10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

____________________________

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2010

Commission File Number 001-31932

___________________________

HYTHIAM, INC.

(Exact name of registrant as specified in its charter)

____________________________

Delaware	88-0464853
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

11150 Santa Monica Boulevard, Suite 1500, Los Angeles, California 90025

(Address of principal executive offices, including zip code)

(310) 444-4300

(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ          No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    

Yes þ          No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer or a smaller reporting company. See definitions of ‘‘accelerated filer,” “large accelerated filer,’’ and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o     Accelerated filer o     Non-accelerated filer o     Smaller reporting company þ

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

As of November 17, there were 182,029,048 shares of registrant's common stock, $0.0001 par value, outstanding.

1

TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION			3
	ITEM 1.  Consolidated Financial Statements		3
		Condensed Consolidated Balance Sheets as of September 30, 2010
		and December 31, 2009	3
		Condensed Consolidated Statements of Operations for the
		Three and Nine Months Ended September 30, 2010 and 2009	4
		Condensed Consolidated Statements of Cash Flows for the
		Nine Months Ended September 30, 2010 and 2009	5
		Notes to Condensed Consolidated Financial Statements	7
	ITEM 2.  Management's Discussion and Analysis of Financial
		Condition and Results of Operations	26
	ITEM 3.  Quantitative and Qualitative Disclosures About Market Risk		36
	ITEM 4.  Controls and Procedures		36
PART II – OTHER INFORMATION			II-1
	ITEM 1.  Legal Proceedings		II-1
	ITEM 2.  Unregistered Sales of Equity Securities and Use of Proceeds		II-1
	ITEM 3.  Defaults Upon Senior Securities		II-1
	ITEM 4.  [Removed and Reserved]		II-1
	ITEM 5.  Other Information		II-1
	ITEM 6.  Exhibits		II-2
SIGNATURES			II-3
EXHIBIT 10.33
EXHIBIT 10.34
EXHIBIT 10.35
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

2

PART I - FINANCIAL INFORMATION

Item 1.                 Consolidated Financial Statements

HYTHIAM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands,except for number of shares)	September 30,			December 31,
	2010			2009
ASSETS	(unaudited)
Current assets
Cash and cash equivalents	$	363		$	4,595
Marketable securities, at fair value		-			9,468
Receivables, net		73			308
Prepaids and other current assets		57			989
Total current assets		493			15,360
Long-term assets
Property and equipment, net of accumulated depreciation
of $7,093 and $6,697 respectively		311			877
Intangible assets, net of accumulated amortization of
$1,879 and $1,702 respectively		2,482			2,658
Deposits and other assets		196			210
Total Assets	$	3,482		$	19,105
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable	$	1,809		$	2,266
Accrued compensation and benefits		912			941
Other accrued liabilities		1,228			2,431
Short-term debt					9,643
Total current liabilities		3,949			15,281
Long-term liabilities
Deferred rent and other long-term liabilities		88			46
Warrant liabilities		72			1,089
Capital lease obligations		7			48
Total liabilities		4,116			16,464
Stockholders' equity
Preferred stock, $.0001 par value; 50,000,000 shares authorized;
no shares issued and outstanding		-			-
Common stock, $.0001 par value; 200,000,000 shares authorized;
81,424,000 and 65,283,000 shares issued and outstanding
at September 30, 2010 and December 31, 2009, respectively		8			7
Additional paid-in-capital		189,671			184,715
Accumulated other comprehensive income		-			696
Accumulated deficit		(190,313	)		(182,777	)
Total Stockholders' Equity		(634	)		2,641
Total Liabilities and Stockholders' Equity	$	3,482		$	19,105

See accompanying notes to the financial statements.

3

HYTHIAM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

	Three Months Ended						Nine Months Ended
(In thousands, except per share amounts)	September 30,						September 30,
	2010			2009			2010			2009
Revenues
Total revenues	$	104		$	268		$	338		$	1,346
Operating expenses
Cost of healthcare services		99			68			174			502
General and administrative		2,581			3,878			9,254			14,007
Impairment losses		1			-			39			1,113
Depreciation and amortization		204			273			705			979
Total operating expenses		2,885			4,219			10,172			16,601
Loss from operations		(2,781	)		(3,951	)		(9,834	)		(15,255	)
Interest and other income		1			19			129			142
Interest expense		(41	)		(221	)		(312	)		(999	)
Loss on extinguishment of debt		-			(54	)		-			(330	)
Gain on the sale of marketable securities		-			160			696			160
Other than temporary impairment of marketable
securities		(32	)		(25	)		-			(185	)
Change in fair value of warrant liability		913			(4,767	)		1,807			(4,683	)
Loss from continuing operations before provision
for income taxes		(1,940	)		(8,839	)		(7,514	)		(21,150	)
Provision for income taxes		2			3			22			13
Loss from continuing operations	$	(1,942	)	$	(8,842	)	$	(7,536	)	$	(21,163	)
Discontinued Operations:
Results of discontinued operations, net of tax		-			-			-			10,449
Net income (loss)	$	(1,942	)	$	(8,842	)	$	(7,536	)	$	(10,714	)
Basic and diluted net income (loss) per share:
Continuing operations	$	(0.02	)	$	(0.16	)	$	(0.10	)	$	(0.38	)
Discontinued operations		-			-			-			0.19
Net income (loss) per share	$	(0.02	)	$	(0.16	)	$	(0.10	)	$	(0.19	)
Weighted number of shares outstanding		79,685			56,373			72,195			55,509

See accompanying notes to the financial statements.

4

HYTHIAM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

	Nine Months Ended
(In thousands)	September 30,
	2010			2009
Operating activities
Net loss	$	(7,536	)	$	(10,714	)
Adjustments to reconcile net loss to net cash used in operating activities:
(Income) from Discontinued Operations	$	-			(10,449	)
Depreciation and amortization		706			978
Amortization of debt discount and issuance costs included in
interest expense		147			735
Other than temporary impairment on marketable securities		-			185
Gain on sale of marketable securities		(696	)		(159	)
Provision for doubful accounts		35			493
Deferred rent		(269	)		88
Share-based compensation expense		2,965			3,465
Loss on debt extinguishment		-			230
Fair value adjustment on warrant liabilitiy		(1,807	)		4,684
Impairment losses		37			1,113
Loss on disposition of assets		-			16
Changes in current assets and liabilities:
Receivables		200			(52	)
Prepaids and other current assets		45			169
Accounts payable		(180	)		(1,733	)
Long term accrued liabilities		-			6
Net cash used in operating activities of continuing operations		(6,353	)		(10,945	)
Net cash used in operating activities of discontinued operations		-			(1,103	)
Net cash used in operating activities		(6,353	)		(12,048	)
Investing activities
Proceeds from sales and maturities of marketable securities	$	10,225		$	1,420
Proceeds from sales of property and equipment		1			13
Proceeds from disposition of CompCare		-			1,500
Restricted cash		-			24
Purchases of property and equipment		(1	)		(17	)
Deposits and other assets		-			16
Net cash from investing activities by continuing operations		10,225			2,956
Net cash from investing activities by discontinued operations		-			39
Net cash provided by investing activities		10,225			2,995

(continued on next page)

5

HYTHIAM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(continued from previous page)

	Nine Months Ended
(In thousands)	September 30,
	2010	2009

Financing activities
Proceeds from the issuance of common stock and warrants	$	2,000		$	7,000
Costs related to the issuance of common stock and warrants		(275	)		(683	)
Proceeds from line of credit		450			2,072
Paydown on line of credit		(6,908	)		(1,346	)
Paydown on senior secured note		(3,332	)		(1,668	)
Capital lease obligations		(39	)		(74	)
Net cash provided by (used in) financing activities.
		(8,104	)		5,301
Net cash from (used in) financing activities by discontinued
operations		-			(73	)
Net cash from (used in) financing activities		(8,104	)		5,228
Net decrease in cash and cash equivalents for continuing operations		(4,232	)		(2,688	)
Net decrease in cash and cash equivalents for discontinued operations		-			(1,137	)
Net decrease in cash and cash equivalents		(4,232	)		(3,825	)
Cash and cash equivalents at beginning of period		4,595			10,893
Cash and cash equivalents at end of period	$	363		$	7,068
Supplemental disclosure of cash paid
Interest	$	154		$	197
Income taxes	$	51		$	77
Supplemental disclosure of non-cash activity
Common stock issued for outside services	$	271		$	168
Common stock issued for settlement of payables	$	1,235		$	-

See accompanying notes to the financial statements.

6

Hythiam, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited)

Note 1.   Basis of Consolidation, Presentation and Going Concern

The accompanying unaudited interim condensed consolidated financial statements as of September 30, 2010 and for the three and nine months ended September 30, 2010 and 2009, for Hythiam, Inc. (referred to herein as the Company, Hythiam, we, us or our) and our subsidiaries have been prepared in accordance with the Securities and Exchange Commission (SEC) rules for interim financial information and do not include all information and notes required for complete financial statements. In our opinion, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation of the financial position of the Company as of September 30, 2010, results of operations for the three and nine months ended September 30, 2010 and 2009, and cash flows for the nine months ended September 30, 2010 and 2009 have been included. Int erim results are not necessarily indicative of the results that may be expected for the entire fiscal year. The accompanying financial information should be read in conjunction with the financial statements and the notes thereto in our most recent Annual Report on Form 10-K for the year ended December 31, 2009. Amounts as of December 31, 2009 are derived from those audited consolidated financial statements.

Our financial statements have been prepared on the basis that we will continue as a going concern. At September 30, 2010, cash and cash equivalents amounted to $363,000 and we had a working capital deficit of approximately $3.5 million. We have incurred significant operating losses and negative cash flows from operations since our inception. During the nine months ended September 30, 2010, our cash used in operating activities amounted $5.4 million. We could continue to incur negative cash flows and net losses for the next twelve months. The financial statements do not include any adjustments relating to the recoverability of the carrying amount of the recorded assets or the amount of l iabilities that might result from the outcome of this uncertainty. As of September 30, 2010, these conditions raised substantial doubt as to our ability to continue as a going concern.

In October 2010, the Company entered into Securities Purchase Agreements with accredited investors, including Socius Capital Group, LLC, an affiliate of our Chairman and CEO, for $500,000 of senior secured convertible notes and warrants to purchase shares of our common stock (see Note 7 Subsequent Events). In November 2010, the Company completed a private placement with accredited investors, including Socius Capital Group, L LC, an affiliate of our Chairman and CEO, and one other Hythiam director in the amount of $6.9 million including the conversion of the October senior secured convertible notes (see Note 7 Subsequent Events).

Our ability to fund our ongoing operations and continue as a going concern is dependent on signing and generating revenue from new Catasys contracts and the success of management’s plans to increase revenue and continue to decrease expenses. Beginning in the fourth quarter of 2008, and continuing through 2010, management has taken actions that have resulted in reducing annual operating expenses. We have, and continue to, renegotiated certain leasing and vendor agreements to obtain more favorable pricing and to restructure payment terms with vendors (see Note 6 Commitments and Contingencies).  In August 2010 we amended the lease for our managed treatment center to extend the lease by six months. The lease was set to expire in A ugust 2010.  Under the terms of the amendment we reduced the square footage leased and decreased the monthly cost to approximately $7,100 per month which represented a 78% reduction in the monthly cost versus the first six months of 2010.  This extension allowed us to reduce existing costs while avoiding additional costs that would have been associated with moving to a new facility and avoid the potential disruption to revenues. In previous quarters, we have exited markets in our licensee operations that we have determined will not provide short-term profitability.  We may exit additional markets in our licensee operations and further curtail or restructure our managed treatment center to reduce costs if management determines that those markets will not provide short-term profitability and/or positive cash flow. We do not expect any direct costs associated with streamlining our organization further to have a material impact on our cash position or our ability to continue as a go ing concern.

7

We are pursuing additional Catasys contracts and are seeking to increase revenue from both our Catasys and private pay businesses.  We are currently implementing the recently signed contract in Nevada, which is expected to become operational in the fourth quarter of 2010.

Pursuant to a Stock Purchase Agreement between WoodCliff (our wholly-owned subsidiary) and Core Corporate Consulting Group, Inc., dated January 14, 2009, and effective as of January 20, 2009, we have disposed of our entire interest in our controlled subsidiary, Comprehensive Care Corporation (CompCare), consisting of 14,400 shares of Class A Series Preferred Stock, and 1,739,130 shares of common stock of CompCare held by Woodcliff, for aggregate gross proceeds of $1.5 million. We did not present CompCare as “held for sale” at December 31, 2008 since all of the criteria specified by SFAS 144, Accounting for the impairment or D isposal of Long-Lived Assets (SFAS 144), had not been met as of that date. The financial statements and footnotes present the operations, assets, liabilities and cash flows of CompCare as a discontinued operation. See Note 5 Discontinued Operations for further discussion.

Based on the provisions of the management services agreement (MSA) between us and our managed professional medical corporation, we have determined that it constitutes a variable interest entity, and that we are the primary beneficiary as defined in Financial Accounting Standards Board (FASB) Interpretation No. 46R, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (FIN 46R).  Accordingly, we are required to consolidate the revenue and expenses of our managed professional medical corporation. See Management Service Agreements heading under Note 2 Summary of Significant Accounting Policies for more discussion.

All intercompany transactions and balances have been eliminated in consolidation.

Note 2.   Summary of Significant Accounting Policies

Revenue Recognition

Healthcare Services

Our healthcare services revenues to date have been primarily derived from licensing our PROMETA Treatment Program and providing administrative services to hospitals, treatment facilities and other healthcare providers, and from revenues generated by our managed treatment centers. We record revenues earned based on the terms of our licensing and management contracts, which requires the use of judgment, including the assessment of the collectability of receivables. Licensing agreements typically provide for a fixed fee on a per-patient basis, payable to us following the providers’ commencement of the use of our program to treat patients. For revenue recognition purposes, we treat the program licensing and related administrative services as one unit of accounting. We record the fees owed to us under the terms of the agreements at the time we have performed substantially all required services for each use of our program, which for the significant majority of our license agreements to date is in the period in which the provider begins using the program for medically directed and supervised treatment of a patient and, in other cases, is at the time that medical treatment has been completed. 

The revenues of our managed treatment center, which we include in our consolidated financial statements, are derived from charging fees directly to patients for medical treatments, including the PROMETA Treatment Program. Revenues from patients treated at the managed treatment center are recorded based on the number of days of treatment completed during the period as a percentage of the total number treatment days for the PROMETA Treatment Program. Revenues relating to the continuing care portion of the PROMETA Treatment Program are deferred and recorded over the period during which the continuing care services are provided.

8

Behavioral Health

Our Catasys contracts are generally designed to provide revenues in the form of member fees and service revenues on a monthly basis. Some of our contracts include performance guarantees and we will defer revenues until the performance measurement period is completed and we have met all the conditions necessary to record revenues.

Cost of Healthcare Services

Healthcare Services

Cost of healthcare services represent direct costs that are incurred in connection with licensing our treatment programs and providing administrative services in accordance with the various technology license and services agreements, and are associated directly with the revenue that we recognize. Consistent with our revenue recognition policy, the costs associated with providing these services are recognized, for a significant majority of our agreements, in the period in which patient treatment commences, and in other cases, at the time treatment has been completed. Such costs include royalties paid for the use of the PROMETA Treatment Program for patients treated by all licensees, and direct labor costs, continuing care expense, medical supplies and program medications for patients treated at the managed treatment center.

Behavioral Health

Behavioral health cost of services is recognized in the period in which an eligible member actually receives services. Our Catasys subsidiary contracts with various healthcare providers, including licensed behavioral healthcare professionals, on a contracted basis. We determine that a member has received services when we receive a claim within the contracted timeframe with all required billing elements correctly completed by the service provider.

Comprehensive Income (Loss)

Our comprehensive loss is as follows:

	Three Months Ended						Nine Months Ended
(In thousands)	September 30,						September 30,
	2010			2009			2010			2009
Net income (loss)	$	(1,910	)	$	(8,842	)	$	(7,536	)	$	(10,714	)
Other comprehensive gain:
Net unrealized gain (loss) on marketable securities available for sale		-			14			-		$	467
Net realized gain on marketable securities included in loss from continuing operations		-			(30	)	$	(696	)	$	(30	)
Comprehensive income (loss)	$	(1,910	)	$	(8,858	)	$	(8,232	)	$	(10,277	)

Basic Income (Loss) per Share

Basic income (loss) per share is computed by dividing the net income (loss) to common stockholders for the period by the weighted average number of common shares outstanding during the period. Diluted income per share is computed by dividing the net income for the period by the weighted average number of common and dilutive common equivalent shares outstanding during the period.

Common equivalent shares, consisting of 25,962,675 and 29,349,000 of incremental common shares as of September 30, 2010 and 2009, respectively, issuable upon the exercise of stock options and warrants have been excluded from the diluted earnings per share calculation because their effect is anti-dilutive.

9

Share-Based Compensation

The Hythiam, Inc. 2003 Stock Incentive Plan and 2008 Stock Incentive Plan (the Plans), both as amended, provide for the issuance of up to 15 million shares of our common stock. Incentive stock options (ISOs) under Section 422A of the Internal Revenue Code and non-qualified options (NSOs) are authorized under the Plans. We have granted stock options to executive officers, employees, members of our board of directors, and certain outside consultants. The terms and conditions upon which options become exercisable vary among grants, but option rights expire no later than ten years from the date of grant and employee and board of director awards generally vest over three to five years. At September 30, 2010, we had 10,988,000 vested and unvested shares outstanding and 3,117,000 shares available for future awards.

Share-based compensation expense attributable to continuing operations amounted to $800,000 and $3 million respectively for the three and nine months ended September 30, 2010, compared to $1 million and $3.5 million respectively for the three and nine months ended September 30, 2009. This includes share-based compensation expense attributable to continuing operations recognized for employees and directors discussed below.

Stock Options – Employees and Directors

We measure and recognize compensation expense for all share-based payment awards made to employees and directors based on estimated fair values on the date of grant. We estimate the fair value of share-based payment awards using the Black Scholes option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the consolidated statements of operations subsequent to January 1, 2006. We accounted for share-based awards to employees and directors using the intrinsic value method under previous FASB rules, allowable prior to January 1, 2006. Under the intrinsic value method, no share-based compensation expense had been recognized in our consolidated statements of operations for awards to employees and directors because the exercise price of our stoc k options equaled the fair market value of the underlying stock at the date of grant.

Share-based compensation expense attributable to continuing operations recognized for employees and directors for the three and nine months ended September 30, 2010 and 2009 amounted to $800 thousand  and $3 million compared to $910,000 and $3.2 million, respectively.

Share-based compensation expense recognized in our consolidated statements of operations for the three and nine months ended September 30, 2010 and 2009 includes compensation expense for share-based payment awards granted prior to, but not yet vested, as of January 1, 2006 based on the grant date fair value estimated in accordance with the pro-forma provisions of SFAS 123, and for the share-based payment awards granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. For share-based awards issued to employees and directors, share-based compensation is attributed to expense using the straight-line single option method. Share-based compensation expense recognized in our consolidated statements of operations for the three months ended September 30, 2010 and 2009 is ba sed on awards ultimately expected to vest, reduced for estimated forfeitures. Accounting rules for stock options require forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

During the three and nine months ended September 30, 2010 and 2009, we granted options to employees for  400,000, 400,000,0,497,000 shares, respectively, at the weighted average per share exercise price of $0.11, $0.11, $0.00, $0.30  respectively, the fair market value of our common stock at the dates of grants. Approximately 271,700

10

of the options granted in 2009 vested immediately on the date of grant. Employee and director stock option activity for the three and nine months ended September 30, 2010, included cancellations only and was as follows:

				Weighted Avg.
	Shares			Exercise Price
Balance December 31, 2009		10,913,000		$	2.16
Three months ended March 31, 2010
Cancelled		(365,000	)		0.93
Balance March 31, 2010		10,548,000		$	2.20
Three months ended June 30, 2010
Cancelled		(886,000	)		2.70
Balance June 30, 2010		9,662,000		$	2.15
Three months ended September 30, 2010
Granted		400,000			0.11
Cancelled		(571,000	)		3.47
Balance September 30, 2010		9,491,000		$	1.99

The estimated fair value of options granted to employees during the three and nine months ended September 30, 2010 was $31,000 and $31,000 respectively, calculated using the Black-Scholes pricing model with the following assumptions:

	Three Months Ended		Nine Months Ended
	September 30,		September 30,
	2010	2009	2010	2009
Expected volatility	82%	72%	82%	72%
Risk-free interest rate	1.76%	2.27-2.37%	1.76%	2.27-2.37%
Weighted average expected lives in years	5.0-6.0	5.0-6.0	5.0-6.0	5.0-6.0
Expected dividend	0%	0%	0%	0%

The expected volatility assumptions have been based on the historical and expected volatility of our stock, measured over a period generally commensurate with the expected term. The weighted average expected option term for the three months ended September 30, 2010 reflects the application of the simplified method prescribed in SEC Staff Accounting Bulletin (SAB) No. 107 (and as amended by SAB 110), which defines the life as the average of the contractual term of the options and the weighted average vesting period for all option tranches.

As of September 30, 2010, there was $3 million of total unrecognized compensation costs related to non-vested share-based compensation arrangements granted under the Plan. That cost is expected to be recognized over a weighted-average period of approximately 2.5 years

Stock Options and Warrants – Non-employees

We account for the issuance of options and warrants for services from non-employees by estimating the fair value of warrants issued using the Black-Scholes pricing model. This model’s calculations include the option or warrant exercise price, the market price of shares on grant date, the weighted average risk-free interest rate, expected life of the option or warrant, expected volatility of our stock and expected dividends.

For options and warrants issued as compensation to non-employees for services that are fully vested and non-forfeitable at the time of issuance, the estimated value is recorded in equity and expensed when the services are performed and benefit is received. For unvested shares, the change in fair value during the period is recognized in expense using the graded vesting method.

11

There were no options granted and no share-based expense attributable to continuing operations relating to stock options and warrants granted to non-employees during the three and nine months ended September 30, 2010. For the same periods in 2009 we granted options for 0 and 60,000 shares at the weighted average per share exercise price of $0.00 and $0.52, the fair market value of our common stock at the dates of grants. For the three and nine months ended September 30, 2010 and 2009, share-based expense attributable to continuing operations relating to stock options and warrants granted to non-employees was $0, $6,000, $43,000 and $67,000, respectively.

Non-employee stock option and warrant activity for the three and nine months ended September 30, 2010 was as follows:

As of September 30, 2010				Weighted Avg.
	Shares			Exercise Price
Balance December 31, 2009		1,690,000		$	3.57
Balance March 31, 2010		1,690,000		$	3.57
Cancelled		(105,000	)		2.60
Balance June 30, 2010		1,585,000		$	3.63
Cancelled		(48,000	)		2.60
Balance September  30, 2010		1,537,000		$	3.67

Common Stock

During the three and nine months ended September 30, 2010 and 2009, we issued 10 million, 16.1 million , 600,000 and 789,000 shares of common stock, respectively, related to the July, 2010, $2 million registered direct financing and in exchange for various services and settlement of claims.  The costs associated with shares issued for services are being amortized to share-based expense on a straight-line basis over the related nine month to one year service periods. For the three and nine months ended September 30, 2010 and 2009, share-based expense relating to all common stock issued for consulting services was $25,000 and $401,000 compared to $52,000 and $227,000, respectively. The cost of the shares issued in settlement of claims in the amount of $1.2 million, due for services provided to us which had not been paid were recognized in prior periods. The court approved the settlements of complaints against us in California state court in exchange for issuing 445,000 shares of common stock in January 2010 and 5,000,000 shares of our common stock in April 2010 pursuant to Section 3(a)(10) of the Securities Act of 1933 as amended. The April settlement is subject to adjustment 180 days subsequent to the issuance of the shares and the owner of the claim will not sell more than the greater of 49,000 shares or 10% of the daily trading volume per the terms of the settlement.

Employee Stock Purchase Plan

We have a qualified employee stock purchase plan (ESPP), approved by our stockholders, which allows qualified employees to participate in the purchase of designated shares of our common stock at a price equal to 85% of the lower of the closing price at the beginning or end of each specified stock purchase period. There were no shares of our common stock issued pursuant to the ESPP and, thus, no expense incurred during the nine months ended September 30, 2010. For the same period in 2009, we issued 8,928 shares of common stock and incurred no expense related to the ESPP discount price.

Income Taxes

We account for income taxes using the liability method in accordance with current FASB income tax accounting rules. To date, no current income tax liability has been recorded due to our accumulated net losses. Deferred tax assets and liabilities are recognized for temporary differences between the financial statement carrying amount of assets and liabilities and the amounts that are reported in the tax return. Deferred tax assets and liabilities

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are recorded on a net basis; however, our net deferred tax assets have been fully reserved by a valuation allowance due to the uncertainty of our ability to realize future taxable income and to recover our net deferred tax assets.

We recognize the impact of tax positions in the consolidated financial statements if that position is more likely than not of being sustained on audit, based on the technical merits of the position. To date, we have not identified any uncertain tax positions.

