Supplier
shall not be responsible for any regulatory efforts required in respect of the
Formulation of the Products, other than regulatory efforts associated with
requests by Purchaser for changes to the Specifications. Annual Product Reviews
(APRs as defined in the Quality Agreement) shall be performed in accordance with
the terms and conditions set out in the Quality Agreement.

All regulatory support services set forth in this Section 7.2 above shall be
charged to Purchaser in accordance with the standard rates established by
Supplier for said services from time to time. Supplier's rate for regulatory
support services is established at CDN$[**] per hour for Calendar Year 2006.

                  ARTICLE VIII - REPRESENTATIONS AND WARRANTIES

8.1   SUPPLIER REPRESENTATIONS AND WARRANTIES.

(a)   REPRESENTATIONS AND WARRANTIES. Supplier represents, warrants and
      covenants, while acknowledging that Purchaser is relying on such
      representations and warranties in entering into this Agreement, that:

            (i) Supplier is the successor in interest to DRAXIS Pharma Inc.;

            (ii) in performing its services hereunder, Supplier shall comply
            with all applicable Laws and the cGMP applicable to such services
            and shall hold, and shall continue to hold during the Term of this
            Agreement, all material Licenses necessary or required for the
            Formulation of the Products and the performance of its obligations
            hereunder;

            (iii) the Facility, all equipment and tooling utilized in the
            Formulation of the Products hereunder, and the procedures and
            processes (including installation, operation and performance
            qualifications) instituted by Supplier in connection herewith are,
            and shall continue during the term of this

                                     - 21 -


            Agreement, to be in material compliance with all applicable Laws and
            maintained in good operating condition;

            (iv) Supplier shall carry and keep in good force during the term of
            this Agreement insurance coverage in such form and amount as a
            reasonable party in similar circumstances would carry and keep to
            fulfil its obligations hereunder; but, without limitation to the
            foregoing, Supplier shall, throughout the Term and thereafter, for a
            period of not less than three (3) years carry and maintain in full
            force and effect, Commercial General Liability insurance written on
            the standard approval Policy Form, including Products Liability and
            Blanket Contractual Liability with limits of liability of not less
            than $5,000,000 Combined Single Limit, Bodily Injury and Property
            Damages, with such insurance policies obtained from an insurance
            company having a Best's rating of A-, Class VIII or higher, and
            Supplier shall furnish Purchaser with certificates of said
            commercial general liability and Product liability insurance;

            (v) Supplier has the lawful right to enter into and perform its
            obligations under this Agreement without breach of any other
            contractual obligations it may have;

            (vi) The warranties in Section 3.1 of the Quality Agreement apply to
            Supplier;

            (vii) The Products Formulated by Supplier under the terms of this
            Agreement:

                  A.    will comply with the Specifications, Purchaser's formula
                        for the Formulation of the Products and applicable Laws,
                        including cGMP;

                  B.    shall not contain any material that would cause the
                        Products to be adulterated within the meaning of the
                        Food and Drug Act (Canada) or, for United States:
                        adulterated or misbranded within the meaning of Section
                        404 or 505 of the Federal Food, Drug and Cosmetic Act as
                        amended (21 USC Sections 351 and 352), or the
                        regulations issued thereunder or within the meaning of
                        any national, international, provincial, state or local
                        law the adulteration and misbranding provisions of which
                        are similar to such Acts; and

                  C.    shall be free from material defects in Materials and
                        workmanship not otherwise caused by (i) Materials
                        supplied by Purchaser or Designated Suppliers or (ii)
                        defect

                                     - 22 -


                        in Purchaser's Specifications and/or Purchaser's formula
                        for the Formulation of the Products.

            (viii) Supplier will not interpret cGMP in a manner inconsistent
            with general industry practice.

(b)   EXCLUSIONS. The warranties with respect to the Products shall not apply to
      any Product which, through no fault of Supplier (to the extent the
      following apply):

            (i) has been tampered with or otherwise altered after delivery to
            the carrier by Supplier;

            (ii) has been subject to misuse, negligence or accident after
            delivery to the carrier by Supplier;

            (iii) has been stored, handled or used in a manner contrary to FDA
            or other Governmental Authority's requirements after delivery to the
            carrier by Supplier;

            (iv) has expired its stated shelf life;

            (v) fails due to defects in the Specifications, in Purchaser's
            formula for the Formulation of the Products or as the result of
            problems with the Materials that could not be detected by the
            quality control tests specified herein.

            (vi) Fails or is non-conforming or deviating as a result of or
            arising from the Materials and/or services supplied by Purchaser or
            by a Designated Supplier.

8.2   PURCHASER REPRESENTATIONS AND WARRANTIES.

(a)   REPRESENTATIONS AND WARRANTIES. Purchaser represents and warrants, while
      acknowledging that Supplier is relying on such representations and
      warranties in entering into this Agreement, that:

            (i) Purchaser shall provide all information within its possession
            necessary for Supplier to Formulate the Products in accordance with
            the Specifications and all applicable Laws, including cGMP, and
            shall make its employees available on a timely basis to respond to
            questions concerning such information;

            (ii) to the extent that Purchaser supplies any Materials or other
            information to Supplier (including packaging and labelling
            requirements) or engages in Formulation with respect to any of the
            Products (either directly or indirectly through a Third Party), all
            such Materials or other information

                                     - 23 -


            and Formulation will comply with the Specifications and applicable
            Laws, including cGMP;

            (iii) it shall comply with all applicable Laws in carrying out its
            obligations under this Agreement;

            (iv) Purchaser will not interpret cGMP in a manner inconsistent with
            general industry practice; and

            (v) Purchaser has not granted, as of the Effective Date, and will
            not grant to any Third Party during the Term of this Agreement any
            right, license or interest in or to the Purchaser Intellectual
            Property licensed to Supplier pursuant to Section 9.1(e) (the
            "Licensed Technology") or any portion thereof, inconsistent with the
            rights granted to Supplier herein;

            (vi) Formulation of the Products pursuant to this Agreement do not
            and shall not require a license under any Intellectual Property
            other than as provided to Supplier by Purchaser hereunder;

            (vii) Purchaser warrants as of the Effective Date of this Agreement
            that it has no knowledge of any Third Party patent rights or other
            Intellectual Property that would be infringed or any Third Party
            trade secrets that would be misappropriated by the Formulation of
            the Products by Supplier hereunder;

