UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q







x
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
              
              For
      the quarterly period ended September 30,
2009




or




o
            TRANSITION REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
              
              For the transition period from
      __________ 
to  __________




COMMISSION FILE NUMBER
001-09727


PATIENT
SAFETY TECHNOLOGIES, INC.


(Exact
name of registrant as specified in its charter)







Delaware
            13-3419202(State
      or other jurisdiction of
              incorporation
      or organization)
            (I.R.S.
      Employer
              Identification
      No.)




43460
      Ridge Park Drive, Suite 140, Temecula, CA  92590
              (Address
      of principal executive
      offices)         (Zip
      Code)Registrant’s
      telephone number, including area code: (951)
  587-6201


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 x   No  ̈




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  ̈   No  ̈




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




Large
      Accelerated Filer o
            
            Accelerated
      Filer oNon-Accelerated
      Filer o
            
            Smaller
      reporting company x(Do
      not check if smaller reporting company)




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




There
were 23,456,188 shares of the registrant’s common stock outstanding as of
November 16, 2009.









PATIENT
SAFETY TECHNOLOGIES, INC.




TABLE
OF CONTENTS




PagePART
      I – FINANCIAL INFORMATIONItem 1. Financial Statements.
              
              3Item
      2. Management’s Discussion and Analysis of Financial Condition and
      Results of Operations.
              
              21Item
      3. Quantitative and Qualitative Disclosures About Market
      Risk.
              
              32Item
      4T. Controls and Procedures.
              
              32PART
      II – OTHER INFORMATIONItem
      1. Legal Proceedings.
              
              34Item
      1A. Risk Factors.
              
              34Item
      2. Unregistered Sales of Equity Securities and Use of
      Proceeds.
              
              34Item
      3. Defaults Upon Senior Securities.
              
              35Item
      4. Submission of Matters to a Vote of Security
    Holders.
              
              35Item 5. Other Information.
              
              36Item
      6. Exhibits.
              
              36SIGNATURES
              
              37




1




CAUTIONARY
NOTE REGARDING FORWARD-LOOKING STATEMENTS




Some of
the statements in this report are forward-looking statements.  You can
sometimes identify forward-looking statements by our use of forward-looking
words like “may,” “should,” “expects,” “intends,” “plans,” “anticipates,”
“believes,” “estimates,” “predicts,” “potential,” or “continue” or the negative
of these terms and other similar expressions.




Although
we believe that the plans and expectations reflected in or suggested by our
forward-looking statements are reasonable, those statements are based only on
the current beliefs and assumptions of our management and on information
currently available to us and, therefore, they involve uncertainties and risks
as to what may happen in the future.  Accordingly, we cannot guarantee
that our plans and expectations will be achieved.  Our actual results
could differ from those expressed in or implied by any forward-looking statement
in this report as a result of many known and unknown factors, many of which are
beyond our ability to predict or control.  These factors include, but
are not limited to, those described under the caption “Risk Factors” in our
Annual Report on Form 10-K for the year ended December 31, 2008 filed with the
Securities and Exchange Commission (the “SEC”) on April 16, 2009, as amended on
May 1, 2009 and further amended on July 13, 2009 (the “Form 10-K”), including
without limitation the following:




·
            the
      early stage of adoption of our Safety-Sponge SystemTM and the
      unpredictability of our sales
cycle;




·
            our
      need for additional financing to support our
  business;




·
            any
      failure of our new management team to operate
  effectively;




·
            our
      reliance on third-party manufacturers, some of whom are sole-source
      suppliers; and




·
            any
      inability to successfully defend our intellectual property
      portfolio.




All
written and oral forward-looking statements attributable to us are expressly
qualified in their entirety by these cautionary statements.




Our
forward-looking statements speak only as of the date they are made and should
not be relied upon as representing our plans and expectations as of any
subsequent date.  Although we may elect to update or revise
forward-looking statements at some time in the future, we specifically disclaim
any obligation to do so, even if our plans and expectations change.




2





PART
I – FINANCIAL INFORMATION




Item
1. Financial Statements


PATIENT SAFETY TECHNOLOGIES, INC. AND
      SUBSIDIARYCondensed
      Consolidated Balance Sheets(In
      thousands, except par value)
  September
      30,
                2009
              
              
              December
      31,
                2009(unaudited)AssetsCurrent
      assets:Cash
      and cash equivalents
              
              $
              779
              
              
              $
              296Accounts
      receivable
              
              
              186
              
              
              
              418Inventories,
      net
              
              
              730
              
              
              
              200Prepaid
      expenses
              
              
              198
              
              
              
              188Total
      current assets
              
              
              1,893
              
              
              
              1,102Restricted
      certificate of deposit
              
              
              94
              
              
              
              94Notes
      receivable
              
              
              121
              
              
              
              121Property
      and equipment, net
              
              
              466
              
              
              
              622Goodwill
              
              
              1,832
              
              
              
              1,832Patents,
      net
              
              
              3,195
              
              
              
              3,439Long-term
      investment
              
              
              667
              
              
              
              667Other
      assets
              
              
              29
              
              
              