Costs associated with streamlining our operations

During the three and nine months ended September 30, 2010 and 2009, we continued to streamline our operations to increase our focus on managed care opportunities and reposition ourselves to be more competitive in the marketplace. We did not record any costs related to streamlining our operations in 2010 compared to $1,000 and $1.2 million of such costs in the three and nine months ended 2009, respectively.

Marketable Securities

At September 30, 2010, investments include certificates of deposit with maturity dates greater than three months when purchased compared to ARS and certificates of deposit at December 31, 2009. These investments are classified as available-for-sale investments, are reflected in current assets as marketable securities and are stated at fair market value in accordance with FASB accounting rules related to investment in debt securities. Unrealized gains and losses are reported in our Consolidated Balance Sheet within the caption entitled “Accumulated other comprehensive income (loss)” and within Comprehensive Income (Loss) under the caption “other comprehensive income (loss).” Realized gains and losses and declines in value judged to be other-than-temporary are recognized as an impairment charge in the statement of operations on the specific identification method in the period in which they occur.

In making our determination whether losses are considered to be other-than-temporary declines in value, we consider the following factors at each quarter-end reporting period:

●   How long and by how much the fair value of the ARS securities have been below cost;

●   The financial condition of the issuers;

●   Any downgrades of the securities by rating agencies;

●   Default on interest or other terms; and

●   Whether it is more likely than not that we will be required to sell the ARS before they recover in value.

In accordance with current accounting rules for investments in debt securities and additional application guidance issued by the FASB in April 2009, other-than-temporary declines in value are reflected as a non-operating expense in our consolidated statement of operations if it is more likely than not that we will be required to sell the ARS before they recover in value, whereas subsequent increases in value are reflected as unrealized gains in accumulated other comprehensive income in stockholders’ equity in our consolidated balance sheet.

Our marketable securities consisted of investments with the following maturities as of September 30, 2010 and December 31, 2009:

(in thousands)	Fair Market		Less than		More than
	Value		1 Year		10 Years
Balance at December 31, 2009
Certificates of deposit	$	133	$	133	$	-
Auction-rate securities		9,468		9,468		-
Balance at September 30, 2010
Certificates of deposit	$	133	$	133	$	-

The carrying value of all securities presented above approximated fair market value at September 30, 2010 and December 31, 2009.

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Auction-Rate Securities

Since February 2008, auctions for these securities had failed; meaning the parties desiring to sell securities could not be matched with an adequate number of buyers, resulting in our having to continue to hold these securities. Although the securities are Aaa/AAA rated and collateralized by portfolios of student loans guaranteed by the U.S. government, based on current market conditions it is likely that auctions will continue to be unsuccessful in the short-term, limiting the liquidity of these investments until the issuer calls the securities. The maturity dates of the underlying securities of our ARS investments ranged from 18 to 37 years.  In October 2008, our portfolio manager, UBS AG (UBS) made a rights offering to its clients, pursuant to which we are entitled to sell to UBS all ARS held by us in our UBS account. We sub scribed to the rights offering in November 2008, which permitted us to require UBS to purchase our ARS for a price equal to original par value plus any accrued but unpaid interest beginning on September 30, 2010 and ending on July 2, 2012, if the securities were not earlier redeemed or sold. During the nine months ended June 30, 2010, $10.2 million (par value) of ARS were redeemed at par by the issuer.

 The rights offering referred to above was effectively a put option agreement. Consequently, we recognized the put option agreement as a separate asset in the amount of approximately $758,000 in accordance with FASB accounting rules and it is included at fair market value in other current assets in our consolidated balance sheet at December 31, 2009. As the ARS were redeemed at par value we determined that the fair market value of the ARS at June 30, 2010 was the redemption amount, and as a result have written down the value of the put option to zero at June 30, 2010.  The related $758,000 reduction in the value of the put option is reflected as a charge to gain on sale of marketable securities in our consolidated income statement for the nine months ended September 30, 2010.

Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Assets and liabilities recorded at fair value in the consolidated balance sheets are categorized based upon the level of judgment associated with the inputs use to measure fair value. The fair value hierarchy distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources observable inputs and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable outputs). The fair value hierarchy consists of three broad levels, which gives the highe st priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below:

Level Input:	Input Definition:
Level I	Inputs are unadjusted, quoted prices for identical assets or liabilities in active markets at the measurement date.
Level II	Inputs, other than quoted prices included in Level I, that are observable for the asset or liability through corroboration with market data at the measurement date.
Level III	Unobservable inputs that reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date.

The following table summarizes fair value measurements by level at September 30, 2010 for assets and liabilities measured at fair value on a recurring basis:

(Dollars in thousands)	Level I		Level II		Level III		Total
Certificates of deposit (1)		133		-		-		133
Total assets		133		-		-		133
Warrant liabilities		-		-		72		72
Total liabilities		-		-		72		72
(1) included in deposits and other assets on our consolidated balance sheets

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Liabilities measured at market value on a recurring basis at September 30, 2010 and December 31, 2009 includes warrant liabilities resulting from debt and equity financing. In accordance with current accounting rules, the warrant liabilities are being marked to market each quarter-end until they are completely settled. The warrants are valued using the Black-Scholes method, using both observable and unobservable inputs and assumptions consistent with those used in our estimate of fair value of employee stock options. See Warrant Liabilities below.

The following table summarizes our fair value measurements by level at December 31, 2009, and changes therein, for the nine months ended September 30, 2010:

	Level III			Level III
	ARS			Warrant
(Dollars in thousands)	& Put			Liabilities
Balance as of December 31, 2009	$	10,225		$	1,089
Transfers in/(out) of Level III		-			-
Change in Fair Value		-			(657	)
Net purchases (sales)		(250	)		-
Net unrealized gains (losses)		(30	)		-
Net realized gains (losses)		30			-
Balance as of March 31, 2010	$	9,975		$	432
Transfers in/(out) of Level III		(2,225	)		-
Change in Fair Value		-			(237	)
Net purchases (sales)		(7,750	)		-
Net unrealized gains (losses)		(693	)		-
Net realized gains (losses)		693			-
Balance as of June 30, 2010	$	-		$	195
Transfers in/(out) of Level III		-			790
Change in Fair Value		-			(913	)
Net purchases (sales)		-			-
Net unrealized gains (losses)		-			-
Net realized gains (losses)		-			-
Balance as of September 30, 2010	$	-		$	72

As discussed above, there have been continued auction failures with our ARS portfolio and as a result, active markets for our ARS did not exist and we relied primarily on Level III inputs, for fair valuation measures as of December 31, 2009. On July 2, 2010, upon trade settlement, we collected the $2.2 million receivable related to the sale of the remainder of our ARS portfolio As of September 30, 2010, our ARS Portfolio was fully liquidated at par.

Intangible Assets

As of September 30, 2010, the gross and net carrying amounts of intangible assets that are subject to amortization are as follows:

	Gross							Amortization
(In thousands)	Carrying		Accumulated			Net		Period
	Amount		Amortization			Balance		(in years)
Intellectual property	$	4,361	$	(1,879	)	$	2,482		11-16

During the nine months ended September 30, 2010, we did not acquire any new intangible assets and at September 30, 2010, all of our intangible assets consisted of intellectual property, which is not subject to renewal or extension. We performed impairment tests on intellectual property as of September 30, 2010 and after considering numerous factors, we determined that the carrying value of certain intangible assets was recoverable as of September 30, 2010.  During the nine months ended September 30, 2010 we did not record impairment charges

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associated with our intellectual property. At December 31, 2009, we had an independent third-party perform a valuation of our intellectual property. They relied on the “relief from royalty” method, as this method was deemed to be most relevant to the intellectual property assets of the Company.  We determined that the estimated useful lives of the remaining intellectual property properly reflected the current remaining economic useful lives of the assets.

Estimated remaining amortization expense for intangible assets for the current year and each of the next five years ending December 31 is as follows:

(In thousands)
Year	Amount
2010	$       177
2011	$       241
2012	$       241
2013	$       241
2014	$       241

Property and Equipment

Property and equipment are stated at cost, less accumulated depreciation. Additions and improvements to property and equipment are capitalized at cost. Expenditures for maintenance and repairs are charged to expense as incurred. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets, which range from two to seven years for furniture and equipment. Leasehold improvements are amortized over the lesser of the estimated useful lives of the assets or the related lease term, which is typically five to seven years.

Variable Interest Entities

Generally, an entity is defined as a Variable Interest Entity (VIE) if it has (a) equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or (b) equity investors that cannot make significant decisions about the entity’s operations, or that do not absorb the expected losses or receive the expected returns of the entity. When determining whether an entity that is a business qualifies as a VIE, we also consider whether (i) we participated significantly in the design of the entity, (ii) we provided more than half of the total financial support to the entity, and (iii) substantially all of the activities of the VIE either involve us or are conducted on our behalf. A VIE is consolidated by its primary beneficiary, which is the party that absorbs or r eceives a majority of the entity’s expected losses or expected residual returns.

As discussed under the heading Management Services Agreements below, we have a MSA with a managed medical corporation. Under this MSA, the equity owner of the affiliated medical group has only a nominal equity investment at risk, and we absorb or receive a majority of the entity’s expected losses or expected residual returns. We participate significantly in the design of this MSA. We also agree to provide working capital loans to allow for the medical group to pay for its obligations. Substantially all of the activities of this managed medical corporation either involve us or are conducted for our benefit, as evidenced by the facts that (i) the operations of the managed medical corporations are conducted primarily using our licensed protocols and (ii) under the MSA, we agree to provide and perform all non-medical management and administrative services for the respective medical group. Payment of our management fee is subordinate to payments of the obligations of the medical group, and repayment of the working capital loans is not guaranteed by the equity owner of the affiliated medical group or other third party. Creditors of the managed medical corporations do not have recourse to our general credit.

Based on the design and provisions of this MSA and the working capital loans provided to the medical group, we have determined that the managed medical corporation is a VIE, and that we are the primary beneficiary as defined in the current accounting rules. Accordingly, we are required to consolidate the revenues and expenses of the managed medical corporation.

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Management Services Agreements

We have executed MSAs with medical professional corporations and related treatment centers, with terms generally ranging from five to ten yearsand provisions to continue on a month-to-month basis following the initial term, unless terminated for cause. In May 2009, we terminated the MSAs with a medical professional corporation and a managed treatment center located in Dallas, Texas “for cause” and because the Company had fully met its funding requirements with respect to the MSAs. As a result, we no longer consolidate these entities as VIEs.

Under the remaining MSA, we license to the treatment center the right to use our proprietary treatment programs and related trademarks and provide all required day-to-day business management services, including, but not limited to:

●   general administrative support services;

●   information systems;

●   recordkeeping;

●   scheduling;

●   billing and collection;

●   marketing and local business development; and

●   obtaining and maintaining all federal, state and local licenses, certifications and regulatory permits.

The treatment center retains the sole right and obligation to provide medical services to its patients and to make other medically related decisions, such as the choice of medical professionals to hire or medical equipment to acquire and the ordering of drugs.

In addition, we provide medical office space to the treatment center on a non-exclusive basis, and we are responsible for all costs associated with rent and utilities. The treatment center pays us a monthly fee equal to the aggregate amount of (a) our costs of providing management services (including reasonable overhead allocable to the delivery of our services and including start-up costs such as pre-operating salaries, rent, equipment, and tenant improvements incurred for the benefit of the medical group, provided that any capitalized costs will be amortized over a five year period), (b) 10%-15% of the foregoing costs, and (c) any performance bonus amount, as determined by the treatment center at its sole discretion. The treatment center’s payment of our fee is subordinate to payment of the treatment center's obligations, includi ng physician fees and medical group employee compensation.

We have also agreed to provide a credit facility to treatment center to be available as a working capital loan, with interest at the Prime Rate plus 2%. Funds are advanced pursuant to the terms of the MSAs described above.  The notes are due on demand or upon termination of the respective MSA. At September 30, 2010, there was one outstanding credit facility under which $10.2 million was outstanding. Our maximum exposure to loss could exceed this amount, and cannot be quantified as it is contingent upon the amount of losses incurred by the respective treatment center that we are required to fund under the credit facility.

Under the MSA, the equity owner of the affiliated treatment center has only a nominal equity investment at risk, and we absorb or receive a majority of the entity’s expected losses or expected residual returns. We participate significantly in the design of the MSA. We also agree to provide working capital loans to allow for the treatment center to pay for its obligations. Substantially all of the activities of these managed medical corporations either involve us or are conducted for our benefit, as evidenced by the facts that (i) the operations of the managed medical corporations are conducted primarily using our licensed protocols and (ii) under the MSA, we agree to provide and perform all non-medical management and administrative services for the respective treatment center. Payment of our management fee is subordinate to pa yments of the obligations of the treatment center, and repayment of the working capital loans is not guaranteed by the equity owner of the affiliated treatment center or other third party. Creditors of the managed medical corporations do not have recourse to our general credit. Based on these facts, we have determined that the managed medical corporations are VIEs and that we are the primary beneficiary as defined in current accounting rules.  Accordingly, we are required to consolidate the assets, liabilities, revenues and expenses of the managed treatment centers.

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The amounts and classification of assets and liabilities of the VIEs included in our Consolidated Balance Sheets at September 30, 2010 and December 31, 2009 are as follows:

	September 30,		December 31,
(in thousands)	2010		2009
Cash and cash equivalents	$	48		23
Receivables, net		1		-
Total assets	$	49		23
Accounts payable		19		14
Note payable *		10,192		9,214
Accrued liabilities		13		6
Total liabilities	$	10,224		9,234
* Eliminated during consolidation

Warrant Liabilities

We had issued warrants in connection with the registered direct placement of our common stock in November 2007, September 2009 and the amended and restated Highbridge senior secured note in July 2008. In July 2010, Hythiam, Inc. entered a into securities purchase agreements with several institutional investors (the “Investors”) relating to the sale and issuance by the Company to the Investors of $ 2,000,000 of shares of the Company’s common stock and warrants (the “Warrants”) to purchase shares (the “Warrant Shares”) of the Company’s common stock.  Each share of common stock was sold at a price of $0.20 per share.  Investors will received Warrants to purchase three shares of common stock at an exercise pr ice of $0.20 per share for every four shares of common stock they purchase in this offering. Total shares issued were 10 million and 7,500,000 warrants valued at $790,000 fair market value based on the Black Scholes calculation.

The warrants include provisions that require us to record them at fair value as a liability in accordance with EITF 00-19, with subsequent changes in fair value recorded as a non-operating gain or loss in our statement of operations. The fair value of the warrants is determined using a Black-Scholes option pricing model, and is affected by changes in inputs to that model including our stock price, expected stock price volatility, interest rates and expected term.

For the three and nine months ended September 30, 2010 and 2009, we recognized non-operating gains/(losses) of $913,000 and $1.8 million compared to ($4.8) million and ($4.7) million, respectively, related to the revaluation of our warrant liabilities. We will continue to re-measure the warrant liabilities at fair value each quarter-end until they are completely settled or expire.

Recent Accounting Pronouncements

Recently Adopted

In February 2010, the FASB issued ASU 2010-09, “Subsequent Events, Amendments to Certain Recognition and Disclosure Requirements” which made a number of changes to the existing requirements to the FASB Accounting Standards Codification 855 Subsequent Events. The amended guidance was effective upon issuance and as a result of the amendments, SEC filers that file financial statements after February 24, 2010 are not required to disclose the date through which subsequent events have been evaluated. This ASU was adopted as of September 30, 2010 and did not have a material impact on our consolidated financial statements.

In January 2010, the FASB issued ASU 2010-06, “Fair Value Measurements and Disclosures: Improving Disclosures about Fair Value Measurements” which is intended to enhance the usefulness of fair value measurements by requiring both the disaggregation of the information in certain existing disclosures, as well as the inclusion of more robust disclosures about valuation techniques and inputs to recurring and non-recurring fair value measurements. The amended guidance is effective for interim and annual reporting periods beginning after December 15, 2009, except for the disaggregation requirement for the reconciliation disclosure of Level 3

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measurements, which is effective for fiscal years beginning after December 31, 2010 and for interim periods within those years. This ASU was adopted as of September 30, 2010 and did not have a material impact on our consolidated financial statements.

In January 2010, the FASB issued ASU 2010-02, “Accounting and Reporting for Decreases in Ownership of a Subsidiary – Scope Clarification” which is intended to clarify which transactions require a decrease in ownership provisions particularly for non-controlling interests in consolidated financial statements. In addition, it requires increased disclosures about deconsolidation of a subsidiary. It requires retrospective application and is effective for the first interim or annual periods ending on or after December 15, 2009. Adoption of this ASU will not have a material impact on our consolidated financial statements.

In January 2010, the FASB issued ASU 2020-01 “Accounting for Distributions to Shareholders with Components of Stock and Cash” which is intended to clarify the accounting treatment for a stock portion of a shareholder distribution that (1) contains both cash and stock components, (2) allows shareholders to select their preferred form of distribution, and (3) limits the total amount of cash to be distributed. It defines a stock dividend as a dividend that takes nothing from the property of an entity and adds nothing to the interests of an entity’s shareholders because the proportional interest of each shareholder remains the same. The stock portion of the distribution must be treated as a stock issuance and be reflected in the EPS calculation prospectively. It requi res retrospective application and is effective for annual periods ending on or after December 15, 2009. Adoption of this ASU will not have a material impact on our consolidated financial statements.

In August 2009, the FASB issued ASU 2009-15, which changes the fair value accounting for liabilities. These changes clarify existing guidance that in circumstances in which a quoted price in an active market for the identical liability is not available, an entity is required to measure fair value using either a valuation technique that uses a quoted price of either a similar liability or a quoted price of an identical or similar liability when traded as an asset, or another valuation technique that is consistent with the principles of fair value measurements, such as an income approach (e.g., present value technique). This guidance also states that both a quoted price in an active market for the identical liability and a quoted price for the identical liability when traded as an as set in an active market when no adjustments to the quoted price of the asset are required are Level 1 fair value measurements. This ASU was adopted effective on January 1, 2010 and did not have a material impact on our consolidated financial statements.

In June 2009, the FASB issued ASU 2009-17, “Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities,” the FASB issued changes to the accounting for variable interest entities. These changes require an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a variable interest entity; to require ongoing reassessments of whether an enterprise is the primary beneficiary of a variable interest entity; to eliminate the quantitative approach previously required for determining the primary beneficiary of a variable interest entity; to add an additional reconsideration event for determining whether an entity is a variable interest entity when any changes in facts and circumstances occur such that holders of the equity investment at risk, as a group, lose the power from voting rights or similar rights of those investments to direct the activities of the entity that most significantly impact the entity’s economic performance; and to require enhanced disclosures that will provide users of financial statements with more transparent information about an enterprise’s involvement in a variable interest entity. These changes became effective for us beginning on January 1, 2010. The adoption of this change did not have a material impact on our consolidated financial statements.

In June 2009, the FASB issued ASU 2009-16, “Accounting for Transfers of Financial Assets,” which changes the accounting for transfers of financial assets. These changes remove the concept of a qualifying special-purpose entity and remove the exception from the application of variable interest accounting to variable interest entities that are qualifying special-purpose entities; limits the circumstances in which a transferor derecognizes a portion or component of a financial asset; defines a participating interest; requires a transferor to recognize and initially measure at fair value all assets obtained and liabilities incurred as a result of a transfer accounted for as a sale; and requires enhanced disclosure; among others. These changes became effective January 1 , 2010 and did not have a material impact on our financial statements.

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Recently Issued

The following Accounting Standards Updates were issued between December 2009 and September 30, 2010 and contain amendments and technical corrections to certain SEC references in FASB's codification:

In April 2010, the FASB issued ASU 2010-13, “Share-based payment awards denominated in certain currencies” provides clarification on an employee share-based payment award that has an exercise price denominated in the currency of the market in which a substantial portion of the entity’s equity shares trades should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity should not classify such an award as a liability if it otherwise qualifies as equity. The amended guidance is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. The Company expects to adopt the amended guidance on January 1, 2011. The Company does not believe that the adoption of the amended guidance will have a significant effect on its consolidated financial statements.

In April 2010, the FASB issued ASU 2010-17, “Milestone Method of Revenue Recognition” guidance to address accounting for research or development arrangements in which a vendor satisfies its performance obligations over time, with all or a portion of the consideration contingent on future events, referred to as milestones. The new guidance allows a vendor to adopt an accounting policy to recognize all of the arrangement consideration that is contingent on the achievement of a milestone in the period the milestone is achieved, if the milestone meets the criteria to be considered a substantive milestone. The milestone method described in the new guidance is not the only acceptable revenue attribution model for milestone consideration. However, other methods that result in the recognition of all of the milestone consideration in the period the milestone is achieved are precluded. A vendor is not precluded from electing to apply a policy that results in the deferral of some portion of the milestone consideration. The new guidance is effective on a prospective basis for milestones achieved in fiscal years, and interim periods within those fiscal years, beginning on or after June 15, 2010, with early adoption permitted. If an entity early adopts in a period that is not the beginning of its fiscal year, it must apply the guidance retrospectively from the beginning of the year of adoption. A vendor may elect to adopt the new guidance retrospectively for all prior periods, but is not required to do so. The Company is still evaluating the effect, if any; the amended guidance may have on its consolidated financial statements.

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Note 3.   Segment Information

We manage and report our operations through two business segments: Behavioral Health and Healthcare Services. During the three months ended March 31, 2009, we revised our segments to reflect the disposal of CompCare (see Note 5 Discontinued Operations), and to properly reflect how our segments are currently managed. Our behavioral health managed care services segment, which had been comprised entirely of the operations of CompCare, is now presented in discontinued operations and is not a reportable segment. The Healthcare Services segment has been segregated into Behavioral Health and Healthcare Services.

We evaluate segment performance based on total assets, revenue and income or loss before provision for income taxes. Our assets are included within each discrete reporting segment. In the event that any services are provided to one reporting segment by the other, the transactions are valued at the market price. No such services were provided during the three and nine months ended September 30,2010 and 2009. Summary financial information for our two reportable segments is as follows:

	Three Months Ended						Nine Months Ended
(in thousands)	September 30,						September 30,
	2010			2009			2010			2009
Healthcare services
Revenues	$	95		$	268		$	319		$	1,346
Loss before provision for income taxes		(1,333	)		(7,978	)		(5,764	)		(17,963	)
Assets *		3,482			20,834			3,482			20,834
Behavioral health
Revenues	$	9		$	-		$	19		$	-
Loss before provision for income taxes		(575	)		(861	)		(1,750	)		(3,187	)
Assets *		-			-			-			-
Consolidated continuing operations
Revenues	$	104		$	268		$	338		$	1,346
Loss before provision for income taxes		(1,908	)		(8,839	)		(7,514	)		(21,150	)
Assets *		3,482			20,834			3,482			20,834
* Assets are reported as of September 30.

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Behavioral Health

Catasys’s integrated substance dependence solution combines innovative medical and psychosocial treatments with elements of traditional disease management and ongoing member support to help organizations treat and manage substance dependent populations to impact both the medical and behavioral health costs associated with substance dependence and the related co-morbidities.

We are currently marketing our Catasys integrated substance dependence solutions to managed care health plans for reimbursement on a case rate or monthly fee, which involves educating third party payors on the disproportionately high cost of their substance dependent population and demonstrating the potential for improved clinical outcomes and reduced cost associated with using our Catasys programs.

The following table summarizes the operating results for Behavioral Health for the three and nine months ended September 30, 2010 and 2009:

	Three Months Ended						Nine Months Ended
(in thousands)	September 30,						September 30,
	2010			2009			2010			2009
Revenues	$	9		$	-		$	19		$	-
Operating Expenses
General and administrative expenses
Salaries and benefits	$	529		$	773		$	1,650		$	1,983
Other expenses		55			88			119			363
Impairment charges		-			-			-			758
Depreciation and amortization		-			-			-			83
Total operating expenses	$	584		$	861		$	1,769		$	3,187
Loss before provision for income taxes	$	(575	)	$	(861	)	$	(1,750	)	$	(3,187	)

Healthcare Services

Our Healthcare Services segment is focused on delivering solutions for those suffering from alcohol, cocaine, methamphetamine and other substance dependencies by researching, developing, licensing and commercializing innovative physiological, nutritional, and behavioral treatment programs. Treatment with our PROMETA Treatment Programs, which integrate behavioral, nutritional, and medical components, are available through physicians and other licensed treatment providers who have entered into licensing agreements with us for the use of our treatment programs. Also included in this segment are licensed and managed treatment centers, which offer a range of addiction treatment and mental health services, including the PROMETA Treatment Programs for dependencies on alcohol, cocaine and methamphetamines.

Our healthcare services segment also comprises international operations; however, these operating segments are not separately reported as they do not meet any of the quantitative thresholds under SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information.