            (viii) Purchaser shall carry and keep in good force during the term
            of this Agreement and for three (3) years thereafter insurance
            coverage in such form and amount as a reasonable party in similar
            circumstances would carry and keep to fulfil its obligations
            hereunder. Purchaser shall submit a certificate of such insurance
            (which shall include such information) to Supplier for its approval
            within thirty (30) days of the date of signature of this Agreement.
            If such certificate is not furnished within thirty (30) days,
            Supplier shall notify Purchaser in writing and give Purchaser thirty
            (30) days to cure such breach. If Purchaser fails to provide the
            certificate during such thirty (30) day cure period, Supplier may,
            at its option, immediately terminate this Agreement or any amendment
            thereof;

            (viii) it has no knowledge as of the Effective Date of any Third
            Party Intellectual Property that would be infringed by Supplier's
            activities under this Agreement; and

            (ix) Purchaser has the lawful right to enter into this Agreement for
            the Formulation of the Product without breach of any other
            contractual obligations it may have.

                                     - 24 -


8.3   MUTUAL REPRESENTATIONS AND WARRANTIES.

(a)   Each Party represents and warrants that neither it, nor any of its
      officers, directors or employees performing services under this Agreement,
      has been debarred or convicted of a crime which could lead to debarment,
      under the Generic Drug Enforcement Act of 1992, 21 United States Code
      Sections 306(a) and (b), or other applicable Law. Each Party shall notify
      the other immediately in the event that such Party or any of its officers,
      directors or employees performing services under this Agreement:

            (i) becomes debarred or receives notice of action or threat of
            action with respect to its debarment; or

            (ii) becomes the object of any investigation or subject of any
            report regarding such Party or any of its officers, directors or
            employees performing services under this Agreement, in connection
            with any activity that could result in debarment or suspension or
            refusal of approval.

8.4   DISCLAIMER OF WARRANTIES.

(A)   Subject to applicable Law, the foregoing representations and warranties in
      this Section 8 are limited and are in lieu of any other warranty, and
      except as set forth above, neither Party makes any warranty or
      representation, express or implied, with respect to the Products or
      otherwise under this Agreement, whether as to merchantability, quality,
      fitness for a particular purpose or otherwise.

                       ARTICLE IX - INTELLECTUAL PROPERTY

9.1   OWNERSHIP

(a)   PURCHASER RIGHTS. Supplier acknowledges that Purchaser is the sole owner
      of Purchaser Intellectual Property and of all data and information
      relating to the Products, including the Specifications and any other
      information relating thereto delivered by Purchaser to Supplier under this
      Agreement, except to the extent such information is in the public domain.

(b)   SUPPLIER RIGHTS. Purchaser acknowledges that Supplier is the sole owner of
      the Supplier Intellectual Property, except to the extent such information
      is in the public domain.

(c)   PRODUCT DEVELOPMENTS. All Intellectual Property relating to a Product
      conceived, reduced to practice, authored or otherwise generated or
      developed in the course of activities under this Agreement, either by or
      on behalf of Supplier,

                                     - 25 -


      except if it has general applicability to the manufacture of
      pharmaceutical products other than the Products (unless such Intellectual
      Property relates to and/or is an improvement, modification, alteration or
      enhancement to any of Purchaser Intellectual Property, in which case it
      shall be a Product Development), shall be "Product Developments".
      Purchaser shall own all right, title and interest in and to all Product
      Developments, whether made, conceived, reduced to practice, authored or
      otherwise generated or developed solely by Supplier personnel, or jointly
      by Supplier and Purchaser personnel, and all rights to Intellectual
      Property arising therefrom. Supplier will, and hereby does, assign to
      Purchaser all of its rights, title and interest in and to Product
      Developments and rights to Intellectual Property arising therefrom.
      Supplier will provide reasonable assistance to Purchaser, at Purchaser's
      expense, in obtaining and enforcing Purchaser's ownership of the Product
      Developments, including as applicable the assignment to Purchaser of the
      right, title and interest of Supplier's employees or independent
      contractors in and to such Product Developments.

(d)   PATENTS. As soon as practicable after creation, development, conception or
      reduction to practice by Supplier of any Product Development, Supplier
      shall inform Purchaser in writing of such Product Development. Upon
      Purchaser's reasonable request and at Purchaser's expense, Supplier shall
      take such reasonable actions as Purchaser deems necessary or appropriate
      to assist Purchaser in obtaining patent or other proprietary protection in
      Purchaser's name with respect to all Product Developments.

(e)   LICENSE. Under the terms and subject to the conditions of this Agreement,
      Purchaser hereby grants Supplier a non-exclusive, royalty-free license to
      use the Purchaser Intellectual Property and the Product Developments
      during the Term solely for the purposes of performing its obligations
      hereunder. Supplier shall have no right to make, use, manufacture, supply,
      distribute, offer to sell, import or sell the Products or use any
      Purchaser Intellectual Property or Product Developments for any other
      purpose.

9.2   REPRODUCTION OF AND RIGHT TO USE TRADEMARKS.

Solely in connection with Supplier's performance of this Agreement, Purchaser
hereby grants Supplier the right to reproduce and print on the Products and/or
Product packaging such trademarks, trade dress, brand names, and/or trade names
that Purchaser may designate in writing from time to time, strictly in
accordance with trademark usage and packaging guidelines set forth in the
Specifications or otherwise provided by Purchaser in writing. Samples of all
such uses of Purchaser's trademarks, trade dress, brand names and/or trade names
on the Products or Product packaging shall be submitted to Purchaser for its
written approval prior to production. The permission granted to Supplier herein
is restricted to usage of such trademarks, trade dress, brand names and/or trade
names on or in connection with the Products supplied under this Agreement, and
such permission extends only for the Term of this Agreement or such shorter
period as may be designated or required by Purchaser. Supplier shall not
establish, operate, sponsor or contribute

                                     - 26 -


content to any site on the Internet which incorporates any of Purchaser's
trademarks trade dress, brand names and/or trade names as its URL address or any
part of such address.

9.3   SUPPLIER'S OWNERSHIP OF OTHER PROPERTY.

Except as otherwise specified herein, it is agreed that Supplier is the sole
owner of any and all machinery and equipment used by Supplier in connection with
the Formulation of the Products in accordance with this Agreement.