              37Total
      assets
              
              $
              8,297
              
              
              $
              7,914Liabilities
      and Stockholders' (Deficit) EquityCurrent
      liabilitiesAccounts
      payable
              
              $
              1,806
              
              
              $
              909Current
      portion of convertible debentures
              
              
              1,425
              
              
              
              1,425Current
      portion of notes payable
              
              
              600
              
              
              
              1,100Warrant
      derivative liability
              
              
              2.399
              
              
              
              1,762Accrued
      liabilities
              
              
              1,360
              
              
              
              1,596Total
      current liabilities
              
              
              7,590
              
              
              
              6,792Long-term
      convertible debentures, less current portion
              
              
              55
              
              
              
              51Long-term
      notes payable, less current portion
              
              
              1,600
              
              
              –Deferred
      tax liability
              
              
              945
              
              
              
              1,042Total
      liabilities
              
              
              10,190
              
              
              
              7,885Stockholders'
      (deficit) equity:Convertible
      preferred stock, $1.00 par value, cumulative 7% dividend: 1,000 shares
      authorized; 11 issued and outstanding at September 30, 2009 and December
      31, 2008; (Liquidation preference of $1.2 million at September 30, 2009
      and December 31, 2008
              
              
              11
              
              
              
              11Common
      stock, $0.33 par value: 100,000 and 25,000 shares authorized; 23,409 and
      17,180 shares issued and outstanding at September 30, 2009 and December
      31, 2008 respectively;
              
              
              7,725
              
              
              
              5,675Additional
      paid-in capital
              
              
              43,702
              
              
              
              36,034Accumulated
      deficit
              
              
              (53,331
              )
              
              
              (41,691
              )Total
      stockholders' (deficit) equity
              
              
              (1,893
              )
              
              
              29Total
      liabilities and stockholders' equity
              
              $
              8,297
              
              
              $
              7,914
  The
      accompanying notes are an integral part of these condensed consolidated
      interim financial statements.
  3
  PATIENT SAFETY TECHNOLOGIES, INC. AND
      SUBSIDIARYCondensed
      Consolidated Statements of Operations(In
      thousands, except per share data)(unaudited)
  For
      the Quarter Ending
                September
      30,
              
              
              For
      the Nine Months Ending
                September
      302009
              
              
              2008
              
              
              2009
              
              
              2008Revenues
              
              $
              978
              
              
              $
              880
              
              
              $
              2,942
              
              
              $
              1,937Cost
      of revenue
              
              
              540
              
              
              
              622
              
              
              
              1,708
              
              
              
              1,342Gross
      profit
              
              
              438
              
              
              
              258
              
              
              
              1,234
              
              
              
              595Operating
      expenses:Research
      and development
              
              
              69
              
              
              
              87
              
              
              
              268
              
              
              
              168Sales
      and marketing
              
              
              610
              
              
              
              662
              
              
              
              1,812
              
              
              
              1,796General
      and administrative
              
              
              1,257
              
              
              
              958
              
              
              
              5,162
              
              
              
              3,680Total
      operating expenses
              
              
              1,936
              
              
              
              1,707
              
              
              
              7,242
              
              
              
              5,644Operating
      loss
              
              
              (1,498
              )
              
              
              (1,449
              )
              
              
              (6,008
              )
              
              
              (5,049
              )Other
      (expenses) income:Interest
      expense
              
              
              (304
              )
              
              
              (79
              )
              
              
              (744
              )
              
              
              (254
              )Change
      in fair value of warrant derivative liability
              
              
              (1,762
              )
              
              
              1,683
              
              
              
              (4,333
              )
              
              
              1,515Realized
      loss assets held for sale, net
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (25
              )Unrealized
      loss on assets held for sale, net
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (65
              )Gain
      on warrant exchange
              
              
              193
              
              
              
              —
              
              
              
              193
              
              
              
              —Other
      (expenses)income
              
              
              2
              
              
              
              36
              
              
              
              2
              
              
              
              35Total
      other (expenses)income
              
              
              (1,871
              )
              
              
              1,640
              
              
              
              (4,882
              )
              
              
              1,206(Loss)
      income from operations before income taxes
              
              
              (3,369
              )
              
              
              191
              
              
              
              (10,890
              )
              
              
              (3,843
              )Income
      tax benefit
              
              
              32
              
              
              
              33
              
              
              
              96
              
              
              
              98Net
      (loss) income
              
              
              (3,337
              )
              
              
              224
              
              
              
              (10,794
              )
              
              
              (3,745
              )Preferred
      dividends
              
              
              (19
              )
              
              
              (19
              )
              
              
              (57
              )
              
              
              (57
              )Net
      (loss) income applicable to common shareholders
              
              $
              (3,356
              )
              
              $
              205
              
              
              $
              (10,851
              )
              
              $
              (3,802
              )Net
      (loss) income applicable to common shareholders - basic and
      diluted
              
              $
              (0.17
              )
              
              $
              0.01
              
              
              $
              (0.60
              )
              
              $
              (0.28
              )Weighted
      average common shares outstanding basic and diluted:
              
              
              20,229
              
              
              
              15,615
              
              
              
              18,220
              
              
              
              13,588
  The
      accompanying notes are an integral part of
      these condensed consolidated interim financial
      statements.
 