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The following table summarizes the operating results for Healthcare Services for the three and nine months ended September, 2010 and 2009:

(In thousands, except patient treatment data)		Three months ended						Nine months ended
		September 30,						September 30,
		2010			2009			2010			2009
Revenues
	U.S. licensees	$	30		$	123		$	106		$	459
	Managed treatment centers		65			145			213			753
	Other revenues		-			-			-			134
	Total healthcare services revenues	$	95		$	268		$	319		$	1,346
Operating expenses
	Cost of healthcare services	$	99		$	68		$	174		$	502
	General and administrative expenses
	Salaries and benefits		1,595			899			5,243			5,285
	Other expenses		402			2,118			2,242			6,376
	Research and development		-			-			-			-
	Impairment losses		1			-			39			355
	Depreciation and amortization		204			273			705			896
	Total operating expenses	$	2,301		$	3,358		$	8,403		$	13,414
Loss from operations		$	(2,206	)	$	(3,090	)	$	(8,084	)	$	(12,068	)
	Interest and other income		1			19			129			142
	Interest expense		(41	)		(221	)		(312	)		(999	)
	Loss on extinguishment of debt		-			(54	)		-			(330	)
	Gain on the sale of marketable securities		-			160			696			160
	Other than temporary impairment on
	marketable securities		-			(25	)		-			(185	)
	Change in fair value of warrant liabilities		913			(4,767	)		1,807			(4,683	)
Loss before provision for income taxes		$	(1,333	)	$	(7,978	)	$	(5,764	)	$	(17,963	)
PROMETA patients treated
	U.S. licensees		6			24			24			96
	Managed treatment centers		7			22			21			78
	Other		-			-			-			11
			13			46			45			185
Average revenue per patient treated (a)
	U.S. licensees	$	5,017		$	4,435		$	4,398		$	4,298
	Managed treatment centers		2,972			4,206			3,213			5,957
	Other		-			-			-			12,185
	Overall average		3,916			4,326			3,845			5,466
(a)	The average revenue per patient treated excludes administrative fees and other non-PROMETA patient revenues.

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Note 4.   Debt Outstanding

The following table shows the total principal amount, related interest rates and maturities of debt outstanding, as of  September 30, 2010 and December 31, 2009:

	September 30		December 31,
(dollars in thousands, except where otherwise noted)	2010		2009
Short-term debt
Senior secured note due July 15, 2010; interest payable quarterly at prime
plus 2.5% (5.75% at December 31, 2009). $3,332,000 principal net of $147,000
unamortized discount at December 31, 2009.
Debt fully eliminated in July 2010	$	-	$	3,185
UBS line of credit, payable on demand, interest payable monthly at 90-day
T-bill rate plus 120 basis points 1.237% at December 31, 2009
Debt fully eliminated in July 2010		-		6,458
Total Short-term debt	$	-	$	9,643

During the second quarter we sold $10.2 million of par value ARS and settled $8 million with the balance of $2.2 million settling on July 2, 2010. We drew down $450,000 on the UBS line of credit and paid our debt of $6.9 million in full according to the terms and conditions of our line of credit. On July 15, 2010, our senior secured note in the amount of $3.3 million matured and we paid from available funds.

Note 5.   Discontinued Operations

On January 20, 2009, we sold our interest in CompCare, in which we had acquired a controlling interest in January 2007 for $1.5 million in cash. The CompCare operations are now presented as discontinued operations in accordance with accounting rules related to the disposal of long-lived assets. Prior to the sale, the assets, and results of operations related to CompCare had constituted our behavioral health managed care services segment. See Note 3 Segment Information for an updated discussion of our business segments after the sale of CompCare.

We recognized a gain of approximately $11.2 million from this sale, which is included in income from discontinued operations in our Consolidated Statement of Operations for the three months ended March 31, 2009. The revenues and expenses of discontinued operations for the period January 1 through January 20, 2009 are as follows:

	Period from
	January 1 to
	January 20,
(in thousands)	2009
Revenues:
Behavioral managed health care revenues	$	710
Expenses:
Behavioral managed health care operating expenses	$	703
General and administrative expenses		711
Other		50
Income (loss) from discontinued operations before
provision for income tax	$	(754	)
Provision for income taxes	$	1
Income (loss) from discontinued operations, net of tax	$	(755	)
Gain on sale	$	11,204
Results from discontinued operations, net of tax	$	10,449

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Note 6.   Commitments and Contingencies

		Less than	1 - 3	3 - 5	More than
Contractual Commitments	Total	1 year	years	years	5 years
Outstanding Debt Obligations	$             -	$             -
Capital Lease  Obligations	73	65	8	-	-
Operating Lease Obligations	355	340	15	-	-
Clinical Studies	356	356	-	-	-
Total	$          784	$          761	$          23	$           -	$             -

In May 2010, we entered into an amendment to one of our operating leases which resulted in the deferral of rents of approximately $124,000 with $57,000 remaining at the end of the third quarter of 2010.

In August 2006, the Company entered into a 5 year lease agreement for approximately 4,000 square feet of medical space for a company managed treatment center in San Francisco, CA. The Company ceased operations at the center in January 2008. In the first quarter of 2009, the Company ceased making rent payments under the lease. In November of 2009, the landlord filed a lawsuit against the Company seeking damages of at least $350,000, plus attorney fees and costs. On March 23, 2010 the Company settled this lawsuit for $200,000 to be paid in monthly installments from March 23, 2010 to February 2011, with $35,000 remaining at the end of the third quarter.

Note 7.   Subsequent Events

In October 2010, the Company entered into Securities Purchase Agreements with certain accredited investors, including Socius Capital Group, LLC, an affiliate of our Chairman and CEO, for $500,000 of senior 12% secured convertible notes (the “Bridge Notes”) and warrants to purchase 12,500,000 shares of our common stock (the “Bridge Warrants”).

The Bridge Notes were scheduled to mature January 2011 and interest was payable in cash at maturity or upon prepayment or conversion.  The Bridge Notes and any accrued interest were convertible at the holders’ option into common stock or exchangeable for the securities issued in the next financing the Company entered into that results in gross proceeds to the Company of at least $3,000,000.  The Bridge Warrants were exercisable for 5 years at $.04 per share subject to adjustment for financings and share issuances below the initial exercise price. The Bridge Warrants for the non-affiliated investors limit the amount of common stock that the holders may acquire through an exercise to no more than 4.99% of all Company Securities, defined as common stock, voting stock, or other Company securities. All the holders exchanged the Bridge Notes plus interest for securities issued in the Company’s November 2010 financing (see below).

In November 2010, the Company completed a private placement with certain accredited investors, including Socius Capital Group, LLC, an affiliate of our Chairman and CEO, and one other Hythiam director, for gross proceeds of $6.9 million (the “Offering”). Of the gross proceeds, $503,000 represented the exchange of the Bridge Notes and accrued interest and $215,000 represented the cancellation of an accrued compensation liability to our Chairman and CEO. The Company incurred approximately $364,000 in financial advisory, legal and other fees in relation to the offering. In addition, the Company issued warrants to purchase 5,670,000 shares of common stock at $.01 per share to the financial advisors. The Company issued 100,000,000 shares of common stock (“Shares”) at a price of $.01 per share and $5.9 million in aggregate principal of 12% senior secured convertible notes (the “Notes”) to the investors on a pro rata basis. The Notes mature on the second anniversary of the closing.  Interest is payable in cash at maturity or upon prepayment. The Notes are secured by a first priority security interest in all of the Company’s assets. The Notes and any accrued interest convert automatically into common stock if and when sufficient shares become authorized at a conversion price of $.01 per share, subject to certain adjustments, including certain share issuances below $.01 per share. The Company agreed to use its best efforts to file a proxy statement seeking shareholder approval to increase the number of authorized shares within 30 days of closing. In additio n, each investor investing $2,000,000 or more also received 5-year warrants to purchase an aggregate of 21,960,000 shares of Company common stock at an exercise price of $.01 per share. One non-affiliated investor received such warrants. The net cash proceeds to the Company from the Offering are estimated to be $6.4 million inclusive of the October transaction and after offering expenses. 

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The Notes contain customary covenants and defaults, including providing financial information, maintenance of business and insurance, collateral matters, and restrictions on the disposition of assets. 

As a result of the Offering, the Bridge Warrants adjusted to be exercisable for an aggregate of 50 million shares at $0.01 per share.

In April 2010, as a result of a previously disclosed court settlement, we issued 5,000,000 shares of common stock in exchange for settlement of $1,005,000 due for previously rendered services.  In accordance with the approved settlement, the number of shares were subject to adjustment based on the Value Weighted Average Price (VWAP) of our common stock 180 days subsequent to the original issuance of the shares, and during October 2010 the shares were adjusted, resulting in an additional 605,000 shares due to the holders of the claims.

Item 2.                 Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements including the related notes, and the other financial information included in this report. For ease of reference, “we,” “us” or “our” refer to Hythiam, Inc., our wholly-owned subsidiaries and The PROMETA Center, Inc. unless otherwise stated.

CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING INFORMATION

In addition to historical information this report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 with respect to the financial condition, results of operations, business strategies, operating efficiencies or synergies, competitive positions, market and industry segment growth opportunities for existing products, plans and objectives of management, markets for stock of Hythiam and other matters. Statements in this report that are not historical facts are hereby identified as “forward-looking statements” for the purpose of the safe harbor provided by Section 21E of the Exchange Act of 1934 and Section 27A of the Securities Act of 1933. Such forward-looking statements, including, without limitation, those relating to the future business prospects, reve nue and income of Hythiam, wherever they occur, are necessarily estimates reflecting the best judgment of the senior management of Hythiam on the date on which they were made, or if no date is stated, as of the date of this report. These forward-looking statements are subject to risks, uncertainties and assumptions, including those described in the “Risk Factors” in Item 1A of Part I of our most recent Annual Report on Form 10-K, filed with the SEC, that may affect the operations, performance, development and results of our business. Because the factors discussed in this report could cause actual results or outcomes to differ materially from those expressed in any forward-looking statements made by us or on our behalf, you should not place undue reliance on any such forward-looking statements. New factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any fa ctor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. The Company assumes no obligation and does not intend to update these forward-looking statements, except as required by law.

OVERVIEW

General

We are a healthcare services management company, providing through our Catasys® subsidiary behavioral health management services for substance abuse to health plans.  Catasys is focused on offering integrated substance dependence solutions, including our patented PROMETA® Treatment Program, for alcoholism and stimulant dependence. The PROMETA Treatment Program, which integrates behavioral, nutritional, and medical components, is also available on a private-pay basis through licensed treatment providers and a company managed treatment center that offers the PROMETA Treatment Program, as well as other substance dependence and mental health services. We also re search, develop, license and commercialize innovative and proprietary physiological, nutritional, and behavioral treatment programs. 

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Discontinued Operations

On January 20, 2009 we sold our entire interest in our controlled subsidiary CompCare for aggregate gross proceeds of $1.5 million. We recognized a gain of approximately $11.2 million from the sale of our CompCare interest, which is included in Results of Discontinued Operations in our Consolidated Statement of Operations for the three months ended March 31, 2009.

Prior to the sale, we reported the operations of CompCare in our behavioral health managed care segment. For detailed information regarding the impact of the sale of our interest in CompCare, see our consolidated financial statements and Note 5 Discontinued Operations included with this report.

Operations

Under our licensing agreements, we provide physicians and other licensed treatment providers access to our PROMETA Treatment Program, education and training in the implementation and use of the licensed technology. The patient’s physician determines the appropriateness of the use of the PROMETA Treatment Program. We receive a fee for the licensed technology and related services generally on a per patient basis. While we continue to maintain licensing agreements with physicians, hospitals and treatment providers for 50 sites throughout the United States, the number of active sites has decreased as a result of our streamline operations, removing field support personnel and significant reductions or eliminations of advertising related to the private pay business. Eleven sites contributed to revenue in the first six months of 2010. 0;We will continue to enter into agreements on a selective basis with additional healthcare providers to increase the availability of the PROMETA Treatment Program, but generally only in markets we are presently operating or where such sites will provide support for our Catasys products.  As such revenues are generally related to the number of patients treated, key indicators of our financial performance for the PROMETA Treatment Program will be the number of facilities and healthcare providers that license our technology, and the number of patients that are treated by those providers using our PROMETA Treatment Program. As discussed below in Recent Developments, we are currently evaluating and considering additional actions to streamline our operations that may impact the licensing operations.

We currently manage, under a licensing agreement, one treatment center located in Santa Monica, California (dba The Center to Overcome Addiction).  We manage the business components of the treatment center and license the PROMETA Treatment Program and use of the name in exchange for management and licensing fees under the terms of full business service management agreements. The center offers treatment with the PROMETA Treatment Program for dependencies on alcohol, cocaine and methamphetamines and also offers medical and psychosocial interventions for other substance dependencies and mental health disorders. The revenues and expenses of these centers are included in our consolidated financial statements under accounting standards applicable to variable interest entities.  As discussed below in Recent Developments, we are currently evaluating and considering additional actions to streamline our operations that may impact the managed treatment center.

Beginning in 2007, we developed our Catasys integrated substance dependence solutions for third-party payors. We believe that our Catasys offerings will address a high cost segment of the healthcare market for substance dependence, and we are currently marketing our Catasys integrated substance dependence solutions to managed care health plans on a case rate or monthly fee, which involves educating third party payors on the disproportionately high cost of their substance dependent population and demonstrating the potential for improved clinical outcomes and reduced cost associated with using our Catasys programs.

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RESULTS OF OPERATIONS

Table of Summary Consolidated Financial Information

The table below and the discussion that follows summarize our results of consolidated continuing operations for the three and nine months ended September 30, 2010 and 2009:

	Three Months Ended						Nine Months Ended
(In thousands, except per share amounts)	September 30,						September 30,
	2010			2009			2010			2009
Revenues
Total revenues	$	104		$	268		$	338		$	1,346
Operating expenses
Cost of healthcare services		99			68			174			502
General and administrative		2,581			3,878			9,254			14,007
Impairment losses		1			-			39			1,113
Depreciation and amortization		204			273			705			979
Total operating expenses		2,885			4,219			10,172			16,601
Loss from operations		(2,781	)		(3,951	)		(9,834	)		(15,255	)
Interest and other income		1			19			129			142
Interest expense		(41	)		(221	)		(312	)		(999	)
Loss on extinguishment of debt		-			(54	)		-			(330	)
Gain on the sale of marketable securities		-			160			696			160
Other than temporary impairment of marketable
securities		(32	)		(25	)		-			(185	)
Change in fair value of warrant liability		913			(4,767	)		1,807			(4,683	)
Loss from continuing operations before provision
for income taxes		(1,940	)		(8,839	)		(7,514	)		(21,150	)

Summary of Consolidated Operating Results

The net loss from continuing operations before provision for income taxes decreased by $6.9 million and $13.6 million during the three and nine months ended September 30, 2010 respectively, compared to the same periods in 2009. The decrease was primarily due to the impact of actions to streamline our Healthcare Services operations and by an increase in the change in fair value of warrant liability of $5.7 million and $6.5 million for the same periods during 2009.

Revenues

Revenue decreased by $164,000 and $1.0 million for the three and nine months ended September 30, 2010, respectively, compared to the same periods in 2009, due mainly to a decline in licensed sites contributing to revenue and in the number of patients treated at our U.S licensed sites and the managed treatment centers, and a decrease in administrative fees earned from licensees. The number of patients treated decreased by 72% and 76% in the three and nine months ended September 30, 2010, respectively, compared to the same periods in 2009. The average revenue per patient treated at U.S. licensed sites and at Company managed centers decreased by approximately $400 and $1,600 during the three and nine months ended Septemb er 30, 2010, respectively, compared to the same periods in 2009.

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Cost of Healthcare Services

Cost of healthcare services consists of royalties we pay for the use of the PROMETA Treatment Program, and costs incurred by our consolidated managed treatment center (The Center to Overcome Addiction) for direct labor costs for physicians and nursing staff, continuing care expense, medical supplies and treatment program medicine costs. The decrease in these costs reflects a decrease in revenues from the reduction of treatment centers; management services agreements, licensed sites and corresponding patient volume in the first nine months of 2010.

General and Administrative Expenses

Total general and administrative expenses decreased by $1.3 million and $4.7 million in the three and nine months ended September 30, 2010, respectively, compared to the same periods in 2009. This decrease is attributable to decreases of $456,000 and $2.4 million in salaries and benefits for the three and nine months ended September 30, 2010, respectively, compared to the same periods in 2009.  General and administrative expenses for the first nine months of 2010 include $3.0 million in non-cash expense for share-based compensation, compared to $3.5 million of such expense for the same period in 2009.

Depreciation and amortization decreased by $69,000 and $274,000 during the three and nine months ended September 30, 2010, respectively, compared to the same periods in 2009.

Impairment Losses

There was an impairment loss related to property plant and equipment of $1,000 and $39,000 for the three and nine months ended September 30, 2010, respectively, compared to $0 and $1.1 million for the three and nine months ended September 30, 2009, respectively.  During the three and nine month periods ended September 30, 2009, impairment charges included $122,000 for intangible assets related to our managed treatment center in Dallas and $233,000 related to intellectual property for additional indications for the use of the PROMETA Treatment Program that are currently non-revenue-generating. There was no impairment charge related to intellectual property in the three and nine months ended September 30, 2010.

Interest and other income

      During the three and nine months ended September 30, 2010, we recorded $759,000 and $129,000, respectively, in interest and other income or loss compared to $19,000 and $142,000, respectively, for the three and nine months ended September 30, 2009.

Interest Expense

Interest expense declined by $180,000 and $687,000, respectively, from the three and nine months ended September 30, 2010 compared to the same periods in 2009, primarily due to a reduction of $9.6 million in interest bearing liabilities.

Loss from Extinguishment of Debt

There was no charge for loss from extinguishment of debt during the three and nine months ended September 30, 2010. In the first quarter of 2009 we recognized a $276,000 loss on extinguishment of debt resulting from the $1.4 million pay down on the Highbridge senior secured note, primarily representing unamortized discount.

Gain/(Loss)on Sale of Marketable Securities

As a result of the sale of approximately $10.2 million in ARS, we recorded ($758,000) and $696,000 of gain on sale of marketable securities for the three and nine months ended September 20, 2010, respectively.

Other than Temporary Impairment on Marketable Securities

There was no impairment charge related to certain ARS during the three and nine months ended September 30, 2010 compared to $25,000 and $185,000, respectively, for the same periods in 2009. The charge was based on an updated valuation of the securities

29

performed by management as of March 31, 2009 and deemed necessary after an analysis of other-than-temporary impairment factors, most notably, our inability to hold the ARS until they might recover in value.

Change in fair value of warrant liability

We issued warrants in connection with our registered direct stock placements completed in November 2007, September 2009 and July 2010, and the amended and restated Highbridge senior secured note in July 2008. The warrants are being accounted for as liabilities in accordance with FASB accounting rules, due to provisions in some warrants that protect the holders from declines in the Company’s stock price and a requirement to deliver registered shares upon exercise of the warrants, which is considered outside the control of the Company.  The warrants are marked-to-market each reporting period, using the Black-Scholes pricing model, until they are completely settled or expire.

The change in fair value of the warrants for the three and nine months ended September 30, 2010 and 2009 was gains/(losses) $913,000, $1.8 million, $(4.8) million and $(4.7) million, respectively. We will continue to mark the warrants to market value each quarter-end until they are completely settled.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity and Going Concern

As of September 30, 2010, we had a balance of approximately $363,000 in cash, cash equivalents. We had a working capital deficit of approximately $3.5 million at September 30, 2010.  We have incurred significant net losses and negative operating cash flows since our inception. We expect to continue to incur negative cash flows and net losses for the next twelve months. In July 2010 we closed on $2 million of a registered direct financing with certain institutional investors which represented $1.7 million in net proceeds to the Company.

In October 2010, Hythiam, Inc. (the “Company”) entered into Securities Purchase Agreements (the “Agreements”) with accredited investors, for $500,000 of 12% senior secured convertible notes (the “Bridge Notes”) and warrants to purchase shares of our common stock (the “Bridge Warrants”) (see Note 7 Subsequent Events).

In November 2010, the Company completed a private placement with certain accredited investors. Investors included Socius Capital Group, LLC, an affiliate of our Chairman and CEO, and a Hythiam director (see Note 7 Subsequent Events). This transaction should provide enough working capital into late 2011. In addition, all of the holders of Bridge Notes exchanged the Bridge Notes plus interest into securities issued in this financing. The Company had approximately $6.1 million after this transaction and as of this report date.

Our ability to fund our ongoing operations and continue as a going concern is dependent on signing and generating revenue from new contracts for our Catasys managed care programs and the success of management’s plans to increase revenue and continue to decrease expenses. We are currently in the process of implementing our recent Catasys contract in Nevada and we expect that contract to become operational in the fourth quarter of 2010. Beginning in the fourth quarter of 2008, and continuing in each of the quarters during 2010, management took actions that have resulted in reducing annual operating expenses.  We have renegotiated certain leasing and vendor agreem ents to obtain more favorable pricing and to restructure payment terms with vendors, and have paid some expenses through the issuance of common stock. We amended the lease on premises which resulted in deferring payments and agreed to settle a lawsuit filed by a landlord in March 2010 related to a facility that is no longer in use. This amendment and the legal settlement require payments aggregating $234,000 between July 1, 2010 and February 2011. To date we have made all payments under these arrangements as they have come due with only $72,000 remaining as of this report date. In addition, during the nine months ended September 30, 2010, we settled, through the issuance of common stock, approximately $1.2 million of liabilities. In previous periods, we have exited markets for our licensee operations that we have determined would not provide short-term profitability. We may exit additional markets for our licensee operations and further curtail or restructure our managed treatment center to reduce costs if m anagement determines that those markets are not expected to provide short-term

30

profitability and/or positive cash flow. We do not expect any direct costs associated with streamlining our organization to have a material positive impact on our cash position or our ability to continue as a going concern.

Cash Flows

We used $5.4 million of cash for continuing operating activities during the nine months ended September 30, 2010 compared to $11.0 million of cash for continuing operating activities during the same period last year. Use of funds in operating activities include general and administrative expense (excluding share-based expense), and the cost of healthcare services revenue, which totaled approximately $3.1 million for the nine months ended September 30, 2010, compared to $4.0 million for the same period in 2009. This decrease in net cash used reflects the decline in such expenses from our efforts to streamline operations.

Capital expenditures for the nine months ended September 30, 2010 were not material. Our future capital expenditure requirements will depend upon many factors, including progress with our marketing efforts, the time and costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims and other proprietary rights, the necessity of, and time and costs involved in obtaining, regulatory approvals, competing technological and market developments, and our ability to establish collaborative arrangements, effective commercialization, marketing activities and other arrangements.

Highbridge Senior Secured Note

On August 11, 2009, we amended our amended and restated senior secured note with Highbridge International LLC (Highbridge), to extend the maturity date from January 15, 2010 to July 15, 2010, and Highbridge agreed to give up its optional redemption rights. We also committed to exercising our right to sell our ARS in accordance with the terms of the rights offering by UBS, who sold them to us, and use the proceeds from the sale to redeem the note. The amended note also called for redemption of the note at 110% by applying a portion of any borrowed or raised capital. We also amended all 1.8 million warrants that had been previously issued to Highbridge to purchase shares of our common stock (including 1.3 million issued in conjunction with the amend ed and restated note in 2008 and 540,000 issued in conjunction with the November 2007 registered direct financing), to change the exercise price to $0.28 per share, and extend the expiration date to five years from the amendment date. During the three months ended March 31, 2009, we drew down an additional $1.5 million under the UBS demand margin loan facility, and used $1.4 million of the proceeds to pay down the principal balance on our senior secured note with Highbridge International

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LLC. During April and July 2010, we issued common stock which triggered an anti-dilution adjustment to the 1.3 million warrants associated with the 2008 amended and restated senior and secured note held by Highbridge LLC. The adjustment resulted in an increase to the number of warrants outstanding in the amount of 72.000 and a decrease in the exercise price from $0.28 to $0.27 per share. We paid this note in full upon maturity in July 2010.

UBS Line of Credit

In May 2008, our investment portfolio manager, UBS, provided us with a demand margin loan facility collateralized by our ARS, which allowed us to borrow up to 50% of the UBS-determined market value of our ARS.

In October 2008, UBS made a “Rights” offering to its clients pursuant to which we were entitled to sell to UBS all ARS held in our UBS account. As part of the offering, UBS provided us a line of credit (replacing the demand margin loan), subject to certain restrictions as described in the prospectus, equal to 75% of the market value of the ARS, until they are purchased by UBS. We accepted the UBS offer on November 6, 2008. Loans under the line of credit were subject to a rate of interest based upon the current 90-day U.S Treasury bill rate plus 120 basis points, payable monthly and were carried in short-term liabilities on our Condensed Consolidated Balance at December 31, 2009. As of June 30 2010 all ARS were redeemed at par and the line of credit was paid in full.

CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS

The following table sets forth a summary of our material contractual obligations and commercial commitments as of September 30, 2010 (in thousands):

		Less than	1 - 3	3 - 5	More than
Contractual Commitments	Total	1 year	years	years	5 years
Outstanding Debt Obligations	$             -	$             -
Capital Lease  Obligations	73	65	8	-	-
Operating Lease Obligations	355	340	15	-	-
Clinical Studies	356	356	-	-	-
Total	$          784	$          761	$          23	$           -	$             -

OFF BALANCE SHEET ARRANGEMENTS

As of September 30, 2010 we had no off-balance sheet arrangements.