9.4   INFRINGEMENT.

(a)   NOTICE. In the event that either Party becomes aware of actual or
      threatened infringement of Intellectual Property related to any Product,
      that Party shall promptly so notify the other in writing. Purchaser shall
      have the right, but not the obligation, to bring at its own expense an
      infringement action or file any other appropriate action or claim related
      to infringement of such Intellectual Property against any Third Party.
      Supplier shall have the option to join in (but not control) such action to
      the extent Supplier believes it has been damaged by the actions of such
      Third Party.

(b)   SETTLEMENT. Each Party shall cooperate and provide reasonable assistance
      in any action as described in Section 9.4(a) above. No settlement or other
      voluntary final disposition of any suit defended or action brought by or
      against either Party may be entered into without the consent of the other
      Party if such settlement would require such other Party to be subject to
      an injunction or to make a monetary payment, or would adversely affect
      such other Party's rights under this Agreement.

(c)   DAMAGES. Purchaser shall retain any damages or other monetary awards that
      it recovers pursuant to any action under Section 9.4 hereto.

9.5   RIGHT TO NOT FORMULATE

(a)   SITUATIONS. Supplier shall not be required to Formulate or otherwise be
      involved in the distribution of any Product to which:

            (i) Any Third Party Person claims the Formulation or distribution
            infringes or otherwise violates any Law respecting patents or
            trademarks or a Third Party's Intellectual Property unless Purchaser
            agrees to indemnify Supplier against any such claim; or

            (ii) Any Governmental Authority notifies Supplier that such
            Formulation or distribution violates any Law. Purchaser shall
            provide immediate written notice of any claim of any Governmental
            Authority to Supplier in this regard; or

                                     - 27 -


            (iii) The Formulation of same would violate any applicable Laws
            based on a written legal opinion from a reputable law firm; or

            (iv) Supplier has not received Purchaser's approval for a change in
            the Specifications to conform to the GMP or applicable Law within
            thirty (30) days or if any non-conformance or deviation, which
            Supplier reasonably believes could impair the Formulation or tests
            results of a Batch of Products, has not be resolved to the mutual
            satisfaction of the Parties within thirty (30) days, unless
            Purchaser agrees in writing to indemnify Supplier against any such
            failed or non-conforming Batch of Products, provided Supplier has
            performed Material qualifications properly, followed the formula for
            the Formulation of the Product and provided that the equipment used
            for the Formulation of the Product functioned properly, in
            accordance with applicable Law and GMP. This indemnification is
            added to any other rights for Supplier to be indemnified hereunder
            and is subject to Sections 10.1, 10.3 and 10.4; or

            (v) At any time, to the extent of any outstanding invoices, pending
            charges and fees due by Purchaser pursuant to this Agreement,
            providing that a default notice has been sent by the Supplier to the
            Purchaser, and there shall be prompt resumption of service upon
            receipt of payment by Supplier of the unpaid sums set forth in the
            default notice.

(b)            Each Party shall promptly notify the other of any claim received
               by it that the Formulation or distribution of the Product
               infringes or otherwise violates any Law respecting patents or
               trademarks or Third Party Intellectual Property. The Parties
               agree to consult with one another to arrive to a mutually
               acceptable procedure to contest any such claim and to set
               guidelines relating to the acceptable levels of costs and
               expenses and reimbursement of same; provided, however, that
               nothing contained herein shall prevent Supplier from ceasing to
               Formulate or supply Products as required by this Agreement until
               such time as the infringement claim is dealt with to its
               satisfaction unless and until Purchaser agrees to fully indemnify
               Supplier against such claim and an acceptable proposal for the
               reimbursement of Supplier's costs and expenses is made by
               Purchaser to Supplier, which indemnification shall be subject to
               the provisions of Sections 10.1, 10.3 and 10.4.

(C)            REIMBURSEMENT. Purchaser shall promptly reimburse Supplier for
               all of Supplier's costs and expenses (including without
               limitation reasonable attorney's fees and expenses) incurred as a
               result of the Formulation and or distribution of the Product by
               Supplier at Purchaser's request following any actions or
               allegations described in this Section 9.5 and shall defend,
               indemnify and hold Supplier, its Affiliates and the officers,
               directors, employees, agents, representatives and shareholders of
               each and hold Supplier harmless in connection therewith, to the
               extent not otherwise

                                     - 28 -


               payable by Purchaser pursuant to this Agreement, subject to the
               provisions of Sections 10.1, 10.3 and 10.4.

              ARTICLE X - INDEMNITIES AND LIMITATION OF LIABILITIES

10.1  INDEMNITY OF SUPPLIER.

Subject to the limitations provided for in Section 10.4 hereof, Purchaser shall
defend, indemnify and hold Supplier, its Affiliates, and their officers,
directors, employees, agents, representatives and shareholders (the "Supplier
Indemnitees") harmless from and against any and all Losses suffered, incurred or
sustained by any of them or to which any of them becomes subject at any time
during the Term of this Agreement and for five (5) years thereafter, by reason
of any Proceeding to the extent arising out of or resulting from:

      (a)   the use, manufacture, processing, testing, packaging, labelling or
            storage of or any other dealing with any or all of the Products;

      (b)   subject to Section 5.3, any recall of any Product;

      (c)   any claim from a Third Party that the Formulation of a Product under
            this Agreement or its distribution infringes such party's
            Intellectual Property; or

      (d)   the breach by Purchaser of any of the terms of this Agreement
            including, without limitation, the Purchaser representations and
            warranties provided for in Section 8 hereof;

provided, however, that Supplier shall not be indemnified for any Losses to the
extent arising out of or from (i) any breach of this Agreement (including the
representations and warranties provided for in Section 8) by Supplier, or (ii)
the negligence or wilful misconduct of any Supplier Indemnitee in connection
with the performance of Supplier's obligations.

10.2  INDEMNITY OF PURCHASER.

Subject to the limitations provided for in Section 10.4 hereof, Supplier shall
defend, indemnify and hold Purchaser, its Affiliates, and the officers,
directors, employees, agents, representatives and shareholders of each, harmless
from and against any and all Losses suffered, incurred or sustained by any of
them or to which any of them becomes subject at any time during the Term of this
Agreement and for five (5) years thereafter, by reason of any Proceeding to the
extent arising out of or resulting from:

      (a)   the negligence or wilful misconduct of Supplier in performing its
            obligations under this Agreement; or

                                     - 29 -


      (b)   a breach by Supplier of any of the terms of this Agreement
            including, without limitation, the Supplier representations and
            warranties provided for in Section 8 hereof.