 4
  PATIENT SAFETY TECHNOLOGIES, INC.
      AND SUBSIDIARYCondensed
      Consolidated Statements of Cash Flows(In
      thousands)(unaudited)
  For
      the Nine Months Ending
                September
      30,2009
              
              
              2008Operating
      activities:Net
      loss
              
              $
              (10,794
              )
              
              $
              (3,745
              )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
              
              
              253
              
              
              
              261Amortization
      of patents
              
              
              244
              
              
              
              244Amortization
      of debt discount
              
              
              461Non-cash
      interest
              
              
              1,323
              
              
              
              145Non-cash
      payments
              
              
              —
              
              
              
              568Realized
      loss on assets held for sale, net
              
              
              —
              
              
              
              25Unrealized
      loss on assets held for sale, net
              
              
              
              
              
              
              65Gain
      on warrant exchange
              
              
              (193
              )
              
              
              —Stock-based
      compensation to employees and directors
              
              
              896
              
              
              
              1,229Change
      in fair value of warrant derivative liability
              
              
              4,333
              
              
              
              (1,515
              )Income
      tax benefit
              
              
              (97
              )
              
              
              (98
              )Changes
      in operating assets and liabilities:Accounts
      receivable
              
              
              232
              
              
              
              (253
              )Inventories
              
              
              (530
              )
              
              
              (35
              )Prepaid
      expenses
              
              
              (10
              )
              
              
              30Other
      assets
              
              
              8
              
              
              
              (10
              )Accounts
      payable
              
              
              897
              
              
              
              (105
              )Accrued
      liabilities
              
              
              (100
              )
              
              
              151Net
      cash used in operating activities
              
              
              (3,077
              )
              
              
              (3,043
              )Investing
      activities:Purchase
      of property and equipment
              
              
              (89
              )
              
              
              (319
              )Proceeds
      from sale of assets held for sale, net
              
              
              —
              
              
              
              226Net
      cash used in investing activities
              
              
              (89
              )
              
              
              (93
              )
 Financing
      activities:Proceeds
      from issuance of common stock and warrants
                  
                  
                  1,706
                  
                  
                  
                  3,877Proceeds
      from issuance of notes payable
                  
                  
                  2,000
                  
                  
                  
                  500Payments
      on notes payable
                  
                  
                  —
                  
                  
                  
                  (551
                  )Payments
      of preferred dividends
                  
                  
                  (57
                  )
                  
                  
                  (57
                  )Net
      cash provided by financing activities
                  
                  
                  3,649
                  
                  
                  
                  3,769Net
      increase in cash and cash equivalents
                  
                  
                  483
                  
                  
                  
                  633Cash
      and cash equivalents at beginning of period
                  
                  
                  296
                  
                  
                  
                  405Cash
      and cash equivalents at end of period
                  
                  $
                  779
                  
                  
                  $
                  1,038Supplemental
      disclosures of cash flow information:Cash
      paid during the period for interest
                  
                  $
                  110,000
                  
                  
                  $
                  49Cash  paid
      for income taxes
                  
                  
                  —
                  
                  
                  
                  —Non
      cash investing and financing activities:Dividends
      accrued
                  
                  
                  57
                  
                  
                  
                  38Issuance
      of common stock for an accrued liability
                  
                  
                  —
                  
                  
                  
                  185Issuance
      of common stock in payment of notes payable and accrued
      interest
                  
                  
                  258
                  
                  
                  
                  859Issuance
      of common stock for inventory
                  
                  
                  —
                  
                  
                  
                  700Debt
      discount associated with issuance of notes payable
                  
                  
                  1,311
                  
                  
                  
                  —Reclassification
      of warrants in equity to warrant derivative liability
                  
                  
                  4,241
                  
                  
                  
                  4,350Cancellation
      of warrants in connection with warrant exchange
                  
                  
                  5,722
                  
                  
                  
                  —Reclassification
      of accrued interest to notes payable
                  
                  
                  165
                  
                  
                  
                  —Reclassification
      of warrant derivative liability to equity
                  
                  
                  2,153
                  
                  
                  
                  —
  The
      accompanying notes are an integral part of thesecondensed consolidated
      interim financial statements.
  5
  PATIENT SAFETY
      TECHNOLOGIES, INC. AND SUBSIDIARYConsolidated
      Statements of Stockholder's Equity(In
      thousands)
 Preferred Stock
                
                
                Common Stock
                
                
                Paid-in
                
                
                Accumulated
                
                
                Total
      Stockholder'sShares
                
                
                Amount
                
                
                Shares
                
                
                Amount
                
                
                Capital
                
                
                Deficit
                
                
                EquityBALANCES,
      December 31, 2008
                
                
                11
                
                
                $
                11
                
                
                
                17,198
                
                
                $
                5,675
                
                
                $
                36,034
                
                
                $
                (41,691
                )
                
                $
                29Cumulative
      effect of change in accounting principle
                
                ─
                
                
                ─
                
                
                ─
                
                
                ─
                
                
                