CRITICAL ACCOUNTING ESTIMATES

Critical Accounting Estimates

The discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). GAAP requires management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities. We base our estimates on experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that may not be readily apparent from other sources. On an on-going basis, we evaluate the appropriateness of our estimates and we maintain a thorough process to review the application of our accounting policies. Our actual results may differ from these estimates.

We consider our critical accounting estimates to be those that (1) involve significant judgments and uncertainties, (2) require estimates that are more difficult for management to determine, and (3) may produce materially different results when using different assumptions. We have discussed these critical accounting estimates, the basis for their underlying assumptions and estimates and the nature of our related disclosures herein with the audit committee of our Board of Directors. We believe our accounting policies specific to share-based compensation expense; the impairment assessments for intangible assets, valuation of derivative liabilities, and valuation of

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marketable securities involve our most significant judgments and estimates that are material to our consolidated financial statements. They are discussed further below.

Warrant Liabilities

We have issued warrants in connection with the registered direct placements of our common stock in November 2007, September 2009, July 2010, Bridge Financing, November financings noted below, and the amended and restated Highbridge senior secured note in July 2008. The warrant agreements include provisions that require us to record them as a liability, at fair value, pursuant to FASB accounting rules and include provisions in some warrants that protect the holders from declines in the Company’s stock price and a requirement to deliver registered shares upon exercise, which is considered outside the control of the Company. The warrant liabilities are marked-to-market each reporting period and changes in fair value are recorded as a non-operating gain or los s in our statement of operations, until they are completely settled or expire. The fair value of the warrants is determined each reporting period using the Black-Scholes option pricing model, and is affected by changes in inputs to that model including our stock price, expected stock price volatility, interest rates and expected term.

The change in fair value of the warrant liabilities amounted to net gains of $913,000 and $1.8 million for the three and nine months ended September 30, 2010, compared to net losses of $4.8 million and $4.7 million for the same periods in 2009. The gains resulted mainly from a decline in the Company’s stock price. We will continue to re-measure the warrant liabilities at fair value each quarter-end until they are completely settled or expire.

In October 2010, the Company entered into Securities Purchase Agreements, for $500,000 of senior secured convertible notes (the “Bridge Notes”) and warrants to purchase shares of our common stock (the “Bridge Warrants”). The investors received warrants to purchase an aggregate 12,500,000 shares of Company common stock at $.04 per share (see Note 7 Subsequent Events).

In November 2010, the Company completed a private placement with accredited investors, in the amount of $6.9 million (the “Offering”). In addition, investors investing $2,000,000 or more also received warrants to purchase 21,960,000 shares of Company common stock at $.01 per share (see Note 7 Subsequent Events).

Share-based expense

Commencing January 1, 2006, we implemented the accounting provisions of Statement of Financial Accounting Standards (SFAS) 123R on a modified-prospective basis to recognize share-based compensation for employee stock option awards in our statements of operations for future periods. We accounted for the issuance of stock, stock options and warrants for services from non-employees in accordance with SFAS 123, Accounting for Stock-Based Compensation and FASB Emerging Issues Task Force Issue No. 96-18, Accounting For Equity Instruments That Are Issued To Other Than Employees For Acquiring Or In Conjunction With Selling Goods Or Services . We estimate the fair value of options and warrants issued using the Black-Scholes pricing model. This model’s calculations include the exe rcise price, the market price of shares on grant date, weighted average assumptions for risk-free interest rates, expected life of the option or warrant, expected volatility of our stock and expected dividend yield.

The amounts recorded in the financial statements for share-based expense could vary significantly if we were to use different assumptions. For example, the assumptions we have made for the expected volatility of our stock price have been based on the historical volatility of our stock measured over a period generally commensurate with the expected term, since we have a limited history as a public company and complete reliance on our actual stock price volatility would not be meaningful. If we were to use the actual volatility of our stock price, there may be a significant variance in the amounts of share-based expense from the amounts reported. Based on the 2008 assumptions used for the Black-Scholes pricing model, a 50% increase in stock price volatility would have increased the fair values of options by approximately 25%. The weighted average expected option term for 2008, 2007 and 2006 reflects the application of the simplified method set out in SEC Staff Accounting Bulletin No. 107, which defines the life as the average of the contractual term of the options and the weighted average vesting period for all option tranches.

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From time to time, we have retained terminated employees as part-time consultants upon their resignation from the company. Because the employees continued to provide services to us, their options continued to vest in accordance with the original terms. Due to the change in classification of the option awards, the options were considered modified at the date of termination in accordance with SFAS 123R. The modifications were treated as exchanges of the original awards in return for the issuance of new awards. At the date of termination, the unvested options were no longer accounted for as employee awards under SFAS 123R and were accounted for as new non-employee awards under EITF 96-18. The accounting for the portion of the total grants that have already vested and have been previously expensed as equity awards is not changed.

Impairment of Intangible Assets

We have capitalized significant costs for acquiring patents and other intellectual property directly related to our products and services. We review our intangible assets for impairment whenever events or circumstances indicate that the carrying amount of these assets may not be recoverable. In reviewing for impairment, we compare the carrying value of such assets to the estimated undiscounted future cash flows expected from the use of the assets and/or their eventual disposition. If the estimated undiscounted future cash flows are less than their carrying amount, we record an impairment loss to recognize a loss for the difference between the assets’ fair value and their carrying value. Since we have not recognized significant revenue to date, our estimates of future revenue may not be realized and the net realizable value of our c apitalized costs of intellectual property or other intangible assets may become impaired.

During the nine months ended September 30, 2010 we did not acquire any new intangible assets and at September 30, 2009, all of our intangible assets consisted of intellectual property, which is not subject to renewal or extension. We performed impairment tests on intellectual property as of September 30, 2010 and after considering numerous factors, we determined that the carrying value of certain intangible assets was recoverable as of September 30, 2010.  During the nine months ended September 30, 2010 we did not record impairment charges associated with our intellectual property. At March 31, 2010, we had an independent third-party perform a valuation of our intellectual property. They relied on the “relief from royalty” method, as this method was deemed to be most relevant to the intellectual property assets of t he Company.  We determined that the estimated useful lives of the remaining intellectual property properly reflected the current remaining economic useful lives of the assets.

Valuation of Marketable Securities

Investments include ARS and certificates of deposit with maturity dates greater than three months when purchased, which are classified as available-for-sale investments and reflected in current or long-term assets, as appropriate, as marketable securities at fair market value. Unrealized gains and losses are reported in our Condensed Consolidated Balance Sheet within accumulated other comprehensive loss and within other comprehensive loss. Realized gains and losses and declines in value judged to be “other-than-temporary” are recognized as a non-reversible impairment charge in the Statement of Operations on the specific identification method in the period in which they occur.

We regularly review the fair value of our investments. If the fair value of any of our investments falls below our cost basis in the investment, we analyze the decrease to determine whether it represents an other-than-temporary decline in value. In making our determination for each investment, we consider the following factors:

●   How long and by how much the fair value of the investments have been below cost;

●   The financial condition of the issuers;

●   Any downgrades of the investment by rating agencies;

●   Default on interest or other terms; and

●   Our intent and ability to hold the investments long enough for them to recover their value.

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RECENT ACCOUNTING PRONOUNCEMENTS

Recently Adopted

In February 2010, the FASB issued ASU 2010-09, “Subsequent Events, Amendments to Certain Recognition and Disclosure Requirements” which made a number of changes to the existing requirements to the FASB Accounting Standards Codification 855 Subsequent Events. The amended guidance was effective upon issuance and as a result of the amendments, SEC filers that file financial statements after February 24, 2010 are not required to disclose the date through which subsequent events have been evaluated. This ASU was adopted as of September 30, 2010 and did not have a material impact on our consolidated financial statements.

In January 2010, the FASB issued ASU 2010-06, “Fair Value Measurements and Disclosures: Improving Disclosures about Fair Value Measurements” which is intended to enhance the usefulness of fair value measurements by requiring both the disaggregation of the information in certain existing disclosures, as well as the inclusion of more robust disclosures about valuation techniques and inputs to recurring and non-recurring fair value measurements. The amended guidance is effective for interim and annual reporting periods beginning after December 15, 2009, except for the disaggregation requirement for the reconciliation disclosure of Level 3 measurements, which is effective for fiscal years beginning after December 31, 2010 and for interim periods within those years. This ASU was adopted as of September 30, 2010 and did not have a material impact on our consolidated financial statements.

In January 2010, the FASB issued ASU 2010-02, “Accounting and Reporting for Decreases in Ownership of a Subsidiary – Scope Clarification” which is intended to clarify which transactions require a decrease in ownership provisions particularly for non-controlling interests in consolidated financial statements. In addition, it requires increased disclosures about deconsolidation of a subsidiary. It requires retrospective application and is effective for the first interim or annual periods ending on or after December 15, 2009. Adoption of this ASU will not have a material impact on our consolidated financial statements.

In January 2010, the FASB issued ASU 2020-01 “Accounting for Distributions to Shareholders with Components of Stock and Cash” which is intended to clarify the accounting treatment for a stock portion of a shareholder distribution that (1) contains both cash and stock components, (2) allows shareholders to select their preferred form of distribution, and (3) limits the total amount of cash to be distributed. It defines a stock dividend as a dividend that takes nothing from the property of an entity and adds nothing to the interests of an entity’s shareholders because the proportional interest of each shareholder remains the same. The stock portion of the distribution must be treated as a stock issuance and be reflected in the EPS calculation prospectively. It requires retrospective application and is effective for annual periods ending on or after December 15, 2009. Adoption of this ASU will not have a material impact on our consolidated financial statements.

In August 2009, the FASB issued ASU 2009-15, which changes the fair value accounting for liabilities. These changes clarify existing guidance that in circumstances in which a quoted price in an active market for the identical liability is not available, an entity is required to measure fair value using either a valuation technique that uses a quoted price of either a similar liability or a quoted price of an identical or similar liability when traded as an asset, or another valuation technique that is consistent with the principles of fair value measurements, such as an income approach (e.g., present value technique). This guidance also states that both a quoted price in an active market for the identical liability and a quoted price for the identical liability when traded as an asset in an active market when no adjustments to the quoted price of the asset are required are Level 1 fair value measurements. This ASU was adopted effective on January 1, 2010 and did not have a material impact on our consolidated financial statements.

In June 2009, the FASB issued ASU 2009-17, “Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities,” the FASB issued changes to the accounting for variable interest entities. These changes require an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a variable interest entity; to require ongoing reassessments of whether an enterprise is the primary beneficiary of a variable interest entity; to eliminate the quantitative approach previously required for determining the primary beneficiary of a variable interest entity; to add an additional reconsideration event for determining whether an entity is a variable interest entity wh en any changes in facts and circumstances occur such that holders of the equity investment at risk, as a group, lose the power from voting rights or similar rights of those investments to direct the activities of the entity that most significantly impact the entity’s

35

economic performance; and to require enhanced disclosures that will provide users of financial statements with more transparent information about an enterprise’s involvement in a variable interest entity. These changes became effective for us beginning on January 1, 2010. The adoption of this change did not have a material impact on our consolidated financial statements.

In June 2009, the FASB issued ASU 2009-16, “Accounting for Transfers of Financial Assets,” which changes the accounting for transfers of financial assets. These changes remove the concept of a qualifying special-purpose entity and remove the exception from the application of variable interest accounting to variable interest entities that are qualifying special-purpose entities; limits the circumstances in which a transferor derecognizes a portion or component of a financial asset; defines a participating interest; requires a transferor to recognize and initially measure at fair value all assets obtained and liabilities incurred as a result of a transfer accounted for as a sale; and requires enhanced disclosure; among others. These changes became effective January  1, 2010 and did not have a material impact on our financial statements.

Recently Issued

The following Accounting Standards Updates were issued between December 2009 and September 30, 2010 and contain amendments and technical corrections to certain SEC references in FASB’s codification:

In April 2010, the FASB issued ASU 2010-13, “Share-based payment awards denominated in certain currencies” provides clarification on an employee share-based payment award that has an exercise price denominated in the currency of the market in which a substantial portion of the entity’s equity shares trades should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity should not classify such an award as a liability if it otherwise qualifies as equity. The amended guidance is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. The Company expects to adopt the amended guidance on January 1, 2011. The Company does not believe that the adoption of the amended guidance will have a significant effect on its consolidated financial statements.

In April 2010, the FASB issued ASU 2010-17, “Milestone Method of Revenue Recognition” guidance to address accounting for research or development arrangements in which a vendor satisfies its performance obligations over time, with all or a portion of the consideration contingent on future events, referred to as milestones. The new guidance allows a vendor to adopt an accounting policy to recognize all of the arrangement consideration that is contingent on the achievement of a milestone in the period the milestone is achieved, if the milestone meets the criteria to be considered a substantive milestone. The milestone method described in the new guidance is not the only acceptable revenue attribution model for milestone consideration. However, other methods that result in the recognition of all of the milestone consideration in the period the milestone is achieved are precluded. A vendor is not precluded from electing to apply a policy that results in the deferral of some portion of the milestone consideration. The new guidance is effective on a prospective basis for milestones achieved in fiscal years, and interim periods within those fiscal years, beginning on or after June 15, 2010, with early adoption permitted. If an entity early adopts in a period that is not the beginning of its fiscal year, it must apply the guidance retrospectively from the beginning of the year of adoption. A vendor may elect to adopt the new guidance retrospectively for all prior periods, but is not required to do so. The Company is still evaluating the effect, if any, and the impact the amended guidance may have on its consolidated financial statements.

Item 3.                 Quantitative and Qualitative Disclosures About Market Risk

Not applicable.

Item 4.                 Controls and Procedures

We have evaluated, with the participation of our chief executive officer and our chief financial officer, the effectiveness of our system of disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation our chief executive officer and our chief financial officer have determined that they are effective in connection with the preparation of this report.  There were no changes in the internal controls over financial reporting that occurred during the quarter ended September 30, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II – OTHER INFORMATION

Item 1.                 Legal Proceedings

From time to time, we may be involved in litigation relating to claims arising out of our operations in the normal course of business.   

As of the date of this report, we are not currently involved in any material legal proceeding that we believe would have a material adverse effect on our business, financial condition or operating results.

Item 2.                 Unregistered Sales of Equity Securities and Use of Proceeds

The information set forth in Item 5. “Recent Sales of Unregistered Securities” in our Annual Report on form 10-K for the year ended December 31, 2009 is incorporated by reference.

In October 2010, Hythiam, Inc. (the “Company”) entered into Securities Purchase Agreements (the “Agreements”) with accredited investors, including Socius Capital Group, LLC, an affiliate of our Chairman and CEO, for $500,000 of senior secured convertible notes (the “Notes”) and warrants to purchase shares of our common stock (the “Warrants”) (see Note 7 Subsequent Events).

In November 2010, the Company completed a private placement with certain accredited investors for gross proceeds of $6.9 million. Investors included Socius Capital Group, LLC, an affiliate of our Chairman and CEO, and one other Hythiam director (see Note 7 Subsequent Events).

Item 3.                 Defaults Upon Senior Securities

None.

Item 4.                 [Removed and Reserved]

Item 5.                 Other Information

Related Party Transactions

In October 2010, the Company entered into Securities Purchase Agreements with accredited investors, including Socius Capital Group, LLC, an affiliate of our Chairman and CEO, for $500,000 of senior secured convertible notes (the “Bridge Notes”) and warrants to purchase shares of our common stock (the “Bridge Warrants”) (see Note 7 Subsequent Events).

In November 2010, Hythiam, Inc. (the “Company”) completed a private placement with accredited investors for gross proceeds of $6.9 million, including Socius Capital Group, LLC, an affiliate of our Chairman and CEO, and one other Hythiam director (see Note 7 Subsequent Events).

Item 6.                 Exhibits

Exhibit 10.33	Securities Purchase Agreement dated November __, 2010
Exhibit 10.34	Secured Convertible Promissory Note dated November __, 2010
Exhibit 10.35	Security Interest Agreement dated November __, 2010
Exhibit 31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 32.1	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
Exhibit 32.2	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

II-1

SIGNATURES

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

	HYTHIAM, INC.
Date:   November 18, 2010	By:	/s/ TERREN S. PEIZER
		Terren S. Peizer
		Chief Executive Officer (Principal Executive Officer)
Date:   November 18, 2010	By:	/s/ PETER L. DONATO
		Peter L. Donato
		Chief Financial Officer (Principal Financial and Accounting Officer)

II-2

EX-10.33

EXHIBIT 10.33

SECURITIES PURCHASE AGREEMENT

This Securities Purchase Agreement (this “Agreement”) is dated as of November __, 2010 (the “Effective Date”), by and between Hythiam, Inc., a Delaware corporation (the “Company”), and the Person listed on the signature page hereto (the “Investor”).

RECITALS

A.            The Company wishes to sell to the Investor and other accredited investors (the “Investors”) on the terms and subject to the conditions set forth in this Agreement, (i) the number of shares of Common Stock set forth on the Investor’s signature page hereto (the “Shares”) at a price per share of $0.01 (the “Per Share Price”), and (ii) a Secured Convertible Promissory Note in the form attached hereto as Exhibit A (the “Note”), convertible into shares of Common Stock at the Per Share Price, for the aggregate amount listed on the Investor’s signature page hereto (the “Purchase Price”).  In addition, Investors investing over $2 million will get a warrant to purchase that number of shares of Common Stock (each, a “Lead Investor Warrant” and together, the “Lead Investor Warrants”).

B.            The Company is offering the Shares, Notes and Lead Investor Warrants in a private placement to a limited number of accredited investors, as such term is defined in Regulation D promulgated under the Securities Act.  The Company and each Investor are executing and delivering this Agreement in reliance upon the exemption from registration afforded by Section 4(2) of the Securities Act, and Rule 506 of Regulation D thereunder (“Regulation D”).

C.            Each Investor, severally and not jointly, wishes to purchase, and the Company wishes to accept such investment and issue the Shares and a Note to the Investor, upon the terms and conditions stated in this Agreement, in the amounts set forth on the signature page hereto for each Investor (in aggregate for all Investors, the “Investment Amount”).

D.            The aggregate number of Shares purchased by all Investors is equal to [100,000,000] shares of Common Stock (which represents substantially all of the 200,000,000 authorized shares of Common Stock not yet issued), for an aggregate purchase price of $[1,000,000.00].  Each Investor is purchasing a pro rata proportion of shares of Common Stock, equal to such Investor’s Purchase Price, divided by the Investment Amount, multiplied by $[1,000,000.00].

E.            The aggregate investment in Notes will be equal to the Investment Amount minus $1,000,000.00.  Each Investor is purchasing a Note in the amount equal to the Purchase Price, minus the number of Shares multiplied by the Per Share Price.

F.            The Notes will convert automatically into shares of Common Stock immediately upon availability of a sufficient number of authorized shares of Common Stock, following effectuation of a reverse stock split (the “Reverse Stock Split”), in a ratio to be determined in the sole discretion of the Board of Directors of the Company (the “Board”), which must be approved by the holders of more than 50% of the then outstanding Common Stock as more fully described in the Notes.

AGREEMENT

NOW, THEREFORE, in consideration of the mutual covenants contained in this Agreement, and for other good and valuable consideration the receipt and adequacy of which are hereby acknowledged, the Company and the Investor hereby agree as follows:

ARTICLE I

DEFINITIONS

1.1           Definitions.  In addition to the terms defined elsewhere in this Agreement, for all purposes of this Agreement, the following terms shall have the meanings indicated in this Section 1.1:

“Action” has the meaning set forth in Section 3.1(j).

“Affiliate” means any Person that, directly or indirectly through one or more intermediaries, controls or is controlled by or is under common control with a Person, as such terms are used in and construed under Rule 144.

“Board” has the meaning set forth in the Recitals.

“Business Day” means any day except Saturday, Sunday and any day which shall be a federal legal holiday or a day on which banking institutions in the State of New York are authorized or required by law or other governmental action to close.

“Closing” has the meaning set forth in Section 2.2.

“Closing Date” has the meaning set forth in Section 2.2.

“Commission” means the U.S. Securities and Exchange Commission.

“Common Stock” means the common stock of the Company, $0.0001 par value per share, and any securities into which such common stock may hereafter be reclassified.

“Conversion Shares” means the Common Stock into which the Note is convertible.

“Evaluation Date” has the meaning set forth in Section 3.1(r).

“Exchange Act” means the Securities Exchange Act of 1934, as amended.

“Excluded Stock” shall mean (A) shares of Common Stock issued (or issuable upon exercise of rights, options or warrants outstanding from time to time) granted or issued to officers, directors or employees of, or consultants to, the Company pursuant to a stock grant, stock option plan, employee stock purchase plan, restricted stock plan or other similar plan, in each case as approved by the Company’s Board of Directors, (B) shares of Common Stock issued (or issuable upon exercise of rights, options or warrants outstanding from time to time) granted or issued to financial institutions, equipment lessors, brokers or similar persons in connection with commercial credit agreements, equipment financings, commercial property lease transactions or similar transactions, (C) securities issued in connection with a strategic alliances, acquisitions or similar transactions, (D) shares of Common Stock issued (or issuable upon exercise of rights, options or warrants outstanding from time to time) for bona fide services; or (E) shares issued or issuable as a result of any stock split, combination, dividend, distribution, reclassification, exchange or substitution.

“GAAP” means United States generally accepted accounting principles applied on a consistent basis during the periods involved.

“Intellectual Property Rights” has the meaning set forth in Section 3.1(o).

“Investment Amount” has the meaning set forth in the Recitals.

“Investment Company Act” means the Investment Company Act of 1940, as amended.

“Investor” has the meaning set forth in the Preamble.

“Investor Parties” has the meaning set forth in Section 5.6(a).

“Lead Investor Warrant Shares” means the shares of Common Stock issuable upon exercise of the Lead Investor Warrants.

“Liens” means a lien, charge, security interest, encumbrance, right of first refusal, preemptive right or other restriction other than a Permitted Lien.

“Material Action” means (1) the Company effects any merger or consolidation of the Company with or into another Person, (2) the Company effects any sale of all or substantially all of its assets in one or a series of related transactions, or (3) the Company effects any reclassification of the Common Stock or any compulsory share exchange pursuant to which the Common Stock is effectively converted into or exchanged for other securities, cash or property.

“Material Adverse Effect” means any material adverse effect on (i) the legality, validity or enforceability of any Transaction Document, (ii) the results of operations, assets, business, prospects or financial condition of the Company and the Subsidiaries, taken as a whole, or (iii) the Company’s ability to perform in any material respect on a timely basis its obligations under any Transaction Document.

“Material Permits” has the meaning set forth in Section 3.1(m).

“Note” has the meaning set forth in the Recitals.

“Per Share Price” has the meaning set forth in the Recitals.

“Permitted Liens” means the individual and collective reference to the following: (a) Liens for taxes, assessments and other governmental charges or levies not yet due or Liens for taxes, assessments and other governmental charges or levies being contested in good faith and by appropriate proceedings for which adequate reserves (in the good faith judgment of the management of the Company) have been established in accordance with GAAP; (b) carriers’, warehousemen’s and mechanics’ Liens, statutory landlords’ Liens, and other similar Liens arising in the ordinary course of the Company’s business, and which (x) do not individually or in the aggregate materially detract from the value of such property or assets or materially impair the use the reof in the operation of the business of the Company and its consolidated subsidiaries or (y) are being contested in good faith by appropriate proceedings, which proceedings have the effect of preventing for the foreseeable future the forfeiture or sale of the property or asset subject to such Lien; and (c) the security interest on the assets of the Company held by Socius Capital Group, LLC and Esousa Holdings, LLC pursuant to the Securities Purchase Agreements dated October 19, 2010 between them and the Company and the related transactions thereunder.

“Person” means an individual or corporation, partnership, trust, incorporated or unincorporated association, joint venture, limited liability company, joint stock company, government (or an agency or subdivision thereof) or other entity of any kind.

“Purchase Price” has the meaning set forth in the Recitals.“Regulation D” has the meaning set forth in the Recitals.

“Reverse Stock Split” has the meaning set forth in the Recitals.

“Rule 144” means Rule 144 promulgated by the Commission pursuant to the Securities Act, as such Rule may be amended from time to time, or any similar rule or regulation hereafter adopted by the Commission having substantially the same effect as such Rule.

“SEC Guidance” means (i) any publicly-available written or oral guidance, comments, requirements or requests of the Commission staff, (ii) the Securities Act, and (iii) the Exchange Act, as applicable.

“SEC Reports” includes all reports required to be filed by the Company under the Securities Act and/or the Exchange Act, including pursuant to Section 13(a) or 15(d) thereof, for the two years preceding the Effective Date (or such shorter period as the Company was required by law to file such material) and for the period in which this Agreement is in effect.