10.3  INDEMNITY PROCEEDINGS.

      (a)   NOTICE OF CLAIM. If a claim by a Third Party is made against an
            Indemnitee, and if the Indemnitee intends to seek indemnity with
            respect thereto under this Agreement, the Indemnitee shall promptly
            (and in any case within [**] days of such claim being made) notify
            the Indemnitor of such claim with reasonable particulars. The
            Indemnitor shall have [**] days after receipt of such notice to
            undertake, conduct and control, through counsel of its own choosing
            (reasonably acceptable to Indemnitee) and at its own expense, the
            settlement or defense thereof, and the Indemnitee shall reasonably
            cooperate with them in connection therewith, except that with
            respect to settlements entered into by the Indemnitor: (i) the
            consent of the Indemnitee shall be required if the settlement
            provides for any payment from or equitable relief against the
            Indemnitee, which consent shall not be unreasonably withheld or
            delay; and (ii) the Indemnitor shall obtain the release of the
            Indemnitee.

      (b)   CONDUCT OF PROCEEDINGS. If the Indemnitor undertakes, conducts and
            controls the settlement or defense of such claim, (i) the Indemnitor
            shall permit the Indemnitee to participate in such settlement or
            defense through counsel chosen by the Indemnitee, provided that the
            fees and expenses of such counsel shall be borne by the Indemnitee;
            and (ii) the Indemnitor shall promptly reimburse the Indemnitee for
            the full amount of any Loss resulting from any claim and all related
            expenses (other than the fees and expenses of counsel as aforesaid)
            incurred by the Indemnitee. The Indemnitee shall not pay or settle
            any claim so long as the Indemnitor is reasonably contesting any
            such claim in good faith on a timely basis. Notwithstanding the two
            immediately preceding sentences, the Indemnitee shall have the right
            to pay or settle any such claim, provided that in such event it
            shall waive any right to indemnity therefor by the Indemnitor.

      (c)   INDEMNITEE RIGHTS. With respect to Third Party claims, if the
            Indemnitor does not notify the Indemnitee within [**] days after the
            receipt of the Indemnitee's notice of a claim of indemnity hereunder
            that it elects to undertake the defense thereof, the Indemnitee
            shall have the right, but not the obligation, to contest, settle or
            compromise the claim in the exercise of its reasonable judgement
            using counsel of its choice at the expense of the Indemnitor.

      (d)   EMPLOYEE ASSISTANCE. In the event of any claim by a Third Party
            against an Indemnitee, the defense of which is being undertaken and
            controlled by the Indemnitor, the Indemnitee will use all reasonable
            efforts to make available to the Indemnitor those employees whose
            assistance, testimony or presence is necessary to assist the
            Indemnitor in evaluation and in defending any such claim; provided
            that the Indemnitor shall be responsible for the expense associated
            with any

                                     - 30 -

      employees made available by the Indemnitee to the Indemnitor hereunder,
      which expense shall be equal to an amount to be mutually agreed upon per
      person per hour for each hour or portion thereof that such employees are
      assisting, and which shall not exceed the actual cost to the Indemnitee
      associated with such employees.

10.4  LIMITATIONS OF LIABILITY.

(a)   INDIRECT DAMAGES. Notwithstanding the provisions of this Agreement
      which might otherwise be to the contrary, neither Party shall be
      liable to the other, or have any obligation to indemnify any
      Indemnitee, as the case may be, for any indirect, incidental,
      special or consequential damages or Losses, including any loss of
      profits or of expected revenue, suffered by either Party, however
      caused and on any theory of liability;

(b)   AGGREGATE LIABILITY. Each Party's total aggregate liability for
      damages sustained by the other Party pursuant to the terms of this
      Agreement shall be no greater than the Price paid or payable by
      Purchaser hereunder, or [**] Canadian dollars (Cdn$[**]), which ever
      is greater, save and except for (i) acts of wanton recklessness or
      indifference or negligence or intentional misconduct by the liable
      Party in performing its obligations hereunder, and (ii) such Party's
      indemnification obligations with respect to Third Party claims
      hereunder.

                        ARTICLE XI - TERM AND TERMINATION

11.1  TERM OF AGREEMENT.

(a)   INITIAL TERM. This Agreement is effective from the date of its
      execution and shall continue in effect for three (3) years from such
      date ("Initial Term") unless earlier terminated or extended in
      accordance with the terms of the Agreement.

(b)   RENEWAL TERM. This Agreement will be automatically renewed for
      successive periods no longer than ONE (1) year each ("Renewal
      Terms") following the expiration of the Initial term, unless
      otherwise indicated by either Party to the other with a prior one
      hundred eighty (180) day written notice.

11.2  TERMINATION OF AGREEMENT.

(a)   TERMINATION FOR BREACH. Either Party may terminate this Agreement
      with written notice to the other Party, if the other Party defaults
      in a material respect in the performance or observance of any of its
      obligations under this Agreement and such default continues,
      unremedied, for a period of sixty (60) days following written notice
      of such default to the defaulting Party. Such cure period shall be
      reduced to thirty (30) days in the event of a default of payment by
      Purchaser.

                                     - 31 -


            Notwithstanding anything to the contrary contained herein, the
            Parties agree that Supplier shall have the right to suspend the
            Formulation and supply of any Products ordered pursuant to Accepted
            Purchase Orders in the event that Purchaser is in default under this
            Agreement until Purchaser cures such breach to Supplier's
            satisfaction, acting reasonably.

      (b)   BANKRUPTCY, ETC. To the extent permitted by applicable Law, either
            Party may terminate this Agreement upon notice to the other Party,
            if the other Party makes an assignment for the benefit of its
            creditors, is adjudged bankrupt, becomes insolvent, ceases or
            threatens to cease to carry on business, files or consents to the
            filing of a petition in bankruptcy, seeks to take advantage of any
            legislation relating to insolvency, arrangement or relief of
            debtors, winds-up or liquidates, or if any receiver, trustee,
            liquidator or similar official is appointed of such other Party or
            any of its property.

      (c)   TERMINATION FOR CONVENIENCE. Either Supplier or Purchaser may
            terminate this Agreement, without penalty, for any reason upon
            giving eighteen (18) months prior written notice to the other Party
            of such termination.