                794
                
                
                
                (794
                )
                
                ─Net
      Loss  through September 30, 2009
                
                ─
                
                
                ─
                
                
                ─
                
                
                ─
                
                
                ─
                
                
                
                (10,794
                )
                
                
                (10,794
                )Preferred
      Dividends
                
                ─
                
                
                ─
                
                
                ─
                
                
                ─
                
                
                ─
                
                
                
                (57
                )
                
                
                (57
                )Common
      stock issued in private placement
                
                ─
                
                
                ─
                
                
                
                5,965
                
                
                
                1,969
                
                
                
                5,255
                
                
                ─
                
                
                
                7,224Warrants
      issued in connection with anti-dilution adjustment
                
                ─
                
                
                ─
                
                
                ─
                
                
                ─
                
                
                
                1,323
                
                
                ─
                
                
                
                1,323Warrants
      issued in connection with debt
                
                ─
                
                
                ─
                
                
                ─
                
                
                ─
                
                
                
                1,311
                
                
                ─
                
                
                
                1,311Stock
      based compensation
                
                ─
                
                
                ─
                
                
                ─
                
                
                ─
                
                
                
                896
                
                
                ─
                
                
                
                896Common
      stock issued in connection with conversion of notes
payable
                
                ─
                
                
                ─
                
                
                
                246
                
                
                
                81
                
                
                
                177
                
                
                ─
                
                
                
                258Warrants
      reclassified from equity to liability
                
                ─
                
                
                ─
                
                
                ─
                
                
                ─
                
                
                
                (4,241
                )
                
                ─
                
                
                
                (4,241
                )Warrants
      reclassified from liability to equity
                
                ─
                
                
                ─
                
                
                ─
                
                
                ─
                
                
                
                2,153
                
                
                ─
                
                
                
                2,153BALANCES,
      September 30, 2009
                
                
                11
                
                
                $
                11
                
                
                
                23,409
                
                
                $
                7,725
                
                
                $
                43,702
                
                
                $
                (53,331
                )
                
                $
                (1,893
                )
  The
accompanying notes are an integral part of thesecondensed consolidated interim
financial statements.
  6
  1.
DESCRIPTION OF BUSINESS
 
 Patient
Safety Technologies, Inc. ("PST" or
the "Company")
is a Delaware corporation. The Company’s operations are conducted through its
wholly-owned operating subsidiary, SurgiCount Medical, Inc. (“SurgiCount”),
a California corporation.
 
 The
Company’s operating focus is the development, marketing and sales of products
and services focused in the medical patient safety markets.  The
SurgiCount Safety-SpongeTMSystem
is a patented system of bar-coded surgical sponges, SurgiCounterTM scanners and
software applications which integrate together to form a comprehensive counting
and documentation system to avoid unintentionally leaving sponges inside of
patients during surgical procedures.
  2.
LIQUIDITY AND GOING CONCERN
 
 The
accompanying unaudited condensed consolidated financial statements have been
prepared assuming that the Company will continue as a going concern. At
September 30, 2009, the Company had an accumulated deficit of approximately
$53.3 million and a working capital deficit of approximately $5.7 million, of
which $2.4 million represents the estimated fair value of warrant derivative
liabilities (see Note 13). For the three and nine
months ended September 30, 2009, the Company incurred net losses of
approximately $3.4 and $10.8 million, respectively.  For the nine
months ended September 30, 2009 the Company used approximately $3.6 million in
cash to fund its operating activities.
 
 The
Company believes that existing cash resources, combined with projected cash flow
from operations, will not be sufficient to fund its working capital requirement
for the next twelve months.  In order to continue to operate as a
going concern it will be necessary to raise additional capital.
 
 The
Company expects to be able to raise sufficient additional capital to meet its
currently projected requirements but cannot be certain that additional capital
will be available when needed, or that it will be offered on terms acceptable to
the Company. The Company also cannot be certain when, and if, the Company will
achieve profitable operations and positive cash flow.  The condensed
consolidated interim financial statements do not include any adjustments that
might result from the outcome of this uncertainty.
  3.
BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING
POLICIES
 
 Basis
of Presentation
 
 The
accompanying unaudited condensed consolidated interim financial statements have
been prepared in accordance with the instructions to Form 10-Q and Article 8-03
of Regulation S-X and do not include all the information and disclosures
required by accounting principles generally accepted in the United States of
America.  The condensed consolidated interim financial information is
unaudited but reflects all normal adjustments that are, in the opinion of
management, necessary to make the financial statements not
misleading.  The condensed consolidated balance sheet as of December
31, 2008 was derived from the Company’s audited financial
statements.  The condensed consolidated interim financial statements
should be read in conjunction with the consolidated financial statements in the
Company’s Annual Report on Form 10-K for the year ended December 31,
2008.  Results of the three and nine months ended September 30, 2009
are not necessarily indicative of the results to be expected for the full year
ending December 31, 2009.
 
 Use
of Estimates
 
 The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes.  The actual results may differ from
management’s estimates.
 