“Securities” means the Notes, the Shares, the Lead Investor Warrants, the Conversion Shares and the Lead Investor Warrant Shares.

“Securities Act” means the Securities Act of 1933, as amended.

“Security Agreement” means the Security Agreement by and between the Company and each of the Investors.

“Subsidiary” means any Person the Company owns or controls, or in which the Company, directly or indirectly, owns a majority of the capital stock or similar interest that would be disclosable pursuant to Regulation S-K, Item 601(b)(21).

“Trading Day” means (i) a day on which the Common Stock is traded on a Trading Market, or (ii) if the Common Stock is not listed on a Trading Market, a day on which the Common Stock if traded in the over-the-counter market is quoted in the over-the-counter market as reported by the National Quotation Bureau Incorporated (or any similar organization or agency succeeding to its functions of reporting prices); provided, that in the event that the Common Stock is not listed or quoted as set forth in (i) or (ii) hereof, then Trading Day shall mean a Business Day.

“Trading Market” means whichever of the New York Stock Exchange, the NYSE Amex, The NASDAQ Global Market, The NASDAQ Global Select Market, The NASDAQ Capital Market or OTC Bulletin Board on which the Common Stock is listed or quoted for trading on the date in question, but does not include the Pink Sheets inter-dealer electronic quotation and trading system.

“Transaction Documents” means this Agreement, the Note, the Lead Investor Warrant, the Security Agreement, and any other documents or agreements executed in connection with the transactions contemplated hereunder, documents referenced herein, and the exhibits and schedules hereto and thereto.

ARTICLE II.

PURCHASE AND SALE

2.1           Purchase and Sale.  Upon the terms and subject to the satisfaction or waiver of the conditions set forth herein, the Company agrees to sell to the Investor, and the Investor agrees to purchase from the Company, the Note and the.

2.2            Closing.  The closing of the transactions contemplated herein (the “Closing”) will take place on the Effective Date, or at such other time as the Company and the Investor shall determine (the “Closing Date”).  At the Closing, (A) this Agreement and the other Transaction Documents shall have been executed and delivered by the Company and the Investor, (B) each of the conditions to the Closing described in this Agreement shall have been satisfied or waived as specified herein and (C) full payment o f the Purchase Price shall have been made by the Investor by wire transfer of immediately available funds, against physical delivery of the Notes within three days of the Closing and irrevocable instructions by the Company to its transfer agent to issue duly executed certificates representing the Shares.

ARTICLE III.

REPRESENTATIONS AND WARRANTIES OF THE COMPANY

3.1            The Company hereby represents and warrants to, and as applicable covenants with, Investor as of the Closing Date, as follows:

(a)    Subsidiaries.  The Company owns, directly or indirectly, all of the capital stock or other equity interests of each Subsidiary, and all of such directly or indirectly owned capital stock or other equity interests are owned free and clear of any Liens.  All the issued and outstanding shares of capital stock of each Subsidiary are duly authorized, validly issued, fully paid, non-assessable and free of preemptive and similar rights to subscribe for or purchase securities.

(b)    Organization and Qualification.  Each of the Company and each Subsidiary is an entity duly incorporated or otherwise organized, validly existing and in good standing under the laws of the jurisdiction of its incorporation or organization, as applicable, with the requisite power and authority to own and use its properties and assets and to carry on its business as currently conducted.  Neither the Company nor any Subsidiary is in violation or default of any of the provisions of its respective certificate or articles of incorporation, bylaws or other organizational or charter documents.  Each of the Company and each Subsidiary is duly qualified to conduct business and is in good standing as a foreign corporation or other entity in each jurisdiction in which the nature of the business conducted or property owned by it makes such qualification necessary, except where the failure to be so qualified or in good standing, as the case may be, could not have or reasonably be expected to result in a Material Adverse Effect and no proceeding has been instituted in any such jurisdiction revoking, limiting or curtailing or seeking to revoke, limit or curtail such power and authority or qualification.

(c)    Authorization; Enforcement.  The Company has the requisite corporate power and authority to enter into and to consummate the transactions contemplated by each of the Transaction Documents and otherwise to carry out its obligations hereunder or thereunder.  The execution and delivery of each of the Transaction Documents by the Company and the consummation by it of the transactions contemplated hereby or thereby have been duly authorized by all necessary action on the part of the Company and no further consent or action is required by the Company.  Each of the Transaction Documents has been, or upon delivery will be, duly executed by the Company and, when delivere d in accordance with the terms hereof, will constitute the valid and binding obligation of the Company, enforceable against the Company in accordance with its terms, except (i) as limited by general equitable principles and applicable bankruptcy, insolvency, reorganization, moratorium and other laws of general application affecting enforcement of creditors’ rights generally, (ii) as limited by laws relating to the availability of specific performance, injunctive relief or other equitable remedies and (iii) insofar as indemnification and contribution provisions may be limited by applicable law.  Neither the Company nor any Subsidiary is in violation of any of the provisions of its respective certificate or articles of incorporation, by-laws or other organizational or charter documents.

(d)    No Conflicts.  The execution, delivery and performance of the Transaction Documents by the Company, the issuance and sale of the Securities and the consummation by the Company of the other transactions contemplated thereby do not and will not (i) conflict with or violate any provision of the Company’s or any Subsidiary’s certificate or articles of incorporation, articles of association, bylaws, or other organizational or charter documents, or (ii) conflict with, or constitute a default (or an event that with notice or lapse of time or both would become a default) under, result in the creation of any Lien upon any of the properties or assets of the Company or any Subsidi ary, or give to others any rights of termination, amendment, acceleration or cancellation (with or without notice, lapse of time or both) of, any agreement, credit facility, debt or other instrument (evidencing a Company or Subsidiary debt or otherwise) or other understanding to which the Company or any Subsidiary is a party or by which any property or asset of the Company or any Subsidiary is bound or affected, or (iii) conflict with or result in a violation of any law, rule, regulation, order, judgment, injunction, decree or other restriction of any court or governmental authority to which the Company or a Subsidiary is subject (including federal and state securities laws and regulations), or by which any property or asset of the Company or a Subsidiary is bound or affected, or (iv) conflict with or violate the terms of any agreement by which the Company or any Subsidiary is bound or to which any property or asset of the Company or any Subsidiary is bound or affected; except in the case of each of clauses (ii) and (iii), such as could not have or reasonably be expected to result in a Material Adverse Effect.

(e)    Filings, Consents and Approvals.  Neither the Company nor any Subsidiary is required to obtain any consent, waiver, authorization or order of, give any notice to, or make any filing or registration with, any court or other federal, state, local or other governmental authority or other Person in connection with the execution, delivery and performance by the Company of the Transaction Documents, other than any required federal and state securities filings and such filings and approvals as are required to be made or obtained under the applicable Trading Market rules in connection with the transactions contemplated hereby, each of which has been, or (if not yet required to be filed) sh all be, timely filed.

(f)    Issuance of the Securities.  The Shares and the Notes are duly authorized, and the Conversion Shares will be duly authorized upon effectuation of the Reverse Stock Split, and, when issued and paid for in accordance with the applicable Transaction Documents, the Securities will be duly and validly issued, fully paid and nonassessable, free and clear of all Liens.

(g)    Capitalization.  The capitalization of the Company is as described in the Company’s most recently filed periodic SEC Report as updated by the Company’s Current Report on Form 8-K filed with the Commission on October 20, 2010.  No Person has any right of first refusal, preemptive right, right of participation, or any similar right to participate in the transactions contemplated by the Transaction Documents.  Except as a result of the purchase and sale of the Securities or as set forth in the SEC Reports, there are no outstanding options, warrants, script rights to subscribe to, calls or commitments of any character whatsoever relating to, or securitie s, rights or obligations convertible into or exchangeable for, or giving any Person any right to subscribe for or acquire, any shares of Common Stock, or contracts, commitments, understandings or arrangements by which the Company or any Subsidiary is or may become bound to issue additional shares of Common Stock or securities convertible into or exercisable for shares of Common Stock.  Except as set forth in the SEC Reports, the issuance and sale of the Securities will not obligate the Company to issue shares of Common Stock or other securities to any Person (other than Investor) and will not result in a right of any holder of Company securities to adjust the exercise, conversion, exchange, or reset price under such securities. All of the outstanding shares of capital stock of the Company are validly issued, fully paid and nonassessable, have been issued in compliance with all federal and state securities laws, and none of such outstanding shares was issued in violation of any preemptive rights or similar rights to subscribe for or purchase securities.  No further approval or authorization of any stockholder, the Board of Directors of the Company or others is required for the issuance and sale of the Securities.  There are no stockholders agreements, voting agreements or other similar agreements with respect to the Company’s capital stock to which the Company is a party or, to the knowledge of the Company, between or among any of the Company’s stockholders.

(h)    SEC Reports; Financial Statements.  The Company has filed all required SEC Reports for the two years preceding the Effective Date (or such shorter period as the Company was required by law to file such SEC Reports) on a timely basis.  As of their respective dates, the SEC Reports complied in all material respects with the requirements of the Securities Act and the Exchange Act and the rules and regulations of the Commission promulgated thereunder, as applicable, and none of the SEC Reports, when filed as amended from time to time, contained any untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary in order to ma ke the statements therein, in light of the circumstances under which they were made, not misleading.  The financial statements of the Company included in the SEC Reports comply in all material respects with applicable accounting requirements and the rules and regulations of the Commission with respect thereto as in effect at the time of filing.  Such financial statements have been prepared in accordance with GAAP, except as may be otherwise specified in such financial statements or the notes thereto and except that unaudited financial statements may not contain all footnotes required by GAAP, and fairly present in all material respects the financial position of the Company and its consolidated subsidiaries as of and for the dates thereof and the results of operations and cash flows for the periods then ended, subject, in the case of unaudited statements, to normal, immaterial, year-end audit adjustments.

(i)    Material Changes.  Since the date of the latest audited financial statements included within the SEC Reports (i) there has been no event, occurrence or development that has had, or that could reasonably be expected to result in, a Material Adverse Effect, (ii) the Company has not incurred any liabilities (contingent or otherwise) other than (A) trade payables and accrued expenses incurred in the ordinary course of business consistent with past practice, and (B) liabilities not required to be reflected in the Company’s financial statements pursuant to GAAP or required to be disclosed in filings made with the Commission, (iii) the Company has not altered its method of accountin g, (iv) the Company has not declared or made any dividend or distribution of cash or other property to its stockholders or purchased, redeemed or made any agreements to purchase or redeem any shares of its capital stock (other than as contemplated and permitted by the Transaction Documents), and (v) except as set forth on Schedule 3.1 hereto the Company has not issued any equity securities to any officer, director or Affiliate, except (A) pursuant to existing Company equity incentive plans as disclosed in the SEC Reports and (B) as otherwise disclosed in the SEC Reports.  The Company does not have pending before the Commission any request for confidential treatment of information.

(j)    Litigation.  There is no action, suit, inquiry, notice of violation, proceeding or investigation pending or, to the knowledge of the Company, threatened against or affecting the Company, any Subsidiary or any of their respective properties before or by any court, arbitrator, governmental or administrative agency or regulatory authority (federal, state, county, local or foreign) (collectively, an “Action”), which (i) adversely affects or challenges the legality, validity or enforceability of any of the Transaction Documents or the Securities, or (ii) would reasonably be expected to result in a Material Adverse Effect.  Neither the Company nor any Subsidiary, no r to the knowledge of the Company any director or officer thereof, is or has been the subject of any Action involving a claim of violation of or liability under federal or state securities laws or a claim of breach of fiduciary duty.  There has not been, and to the knowledge of the Company, there is not pending or contemplated, any investigation by the Commission involving the Company or any current or former director or officer of the Company.  The Commission has not issued any stop order or other order suspending the effectiveness of any registration statement filed by the Company or any Subsidiary under the Exchange Act or the Securities Act.

(k)    Labor Relations.  No material labor dispute exists or, to the knowledge of the Company, is imminent with respect to any of the employees of the Company, which could reasonably be expected to result in a Material Adverse Effect.

(l)    Compliance.  Neither the Company nor any Subsidiary (i) is in default under or in violation of (and no event has occurred that has not been waived that, with notice or lapse of time or both, would result in a default by the Company or any Subsidiary under), nor has the Company or any Subsidiary received notice of a claim that it is in default under or that it is in violation of, any indenture, loan or credit agreement or any other similar agreement or instrument to which it is a party or by which it or any of its properties is bound (whether or not such default or violation has been waived), (ii) is in violation of any order of any court, arbitrator or governmental body, or (iii) i s or has been in violation of any statute, rule or regulation of any governmental authority, including without limitation all foreign, federal, state and local laws applicable to its business, except in each case under clauses (i)-(iii) above as could not have a Material Adverse Effect.

(m)    Regulatory Permits.  The Company and each Subsidiary possess all certificates, authorizations and permits issued by the appropriate federal, state, local or foreign regulatory authorities necessary to conduct their respective businesses as described in the SEC Reports, except where the failure to possess such permits could not, individually or in the aggregate, have or reasonably be expected to result in a Material Adverse Effect (“Material Permits”), and neither the Company nor any Subsidiary has received any notice of proceedings relating to the revocation or modification of any Material Permit.

(n)    Title to Assets.  The Company and each Subsidiary have good and marketable title in fee simple to all real property owned by them that is material to the business of the Company and each Subsidiary and good and marketable title in all personal property owned by them that is material to the business of the Company and each Subsidiary, in each case free and clear of all Liens, except for Liens that do not materially affect the value of such property and do not materially interfere with the use made and proposed to be made of such property by the Company and each Subsidiary and Liens for the payment of federal, state or other taxes, the payment of which is neither delinquent nor subje ct to penalties.  Any real property and facilities held under lease by the Company and each Subsidiary are held by them under valid, subsisting and enforceable leases of which the Company and each Subsidiary are in compliance.

(o)    Patents and Trademarks.  The Company and each Subsidiary have, or have rights to use, all patents, patent applications, trademarks, trademark applications, service marks, trade names, copyrights, licenses and other similar rights that are necessary or material for use in connection with their respective businesses as described in the SEC Reports and which the failure to so have could have a Material Adverse Effect (collectively, the “Intellectual Property Rights”).  Neither the Company nor any Subsidiary has received a written notice that the Intellectual Property Rights used by the Company or any Subsidiary violates or infringes upon the rights of any Person.   To the knowledge of the Company, all such Intellectual Property Rights are enforceable and there is no existing material infringement by another Person of any of the Intellectual Property Rights of the Company or each Subsidiary.

(p)    Insurance.  The Company and each Subsidiary are insured by insurers of recognized financial responsibility against such losses and risks and in such amounts as are prudent and customary in the businesses in which the Company and each Subsidiary are engaged, including but not limited to directors and officers insurance coverage at least equal to an amount, and with policy coverage terms, that would cover any claims the Company could reasonably be required to pay pursuant to its breach of any of the Transaction Documents.  To the best of Company’s knowledge, such insurance contracts and policies are accurate and complete.  Neither the Company nor any Subsidi ary has any reason to believe that it will not be able to renew its existing insurance coverage as and when such coverage expires or to obtain similar coverage from similar insurers as may be necessary to continue its business without a significant increase in cost.

(q)    Transactions With Affiliates and Employees.  Except as set forth in the SEC Reports, and excluding the transactions contemplated in this Agreement, none of the officers or directors of the Company and, to the knowledge of the Company, none of the employees of the Company is presently a party to any transaction with the Company or any Subsidiary (other than for services as employees, officers and directors), including any contract, agreement or other arrangement providing for the furnishing of services to or by, providing for rental of real or personal property to or from, or otherwise requiring payments to or from any officer, director or such employee or, to the knowledge of the C ompany, any entity in which any officer, director, or any such employee has a substantial interest or is an officer, director, trustee or partner, in each case in excess of $120,000 other than (i) for payment of salary or consulting fees for services rendered, (ii) reimbursement for expenses incurred on behalf of the Company and (iii) for other employee benefits, including stock option agreements under any equity incentive plan of the Company.

(r)    Sarbanes-Oxley; Internal Accounting Controls.  The Company is in material compliance with all provisions of the Sarbanes-Oxley Act of 2002, which are applicable to it as of the Effective Date and the Closing Date.  The Company and each Subsidiary maintain a system of internal accounting controls sufficient to provide reasonable assurance that (i) transactions are executed in accordance with management’s general or specific authorizations, (ii) transactions are recorded as necessary to permit preparation of financial statements in conformity with GAAP and to maintain asset accountability, (iii) access to assets is permitted only in accordance with management’s general or specific authorization, and (iv) the recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences.  The Company has established disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the Company and designed such disclosure controls and procedures to ensure that material information relating to the Company, including its Subsidiaries, is made known to the certifying officers by others within those entities, particularly during the period in which the Company’s most recently filed periodic report under the Exchange Act, as the case may be, is being prepared.  The Company’s certifying officers have evaluated the effectiveness of the Company’s disclosure controls and procedures as of the date prior to the filing date of the most recently filed periodic report under the Exchange Act (such date, the “Evaluation DateR 21;).  The Company presented in its most recently filed periodic report under the Exchange Act the conclusions of the certifying officers about the effectiveness of the Company’s disclosure controls and procedures based on their evaluations as of the Evaluation Date.  Since the Evaluation Date, there have been no significant changes in the Company’s internal accounting controls or its disclosure controls and procedures or, to the Company’s knowledge, in other factors that could materially affect the Company’s internal accounting controls or its disclosure controls and procedures.

(s)    Certain Fees.  Except for fees payable to Rodman & Renshaw LLC and other registered broker-dealers in the amount of 7% of the Investment Amount and warrants for a number of shares equal to 7% of the aggregate Shares issued to the Investors divided by the Per Share Price, no brokerage or finder’s fees or commissions are or will be payable by the Company to any broker, financial advisor or consultant, finder, placement agent, investment banker, bank or other Person with respect to the transactions contemplated by this Agreement.

(t)    Private Placement. Assuming the accuracy of each Investor’s representations and warranties as set forth herein with respect to private placement requirements to meet the safe harbor of Regulation D or otherwise qualify as a non-public offering pursuant to the applicable provisions of Section 4 of the Securities Act, no registration under the Securities Act is required for the offer and sale of the Securities by the Company to Investor as contemplated hereby. The issuance and sale of the Securities hereunder does not contravene the rules and regulations of any Trading Market.

(u)    Investment Company. The Company is not, and is not an Affiliate of, and immediately after receipt of payment for the Securities, will not be or be an Affiliate of, an “investment company” within the meaning of the Investment Company Act.  The Company shall conduct its business in a manner so that it will not become subject to the Investment Company Act.

(v)    Listing and Maintenance Requirements.  Except as set forth in the SEC Reports, the Common Stock is registered pursuant to Section 12 of the Exchange Act, and the Company has taken no action designed to, or which to its knowledge is likely to have the effect of, terminating the registration of the Common Stock under the Exchange Act, nor has the Company received any notification that the Commission is contemplating terminating such registration.  The Company has not, in the 12 months preceding the Effective Date, received notice from any Trading Market on which the Common Stock is or has been listed or quoted to the effect that the Company is not in compliance with the lis ting or maintenance requirements of such Trading Market. The Company is, and has no reason to believe that it will not in the foreseeable future continue to be, in compliance with all such listing and maintenance requirements.

(w)    Application of Takeover Protections.  The Company and its Board of Directors have taken all necessary action, if any, in order to render inapplicable any control share acquisition, business combination, poison pill (including any distribution under a rights agreement) or other similar anti-takeover provision under the Company’s Certificate of Incorporation (or similar charter documents) or the laws of its state of incorporation that is or could become applicable to any Investor as a result of Investor and the Company fulfilling their obligations or exercising their rights under the Transaction Documents, including without limitation the Company’s issuance of the Securit ies and any Investor’s ownership of the Securities.

(x)    No Integrated Offering. Neither the Company, nor any of its Affiliates, nor any Person acting on its or their behalf has, directly or indirectly, made any offers or sales of any security or solicited any offers to buy any security, under circumstances that would cause this offering of the Securities to be integrated with prior offerings by the Company for purposes of the Securities Act or which could violate any applicable stockholder approval provisions, including, without limitation, under the rules and regulations of the Trading Market.

(y)    Financial Condition.  In connection with the transactions contemplated by the Transaction Documents: (i)  except as set forth in the SEC Reports, the Company has paid undisputed debts as they matured for at least one year prior to the Effective Date, (ii) the Company will not be rendered insolvent by such transactions, (iii) after giving effect to such transactions, the Company will be able to pay its debts as they become due, (iv) the Company did not and does not have any intent to hinder, delay, or defraud any of its creditors, (v) the Company has a valid business reason for entering into such transactions, and (vi) the Company is receiving new value and consideration t herefor constituting reasonably equivalent value and fair market value consideration.  The Company does not intend to incur debts beyond its ability to pay such debts as they mature (taking into account the timing and amounts of cash to be payable on or in respect of its debt).

(z)    Tax Status.  The Company and each of its Subsidiaries has made or filed all federal, state and foreign income and all other tax returns, reports and declarations required by any jurisdiction to which it is subject (unless and only to the extent that the Company and each of its Subsidiaries has set aside on its books provisions reasonably adequate for the payment of all unpaid and unreported taxes) and has paid all taxes and other governmental assessments and charges that are material in amount, shown or determined to be due on such returns, reports and declarations, except those being contested in good faith and has set aside on its books provisions reasonably adequate for the paym ent of all taxes for periods subsequent to the periods to which such returns, reports or declarations apply.  There are no unpaid taxes in any material amount claimed to be due by the taxing authority of any jurisdiction, and the officers of the Company know of no basis for any such claim.  The Company has not executed a waiver with respect to the statute of limitations relating to the assessment or collection of any foreign, federal, statue or local tax.  None of the Company’s tax returns is presently being audited by any taxing authority.

(aa)    No General Solicitation or Advertising.  Neither the Company nor, to the knowledge of the Company, any of its directors or officers (i) has conducted or will conduct any general solicitation (as that term is used in Rule 502(c) of Regulation D) or general advertising with respect to the sale of the Securities, or (ii) made any offers or sales of any security or solicited any offers to buy any security under any circumstances that would require registration of the Securities under the Securities Act or made any “directed selling efforts” as defined in Rule 902 of Regulation S.

(bb)    Foreign Corrupt Practices.  Neither the Company, nor to the knowledge of the Company, any agent or other person acting on behalf of the Company, has (i) directly or indirectly, used any corrupt funds for unlawful contributions, gifts, entertainment or other unlawful expenses related to foreign or domestic political activity, (ii) made any unlawful payment to foreign or domestic government officials or employees or to any foreign or domestic political parties or campaigns from corporate funds, (iii) failed to disclose fully any contribution made by the Company (or made by any person acting on its behalf of which the Company is aware) which is  in violation of law, or (iv) violated in any material respect any provision of the Foreign Corrupt Practices Act of 1977, as amended.

(cc)    Acknowledgment Regarding Investors’ Purchase of Securities.  The Company acknowledges and agrees that the Investors are acting solely in the capacity of an arm’s length purchaser with respect to this Agreement and the transactions contemplated hereby.  The Company further acknowledges that Investors are not acting as a financial advisor or fiduciary of the Company (or in any similar capacity) with respect to this Agreement and the transactions contemplated hereby and any statement made by Investor or any of their representatives or agents in connection with this Agreement and the transactions contemplated hereby is not advice or a recommendation and is merely incidental to the Investors’ purchase of the Securities.

(dd)    Accountants.  The Company’s accountants are set forth in the SEC Reports and such accountants are an independent registered public accounting firm as required by the SEC Guidance.

(ee)    No Disagreements with Accountants and Lawyers.  There are no disagreements of any kind presently existing, or reasonably anticipated by the Company to arise, between the accountants and lawyers formerly or presently employed by the Company, and the Company is current with respect to any fees owed to its accountants, except for any past-due amounts of less than one year that may be owed in the ordinary course of business.

(ff)    Section 5 Compliance. No representation or warranty or other statement made by Company in the Transaction Documents contains any untrue statement or omits to state a material fact necessary to make any of them, in light of the circumstances in which it was made, not misleading.  The Company is not aware of any facts or circumstances that would cause the transactions contemplated by the Transaction Documents, when consummated, to violate Section 5 of the Securities Act or other federal or state securities laws or regulations.

ARTICLE IV.

REPRESENTATIONS AND WARRANTIES OF THE INVESTORS

4.1      Each Investor hereby represents and warrants, severally and not jointly, to the Company as follows:

(a)    Organization.  The Investor, if an entity, is duly organized, validly existing and in good standing under the laws of the jurisdiction of its organization with the requisite power and authority to enter into and consummate the transactions contemplated by the applicable Transaction Documents and otherwise to carry out its obligations thereunder.

(b)    No Registration.  The Investor understands that the Securities have not been, and will not be, registered under the Securities Act by reason of a specific exemption from the registration provisions of the Securities Act, the availability of which depends upon, among other things, the accuracy of the Investor’s representations as expressed herein or otherwise made pursuant hereto.