      (d)   EFFECT OF TERMINATION.

      Following termination or expiration of this Agreement for any reason:

                  (i) Purchaser shall purchase from Supplier all (i) remaining
                  Materials, which conforms to the Materials Specifications,
                  purchased by Supplier to conform to the Firm Zone and Material
                  Zone in accordance with Section 4.2 (a) and (b) hereof (unless
                  Supplier has terminated the Agreement for convenience pursuant
                  to Section 11.2 (c)), (ii) all Long Lead Time Materials
                  purchased by Supplier in accordance with Section 4.2 (d)
                  hereof, (iii) all finished Products Formulated by Supplier
                  hereunder in accordance with the Firm Zone and (iv) all of the
                  Safety Stock within thirty (30) days of the delivery of same
                  to Purchaser by Supplier;

                  (ii) Purchaser will have access to any Formulation Records and
                  Batch samples relating to the Formulation of the Products
                  under this Agreement for the period during which the
                  Formulation Records and Batch sample must be kept by Supplier
                  in accordance with this Agreement or the Quality Agreement;

                  (iii) Supplier shall provide to Purchaser the originals of all
                  Specifications; provided, however, that a copy of such
                  document may be retained by Supplier for archival purposes, as
                  means of determining any continuing obligation or
                  confidentiality, but for no other purpose; and

                  (iv) Purchaser shall, within the relevant payment period
                  specified in this Agreement, or, if no payment period is
                  specified in this Agreement,

                                     - 32 -


                  within thirty (30) days of the date of termination of this
                  Agreement, pay to Supplier any outstanding payments to be made
                  pursuant to this Agreement with respect to the supply of
                  Materials, Products and services performed by Supplier
                  hereunder. Any other outstanding payments shall be made
                  pursuant to the applicable written agreement entered into
                  between the parties. In the event no such payment terms were
                  agreed to, Purchaser shall, within thirty (30) days of the
                  date of termination of this Agreement, make any such
                  outstanding payments.

                           ARTICLE XII - MISCELLANEOUS

12.1  RELATIONSHIP OF THE PARTIES.

The relationship between Supplier and Purchaser created pursuant to this
Agreement is intended to be and shall be solely that of independent contractors.
Neither Party, nor its employees, agents or representatives shall under any
circumstances be considered employees, agents, partners, joint venturers or
representatives of the other Party. Neither Party, nor its employees, agents or
representative shall act or attempt to act, or represent themselves, directly or
by implication, as an employee, agent, joint venturer, partner or representative
of the other Party or in any manner assume or create, or attempt to assume or
create, any obligation or liability of any kind, express or implied, on behalf
of or in the name of the other Party. No Person other than Supplier or Purchaser
may rely on or enforce any provision of this Agreement.

12.2  FORCE MAJEURE.

(a)   DEFINED. In this Agreement, "Force Majeure" means an event or occurrence
      beyond the reasonable control of a Party which by the exercise of
      reasonable diligence could not be overcome, which may include, but are not
      limited to, strikes, lock-outs, labour disruptions, acts of God, changes
      in the Law, restraints of governments, riots, arrests of people, acts of
      war, civil disturbances, terrorist actions, rebellion or sabotage, severe
      breakage of or accidents to machinery, plant or equipment, pipeline or
      pipe failure, failure of fuel or water supply or transportation, fire,
      flood, ice, lightning, epidemic, explosion, hydro electric power failures,
      defaults by Third Party suppliers, including Designated Suppliers, not
      caused by the act or omission of the Party, or any delay or failure by a
      Governmental Authority to issue any relevant permit or order not caused by
      the act or omission of the Party.

(b)   NON-DEFAULT. A Party shall be deemed not to be in default with respect to
      non-performance of any of its obligations under this Agreement, if and so
      long as such non-performance is due in whole or in some material way to an
      event of Force Majeure and that Party has used commercially reasonable
      efforts to remove the event of Force Majeure and to perform its
      obligations under the Agreement. If an

                                     - 33 -


      event of Force Majeure occurs, the Party affected shall promptly notify
      the other Party of the occurrence of the event, its extent and probable
      duration.

(c)   CESSATION OF FORCE MAJEURE. Subject to Section 12.2(b) hereof, if Supplier
      is unable to supply Purchaser with its requirements of Products by reason
      of Force Majeure, Force Majeure shall excuse Supplier's performance until
      the Force Majeure has ceased and for a reasonable period of time
      thereafter, to allow Supplier to restore itself to the position it was in
      with respect to the Formulation of Products immediately prior to the Force
      Majeure. Within ninety (90) days of notification by Supplier that it is
      able to resume the necessary supply of the Products to Purchaser, or the
      period specified in Section 2.1, whichever is later, Purchaser shall
      resume obtaining its requirements of Products from Supplier pursuant to
      the terms of this Agreement. Purchaser shall be excused from its
      obligation set forth in Section 2.1 hereof during Supplier's inability to
      perform the Formulation of the Products as a result of a Force Majeure
      event (and the parties hereby agree that Supplier may use the Safety Stock
      to support the manufacturing of Purchaser's orders), until the cessation
      of such Force Majeure event in accordance with this Section 12.2 (c) and
      thereafter as specified in Section 2.1. Supplier shall suffer no penalty
      or incur any liability for its inability to perform hereunder by reason of
      Force Majeure.

(d)   TERMINATION. If a Party fails to perform any of its obligations under this
      Agreement by reason of Force Majeure and such non-performance continues
      for a period of [**] days from the first occurrence of the event of Force
      Majeure, the other Party may, if itself is not in default under the
      Agreement, terminate this Agreement by providing written notice to that
      effect to the non-performing Party. In the event of such termination, both
      Parties' respective rights and obligations under this Agreement shall
      terminate except for any amounts previously due and owing by one Party to
      the other and except for any other obligations which this Agreement
      expressly provides shall survive termination, including Sections 11.2(d)
      and 12.16.

12.3  FURTHER ASSURANCES.

Each Party will at any time and from time to time, upon the request of the other
Party, execute and deliver such further documents and do such further acts and
things as the other Party may reasonably request to evidence, carry out and give
full effect to the terms, conditions, intent and meaning of this Agreement.

12.4  CONFIDENTIALITY.

This Agreement is subject to the confidentiality provisions attached hereto as
Schedule "D".