 Reclassifications
 
 Certain
prior year amounts have been reclassified to conform to the 2009 presentation.
These reclassifications had no effect on previously reported results of
operations or accumulated deficit.
  7
 
 Recent
Accounting Pronouncements
 
 In June
2009, the Financial Accounting Standards Board (“FASB”) issued Statement
No. 168, The FASBAccountingStandardsCodificationTMand the Hierarchy of Generally
Accepted Accounting Principles, a replacement of FASB Statement No. 162(the “ASC”). Effective for interim and annual periods ended after
September 15, 2009, the ASC became the source of authoritative U.S.
generally accepted accounting principles (“GAAP”) recognized by the FASB to be
applied by nongovernmental entities. Rules and interpretive releases of the
Securities and Exchange Commission (“SEC”) under authority of federal securities
laws are also sources of authoritative GAAP for SEC registrants. This statement
does not change existing GAAP, but reorganizes GAAP into Topics.  In
circumstances where previous standards require a revision, the FASB will issue
an Accounting Standards Update (“ASU”) on the Topic.  The Company’s
adoption of this standard during the quarter ended September 30, 2009 did not
have any impact on the Company’s consolidated financial
statements.
 
 In
September 2006, the FASB issued guidance as
codified in ASC 820, Fair Value Measurements and
Disclosures, (previously Statement of Financial Accounting Standards
(“SFAS”) No.157, Fair Value
Measurements). ASC 820 defines fair value, establishes a framework for
measuring fair value in GAAP, and expands disclosures about fair value
measurements.  ASC 820 applies in those instances where other
accounting pronouncements require or permit fair value measurements and the
board of directors has previously concluded in those accounting pronouncements
that fair value is the relevant measurement attribute.  Accordingly,
ASC 820 does not require any new fair value measurements.  However for
some entities, the application of ASC 820 will change the current
practice.  In February 2008, the FASB issued ASC 820, which defers the
effective date of ASC 820 for all non-financial assets and liabilities, except
those items recognized or disclosed at fair value on an annual or more frequent
recurring basis until years beginning after November 15, 2008.  The
Company’s adoption of ASC 820-10 for its financial assets and liabilities on
January 1, 2008 and ASC 820 for its non-financial assets and liabilities on
January 1, 2009 did not have a material impact on its consolidated financial
statements.
 
 In
December 2007, the FASB issued guidance, as codified in ASC 805-10 Business Combinations(previously SFAS No. 141(R), Business Combinations)ASC 805-10 requires the
acquiring entity in a business combination to record all assets acquired and
liabilities assumed at their respective acquisition-date fair values, changes
the recognition of assets acquired and liabilities assumed arising from
contingencies, changes the recognition and measurement of contingent
consideration, and requires the expensing of acquisition-related costs as
incurred.  ASC 805-10 also requires additional disclosure of
information surrounding a business combination, such that users of the entity's
financial statements can fully understand the nature and financial impact of the
business combination.  The Company’s adoption of ASC 805-10 on January
1, 2009 did not have a material impact on its consolidated
statements.
  On
January 1, 2009 the Company adopted the requirements of guidance codified in ASC
810-10 Consolidation, Non
Controlling Interests(previously SFAS No. 160; Noncontrolling Interests in
Consolidated Financial Statementsan amendment of ARB51).   ASC 810-10-25 establishes accounting and reporting
standards for ownership interests in subsidiaries held by parties other than the
parent, the amount of consolidated net income attributable to the parent and to
the noncontrolling interest, changes in a parent's ownership interest and the
valuation of retained noncontrolling equity investments when a subsidiary is
deconsolidated. ASC 810-10-25 also established reporting requirements that
provide sufficient disclosures that clearly identify and distinguish between the
interests of the parent and the interests of the noncontrolling owner. The
Company’s adoption of ASC 810-10-25 did not have a material impact on its
consolidated financial statements.
 
 On
January 1, 2009, the Company adopted the requirements of guidance codified in
ASC 815-10 Derivatives and
Hedging (previouslyFASB Statement of Financial Accounting Standards
No. 161, Disclosures
about Derivative Instruments and Hedging Activities—an amendment of FASB
Statement No. 133).  ASC 815-10 requires additional
quantitative disclosures (provided in tabular form) and qualitative disclosures
for derivative instruments.  The required disclosures include how
derivative instruments and related hedged items affect an entity’s financial
position, financial performance, and cash flows; relative volume of derivative
activity; the objectives and strategies for using derivative instruments; the
accounting treatment for those derivative instruments formally designated as the
hedging instrument in a hedge relationship; and the existence and nature of
credit-related contingent features for derivatives.  ASC 815-10 does
not change the accounting treatment for derivative instruments.  The
Company’s adoption of ASC 815-10 did not have a material impact on its
consolidated financial statements.
 