(c)    Investment Intent.  The Investor is acquiring the Securities for its own account.  The Investor does not have any contract, undertaking, agreement or arrangement with any person or entity to sell, transfer or grant participation to such person or entity or to any third person or entity with respect to any of the Securities.

(d)    Investment Experience.  The Investor has substantial experience in evaluating and investing in securities of companies similar to the Company and acknowledges that the Investor can protect its own interests.  The Investor has such knowledge and experience in financial and business matters so that the Investor is capable of evaluating the merits and risks of its investment in the Company.

(e)    Speculative Nature of Investment.  The Investor understands and acknowledges that an investment in the Company is highly speculative and involves substantial risks. The Investor can bear the economic risk of the Investor’s investment and is able, without impairing the Investor’s financial condition, to hold the Securities for an indefinite period of time and to suffer a complete loss of the Investor’s investment.

(f)    Access to Data.  The Investor has had an opportunity to ask questions of, and receive answers from, the officers of the Company concerning the Securities, this Agreement, the exhibits and schedules attached hereto and the transactions contemplated by this Agreement, as well as the Company’s business, management and financial affairs, which questions were answered to its satisfaction. The Investor believes that it has received all the information the Investor considers necessary or appropriate for deciding whether to purchase the Securities.  The Investor also acknowledges that it is relying solely on its own counsel and not on any statements or representations of th e Company or its agents for legal advice with respect to this investment or the transactions contemplated by this Agreement.

(g)    Accredited Investor.  The Investor is an “accredited investor” within the meaning of Regulation D and shall submit to the Company such further assurances of such status as may be reasonably requested by the Company, including without limitation, the residency or principal place of business of the Investor.

(h)    Rule 144.  The Investor acknowledges that the Securities must be held indefinitely unless subsequently registered under the Securities Act or an exemption from such registration is available.  The Investor is aware of the provisions of Rule 144 promulgated under the Securities Act which permit resale of shares purchased in a private placement subject to the satisfaction of certain conditions.

(i)    Authorization.  The Investor has all requisite power and authority to execute and deliver this Agreement, to receive the Securities hereunder as contemplated herein and to carry out and perform its obligations under the terms of this Agreement.  All action on the part of the Investor necessary for the authorization, execution, delivery and performance of this Agreement, and the performance of all of the Investor’s obligations under this Agreement, has been taken or will be taken prior to the Closing Date.  This Agreement, when executed and delivered by the Investor, will constitute valid and legally binding obligations of the Investor, enforceable in accor dance with its terms except: (i) to the extent that the indemnification provisions contained in this Agreement may be limited by applicable law and principles of public policy, (ii) as limited by applicable bankruptcy, insolvency, reorganization, moratorium and other laws of general application affecting enforcement of creditors’ rights generally, and (iii) as limited by laws relating to the availability of specific performance, injunctive relief or other equitable remedies or by general principles of equity.  No consent, approval, authorization, order, filing, registration or qualification of or with any court, governmental authority or third person is required to be obtained by the Investor in connection with the execution and delivery of this Agreement by the Investor or the performance of the Investor’s obligations hereunder.

(j)    Brokers or Finders.  The Investor has not engaged any brokers, finders or agents, and the Company has not and will not incur, directly or indirectly, as a result of any action taken by the Investor, any liability for brokerage or finders’ fees or agents’ commissions or any similar charges in connection with this Agreement.

(k)    Additional Acknowledgements as to the Terms of this Offering.  The Investor acknowledges and agrees that (i) investors who invest $2 million or more in the offering under this Agreement will also receive five year warrants to purchase 21,960,000 shares of common stock at the Per Share Price and may get other rights such as a right to designate a representative to the Board of Directors, (ii) $500,000 principal amount of indebtedness described in the Company's Current Report on Form 8-K dated October 20, 2010 may either be converted into this offering or repaid with a portion of the proceeds of this offering, and (iii) certain liabilities are being settled in Securities (see Schedul e 3.1).

The Company acknowledges and agrees that each Investor does not make, and has not made, any representations or warranties with respect to the transactions contemplated hereby other than those specifically set forth in this Section 4.1.

ARTICLE V.

OTHER AGREEMENTS OF THE PARTIES

5.1           Transfer Restrictions.  (a)   The Securities may only be disposed of in compliance with state and federal securities laws.  In connection with any transfer of Securities other than (i) pursuant to an effective Registration Statement, (ii) to the Company, (iii) to an Affiliate of Investor, or (iv) in connection with a pledge as contemplated in Section 5.1(b), the Company may require the transferor thereof to provide to the Company an opinion of Luce Forward Hamilton & Scripps LLP or other counsel reasonably satisfactory to the Company, the form and substance of which opinion shall be reasonably satisfactory to th e Company, to the effect that such transfer does not require registration of such transferred Securities under the Securities Act.

(b)           Certificates evidencing the Shares and the Conversion Shares will contain a legend in substantially the following form, until such time as not required under applicable state and federal securities laws in the opinion of counsel to Company:

NEITHER THESE SECURITIES NOR THE SECURITIES INTO WHICH THESE SECURITIES ARE EXERCISABLE HAVE BEEN REGISTERED WITH THE SECURITIES AND EXCHANGE COMMISSION OR THE SECURITIES COMMISSION OF ANY STATE IN RELIANCE UPON AN EXEMPTION FROM REGISTRATION UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE “SECURITIES ACT”), AND, ACCORDINGLY, MAY NOT BE OFFERED OR SOLD EXCEPT PURSUANT TO AN EFFECTIVE REGISTRATION STATEMENT UNDER THE SECURITIES ACT OR PURSUANT TO AN AVAILABLE EXEMPTION FROM, OR IN A TRANSACTION NOT SUBJECT TO, THE REGISTRATION REQUIREMENTS OF THE SECURITIES ACT AND IN ACCORDANCE WITH APPLICABLE STATE SECURITIES LAWS. THESE SECURITIES AND THE SECURITIES ISSUABLE UPON EXERCISE OF THESE SECURITIES MAY BE PLEDGED IN CONNECTION WITH A BONA FIDE MARGIN ACCOUNT OR OTHER LOAN SECURED BY SUCH SECURITIES.

The Company agrees to cause such legend to be removed immediately upon effectiveness of a Registration Statement, or when any Shares or Conversion Shares are eligible for sale under Rule 144, provided that the Company may require the transferor thereof to provide to the Company an opinion of Luce Forward Hamilton & Scripps LLP or other counsel reasonably satisfactory to the Company, the form and substance of which opinion shall be reasonably satisfactory to the Company, to the effect that such legend may be removed.  Company further acknowledges and agrees that Investor may from time to time pledge pursuant to a bona fide margin agreement with a registered broker-dealer or grant a security interest in some or all of the Securities to a financial institution that is an “accredited investor” as defined in Rule 501(a) under the Securities Act and who agrees to be bound by the provisions of this Agreement and, if required under the terms of such arrangement, Investor may transfer pledged or secured Securities to the pledgees or secured parties.  Such a pledge or transfer would not be subject to approval of the Company and no legal opinion of legal counsel of the pledgee, secured party or pledgor shall be required in connection therewith.  Further, no notice shall be required of such pledge.  At Investor’s reasonable expense, the Company will execute and deliver such documentation as a pledgee or secured party of Securities may reasonably request in connection with a pledge or transfer of the Securities.

5.2            Furnishing of Information.  As long as Investor owns Securities, the Company covenants to timely file (or obtain extensions in respect thereof and file within the applicable grace period) all reports required to be filed by the Company after the Effective Date pursuant to the Exchange Act.  Upon the request of Investor, the Company shall deliver to Investor a written certification of a duly authorized officer as to whether it has complied with the preceding sentence. As long as Investor owns Securities, if the Company is not required to file reports pursuant to such laws, it will prepare and furnish to Investor and make publicly available in accordance with Rule 144(c) such information as is required for Investor to sell the Securities under Rule 144.  The Company further covenants that it will take such further action as any holder of Securities may reasonably request, all to the extent required from time to time to enable such Person to sell such Securities without registration under the Securities Act within the limitation of the exemptions provided by Rule 144.

5.3            Integration.  The Company shall not sell, offer for sale or solicit offers to buy or otherwise negotiate in respect of any security (as defined in Section 2 of the Securities Act) that would be integrated with the offer or sale of the Securities in a manner that would require the registration under the Securities Act of the sale of the Securities to Investor or that would be integrated with the offer or sale of the Securities for purposes of the rules and regulations of any Trading Market such that it would require stockholder approval prior to the closing of such other transaction unless stockholder approval is obtained before the closing of such subsequent transaction.

5.4            Securities Laws Disclosure; Publicity.  The Company shall timely file a Current Report on Form 8-K as required by this Agreement, and in the Company’s discretion shall file a press release, disclosing the material terms of the transactions contemplated hereby.  No Investor shall issue any such press release with respect to the transactions contemplated hereby or otherwise make any such public statement without the prior consent of the Company, which consent shall not unreasonably be withheld or delayed, except if such disclosure is required by law or Trading Market regulations, in which case the disclosing party shall promptly provide the other party with prior notice of such public statement or communication.  Notwithstanding the foregoing, the Company shall not publicly disclose the name of any Investor, or include the name of any Investor in any filing with the Commission or any regulatory agency or Trading Market, without the prior written consent of Investor, except (i) as contained in the Current Report on Form 8-K described above, (ii) as required by federal securities law in connection with any registration statement under which the Shares, Conversion Shares or Lead Investor Warrant Shares are registered, (iii) to the extent such disclosure is required by law or Trading Market regulations, in which case the Company shall provide Investor with prior notice of such disclosure, or (iv) to the extent such disclosure is required in any SEC Report filed by the Company.

5.5            Shareholders Rights Plan.  No claim will be made or enforced by the Company or, to the knowledge of the Company, any other Person that Investor is an “Acquiring Person” under any shareholders rights plan or similar plan or arrangement in effect or hereafter adopted by the Company, or that Investor could be deemed to trigger the provisions of any such plan or arrangement, by virtue of receiving Securities under the Transaction Documents or under any other agreement between the Company and Investor. The Company shall conduct its business in a manner so that it will not become subject to the Investment Company Act.

5.6           Indemnification of Investor.

(a)    Company Indemnification Obligation.  Subject to the provisions of this Section 5.6, the Company will indemnify and hold Investor, Investor’s Affiliates and attorneys, and each of their directors, officers, shareholders, partners, employees, agents, and any person who controls Investor within the meaning of Section 15 of the Securities Act or Section 20 of the Exchange Act (collectively, the “Investor Parties” and each an “Investor Party”), harmless from any and all losses, liabilities, obligations, claims, contingencies, damages, reasonable costs and expenses, including all judgments, amounts paid in settlements, court costs and reasonable attorneys 217; fees and costs of investigation (collectively, “Losses”) that any Investor Party may suffer or incur as a result of or relating to (i) any breach of any of the representations, warranties, covenants or agreements made by the Company in this Agreement or in the other Transaction Documents, (ii) any untrue statement or alleged untrue statement of a material fact contained in a Registration Statement (or in a Registration Statement as amended by any post-effective amendment thereof by the Company), or arising out of or based upon any omission or alleged omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading, and/or (iii) any untrue statement or alleged untrue statement of a material fact included in any Prospectus (or any amendments or supplements to any Prospectus), in any free writing prospectus, in any “issuer information” (as defined in Rule 433 under the Securities Act) of the Company, or in any Prospectus toge ther with any combination of one or more of the free writing prospectuses, if any, or arising out of or based upon any omission or alleged omission to state a material fact necessary in order to make the statements therein, in the light of the circumstances under which they were made, not misleading.

(b)    Indemnification Procedures.  If any action shall be brought against an Investor Party in respect of which indemnity may be sought pursuant to this Agreement, such Investor Party shall promptly notify the Company in writing, and the Company shall have the right to assume the defense thereof with counsel of its own choosing.  The Investor Parties shall have the right to employ separate counsel in any such action and participate in the defense thereof, but the fees and expenses of such counsel shall be at the expense of the Investor Parties except to the extent that (i) the employment thereof has been specifically authorized by the Company in writing, (ii) the Company has fa iled after a reasonable period of time to assume such defense and to employ counsel or (iii) in such action there is, in the reasonable opinion of such separate counsel, a material conflict with respect to the dispute in question on any material issue between the position of the Company and the position of the Investor Parties such that it would be inappropriate for one counsel to represent the Company and the Investor Parties.  The Company will not be liable to the Investor Parties under this Agreement (i) for any settlement by an Investor Party effected without the Company’s prior written consent, which shall not be unreasonably withheld or delayed; or (ii) to the extent, but only to the extent that a loss, claim, damage or liability is either attributable to Investor’s breach of any of the representations, warranties, covenants or agreements made by Investor in this Agreement or in the other Transaction Documents.

5.7           Fees.  Each party shall be responsible for all fees and expenses that it incurs in connection with the transactions contemplated hereunder, including the fees and expenses of its advisers, counsel, accountants and other experts, if any, and all other expenses incurred incident to the negotiation, preparation, execution, delivery and performance of the Transaction Documents; provided, however, that the Company agrees to reimburse the Investors for reasonable fees and expenses of one counsel. The Company shall pay all stamp and other taxes and duties levied in connection with the sale of the Securities, if any.

5.8           Reservation of Shares.  The Company covenants that it will use its best efforts to file a proxy within thirty (30) Business Days following the Effective Date for the purpose of increasing its authorized but unissued shares of Common Stock either by a Reverse Stock Split or authorization of additional shares of Common Stock or both, and shall use its best efforts to cause the stockholders holding a majority of its outstanding Common Stock to approve such Reverse Stock Split or authorization as soon as practical and in any event within six months of the Effective Date.

5.9           Approval Rights for Material Actions.  If, at any time after the Effective Date and before the conversion or repayment of all of the Notes, the Company desires to take any Material Action, the Company must first obtain the approval of the holders of the Notes who hold, in aggregate, at least two-thirds of the outstanding principal amount of the Notes.

5.10         Investors’ Right of First Refusal.  At any time after the Effective Date and before the date that is one year from the date that all of the Notes have been converted or repaid, each Investor shall have the right to purchase its pro-rata share (equal to such Investor’s Purchase Price divided by the Investment Amount) of any debt, convertible debt, or equity securities issued for financing by the Company, other than any issuances of Excluded Stock.

ARTICLE VI.

CONDITIONS PRECEDENT TO CLOSING

6.1           The obligation of the Company to sell the Shares and the Notes to the Investors at the Closing, and the Investors’ obligations to make such purchase, is subject to the fulfillment, on or before the Closing, of each of the following conditions, unless otherwise waived in advance in writing:

(a)    Representations and Warranties.  The representations and warranties of the Company contained in this Agreement shall have been true and correct when made and shall be true and correct in all respects as of the Closing, with the same force and effect as if made as of the Closing Date, and the Company shall have delivered an Officer’s Closing Certificate to such effect to each Investor, signed by a duly appointed and authorized officer of the Company.

(b)    Performance.  The Company shall have performed and complied with all covenants, agreements, obligations and conditions contained in this Agreement that are required to be performed or complied with by the Investor on or before the Closing.

(c)    Delivery of Documents.  The following documents shall have been delivered to Investors:  (A) this Agreement, executed by the Company and (B) a Secretary’s Certificate as to the resolutions of the Company’s Board of Directors or Special Committee thereof authorizing this Agreement and the Transaction Documents, and the transactions contemplated hereby and thereby.

(d)    No Material Adverse Effect.  Other than for losses incurred in the ordinary course of business, there has not been any Material Adverse Effect on the Company since the date of the last SEC Report filed by the Company.

(e)    Purchase Price. The Company shall have received the Purchase Price from each of the Investors by wire transfer of immediately available funds.

(f)    Representations and Warranties.  The representations and warranties of the Investors contained in this Agreement shall have been true and correct when made and shall be true and correct in all respects as of the Closing, with the same force and effect as if made as of the Closing Date.

ARTICLE VII.

MISCELLANEOUS

7.1           Notices.  Unless a different time of day or method of delivery is set forth in any applicable Transaction Document, any and all notices or other communications or deliveries required or permitted to be provided hereunder shall be in writing and shall be deemed given and effective on the earliest of (i) the date of transmission, if such notice or communication is delivered via facsimile at the facsimile number specified in this Section, or via electronic mail, prior to 6:30 p.m. (New York City time) on a Trading Day and an electronic confirmation of delivery is received by the sender, (ii) the next Trading Day after the date of transmission, if such notice or communication is delivered via facsimile at the facsimile number specified in this Section on a day that is not a Trading Day or later than 6:30 p.m. (New York City time) on any Trading Day, (iii) the Trading Day following the date of mailing, if sent by nationally recognized overnight courier service, or (iv) upon actual receipt by the party to whom such notice is required to be given by personal delivery.  The addresses for such communications shall be:

If to the Company or its Subsidiaries:	Hythiam, Inc.
	11150 Santa Monica Boulevard, Suite 1500
	Los Angeles, California 90025
	Attn:
	Facsimile: (310) 444-5300
	Telephone No.:
If to any Investor:	At the address of such Investor set forth on such Investor’s signature page to this Agreement.

7.2           Amendments; Waivers.  No provision of this Agreement may be waived or amended except in a written instrument signed, in the case of an amendment, by the Company and Investors holding at least two thirds of the outstanding principal amount of the Notes or, in the case of a waiver, by the party against whom enforcement of any such waiver is sought.  No waiver of any default with respect to any provision, condition or requirement of this Agreement shall be deemed to be a continuing waiver in the future or a waiver of any subsequent default or a waiver of any other provision, condition or requirement hereof, nor shall any delay or omi ssion of either party to exercise any right hereunder in any manner impair the exercise of any such right.

7.3           Construction.  The headings herein are for convenience only, do not constitute a part of this Agreement and shall not be deemed to limit or affect any of the provisions hereof.  The Recitals set forth above are incorporated by reference into the body of this Agreement.  The language used in this Agreement will be deemed to be the language chosen by the parties to express their mutual intent, and no rules of strict construction will be applied against any party.  This Agreement shall be construed as if drafted jointly by the parties, and no presumption or burden of proof shall arise favoring or disfavoring any p arty by virtue of the authorship of any provisions of this Agreement or any of the other Transaction Documents.

7.4           Successors and Assigns.  The terms and conditions of this Agreement shall inure to the benefit of and be binding upon the respective successors and permitted assigns of the parties.  Nothing in this Agreement, express or implied, is intended to confer upon any party other than the parties hereto or their respective successors and permitted assigns any rights, remedies, obligations or liabilities under or by reason of this Agreement, except as expressly provided in this Agreement.

7.5           Governing Law; Dispute Resolution.  All questions concerning the construction, validity, enforcement and interpretation of the Transaction Documents shall be governed by and construed and enforced in accordance with the laws of the State of New York, without regard to the principles of conflicts of law that would require or permit the application of the laws of any other jurisdiction.  If either party shall commence an action or proceeding to enforce any provisions of the Transaction Documents, then the prevailing party in such action or proceeding shall be reimbursed by the other party for its reasonable attorneys’ fees and other costs and expenses reasonably incurred in connection with the investigation, preparation and prosecution of such action or proceeding.

7.6           Survival.  The representations and warranties contained herein shall survive the Closing and the delivery and exercise of the Securities.

7.7           Execution.  This Agreement may be executed in two or more counterparts, all of which when taken together shall be considered one and the same agreement and shall become effective when counterparts have been signed by each party and delivered to the other party, it being understood that both parties need not sign the same counterpart.  In the event that any signature is delivered by facsimile transmission or in a PDF by e-mail transmission, such signature shall create a valid and binding obligation of the party executing (or on whose behalf such signature is executed) with the same force and effect as if such facsimile signature pa ge were an original thereof.

7.8           Severability.  If any provision of this Agreement is held to be invalid or unenforceable in any respect, the validity and enforceability of the remaining terms and provisions of this Agreement shall not in any way be affected or impaired thereby and the parties will attempt to agree upon a valid and enforceable provision that is a reasonable substitute therefor, and upon so agreeing, shall incorporate such substitute provision in this Agreement.

7.9           Replacement of Securities.  If any certificate or instrument evidencing any Securities is mutilated, lost, stolen or destroyed, the Company shall issue or cause to be issued in exchange and substitution for and upon cancellation thereof, or in lieu of and substitution therefor, a new certificate or instrument, but only upon receipt of evidence reasonably satisfactory to the Company of such loss, theft or destruction and customary and reasonable indemnity, if requested.  The applicants for a new certificate or instrument under such circumstances shall also pay any reasonable third-party costs associated with the issuance of such re placement Securities.

7.10           Remedies.  In addition to being entitled to exercise all rights provided herein or granted by law, including recovery of damages, Investor shall be entitled to specific performance under the Transaction Documents.  The parties agree that monetary damages may not be adequate compensation for any loss incurred by Investor by reason of any breach of the obligations of the Company described herein, and the Company hereby agrees to waive, in any action for specific performance, the defense that a remedy at law would be adequate.  Investor shall not be liable for special, indirect, consequential or punitive damages suffered o r alleged to be suffered by the Company or any third party, whether arising from or related to the Transaction Documents or otherwise.

7.11           Payment Set Aside.  To the extent that the Company makes a payment or payments to Investor pursuant to any Transaction Document or Investor enforces or exercises its rights thereunder, and such payment or payments or the proceeds of such enforcement or exercise or any part thereof are subsequently invalidated, declared to be fraudulent or preferential, set aside, recovered from, disgorged by or are required to be refunded, repaid or otherwise restored to the Company, a trustee, receiver or any other person under any law (including, without limitation, any bankruptcy law, state or federal law, common law or equitable cause of action), then to the extent of any such restoration the obligation or part thereof originally intended to be satisfied shall be revived and continued in full force and effect as if such payment had not been made or such enforcement or setoff had not occurred.

7.12           Liquidated Damages.  The Company’s obligations to pay any liquidated damages or other amounts owing under the Transaction Documents is a continuing obligation of the Company and shall not terminate until all unpaid liquidated damages and other amounts have been paid notwithstanding the fact that the instrument or security pursuant to which such liquidated damages or other amounts are due and payable shall have been cancelled.

7.13           Time of the Essence.  Time is of the essence with respect to all provisions of this Agreement that specify a time for performance.

7.14           Construction.  The parties agree that each of them and/or their respective counsel has reviewed and had an opportunity to revise the Transaction Documents and, therefore, the normal rule of construction to the effect that any ambiguities are to be resolved against the drafting party shall not be employed in the interpretation of the Transaction Documents or any amendments hereto. The language used in this Agreement will be deemed to be the language chosen by the parties to express their mutual intent, and no rules of strict construction will be applied against any party.

7.15           Independent Nature of Investors’ Obligations and Rights.  The obligations of each of the Investors under any Transaction Document are several and not joint with the obligations of any other Investor, and no Investor shall be responsible in any way for the performance of the obligations of any other Investor under any Transaction Document.  The decision of each Investor to purchase Securities pursuant to the Transaction Documents has been made by such Investor independently of any other Investor.  Nothing contained herein or in any other Transaction Document, and no action taken by any Investor pursuant hereto or t hereto, shall be deemed to constitute the Investors, collectively or in part, as a partnership, an association, a joint venture or any other kind of entity, or create a presumption that the Investors are in any way acting in concert or as a group with respect to such obligations or the transactions contemplated by the Transaction Documents.  Each Investor acknowledges that no other Investor has acted as agent for such Investor in connection with making its investment hereunder and that no Investor will be acting as agent of such Investor in connection with monitoring its investment in the Securities or enforcing its rights under the Transaction Documents.  Each Investor shall be entitled to independently protect and enforce its rights, including without limitation the rights arising out of this Agreement or out of the other Transaction Documents, and it shall not be necessary for any other Investor to be joined as an additional party in any proceeding for such purpose.

7.16           Entire Agreement.  This Agreement, together with the exhibits and schedules hereto, contains the entire agreement and understanding of the parties, and supersedes all prior and contemporaneous agreements, term sheets, letters, discussions, communications and understandings, both oral and written, which the parties acknowledge have been merged into this Agreement.  No party, representative, attorney or agent has relied upon any collateral contract, agreement, assurance, promise, understanding or representation not expressly set forth hereinabove.  The parties hereby expressly waive all rights and remedies, at law and in equity, directly or indirectly arising out of or relating to, or which may arise as a result of, any Person’s reliance on any such assurance.

IN WITNESS WHEREOF, the parties hereto have caused this Securities Purchase Agreement to be duly executed by their respective authorized signatories as of the date first written above.

COMPANY:

HYTHIAM, INC.

By:	/s/ PETER L. DONATO
Its:	Chief Financial Officer

[INVESTOR SIGNATURE PAGE ATTACHED]

INVESTOR SIGNATURE PAGE

By its execution and delivery of this signature page, the undersigned Investor hereby agrees to be bound by the terms and conditions of the foregoing Securities Purchase Agreement with Hythiam, Inc., as to the Purchase Price set forth below, and authorizes this signature page to be attached to the Agreement or counterpart thereof.

	Name of Investor:
	By:
	Name:
	Title:
	Address:
	Telephone No.:
	Facsimile No.:
	Email Address:
Purchase Price: $
Number of Shares:
Principal amount of Note: $

Schedule 3.1

$214,912 of the amount shown on the Company’s balance sheet as accrued compensation and benefits is being satisfied in Securities.