12.5  NOTICES.

                                     - 34 -


Any notice or other communication made under this Agreement (other than routine
business communication) shall be in writing and shall be properly given: (i)
when delivered if sent by personal delivery; (ii) when transmitted if sent by
facsimile with confirmation of transmission; or (iii) three (3) Business Days
after being posted if sent by registered mail return receipt requested,
addressed:

(a)   if to Supplier, to it at:

                            16751 Trans Canada Highway
                            Kirkland, Quebec, Canada  H9H 4J4
                            Attn: President of DRAXIS Pharma Division
                            Facsimile: (514) 694-3841

      with a copy to:       DRAXIS Health Inc.
                            16751 Trans Canada Highway
                            Kirkland, Quebec, Canada  H9H 4J4
                            Attn:  General Counsel and Secretary
                            Facsimile: (514) 630-7159

(b)   if to Purchaser, to it at:

                            Penwest Pharmaceuticals Co.
                            39 Old Ridgebury Road, Suite #11
                            Danbury, Connecticut, U.S.A. 06810
                            Attn.: Kevin Fitzmaurice,
                            Director, Technical Operations
                            Facsimile: (845) 878-3420

      with a copy to:       Penwest Pharmaceuticals Co.
                            39 Old Ridgebury Road, Suite #11
                            Danbury, Connecticut, U.S.A. 06810
                            Attn: Chief Financial Officer
                            Facsimile: (203) 794-1393

A Party may change its address for notice by notifying the other Party at any
time in accordance with the provisions of this Section 12.5.

12.6  ENTIRE AGREEMENT.

This Agreement and the Quality Agreement and all Schedules attached hereto, and
the letter dated [**] and accepted by Penwest on [**] with the subject "Proposal
for the Stability Fee for Timerx(R)-N granules", supersede any prior agreements
between the Parties as to the subject matter of the Agreement, whether oral or
in writing, including, without limitation, the Prior Agreement (other than those
provisions

                                     - 35 -


which survive termination of such agreement, provided, that Section 3.4 therein
shall not apply) and contains the entire understanding between the Parties as to
the subject matter of the Agreement.

12.7  WAIVER.

No delay or failure on the part of a Party in exercising any rights under this
Agreement shall affect any of such Party's rights and any waiver of a Party's
rights under this Agreement shall be in writing and signed by such Party.

12.8  AMENDMENT.

This Agreement may not be modified or amended except by further written
statement signed by both Parties.

12.9  SEVERABILITY.

Any provision of this Agreement that is held to be inoperative, unenforceable or
invalid in any jurisdiction shall be inoperative, unenforceable or invalid in
that jurisdiction without affecting any other provision hereof in that
jurisdiction or the operation, enforceability or validity of that provision in
any other jurisdiction, and to this end the provisions hereof are declared to be
severable.

12.10 ENUREMENT.

This Agreement is binding on and enures to the benefit of each Party and its
successors and permitted assigns.

12.11 ASSIGNMENT.

Neither Purchaser nor Supplier shall assign or otherwise transfer any rights
under or interest in this Agreement without the other Party's prior written
consent, such consent not to be unreasonably withheld or delayed.
Notwithstanding the foregoing, (a) Supplier may assign this Agreement to an
Affiliate provided all Formulation remains at the Facility; (b) Purchaser may
assign this Agreement to an Affiliate, and (c) either Party may assign this
Agreement in the event of a sale or transfer of all or substantially all of its
business related to the Products by way of acquisition or merger.

12.12 COUNTERPARTS.

This Agreement may be executed in counterparts and by facsimile transmission,
each of which shall be deemed to be an original and which together shall
constitute one and the same agreement.

12.13 CONTRA PROFERENTUM.

                                     - 36 -


This Agreement is the result of mutual negotiations between the Parties, and
each Party agrees that no part of this Agreement shall be interpreted against
the other Party on the grounds that particular language was drafted by such
Party.

12.14 SUBCONTRACTING.

Supplier may be permitted to subcontract in whole or in part its obligations
under this Agreement upon the consent of Purchaser, such consent not be to
unreasonably withheld or delayed.

12.15 GOVERNING LAW.

This Agreement shall be governed by and construed in accordance with the laws of
the Province of Quebec and the laws of Canada applicable therein. The Parties
expressly agree to exclude the application of the United Nations Convention on
Contracts for the International Sale of Goods. Any disputes arising between the
Parties relating to this Agreement shall be subject to the exclusive
jurisdiction and venue of the provincial and federal courts located in the
Province of Quebec, and the Parties hereby waive any objection which they may
have now or hereafter to the laying of venue of any proceedings in said courts
and to any claim that such proceedings have been brought in an inconvenient
forum, and further irrevocably agree that a judgment or order in any such
proceedings shall be conclusive and binding upon each of them and may be
enforced in the courts of any other jurisdiction.

12.16 SURVIVAL.

The following provisions shall survive the expiration or termination of this
Agreement: Sections 3.4 (last sentence only), 5.3, 6.4, 6.5, 8.1(a)(iv),
8.2(a)(viii), 8.4, 9.1(a) through (d), 9.4, 10, 11.2(d), 12.1, 12.2(d), 12.4,
12.5, 12.6, 12.7, 12.8, 12.9, 12.10, 12.12, 12.13, 12.15, 12.16 and 12.17, and
Schedule "D" (as provided in Section 9 thereof).

12.17 LANGUAGE CLAUSE.

The Parties have requested that this Agreement and all ancillary documents be
drawn up in the English language only. Les parties ont exige que cette entente
ainsi que tous les documents y afferent soient rediges en anglais seulement.

                  [Remainder of Page Intentionally Left Blank]

                                     - 37 -


      IN WITNESS WHEREOF, the Parties have executed this Agreement as of the
date written above, by their authorized officers, who by signing confirm their
authority and intention to bind the Party they represent.

DRAXIS SPECIALTY PHARMACEUTICALS INC.

Per: /s/ John Durham
     -------------------------------------------
     John Durham
     President of DRAXIS Pharma Division

PENWEST PHARMACEUTICALS CO.

Per: /s/ Benjamin L. Palleiko
     -------------------------------------------
     Benjamin L. Palleiko
     Senior Vice President, Corporate Development
     and Chief Financial Officer

                                     - 38 -


                                  SCHEDULE "A"

                             PRODUCT SPECIFICATIONS

The parties acknowledge that they received copies of the Specifications for the
Product and that said Specifications are now on file.