 On
January 1, 2009, the Company adopted the guidance codified in ASC 350-30, Intangibles – Goodwill and
Other (previously FASB FAS 142-3, Determination of Useful Life of
Intangible Assets).  ASC 350-30 amends the factors that should
be considered in developing the renewal or extension assumptions used to
determine the useful life of a recognized intangible asset also requires
expanded disclosure related to the determination of intangible asset useful
lives and is effective for fiscal years beginning after December 15,
2008.  Earlier adoption is not permitted.  The Company’s
adoption of ASC 350-30 did not have a material impact on its consolidated
financial statements.
  8
 
 Effective
January 1, 2009 the Company adopted the guidance of ASC 470-20 Debt with Conversion and Other
Options(previously FASB Staff Position APB 14-1, Accounting for Convertible Debt Instruments That
May Be Settled in Cash upon Conversion (Including Partial Cash
Settlement)) for convertible debt instruments that have cash settlement
features. These requirements included separation of the liability and equity
components of the instruments. The debt is recognized at the present value of
its cash flows discounted using the issuer’s nonconvertible debt borrowing rate
at the time of issuance with the resulting debt discount being amortized over
the expected life of the debt. The equity component is recognized as the
difference between the proceeds from the issuance of the convertible debt
instrument and the fair value of the liability. The adoption required
retrospective application to all periods presented, and did not grandfather
existing instruments. Retrospective application to all periods presented is
required and a cumulative-effect adjustment is recognized as of the beginning of
the first period presented.  This standard is effective for fiscal
years beginning after December 15, 2008.  The Company’s adoption of
ASC 470-20 on January 1, 2009 did not have a material impact on its consolidated
financial statements.
 
 In June
2008, the FASB issued guidance, as codified in ASC 260-10, Earnings per Share,(previously Emerging Issues Task Force (“EITF”) No.
03-6-1).  ASC 260-10 concludes that unvested share-based payment
awards that contain rights to receive non-forfeitable dividends or dividend
equivalents (whether paid or unpaid) are participating securities, and thus,
should be included in the two-class method of computing earnings per share. ASC
260-10 is effective for fiscal years beginning after December 15, 2008, and
interim periods within those years. Retrospective application to all periods
presented is required and early application is prohibited. The Company’s
adoption of ASC 260-10 did not have a material impact on its consolidated
financial statements.
 
 In June
2008, the FASB ratified guidance issued by the EITF as codified in ASC 815-40,
Derivatives and Hedging –
Contracts in Entity’s Own Equity (previously EITF Issue No. 07-5, Determining whether an Instrument
(or Embedded Feature) is indexed to an Entity’s own
Stock).  ASC 815-40 is effective for financial statements
issued for fiscal years beginning after December 15, 2008, and interim periods
within those fiscal years.   Early application is not
permitted.  ASC 815-10 – specifies that a contract that would
otherwise meet the definition of a derivative but is both (a) indexed to the
Company’s own stock and (b) classified in stockholders’ equity in the statement
of financial position would not be considered a derivative financial
instrument.   ASC 815-40 provides a new two-step model to be
applied in determining whether a financial instrument or an embedded feature is
indexed to an issuer’s own stock and thus able to qualify for the ASC 815-10
scope exception.  The Company’s adoption of ASC
815-40  effective January 1, 2009, resulted in the identification of
certain warrants that were determined to be ineligible for equity classification
because of certain provisions that may result in an adjustment to their exercise
price.  Accordingly, these warrants were reclassified as liabilities
upon the effective date of ASC 815-40 and re-measured at fair value as of
September 30, 2009 with changes in the fair value recognized in other income for
the quarter ended September 30, 2009.  The cumulative effect of the
change in accounting for these warrants was recognized as an adjustment to the
opening balance of accumulated deficit at January 1, 2009 based on the
difference between the amounts recognized in the consolidated balance sheet
before the initial adoption of ASC 815-40 and the amounts recognized in the
consolidated balance sheet as a result of the initial application of ASC 815-40.
(See Note 13).
 
 In April
2009, the FASB issued ASC 820-10, Fair Value Measurements and
Disclosures(previously SFAS No. 157-4, Determining Fair Value When the
Volume and Level of Activity for the Asset or Liability Have Significantly
Decreased and Identifying Transactions That Are Not Orderly ). ASC 820-10
provides for estimating fair value when the volume and level of activity for the
asset or liability have significantly decreased. ASC 820-10 also includes
guidance on identifying circumstances that indicate a transaction is not
orderly. ASC 820-10 emphasizes that even if there has been a significant
decrease in the volume and level of activity for the asset or liability and
regardless of the valuation technique(s) used, the objective of a fair value
measurement remains the same. Fair value is the price that would be received to
sell an asset or paid to transfer a liability in an orderly transaction (that
is, not a forced liquidation or distressed sale) between market participants at
the measurement date under current market conditions. This statement is
effective for interim and annual reporting periods ending after June 15,
2009. The Company’s adoption of this guidance during the quarter ended June 30,
2009 did not have a material effect on its financial statements.
 
 Effective
April 1, 2009, the Company adopted the disclosure requirements of ASC 820-10
(previously SFAS 107-1 and APB 28-1, Interim Disclosures About Fair Value
of Financial Instruments).This guidance became effective for
interim and annual reporting periods ending after June 15, 2009. The
adoption of this guidance did not have a material effect on the Company’s
consolidated financial statements.
 