Exhibit A

Form of Note

(See Attached)

EX-10.34

EXHIBIT 10.34

THIS NOTE AND THE SECURITIES ISSUABLE UPON CONVERSION OF THIS NOTE HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE “SECURITIES ACT”), OR QUALIFIED UNDER ANY STATE SECURITIES LAW, AND MAY NOT BE OFFERED FOR SALE OR SOLD UNLESS A REGISTRATION STATEMENT UNDER THE SECURITIES ACT AND APPLICABLE STATE SECURITIES LAWS SHALL BE EFFECTIVE WITH RESPECT THERETO OR AN EXEMPTION FROM REGISTRATION UNDER THE SECURITIES ACT AND/OR QUALIFICATION UNDER APPLICABLE STATE SECURITIES LAWS IS AVAILABLE IN CONNECTION WITH SUCH OFFER OR SALE. THIS NOTE DOES NOT REQUIRE PHYSICAL SURRENDER HEREOF IN ORDER TO EFFECT A PARTIAL PAYMENT, REDEMPTION OR CONVERSION HEREOF.  ACCORDINGLY, THE OUTSTANDING PRINCIPAL AMOUNT OF THIS NOTE MAY BE LESS THAN THE PRINCIPAL AMOUNT SHOWN BELOW.

HYTHIAM, INC.

SECURED CONVERTIBLE PROMISSORY NOTE

Issue Date: November __, 2010 $[__________]

FOR VALUE RECEIVED, HYTHIAM, INC., a Delaware corporation (the “Company”), hereby promises to pay to the order of [____________], or its successors or assigns (the “Holder”) the sum of $[_________]) in same day funds on or before the two-year anniversary of the Issue Date (the “Maturity Date”), unless this Secured Convertible Promissory Note (this “Note”) is earlier converted pursuant to Section 3 hereof.

The following terms shall apply to this Note:

1.DEFINITIONS.

“Applicable Interest Rate” means an annual rate equal to twelve percent (12%) prior to any Event of Default, and twenty percent (20%) after the occurrence of any Event of Default until such Event of Default is cured, computed on the basis of a 365-day year and calculated using the actual number of days elapsed since the Issue Date or the date on which Interest was most recently paid.

“Business Day” means any day other than a Saturday, a Sunday or a day on which the New York Stock Exchange is closed or on which banks are authorized by law to close in New York, New York.

“Common Stock” means the common stock of the Company, $0.0001 par value per share, and any securities into which such common stock may hereafter be reclassified.

“Conversion Date” means the date that a Reverse Stock Split has occurred.

“Highest Lawful Rate” means the maximum non-usurious rate of interest, as in effect from time to time, which may be charged, contracted for, reserved, received or collected by the Holder in connection with this Note under applicable law.

“Issue Date” means the date first written above.

“Maturity Date” has the meaning set forth in the preamble of this Note.

“Notes” means the notes issued pursuant to the Purchase Agreements.

“Conversion Price” means $0.01 per share of Common Stock.

“Reverse Stock Split” means a reverse stock split (the “Reverse Stock Split”), in a ratio to be determined in the sole discretion of the Board of Directors of the Company, which must be approved by the holders of more than 50% of the then outstanding Common Stock.

1

“Purchase Agreements” means those certain Securities Purchase Agreements dated as of the date hereof by and between the Company and the investors signatory thereto; “Purchase Agreement” means the Securities Purchase Agreement dated as of the date hereof between the Company and the Holder.

All definitions contained in this Note are equally applicable to the singular and plural forms of the terms defined.  The words “hereof,” “herein” and “hereunder” and words of similar import referring to this Note refer to this Note as a whole and not to any particular provision of this Note.  Any capitalized term used but not defined herein has the meaning specified in the Purchase Agreement.

INTEREST.

(a)           Interest Rate.  This Note shall bear interest on the unpaid principal amount hereof (“Interest”) at a rate per annum equal to the Applicable Interest Rate.

(b)           Interest Payments.  The Company shall pay accrued and unpaid Interest (unless this Note is converted pursuant to the terms hereof) (i) on the Maturity Date and (ii) on any date on which the entire principal amount of this Note is paid in full (whether through conversion or otherwise).  The Company shall pay Interest either (i) in cash by wire transfer of immediately available funds or (ii) in shares of Common Stock.

CONVERSION.

(c)           Conversion upon Reverse Stock Split.  Upon a Reverse Stock Split, the Note shall be automatically converted into such number of shares of Common Stock (a “Conversion”) up to the entire unpaid principal amount of this Note, together with any Interest accrued but unpaid thereon, divided by the Conversion Price.  Upon a Conversion, the Holder shall be entitled to receive, and shall be issued, a certificate representing the number of shares of Common Stock into which the Note is automatically converted (the “Conve rsion Shares”).

(d)           Conversion Mechanics.  The Holder shall not be required to physically surrender this Note to the Company in order for the Conversion to take effect.  Upon a Conversion, the Holder shall be deemed to be the holder of record of the Conversion Shares upon the Conversion Date.  As soon as practicable after the Conversion Date, the Company shall, at its expense, issue and deliver to Holder, one or more certificates (bearing such legends as are required by applicable state and federal securities laws in the opinion of counsel to the Company) for the applicable Conversion Shares, registered in the name of Holder, free of any an d all liens, encumbrances or other impediments to clear title.  No fractional Conversion Shares shall be issued upon conversion of this Note, and any fractional Conversion Shares to which the Holder would otherwise be entitled shall be rounded up to the nearest whole Conversion Share and issued to the Holder along with the other Conversion Shares.  Upon the Conversion or payment, as applicable, of all amounts due Holder in accordance with this terms of this Note, this Note shall be cancelled and no further amounts shall be due hereunder.

(e)            Adjustment of Conversion Price.  Until the Note has been paid in full or converted in full, the Conversion Price shall be subject to adjustment from time to time as follows (but shall not be increased, other than pursuant to Section 3(c)(i) hereof):

(i)           Adjustments for Stock Splits and Combinations.  If the Company shall at any time or from time to time after the Issue Date effect a stock split of the outstanding Common Stock, the applicable Conversion Price in effect immediately prior to the stock split shall be proportionately decreased. If the Company shall at any time or from time to time after the Issue Date, combine the outstanding shares of Common Stock, the applicable Conversion Price in effect immediately prior to the combination shall be proportionately increased. Any adjustments under this Section 3(c)(i) shall be effective at the close of business on the date the stock split or combination occurs.

(ii)           Adjustments for Certain Dividends and Distributions.  If the Company shall at any time or from time to time after the Issue Date make or issue or set a record date for the determination of holders of Common Stock entitled to receive a dividend or other distribution payable in shares of Common Stock, then, and in each event, the applicable Conversion Price in effect immediately prior to such event shall be decreased as of the time of such issuance or, in the event such record date shall have been fixed, as of the close of business on such record date, by multiplying the applicable Conversion Price then in effect by a fraction:

2

(A) the numerator of which shall be the total number of shares of Common Stock issued and outstanding immediately prior to the time of such issuance or the close of business on such record date; and

(B) the denominator of which shall be the total number of shares of Common Stock issued and outstanding immediately prior to the time of such issuance or the close of business on such record date plus the number of shares of Common Stock issuable in payment of such dividend or distribution.

(iii)           Adjustment for Other Dividends and Distributions.  If the Company shall at any time or from time to time after the Issue Date make or issue or set a record date for the determination of holders of Common Stock entitled to receive a dividend or other distribution payable in other than shares of Common Stock, then, and in each event, an appropriate revision to the applicable Conversion Price shall be made and provision shall be made (by adjustments of the Conversion Price or otherwise) so that the holders of this Note shall receive upon conversions thereof, in addition to the number of shares of Common Stock receivable thereon, the number of securities of the Company or other issuer (as appli cable) or other property that they would have received had this Note been converted into Common Stock on the date of such event and had thereafter, during the period from the date of such event to and including the Conversion Date, retained such securities (together with any distributions payable thereon during such period) or assets, giving application to all adjustments called for during such period under this Section 3(c)(iii) with respect to the rights of the holders of the Notes; provided, however, that if such record date shall have been fixed and such dividend is not fully paid or if such distribution is not fully made on the date fixed therefor, the Conversion Price shall be adjusted pursuant to this paragraph as of the time of actual payment of such dividends or distributions.

(iv)           Adjustments for Reclassification, Exchange or Substitution.  If the Common Stock at any time or from time to time after the Issue Date shall be changed to the same or different number of shares or other securities of any class or classes of stock or other property, whether by reclassification, exchange, substitution or otherwise (other than by way of a stock split or combination of shares or stock dividends provided for in Sections 3(c)(i), (ii) and (iii)), then, and in each event, an appropriate revision to the Conversion Price shall be made and provisions shall be made (by adjustments of the Conversion Price or otherwise) so that the Holder shall have the right thereafter to convert this N ote into the kind and amount of shares of stock or other securities or other property receivable upon reclassification, exchange, substitution or other change, by holders of the number of shares of Common Stock into which such Note might have been converted immediately prior to such reclassification, exchange, substitution or other change, all subject to further adjustment as provided herein.

(v)           Adjustments for Issuance of Additional Shares of Common Stock.  In the event the Company shall at any time or from time to time issue or sell any additional shares of Common Stock (otherwise than as provided in the foregoing subsections (i) through (iv) of this Section 3(c) or pursuant to Common Stock Equivalents (hereafter defined) granted or issued prior to the Issue Date) other than Excluded Stock (as defined herein) (“Additional Shares of Common Stock”), at an effective price per share less than the Conversion Price then in effect or without consideration, then the Conversion Price upon each such issuance shall be reduced to a price equal to a price equal to the amount determined by multiplying the Conversion Price by a fraction: (A) the numerator of which shall be (x) the total number of shares of Common Stock outstanding (including shares of Common Stock issuable upon exercise or conversion of outstanding options, warrants and convertible securities) immediately prior to such issuance of Additional Shares of Common Stock, plus (y) the number of shares of Common Stock which the net aggregate consideration, if any, received by the Company upon such issuance of Additional Shares of Common Stock would purchase at the Conversion Price in effect immediately prior to such issuance; and (B) the denominator of which shall be (x) total number of shares of Common Stock outstanding (including shares of Common Stock issuable upon exercise or conversion of outstanding options, warrants and convertible securities) immediately prior to such issuance of Additional Shares of Common Stock, plus (y) the number of additional shares of Common S tock issued as part of such issuance of Additional Shares of Common Stock.  “Excluded Stock” shall mean (A) shares of Common Stock issued (or issuable upon exercise of rights, options or warrants outstanding from time to time) granted or issued to officers, directors or employees of, or consultants to, the Company pursuant to a stock grant, stock option plan, employee stock purchase plan, restricted stock plan or other similar plan, in each case as approved by the Company’s Board of Directors, (B) shares of Common Stock issued (or issuable upon exercise of rights, options or warrants outstanding from time to time) granted or issued to financial institutions, equipment lessors, brokers or similar persons in connection with commercial credit arrangements, equipment financings, commercial property lease transactions or similar transactions, (C) securities issued in connection with a strategic alliance, acquisition or similar transaction, (D) shares of Common Stock issued (or issuable upon exercise of rights, options or warrants outstanding from time to time) for bona fide services; or (E) shares issued or issuable as a result of any stock split, combination, dividend, distribution, reclassification, exchange or substitution.

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(vi)           Issuance of Common Stock Equivalents.  The provisions of this Section 3(c) shall apply if (a) the Company, at any time after the Issue Date, shall issue any securities convertible into or exchangeable for, directly or indirectly, Common Stock (“Convertible Securities”), other than the Notes, or (b) any rights or warrants or options to purchase any such Common Stock or Convertible Securities (collectively, the “Common Stock Equivalents”) shall be issued or sold. If the price per share for which Additional Shares of Common Stock may be issuable pursuant to any such Common Stock Equivalent shall be less than the applicable Conversion Price then in effect, or if, after any such issuance of Common Stock Equivalents, the price per share for which Additional Shares of Common Stock may be issuable thereafter is amended or adjusted, and such price as so amended shall be less than the applicable Conversion Price in effect at the time of such amendment or adjustment, then the applicable Conversion Price upon each such issuance or amendment shall be adjusted as provided in subsection (v) of this Section 3(c).  In the case of the issuance, sale, distribution or granting of any rights or warrants or options as part of a unit consisting of such rights or warrants or options and Common Stock and/or Convertible Securities, then for purposes of calculating any adjustment pursuant to subsection (v) of this Section 3(c), no value shall be attributed to such rights, warrants or options in allocating the price paid for the unit among the securities comprising such unit.

(vii)           Consideration for Stock.  In case any shares of Common Stock or any Common Stock Equivalents shall be issued or sold:

(A)           in connection with any merger or consolidation in which the Company is the surviving corporation (other than any consolidation or merger in which the previously outstanding shares of Common Stock of the Company shall be changed to or exchanged for the stock or other securities of another corporation), the amount of consideration therefor shall be, deemed to be the fair value, as determined reasonably and in good faith by the Board of Directors of the Company, of such portion of the assets and business of the nonsurviving corporation as such Board may determine to be attributable to such shares of Common Stock, Convertible Securities, rights or warrants or options, as the case may be; or

(B)           in the event of any consolidation or merger of the Company in which the Company is not the surviving corporation or in which the previously outstanding shares of Common Stock of the Company shall be changed into or exchanged for the stock or other securities of another corporation, or in the event of any sale of all or substantially all of the assets of the Company for stock or other securities of any corporation, the Company shall be deemed to have issued a number of shares of its Common Stock for stock or securities or other property of the other corporation computed on the basis of the actual exchange ratio on which the transaction was predicated, and for a consideration equal to the fair market value on the date of such transaction of all such stock or securitie s or other property of the other corporation. If any such calculation results in adjustment of the applicable Conversion Price, or the number of shares of Common Stock issuable upon conversion of the Notes, the determination of the applicable Conversion Price or the number of shares of Common Stock issuable upon conversion of the Notes immediately prior to such merger, consolidation or sale, shall be made after giving effect to such adjustment of the number of shares of Common Stock issuable upon conversion of the Notes. In the event Common Stock is issued with other shares or securities or other assets of the Company for consideration which covers both, the consideration computed as provided in this Section 3(c)(vii) shall be allocated among such securities and assets as determined in good faith by the Board of Directors of the Company.

(f)           Record Date.  In case the Company shall take record of the holders of its Common Stock for the purpose of entitling them to subscribe for or purchase Common Stock or Convertible Securities, then the date of the issue or sale of the shares of Common Stock shall be deemed to be such record date.

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EVENTS OF DEFAULT.  Upon the occurrence of any of the following events (each, an “Event of Default”):

(g)           the Company or any of its Subsidiaries shall (i) apply for or consent to the appointment of a receiver, trustee or liquidator of itself or of its property, (ii) be unable, or admit in writing its inability, to pay its debts as they mature, (iii) make a general assignment for the benefit of creditors, (iv) be adjudicated a bankrupt or insolvent, (v) file a voluntary petition in bankruptcy, or a petition or answer seeking reorganization or an arrangement with creditors to take advantage of any insolvency law, or an answer admitting the material allegations of a bankruptcy, reorganization or insolvency petition filed against it, (vi) take corporate action for the purpose of effecting any of the foregoing, or (vii) ha ve an order for relief entered against it in any proceeding under the United States Bankruptcy Code;

(h)           an order, judgment or decree shall be entered, without the application, approval or consent of the Company or any of its Subsidiaries, by any court of competent jurisdiction, approving a petition seeking reorganization of the Company or any of its Subsidiaries, or appointing a receiver, trustee or liquidator of the Company or any of its Subsidiaries, or of all or a substantial part of its assets, and such order, judgment or decree shall not be dismissed within thirty (30) consecutive days thereof;

(i)            the Company or any of its Subsidiaries shall fail to pay as and when due any principal or Interest hereunder, and such failure to pay continues uncured for thirty (30) days after receipt of notice thereof;

(j)            the Company breaches any condition or obligation under this Note, the Transaction Documents, or any other outstanding indebtedness of the Company, and such breach continues uncured for thirty (30) days after receipt of notice thereof; or

(k)           the Company or any of its Subsidiaries shall cease its business operations;

then, upon any such event, the Company shall redeem this Note at a redemption price equal to the greater of (i) the outstanding principal amount of this Note and (ii) the fair market value of the Common Stock that would have been acquired upon a Conversion, such fair market value to be determined by an independent third party approved by the Company’s Board of Directors (the “Redemption”), and such Redemption shall not impair any or all of the Holder’s other rights and remedies available to the Holder under applicable law.

HOLDER COSTS. The Company agrees to promptly pay, on demand, all of the reasonable losses, costs, and expenses (including, without limitation, reasonable attorneys’ fees and disbursements) which the Holder incurs in connection with enforcement of this Note, or the protection or preservation of the Holder’s rights under this Note, whether by judicial proceeding or otherwise, except that the Company shall be reimbursed for any such costs, fees and expenses if it is subsequently determined by a court that Holder is not entitled to such enforcement.  Such costs and expenses include, without limitation, those incurred in connection with any workout or refinancing, or any bankruptcy , insolvency, liquidation or similar proceedings.

PREPAYMENT. This Note may not be prepaid, in whole or in part, at any time.

COMPANY WAIVERS. The Company hereby waives diligence, demand, presentment, protest or notice of any kind.  The Company agrees to make all payments under this Note without setoff or deduction and regardless of any counterclaim or defense.

SECURITY.

(a)           Security Interest.  As security for the due and prompt payment and performance of all payment obligations under this Note and any modifications, replacements and extensions hereof (collectively, “Secured Obligations”), the Company hereby pledges and grants a security interest to the Holder in all assets of the Company, whether now owned or hereafter acquired, including without limitation all intellectual property, as more fully set forth on Schedule 1 hereto   (collectively, the “Collateral”).  All rights granted hereby in the Collateral are on a pari passu basis with the security interests on the assets of the Company held by Socius Capital Gro up, LLC and Esousa Holdings, LLC pursuant to the Securities Purchase Agreements entered into by them with the Company, dated October 19, 2010, and the related transaction documents.

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(b)           Financing Statement; Further Assurances.  The Company agrees, concurrently with executing this Note, that the Holder may file a UCC-1 financing statement relating to the Collateral in favor of the Holder, and any similar financing statements in any jurisdiction in which the Holder reasonably determines such filing to be necessary.  The Company further agrees that at any time and from time to time the Company shall promptly execute and deliver all further instruments and documents that the Holder may request in order to perfect and protect the security interest granted hereby, or to enable the Holder to exercise and enforce its rights and remedies with respect to any Collateral follow ing an Event of Default.

(c)           Default.  Following an Event of Default, and, if a Redemption has not occurred, the Company shall deliver the Collateral, including original certificates or other instruments representing any Collateral, to the Holder to hold as secured party, and Company shall, if requested by the Holder, execute a securities account control agreement. In addition, the Holder shall have all rights of a secured party under the Uniform Commercial Code, including without limitation the right to foreclose on all or any of the Collateral, in any order.

(d)           Powers of the Holder.  The Company hereby appoints the Holder as Company’s true and lawful attorney-in-fact to perform any and all of the following acts, which power is coupled with an interest, is irrevocable until the Secured Obligations are paid and performed in full, and may be exercised from time to time by the Holder in its discretion: To take any action and to execute any instrument which the Holder may deem reasonably necessary or desirable to accomplish the purposes of this Section 8(d) and, more broadly, this Note including, without limitation: (i) during the continuance of any Event of Default hereunder, to receive, endorse and collect all instruments or other forms of payment made payable to the Company representing any dividend, interest payment or other distribution in respect of the Collateral or any part thereof and to give full discharge for the same, when and to the extent permitted by this Note, (ii) to perform or cause the performance of any obligation of the Company hereunder in the Company’s name or otherwise, (iii) during the continuance of any Event of Default hereunder, to liquidate any Collateral pledged to the Holder hereunder and to apply proceeds thereof to the payment of the Secured Obligations or to place such proceeds into a cash collateral account or to transfer the Collateral into the name of the Holder, all at the Holder’s sole discretion, (iv) to enter into any extension, reorganization or other agreement relating to or affecting the Collateral, and, in connection therewith, to deposit or surrender control of the Collateral, (v) to accept other property in exchange for the Collateral, (vi) to make any compromise or settlement the Holder deems desirable or proper, and (vii) to execute on the Company’s behalf and in the Company’s name any documents required in order to give the Holder a continuing first lien upon the Collateral or any part thereof.

(e)           Full Recourse Note.  This is a full recourse Note. Accordingly, notwithstanding that the Company’s obligations under this Note are secured by the Collateral, in the event of a material default hereunder, the Holder shall have full recourse to all the other assets of Company.  Moreover, the Holder shall not be required to proceed against or exhaust any Collateral, or to pursue any Collateral in any particular order, before the Holder pursues any other remedies against Company or against any of Company’s assets.

MISCELLANEOUS.

(l)            Notices.  Any and all notices or other communications or deliveries required or permitted to be provided hereunder shall be in writing, shall be given at the addresses set forth in the Purchase Agreement, and shall be deemed given and effective on the earliest of (i) the date of transmission, if such notice or communication is delivered via facsimile at the facsimile number specified in this Section, or via electronic mail, prior to 6:30 p.m. (New York City time) on a Trading Day and an electronic confirmation of delivery is received by the sender, (ii) the next Trading Day after the date of transmission, if such notice or communication is delivered via facsimile at the facsimile number specified in this Section on a day that is not a Trading Day or later than 6:30 p.m. (New York City time) on any Trading Day, (iii) the Trading Day following the date of mailing, if sent by nationally recognized overnight courier service, or (iv) upon actual receipt by the party to whom such notice is required to be given by personal delivery.

(m)          Amendments; Waivers; No Oral Changes.  No provision of this Note may be waived or amended except in a written instrument signed by the Company and the holders of 66 2/3% of the outstanding principal of the Notes.  No waiver of any default with respect to any provision, condition or requirement of this Note shall be deemed to be a continuing waiver in the future or a waiver of any subsequent default or a waiver of any other provision, condition or requirement hereof, nor shall any delay or omission of either party to exercise any right hereunder in any manner impair the exercise of any such right.

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(n)           Lost or Stolen Note.  Upon receipt by the Company of evidence of the loss, theft, destruction or mutilation of this Note, and (in the case of loss, theft or destruction) of indemnity or security reasonably satisfactory to the Company, and upon surrender and cancellation of this Note, if mutilated, the Company shall execute and deliver to the Holder a new Note identical in all respects to this Note.

(o)           Governing Law.  This Note shall be governed by and construed in accordance with the laws of the State of New York applicable to contracts made and to be performed entirely within the State of New York, without giving effect to conflict of law principles thereof.

(p)           Headings.  The headings in this Note are for purposes of reference only, and shall not limit or otherwise affect the meaning hereof.

(q)           Transfer; Successors and Assigns.  The terms of this Note shall inure to the benefit of and bind the parties hereto and their successors and assigns.  As used herein the term “Company” shall include the undersigned Company and any other person or entity who may subsequently become liable for the payment hereof; provided however, that the Company shall not have the right to assign this Note or its obligations or rights hereunder without the prior written consent of the Holder.  The term “Holder” shall include the named Holder as well as any other person or entity to whom this Note or any interest i n this Note is conveyed, transferred or assigned.  The person signing this Note on behalf of the Company represents and warrants that he or she has full authority to do so and that this Note binds the Company in accordance with its terms, and that there are no other agreements, judgments, or other circumstances which would cause this Note to not be fully binding against the Company.  In the event Holder takes any action to enforce any provision of this Note, either through legal proceedings or otherwise, the Company shall reimburse the Holder for attorneys’ fees and all other costs and expenses so incurred.

(r)           Usury.  Anything herein to the contrary notwithstanding, if during any period for which interest is computed hereunder the amount of interest, together with all fees, charges and other payments which are treated as interest under applicable law, as provided for herein or in any other document executed in connection herewith, would exceed the amount of such interest computed on the basis of the Highest Lawful Rate, the Company shall not be obligated to pay, and the Holder shall not be entitled to charge, collect, receive, reserve or take, interest in excess of the Highest Lawful Rate.

IN WITNESS WHEREOF, the Company has caused this Note to be signed in its name by its duly authorized officer on the date first above written.

HYTHIAM, INC.

By:	/s/ PETER L. DONATO
	Peter L. Donato
	Chief Financial Officer

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EX-10.35

EXHIBIT 10.35

SECURITY INTEREST AGREEMENT

This Security Interest Agreement(“Security Agreement”), dated as of November __, 2010, by and among the Persons listed on the signature page hereto (individually, a “Secured Party” and collectively, the “Secured Parties”), and Hythiam, Inc., a Delaware corporation (the “Debtor”).