                                     - 39 -


                                  SCHEDULE "B"

                                QUALITY AGREEMENT


                    Confidential Materials omitted and filed
            separately with the Securities and Exchange Commission.

                                      [**]


                                     - 40 -


                                  SCHEDULE "C"

                                 PRODUCT PRICES



PRODUCT :                                      YEAR 2006 PRICES/PER KG
- ---------                                      -----------------------
                                         
607520 TIMERx(TM)-N :              (720 kg)           CDN $[**] kg
600420 TIMERx(TM)-A :              (480 kg)           CDN $[**] kg
600520 TIMERx(TM)-O:               (160 kg)           CDN $[**] kg
600450 TIMERx(TM)-M50A:            (480 kg)           CDN $[**] kg
600470 TIMERx(TM)-M70A:            (480 kg)           CDN $[**] kg


                                     - 41 -


                                  SCHEDULE "D"

                        CONFIDENTIAL DISCLOSURE AGREEMENT

Between PENWEST PHARMACEUTICALS CO. a corporation incorporated under the laws of
Washington, having offices at 39 Old Ridgebury Road, Suite #11, Danbury,
Connecticut, U.S.A. 06810 and at 2981 Route 22, Patterson, New York, U.S.A.
12563; ("PURCHASER") and DRAXIS SPECIALTY PHARMACEUTICALS INC., a corporation
amalgamated under the laws of Canada having its principal office at 16751
Trans-Canada Highway, Kirkland, Quebec H9H 4J4 ("SUPPLIER");

1. Supplier possesses certain information concerning its business and other
confidential information (along with such information disclosed pursuant to the
Prior Agreement, the "Supplier Information") which it wishes to disclose to
Purchaser for purposes of carrying out the Manufacture and Supply Agreement
between the parties (the "Agreement") (the "Purpose"). Purchaser possesses
certain information concerning its business and other confidential information
(along with such information disclosed pursuant to the Prior Agreement, the
"Purchaser Information") which it wishes to disclose to Supplier for the
Purpose. In addition to the terms defined above, unless something in the context
or subject matter is inconsistent therewith:

      (a) "Discloser" means Supplier with respect to the disclosure of the
Supplier Information and means Purchaser with respect to the disclosure of the
Purchaser Information;

      (b) "Information" means Supplier Information with respect to the
disclosure or receipt of Supplier Information and means Purchaser Information
with respect to the disclosure or receipt of Purchaser Information; and

      (c) "Recipient" means Supplier with respect to the receipt of Purchaser
Information and means Purchaser with respect to the receipt of Supplier
Information.

2. Discloser shall at its discretion provide such of the Information to
Recipient as is required for the Purpose. Nothing in this Agreement obligates
Discloser to make any particular disclosure of Information.

3. All right, title and interest in and to the Information shall remain the
exclusive property of Discloser and the Information shall be held in trust and
confidence by Recipient for Discloser. No interest, license or any right
respecting the Information, other than as expressly set out herein, is granted
to Recipient under this Agreement by implication or otherwise.

4. Recipient shall not use the Information in any manner except as reasonably
required for the Purpose.

                                     - 42 -


5. Recipient shall use all reasonable efforts to protect Discloser's interest in
the Information and keep it confidential, using a standard of care no less than
the degree of care that Recipient would be reasonable expected to employ for its
own similar confidential information. In particular, Recipient shall not,
directly or indirectly, disclose, allow access to, transmit or transfer the
Information to a Third Party without the Discloser's prior written consent.
Recipient shall disclose the Information only to those of its or its Affiliates'
employees, or to those employees of any consultant of the Recipient, who have a
need to know the Information for the Purpose. Recipient shall, prior to
disclosing the Information to such employees and consultants, issue appropriate
instructions to them to satisfy its obligations herein and obtain their written
agreement to receive and use the Information on a confidential basis on the same
conditions as contained in this Schedule "D".

6. The Information shall not be copied, reproduced in any form or stored in a
retrieval system or database by Recipient without the prior written consent of
Discloser, except for such copies and storage as may reasonably be required
internally by Recipient for the Purpose.

7. The obligations of the Recipient under Sections 4, 5 and 6 of this Schedule
"D" shall not apply to Information:

      (a) which at the time of disclosure is or was readily available to the
trade or the public;

      (b) which after disclosure becomes readily available to the trade or the
public, other than through a breach of the Prior Agreement or this Agreement;

      (c) which is subsequently lawfully and in good faith obtained by Recipient
from an independent Third Party without breach of the Prior Agreement or this
Agreement, as shown by documentation sufficient to establish the Third Party as
a source of the Information, and not obtained by the Third Party from Discloser;

      (d) which Recipient can establish, by documented and competent evidence,
was in its possession prior to the date of disclosure of such Information by
Discloser, or

      (e) any Information which the Recipient is required to disclose pursuant
to Law, applicable court order or regulatory order, provided that Recipient
shall (to the extent permitted by Law) promptly notify Discloser in writing of
any such requirement for disclosure prior to the disclosure of the Information
in accordance with such applicable law, regulatory order or court order.

8. Recipient shall, upon request of Discloser, immediately return the
Information and all copies thereof in any form whatsoever under the power or
control of Recipient to

                                     - 43 -


Discloser, and delete the Information from all retrieval systems and databases,
save for one copy which may be kept for legal archival purposes only.

9. Due to the valuable and proprietary nature of the Information to Discloser,
the obligations assumed by Recipient under this Schedule "D" shall continue for
ten (10) years after disclosure of such Information.

10. Each Party acknowledges that any breach of this Schedule "D" may cause
irreparable harm to the other Party, and agrees that the remedies for breach may
include, in addition to damages and other available remedies, injunctive relief
against such breach. The prevailing Party shall be entitled to the award of its
reasonable attorney fees in any action to enforce this Schedule "D".