 Effective
April 1, 2009, the Company adopted the requirements of ASC 855-10, Subsequent Events(previously
SFAS No. 165, Subsequent
Events), which established standards for the accounting for and
disclosure of events that occur after the balance sheet date but before
financial statements are available to be issued (subsequent
events).  This guidance is largely the same guidance on subsequent
events that previously existed only in auditing literature, except that the two
types of subsequent events, previously referred to in practice as Type I or Type
II subsequent events, are re-names as recognized or un-recognized subsequent
events, respectively. In addition, ASC 855-10 requires disclosure of the date
through which subsequent events have been evaluated, as well as whether that
date is the date the financial statements were issued or the date the financial
statements were available to be issued.
  9
 
 For
purposes of this interim financial information, November 16, 2009 is the date
through which subsequent events have been evaluated and represents the date the
financial statements were issued.
  ASU
2009-13, Multiple Deliverable
Revenue Arrangements, addresses the accounting for multiple deliverable
arrangements to enable vendors to account for products and services
(deliverables) separately rather than as a combined unit. The amendments in ASU
2009-13 are effective prospectively for revenue arrangements entered into or
materially modified in the fiscal years beginning on or after June 15, 2010.
Early adoption is permitted.  The impact of this accounting update on
the Company’s financial statements has not been evaluated.
  ASU
2009-14, Certain Revenue
Arrangements That Include Software Elements, changes the accounting model
for revenue arrangements that include both tangible products and software
elements that are “essential to the functionality,” and scopes these products
out of current software revenue guidance. The new guidance will include factors
to help companies determine what software elements are considered “essential to
the functionality.” The amendments included in ASU 2009-14 are effective
prospectively for revenue arrangements entered into or materially modified in
the fiscal years beginning on or after June 15, 2010. Early adoption is
permitted.   The impact of this accounting update on the
Company’s financial statements has not been evaluated.
  4.
CONCENTRATION OF CREDIT RISK
 
 From time
to time, the Company maintains its cash balances at a financial institution that
exceeds the Federal Deposit Insurance Corporation coverage of $250
thousand.  The Company has not experienced any losses in such accounts
and believes it is not exposed to any significant credit risk related to its
cash and cash equivalents.
 
 At
September 30, 2009 and 2008, due to the Company’s distribution agreement with
Cardinal Health, it had one individual customer whose receivable balance
outstanding represented 65% and 0%, respectively, of its gross accounts
receivable balance.  Cardinal’s sales represent 89% and 85% of total
gross sales for respective periods.
  5.
SOLE SOURCE SUPPLIER
 
 The
Company relies primarily on A Plus International to supply its sponge products,
but also relies on a number of other third parties to manufacture certain of its
other products. If A Plus International or any of the Company’s third-party
manufacturers cannot, or will not, manufacture products in the required volumes,
on a cost-effective basis, in a timely manner, or at all, the Company will have
to secure additional manufacturing capacity.  Any interruption or
delay in manufacturing could have a material adverse effect on business and
operating results.
 
 The
Company’s operations may also be harmed by lengthy or recurring disruptions at
any of the Company’s suppliers’ manufacturing facilities and by disruptions in
the distribution channels from the Company’s suppliers and to the Company’s
customers. Any such disruptions could cause significant delays in shipments
until the Company is able to shift the products from an affected manufacturer to
another manufacturer. If the affected supplier was a sole-source supplier, the
Company may not be able to obtain the product without significant cost and
delay. The loss of a significant third-party supplier or the inability of a
third-party supplier to meet performance and quality specifications or delivery
schedules could harm the Company’s ability to meet the Company’s delivery
obligations to the Company’s customers and negatively impact the Company’s
revenues and business operations.
  6.  STOCK-BASED
COMPENSATION
 
 In
September 2005, the Board of Directors of the Company approved the Amended and
Restated 2005 Stock Option and Restricted Stock Plan (the “2005
SOP”) and the Company’s stockholders approved the 2005 SOP in November
2005. The 2005 SOP reserves 2.5 million shares of common stock for grants of
incentive stock options, nonqualified stock options, warrants and restricted
stock awards to employees, non–employee directors and consultants performing
services for the Company. Options granted under the 2005 SOP have an exercise
price equal to or greater than the fair market value of the underlying common
stock at the date of grant and become exercisable based on a vesting
schedule determined at the date of grant. The options generally expire
10 years from the date of grant. Restricted stock awards granted under the
2005 SOP are subject to a vesting period determined at the date of
grant.
 
 On March
11, 2009, the Board of Directors of the Company approved the 2009 Stock Option
Plan (the “2009
SOP”) and the Company’s stockholders approved the 2009 SOP August 6,
2009. The 2009 SOP  reserves 3.0 million shares of common stock for
grants of incentive stock options, nonqualified stock options, warrants and
restricted stock awards to employees, non–employee directors and consultants
performing services for the Company. Options granted under the 2009 SOP have an
exercise price equal to or greater than the fair market value of the underlying
common stock at the date of grant and become exercisable based on a vesting
schedule determined at the date of grant. The options generally expire
10 years from the date of grant. Restricted stock awards granted under the
2009 SOP are subject to a vesting period determined at the date of
grant.
  10
  All
options that the Company granted during the three and nine months ended
September 30, 2009 and 2008 were granted at the per share fair market value on
the grant date. Vesting of options differs based on the terms of each option.
The Company utilized the Black-Scholes option pricing model and the assumptions
used for each period are as follows:
  Nine
      months ended
                  September
      302009
                