RECITALS

WHEREAS, reference is made to (i) the Securities Purchase Agreements dated as of October 19, 2010 and of even date herewith (collectively, the “Purchase Agreements”) to which the Debtor and Secured Parties are parties, and (ii) the Transaction Documents (as defined in the Purchase Agreements), including, without limitation, the Notes.  Capitalized terms not otherwise defined herein shall have the meanings ascribed to them in the relevant Transaction Documents.

WHEREAS, pursuant to the Transaction Documents, the Debtor has certain obligations to each of the Secured Parties (all such obligations under all Transaction Documents, the “Obligations”).

WHEREAS, the Debtor has determined that it shall benefit from the execution of the Transaction Documents and the transactions contemplated thereby. In furtherance thereof, and not in limitation thereof, the Debtor has deemed that the execution and delivery of this Security Agreement to which it is a party, and the Debtor’s performance of its obligations under it, to be necessary and convenient to the conduct, promotion or attainment of the business of the Debtor from the Purchase Agreement or otherwise.

WHEREAS, in order to induce the Secured Parties to execute and deliver the Transaction Documents and to make the payments to the Debtor contemplated thereby, and as contemplated by the Purchase Agreement and the Notes, the Debtor has agreed to grant to the Secured Parties a security interest in the Collateral (as defined below) to secure the due and punctual fulfillment of the Obligations. The Secured Parties are willing to enter into the Purchase Agreement and the other Transaction Documents only upon receiving the Debtor’s execution of this Security Agreement.

NOW, THEREFORE, in consideration of the premises, the mutual covenants and conditions contained herein, and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereto hereby agree as follows:

ARTICLE I.

GRANT OF SECURITY INTEREST

1.1.           In order to secure the due and punctual fulfillment of the Obligations, the Debtor hereby grants, conveys, transfers and assigns to the Secured Parties (and to each of them based on their respective Allocable Shares, as defined below), on a pari passu non-preferential basis, a continuing security interest in the Collateral.

1.2.           For purposes of this Agreement, the following terms shall have the meanings indicated:

“Collateral” is all right, title and interest of Debtor in and to all of the following, whether now owned or hereafter arising or acquired and wherever located: All assets of the Debtor, including, but not limited to: all personal and fixture property of every kind and nature, including without limitation all goods (including inventory, equipment and any accessions thereto), instruments (including promissory notes), documents, accounts (including accounts receivable), chattel paper (whether tangible or electronic), deposit accounts, letter-of-credit rights (whether or not the letter of credit is evidenced by a writing), commercial tort claims, Securities and all other investment property, supporting obligations, any other contract rights or rights to the payment of mo ney, insurance claims and proceeds, and all general intangibles (including all payment intangibles); all Equipment; all Intellectual Property; and any and all claims, rights and interests in any of the above, and all guaranties and security for any of the above, and all substitutions and replacements for, additions, accessions, attachments, accessories, and improvements to, and proceeds (including proceeds of any insurance policies, proceeds of proceeds and claims against third parties) of, any and all of the above, and all Debtor’s books relating to any and all of the above and includes, without limiting the generality of the above, the Intellectual Property listed in the attached Exhibit B.

“Code” is the Uniform Co1mmercial Code, in effect in the State of Delaware as in effect from time to time.

“Copyrights” are all copyrights, copyright rights, applications or registrations and like protections in each work or authorship or derivative work, whether published or not (whether or not it is a trade secret) now or later existing, created, acquired or held.

“Equipment” has the meaning set forth in the Code and includes all present and future machinery, equipment, tenant improvements, furniture, fixtures, vehicles, tools, parts and attachments in which Debtor has any interest.

“Intellectual Property” is all present and future (a) Copyrights, (b) trade secret rights, including all rights to unpatented inventions and know-how, and confidential information; (c) Patents; (d) Trademarks; (e) computer software and computer software products; (f) designs and design rights; (g) technology; (h) all claims for damages by way of past, present and future infringement of any of the rights included above; and (i) all licenses or other rights to use any property or rights of a type described above; a schedule of Intellectual Property and a schedule of Intellectual Property applications is provided in Exhibit B, but such listing shall not limit the Secured Party’s interest in any other Intellect ual Property or Intellectual Property applications.

“Lien” means a lien, charge, security interest, encumbrance, right of first refusal, preemptive right or other restriction other than a Permitted Lien.

“Patents” are patents, patent applications and like protections, including improvements, divisions, continuations, renewals, reissues, extensions and continuations ­in-part of the same.

“Permitted Liens” means the individual and collective reference to the following: (a) Liens for taxes, assessments and other governmental charges or levies not yet due or Liens for taxes, assessments and other governmental charges or levies being contested in good faith and by appropriate proceedings for which adequate reserves (in the good faith judgment of the management of the Company) have been established in accordance with GAAP; (b) carriers’, warehousemen’s and mechanics’ Liens, statutory landlords’ Liens, and other similar Liens, arising in the ordinary course of the Company’s business, and which (x) do not individually or in the aggregate materially detract from the value of such property or assets or materially impair the use th ereof in the operation of the business of the Company and its consolidated subsidiaries or (y) are being contested in good faith by appropriate proceedings, which proceedings have the effect of preventing for the foreseeable future the forfeiture or sale of the property or asset subject to such Lien; and (c) the security interest on the assets of the Company held by Socius Capital Group, LLC and Esousa Holdings, LLC pursuant to the Securities Purchase Agreements dated October 19, 2010 between them and the Company and the related transactions thereunder.

 “Securities” has the meaning ascribed to it in the Securities Act of 1933, as amended, and includes, but is not necessarily limited to, common stock, preferred stock, warrants, rights and other options, promissory notes or other instruments reflecting obligations of other entities; in furtherance of the foregoing, but not in limitation thereof, the term “Securities” specifically includes the securities listed in the attached Exhibit A.

“Trademarks” are trademarks, servicemarks, trade styles, and trade names, whether or not any of the foregoing are registered, and all applications to register and registrations of the same and like protections, and the entire goodwill of the business of Debtor connected with and symbolized by any such trademarks.

1.3.           The security interests granted pursuant to this Section (the “Security Interests”) are granted as security only and shall not subject any of the Secured Parties to, or transfer or in any way affect or modify, any obligation or liability of the Debtor under any of the Collateral or any transaction which gave rise thereto.

1.4.           The term “Allocable Share” means, with respect to each of the Secured Parties, as of the relevant date, the fraction equal to (i) the outstanding principal of the Notes then held by such Secured Party, divided by (ii) the aggregate outstanding principal of the Notes then held by all Secured Parties.

ARTICLE II.

FILING; FURTHER ASSURANCES

2.1.           The Debtor will, at its expense, cause to be searched the public records with respect to the Collateral and will execute, deliver, file and record (in such manner and form as each of the Secured Parties may require), or permit each of the Secured Parties to file and record. as its attorney in fact, any financing statement, any carbon, photographic or other reproduction of a financing statement or this Security Agreement (which shall be sufficient as a financing statement hereunder), any specific assignments or other paper that may be reasonably necessary or desirable, or that the Secured Parties may request, in order to create, preserve, perfect or validate any Security Interest or to enable ea ch of the Secured Parties to exercise and enforce its rights hereunder with respect to any of the Collateral. The Debtor hereby appoints each Secured Party as Debtor’s attorney-in-fact to execute in the name and behalf of Debtor such additional financing statements as such Secured Party may request.

1.           Secured Parties holding a majority of the aggregate amounts due under the Notes may designate an Agent as provided in the Section titled “Agent” below.  Among other things, any such Agent shall be agent of each Secured Party for execution of and identification on any financing statement or similar instrument referring to or describing the Collateral.

2.           The Agent is authorized to execute and file any and all financing statements desired to be filed by the relevant Secured Party to reflect the security interest in the Collateral in any and all jurisdictions (including the U.S. Patent and Trademark Office). For such purposes, the Debtor irrevocably appoints the Agent, with full power of substitution to execute and file such financing statements naming the Debtor as debtor thereon.

ARTICLE III.

REPRESENTATIONS AND WARRANTIES OF DEBTOR

The Debtor hereby represents and warrants to each Secured Party that, other than with respect to the Permitted Liens, (a) the Debtor is, or to the extent that certain of the Collateral is to be acquired after the date hereof, will be, the owner of the Collateral free from any adverse Lien, security interest or encumbrance; (b) no financing statement covering the Collateral is on file in any public office, other than the financing statements filed pursuant to this Security Agreement; and (c) the statements made in the Recitals of this Security Agreement, which are deemed incorporated herein by reference, are true, accurate and complete.

ARTICLE IV.

COVENANTS OF DEBTOR

The Debtor hereby covenants and agrees with each Secured Party that the Debtor (a) will, at the Debtor’s sole cost and expense, defend the Collateral against all claims and demands of all persons at any time claiming any interest therein junior to the Secured Party’s interest; (b) will provide the Secured Party with prompt written notice of (i) any change in the chief executive officer of the Debtor or the office where the Debtor maintains its books and records pertaining to the Collateral; (ii) the movement or location of all or a material part of the Collateral to or at any address other than the address of Debtor set forth in its public filings with the U.S. Securities and Exchange Commission; and (iii) any facts which constitute a Debtor Event of Default (as such term is defined below), or which, with the giving of not ice and/or the passage of time, could or would constitute a Debtor Event of Default, pursuant to the Section titled “Debtor Events of Default” below; (c) will promptly pay any and all taxes, assessments and governmental charges upon the Collateral prior to the date penalties are attached thereto, except to the extent that such taxes, assessments and charges shall be contested in good faith by the Debtor; (d) will immediately notify the Secured Party of any event causing a substantial loss or diminution in the value of all or any material part of the Collateral and the amount or an estimate of the amount of such loss or diminution; (e) will have and maintain adequate insurance at all times with respect to the Collateral, for such other risks as are customary in the Debtor’s industry for the respective items included in the Collateral, such insurance to be payable to the Secured Party and the Debtor as their respective interests may appear, and shall provide for a minimum of ten (10) days pri or written notice of cancellation to the Secured Party, and Debtor shall furnish the Secured Party with certificates or other evidence satisfactory to the Secured Party of compliance with the foregoing insurance provisions; (f) will not sell or offer to sell or otherwise assign, transfer or dispose of the Collateral or any interest therein, without the prior written consent of the Secured Party, except in the ordinary course of business; (g) except as with respect to the Permitted Liens, will keep the Collateral free from any adverse Lien, security interest or encumbrance and in good order and repair, reasonable wear and tear excepted, and will not waste or destroy the Collateral or any part thereof; and (h) will not use the Collateral in material violation of any statute or ordinance the violation of which could materially and adversely affect the Debtor’s business.

ARTICLE V.

RECORDS RELATING TO COLLATERAL

The Debtor will keep its records concerning the Collateral at its principal office or at such other place or places of business of which the Secured Party shall have been notified in writing no less than ten (10) days prior thereto. The Debtor will hold and preserve such records and chattel paper and will permit representatives of the Secured Party at any time during normal business hours upon reasonable notice to examine and inspect the Collateral and to make abstracts from such records and chattel paper, and will furnish to the Secured Party such information and reports regarding the Collateral as the Secured Party may from time to time request.

ARTICLE VI.

GENERAL AUTHORITY

From and during the term of any Debtor Event of Default, the Debtor hereby appoints the Agent as the Debtor’s lawful attorney, with full power of substitution, in the name of the Debtor, for the sole use and benefit of the Secured Parties, but at the Debtor’s expense, to exercise, all or any of the following powers with respect to all or any of the Collateral:

6.1.           to demand, sue for, collect, receive and give acquittance for any and all monies due or to become due;

6.2.           to receive, take, endorse, assign and deliver all checks, notes, drafts, documents and other negotiable and non-negotiable instruments and chattel paper taken or received by the Secured Parties;

6.3.           to settle, compromise, prosecute or defend any action or proceeding with respect thereto;

6.4.           to sell, transfer, assign or otherwise deal in or with the same or the proceeds thereof or the related goods securing the Collateral, as fully and effectually as if the Secured Parties were the sole and absolute owner thereof;

6.5.           to extend the time of payment of any or all thereof and to make any allowance and other adjustments with reference thereto; and

6.6.           to discharge any taxes, Liens, security interests or other encumbrances at any time placed thereon; provided that the Secured Parties or the Agent shall give the Debtor not less than ten (10) business days prior written notice of the time and place of any sale or other intended disposition of any of the Collateral.

The exercise by the Secured Parties or the Agent of or failure to so exercise any authority granted herein shall in no manner affect Debtor’s liability to the Secured Parties, and provided, further, that the Secured Parties and the Agent shall be under no obligation or duty to exercise any of the powers hereby conferred upon them and they shall be without liability for any act or failure to act in connection with the collection of, or the preservation of, any rights under any of the Collateral and no Secured Party shall be required to proceed against any other person or entity who or which has guaranteed the performance of the Obligations or provided any security therefore before proceeding against Debtor or the Collateral.

ARTICLE VII.

DEBTOR EVENTS OF DEFAULT

7.1.           The Debtor shall be in default under this Security Agreement upon the occurrence of any of the following (each, a “Debtor Event of Default”):

1.           an Event of Default (as defined in the Note);

2.           any representation or warranty made by the Debtor in this Security Agreement shall be false or misleading in any material respect; or

3.           Debtor shall breach any covenant of Debtor in this Security Agreement or in any other document or instrument executed by Debtor in favor of or for the benefit of the Secured Parties as contemplated by any of the Transaction Documents.

7.2.           The Debtor hereby irrevocably agrees that, upon the occurrence of a Debtor Event of Default, the Debtor shall be deemed to have consented to an immediate conveyance and transfer to the Secured Parties of the copyrights and all other rights the Debtor may have in the software included in the Collateral. In furtherance of the foregoing, and not in limitation thereof, the Debtor will, upon the occurrence of a Debtor Event of Default, deliver to the Agent copies of the source code of the relevant software, with accompanying written assignment of the software to the Secured Parties. Without limiting the foregoing, such source code and assignment shall be in form sufficient to enable the Agent to reg ister the software in Secured Parties’ name with the Copyright Register. The Debtor hereby agrees to take all steps necessary or appropriate, as requested by the Secured Parties, to effectuate and reflect such conveyance and transfer or assignment to the Secured Parties. In all events, such conveyance, transfer or assignment shall be deemed to vest title in such software in the Secured Parties.

7.3.           In furtherance of the foregoing and not in limitation thereof, the Debtor acknowledges and agrees that the Secured Parties may, upon the occurrence of a Debtor Event of Default, seek the immediate entry of a preliminary injunction prohibiting the Debtor’s use of such software in any shape, way or manner, including, but not necessarily limited to, through the sale of products that use any of such software, and the Debtor hereby irrevocably agrees that it will not contest an application seeking entry of a preliminary injunction and that it will accept the entry of such injunction.

ARTICLE VIII.

REMEDIES UPON DEBTOR EVENT OF DEFAULT

If any Debtor Event of Default shall have occurred, then in addition to the provisions of Section 7 hereof, any Secured Party may exercise all the rights and remedies of a secured party under the Code. Any Secured Party may require the Debtor to assemble all or any part of the Collateral and make it available to the Secured Party at a place to be designated by the Secured Party. The Secured Party shall give the Debtor ten (10) business days prior written notice of the Secured Party’s intention to make any public or private sale or sale at a broker’s board or on a securities exchange of the Collateral. At any such sale the Collateral may be sold in one lot as an entirety or in separate parcels, as the Secured Party, in its sole discretion, may determine, or, if more than one Secured Party is involved, as such Secured Partie s, in their sole discretion, may determine through good faith negotiation.  The Secured Party shall not be obligated to make any such sale pursuant to any such notice.  The Secured Party may, without notice or publication, adjourn any public or private sale or cause the same to be adjourned from time to time by announcement at the time and place fixed for the sale, and such sale may be made at any time or place to which the same may be adjourned. The Secured Party, instead of exercising the power of sale herein conferred upon it, may proceed by a suit or suits at law or in equity to foreclose the Security Interests and sell the Collateral, or any portion thereof, under a judgment or decree of a court or courts of competent jurisdiction.

ARTICLE IX.

APPLICATION OF COLLATERAL AND PROCEEDS

The proceeds of any sale of, or other realization upon, all or any part of the Collateral shall be applied in the following order of priorities: (a) first, to pay the reasonable expenses of such sale or other realization, including, without limitation, attorneys’ fees, and all expenses, liabilities and advances incurred or made by any Secured Party in connection therewith, and any other unreimbursed expenses for which any Secured Party is to be reimbursed pursuant to the Section titled “Expenses; Secured Party’s Lien” below; (b) second, to the payment of the Obligations in such order of priority as the Secured Parties, in their sole discretion, as determined by holders of a majority of the outstanding amounts due under the Notes, shall determine; and (c) finally, to pay to the Debtor, or its successors or assig ns, or as a court of competent jurisdiction may direct, any surplus then remaining from such proceeds.

ARTICLE X.

EXPENSES; SECURED PARTIES’ LIEN.

 If any Debtor Event of Default shall have occurred, the Debtor will forthwith upon demand pay to the Secured Parties: (a) the amount which the Secured Parties may have been required to pay to free any of the Collateral from any Lien thereon; and (b) the amount of any and all out-of-pocket expenses, including, without limitation, the fees and disbursements of its counsel, and of any agents not regularly in its employ, which the Secured Parties may incur in connection with the collection, sale or other disposition of any of the Collateral.

ARTICLE XI.

TERMINATION OF SECURITY INTERESTS; RELEASE OF COLLATERAL

Upon the payment or other satisfaction in full of the Notes held by the Secured Parties, the Security Interests shall terminate and all rights to the Collateral shall revert to the Debtor. Upon any such termination of the Security Interests or release of Collateral, the Secured Parties will, at the Debtor’s expense, to the extent permitted by law, execute and deliver to the Debtor such documents as the Debtor shall reasonably request to evidence the termination of the Security Interests or the release of such Collateral, as the case may be.

ARTICLE XII.

NOTICES

All notices, demands, requests, consents, approvals, and other communications required or permitted hereunder shall be in writing and, unless otherwise specified herein, shall be given in accordance to the notice procedures set forth in the Purchase Agreement.

ARTICLE XIII.

AGENT

13.1.           Anything in the other provisions of this Security Agreement to the contrary notwithstanding, Secured Parties holding a majority of the total outstanding balance due under the Notes may designate another entity to act as agent (the “Agent”) for the Secured Party with respect to any one or more of the rights of the Secured Parties hereunder, including, but not necessarily limited to, the right to hold the security interest and/or be named as secured party (as agent for the Secured Parties) in any filed financing statement and to take action in the name and stead of the Secured Parties hereunder. Such designation may be made with or without power of substitution, Such designation shall remain in effect until canceled by the Secured Parties, as provided herein; provided, however, that such cancellation shall not affect the validity of any action theretofore taken by such agent pursuant to this Security Agreement. The Debtor acknowledges and agrees to honor such designation and acknowledges that the Agent is acting as the agent of the Secured Parties and not as a principal.

13.2.           The Agent shall act as agent for all Secured Parties. Any revocation of the authority of the Agent or the designation of an alternate Agent shall be done only by Secured Parties who represent a Majority in Interest of all the Note Holders (as defined below) at that time; provided that at all times all Secured Parties shall be represented by one and the same Agent. The term “Note Holders” means the Holders, as of the relevant date, of the Notes issued in connection with the Purchase Agreement. The term “Majority in Interest” means, as of the relevant date, with respect to the relevant classification of Note Holders, one or more Note Holders whose respective outstanding p rincipal amounts of the Notes held by each of them, as of such date, aggregate more than fifty percent (50%) of the Allocable Shares on that date.

ARTICLE XIV.

MISCELLANEOUS

14.1.           No failure on the part of any Secured Party to exercise, and no delay in exercising, and no course of dealing with respect to, any right, power or remedy under this Security Agreement shall operate as a waiver thereof; nor shall any single or partial exercise by any Secured Party of any right, power or remedy under this Security Agreement preclude the exercise, in whole or in part, of any other right, power or remedy. The remedies in this Security Agreement are cumulative and are not exclusive of any other remedies provided by law. Neither this Security Agreement nor any provision hereof may be changed, waived, discharged or terminated orally but only by a statement in writing signed by the pa rty against which enforcement of the change, waiver, discharge or termination is sought. The Security Agreement may be amended with the written consent of the Company and the holders of at least two-thirds of the outstanding principal amount of the Notes.

14.2.           The execution and delivery by Debtor of this Security Agreement and all documents delivered in connection herewith have been duly and validly authorized by all necessary corporate action of Debtor and this Agreement and all documents delivered in connection herewith have been duly and validly executed and delivered by Debtor. The execution and delivery by Debtor of this Security Agreement and all documents delivered in connection herewith will not result in a breach or default of or under the Certificate of Incorporation, By-laws or any agreement, contract or indenture of Debtor. This Security Agreement and all documents delivered in connection therewith are legal, valid and binding obligation s of Debtor enforceable against Debtor in accordance with their terms.

14.3.           In the event that any action is taken by Debtor in connection with this Security Agreement against any of the Secured Parties, or any related document or matter, and the Debtor is the losing party in such legal action, in addition to such other damages as Debtor may be required to pay, Debtor shall pay all attorneys’ fees to the prevailing party.

ARTICLE XV.

SEVERABILITY

If any provision hereof shall prove invalid or unenforceable in any jurisdiction whose laws shall be deemed applicable, the other provisions hereof shall remain in full force and effect in such jurisdiction and shall be liberally construed in favor of the Secured Parties.

ARTICLE XVI.

GOVERNING LAW

16.1.           This Security Agreement shall be governed by and construed in accordance with the laws of the State of New York for contracts to be wholly performed in such state and without giving effect to the principles thereof regarding the conflict of laws. To the extent determined by the court, the Debtor shall reimburse the Secured Parties for all legal fees and disbursements incurred by the Secured Parties in enforcement of or protection of any of its rights under this Security Agreement. Nothing in this Section shall affect or limit any right to serve process in any other manner permitted by law.

16.2.           The Debtor and the Secured Party acknowledge and agree that irreparable damage would occur in the event that any of the provisions of this Security Agreement were not performed in accordance with their specific terms or were otherwise breached. It is accordingly agreed that the parties shall be entitled to an injunction or injunctions to prevent or cure breaches of the provisions of this Security Agreement and to enforce specifically the terms and provisions hereof, this being in addition to any other remedy to which any of them may be entitled by law or equity.

ARTICLE XVII.

JURY TRIAL WAIVER

The Debtor and the Secured Party hereby waive a trial by jury in any action, proceeding or counterclaim brought by either of the parties hereto against the other in respect of any matter arising out of or in connection with the Note or this Security Agreement.

ARTICLE XVIII.

ASSIGNMENT

Only in connection with the transfer of all of the rights under the Transaction Documents in accordance with their terms, a Secured Party may assign or transfer the whole of its security interest granted hereunder. Any transferee of the Collateral shall be vested with all of the rights and powers of the assigning Secured Party hereunder with respect to the Collateral.

ARTICLE XIX.

WAIVER

The Debtor waives any right that it may have to require Secured Party to proceed against any other person, or proceed against or exhaust any other security, or pursue any other remedy Secured Party may have.

IN WITNESS WHEREOF, the Parties have executed this Security Agreement as of the day, month and year first above written.

DEBTOR:

HYTHIAM, INC.

By:	/s/ PETER L. DONATO
Its:	Chief Financial Officer

SECURED PARTIES:

Name of Secured Party:

By:

Name:

Title:

EXHIBIT A

SECURITIES

All capital stock of Catasys, Inc., a Delaware corporation.

EXHIBIT B

INTELLECTUAL PROPERTY

(See Attached)

EX-31.1

Exhibit 31.1

CERTIFICATION

I, Terren S. Peizer, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Hythiam, Inc.;

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 officers and I are responsible for establishing and maintaining disclosure controls a nd 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, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes 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 officers 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:  November 18, 2010	/s/ TERREN S. PEIZER
	Terren S. Peizer
	Chief Executive Officer
	(Principal Executive Officer)

EX-31.2

Exhibit 31.2

CERTIFICATION

I, Peter L. Donato, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Hythiam, Inc.;

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 officers 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, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes 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 officers 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:  November 18, 2010	/s/ PETER L. DONATO
	Peter L. Donato
	Chief Financial Officer
	(Principal Financial and Accounting Officer)

EX-32.1

Exhibit 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report on Form 10-Q of Hythiam, Inc. (the “Company) for the quarter ended September 30, 2010, as filed with the Securities and Exchange Commission on the date hereof (the “Report), I, Terren S. Peizer, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 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 (15 U.S.C. 78m(a) or 78o(d)); and
(2)	The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ TERREN S. PEIZER	November 18, 2010
Terren S. Peizer	Date
Chief Executive Officer
(Principal Executive Officer)

EX-32.2

Exhibit 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report on Form 10-Q of Hythiam, Inc. (the “Company) for the quarter ended September 30, 2010, as filed with the Securities and Exchange Commission on the date hereof (the “Report), I, Peter L. Donato, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 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 (15 U.S.C. 78m(a) or 78o(d)); and
(2)	The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ PETER L. DONATO	November 18, 2010
Peter L. Donato	Date
Chief Financial Officer
(Principal Financial and Accounting Officer)