11. Any notice or other communication made under this Schedule "D" (other than
routine business communication) shall be in writing and shall be properly given:
(i) when delivered if sent by personal delivery; (ii) when transmitted if sent
by facsimile with confirmation of transmission; or (iii) three (3) Business Days
after being posted if sent by registered mail return receipt requested,
addressed:

      if to Supplier, to it at:
                                  16751 Trans Canada Highway
                                  Kirkland, Quebec, Canada  H9H 4J4
                                  Attn: President of DRAXIS Pharma Division
                                  Facsimile: (514) 694-3841

      with a copy to:
                                  DRAXIS Health Inc.
                                  16751 Trans Canada Highway
                                  Kirkland, Quebec, Canada  H9H 4J4
                                  Attn:  General Counsel and Secretary
                                  Facsimile: (514) 630-7159

      if to Purchaser, to it at:

                                  Penwest Pharmaceuticals Co.
                                  39 Old Ridgebury Road, Suite #11
                                  Danbury, Connecticut, U.S.A. 06810
                                  Attn.: Kevin Fitzmaurice,
                                  Director, Technical Operations
                                  Facsimile: (845) 878-3420

                                     - 44 -


      with a copy to:             Penwest Pharmaceuticals Co.
                                  39 Old Ridgebury Road, Suite #11
                                  Danbury, Connecticut, U.S.A. 06810
                                  Attn: Chief Financial Officer
                                  Facsimile: (203) 794-1393

A Party may change its address for notice by notifying the other Party at any
time in accordance with the provisions of this Section 11.

12. This Schedule "D" shall be governed by and construed in accordance with the
laws of the Province of Quebec and the laws of Canada applicable therein. Any
disputes arising between the Parties relating to this Schedule "D" shall be
subject to the exclusive jurisdiction and venue of the provincial and federal
courts located in the Province of Quebec, and the Parties hereby waive any
objection which they may have now or hereafter to the laying of venue of any
proceedings in said courts and to any claim that such proceedings have been
brought in an inconvenient forum, and further irrevocably agree that a judgment
or order in any such proceedings shall be conclusive and binding upon each of
them and may be enforced in the courts of any other jurisdiction.

13. This Schedule "D" is incorporated into and made a part of the Agreement.

                                     - 45 -


                                  SCHEDULE "E"

                            LONG LEAD TIME MATERIALS

NONE.

                                     - 46 -

EX-23

EXHIBIT 23

Consent of Independent Registered Public Accounting Firm

We consent to the incorporation by reference in the Registration Statement (Form S-8 No. 333-126897) pertaining to the Penwest Pharmaceuticals Co. 2005 Stock Incentive Plan and Dr. Alan Joslyn Plan, in the Registration Statements (Forms S-8 No. 333-98801 and No. 333-66741) pertaining to the Penwest Pharmaceuticals Co. 1997 Equity Incentive Plan, in the Registration Statement (Form S-8 No. 333-66747) pertaining to the Penwest Pharmaceuticals Co. 1997 Employee Stock Purchase Plan, in the Registration Statement (Form S-8 No.333-66739) pertaining to the Penwest Pharmaceuticals Co. Savings Plan, in the Registration Statement (Form S-8 No. 333-66733) pertaining to the Penwest Pharmaceuticals Co. 1998 Spinoff Option Plan, in the Registration Statements (Forms S-3 No. 333-108513, No. 333-121332, and No. 333-126904) of Penwest Pharmaceuticals Co. and in the related Prospectuses of our reports dated March 13, 2007, with respect to the financial statements and schedule of Penwest Pharmaceuticals Co., Penwest Pharmaceuticals Co.’s management’s assessment of the effectiveness of internal control over financial reporting, and the effectiveness of internal control over financial reporting of Penwest Pharmaceuticals Co., included in this Annual Report (Form 10-K) for the year ended December 31, 2006.

/s/ Ernst & Young LLP

Stamford, Connecticut
March 13, 2007

EX-31.1

EXHIBIT 31.1

CERTIFICATIONS

I, Jennifer L. Good, in my capacity as principal executive officer of Penwest Pharmaceuticals Co., certify that:

1. I have reviewed this Annual Report on Form 10-K of Penwest Pharmaceuticals Co.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements 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 financial statements, and other financial information included in this report, fairly present in all material respects 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 and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange 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)) for the registrant and have:

(a)	Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant 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 in accordance 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 effectiveness of 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 most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’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 likely to 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 over financial reporting.

Date: March 13, 2007	/s/ Jennifer L. Good
	Jennifer L. Good
	President and Chief Executive Officer (principal executive officer)

EX-31.2

EXHIBIT 31.2

CERTIFICATIONS

I, Benjamin L. Palleiko, in my capacity as principal financial officer of Penwest Pharmaceuticals Co., certify that:

1. I have reviewed this Annual Report on Form 10-K of Penwest Pharmaceuticals Co.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements 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 financial statements, and other financial information included in this report, fairly present in all material respects 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 and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange 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)) for the registrant and have:

(a)	Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant 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 in accordance 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 effectiveness of 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 most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’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 likely to 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 over financial reporting.

Date: March 13, 2007	/s/ Benjamin L. Palleiko
	Benjamin L. Palleiko
	Senior Vice President, Corporate Development and Chief Financial Officer (principal financial officer)

EX-32.1

EXHIBIT 32.1

CERTIFICATION OF THE PRINCIPAL EXECUTIVE OFFICER PURSUANT TO RULE 13a-14(b) OF
THE SECURITIES EXCHANGE ACT OF 1934 AND 18 U.S.C. SECTION 1350

     In connection with the Annual Report on Form 10-K of Penwest Pharmaceuticals Co. (the “Company”) for the fiscal year ended December 31, 2006 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), the undersigned, Jennifer L. Good, President and Chief Executive Officer of the Company, hereby certifies, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

     (1) The Report fully complies with the requirements of Section 13(a) or 15(d) 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 Company.

Date: March 13, 2007	/s/ Jennifer L. Good
	Jennifer L. Good
	President and Chief Executive Officer (principal executive officer)

EX-32.2

EXHIBIT 32.2

CERTIFICATION OF THE PRINCIPAL FINANCIAL OFFICER PURSUANT TO RULE 13a-14(b) OF
THE SECURITIES EXCHANGE ACT OF 1934 AND 18 U.S.C. SECTION 1350

     In connection with the Annual Report on Form 10-K of Penwest Pharmaceuticals Co. (the “Company”) for the fiscal year ended December 31, 2006 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), the undersigned, Benjamin L. Palleiko, Senior Vice President, Corporate Development and Chief Financial Officer of the Company, hereby certifies, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

     (1) The Report fully complies with the requirements of Section 13(a) or 15(d) 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 Company.

Date: March 13, 2007	/s/ Benjamin L. Palleiko
	Benjamin L. Palleiko
	Senior Vice President, Corporate Development and Chief Financial Officer ( principal financial officer)