                
                2008Weighted
      average risk free interest rate
                
                
                2.07
                %
                
                
                3.5
                %Weighted
      average life (in years)
                
                6.02
                years
                
                5
                yearsVolatility
                
                
                114.1
                %
                
                
                106.0
                %Expected
      dividend yield
                
                ─
                
                
                ─
                %Weighted
      average grant-date fair value per share of options granted
                
                $
                0.75
                
                
                $
                0.93
 A summary
of stock option activity for the nine months ended September 30, 2009 is
presented below (in thousands,
except per share data):
  Outstanding
      OptionsNumber
      of Shares
              
              
              Weighted
      Average Exercise Price
              
              
              Weighted
      Average Remaining Contractual Life (years)
              
              
              Aggregate
      Intrinsic Value (1)Balance
      at December 31, 2008
              
              
              1,627
              
              
              $
              4.40
              
              
              
              8.43Options
      Granted (2)
              
              
              5,275
              
              
              $
              0.774
              
              
              
              5.99Cancelled/Forfeited
              
              
              (2,156
              )
              
              $
              0.78Balance
      at September 30, 2009
              
              
              4,746
              
              
              $
              1.264
              
              
              
              8.83
              
              
              $
              2,116Vested
      and exercisable as of Sept 30, 2009
              
              
              1,879
              
              
              $
              1.979
              
              
              
              7.89
              
              
              $
              376Unvested
      as of September 30, 2009
              
              
              2,867
              
              
              $
              0.796
              
              
              
              8.83
              
              
              $
              1,740
  (1) The
aggregate intrinsic value is calculated as the difference between the exercise
price of the underlying awards and the closing stock price of $1.40 of the
Company’s common stock at September 30, 2009.
  (2)
includes 3.1 million non-qualified options that were issued outside the 2005 and
2009 stock option plans.
 
 The total
grant date fair value of stock options granted during the three and nine months
ended September 30, 2009 was $99 thousand and $4.1 million,
respectively.
 
 During
the three and nine months ended September 30, 2009, the Company recognized
stock-based compensation expense of $360 thousand and $896 thousand,
respectively.  During the three and nine months ended September 30,
2008, the Company had stock based compensation expense of $185 thousand and $1.2
million, respectively.
 
 As of
September 30, 2009, there was $1.3 million of unrecognized compensation costs
related to outstanding employee stock options.   This amount is
expected to be recognized over a weighted average period of 2.4
years.  To the extent the forfeiture rate is different from what the
Company anticipated; stock-based compensation related to these awards will be
different from the Company’s expectations.
 
 11
  7.  NET
LOSS PER COMMON SHARE
 
 The
Company calculates net loss per share in accordance with FASB ASC 260-10 Earnings Per Share(previously SFAS No. 128, Earnings per
Share).  Basic earnings per share (“EPS”) is
calculated by dividing the net income or loss available to common stockholders
by the weighted average number of common shares outstanding for the period,
without consideration for common stock equivalents.  Diluted EPS is
computed by dividing the net income available to common stockholders by the
weighted average number of common shares outstanding for the period and the
weighted average number of dilutive common stock equivalents outstanding for the
period determined using the treasury-stock method.  For purposes of
this calculation, options are considered to be common stock equivalents and are
only included in the calculation of diluted earnings per share when their effect
is dilutive.
 
 Because
the effects of outstanding options, warrants and the conversion of convertible
preferred stock and convertible debt are anti-dilutive in all periods presented,
shares of common stock underlying these instruments have been excluded from the
computation of loss per common share. The following sets forth the number of
shares of common stock underlying outstanding options, warrants, convertible
preferred stock and convertible debt as of September  30, 2009 and 2008,
(in
thousands):
 
 September
      30,2009
              
              
              2008Options
      to purchase common stock
              
              
              4,746
              
              
              
              1,407Warrant
      to purchase common stock
              
              
              6,754
              
              
              
              10,680Convertible
      debt
              
              
              547
              
              
              
              1,057Convertible
      preferred stock
              
              
              246
              
              
              
              246Total
              
              
              12,293
              
              
              
              13,390
  8.
CONVERTIBLE DEBENTURES & NOTES PAYABLE
 
 Convertible
debentures at September 30, 2009 and December 31, 2008 are comprised of the
following (in
thousands):
 
 September
      30,
                2009
              
              
              December
      31,
                2008Ault
      Glazer Capital Partners LLC (a)*
              
              $
              1,425
              
              
              $
              1,425David
      Spiegel (b)
              
              
              65
              
              
              
              65Total
      convertible debentures
              
              
              1,490
              
              
              
              1,490Less:
      unamortized discount
              
              
              (10
              )
              
              
              (14
              )1,480
              
              
              
              1,476Less:
      current portion
              
              
              (1,425
              )
              
              
              (1,425
              )Convertible
      debentures - long term portion
              
              $
              55
              
              
              $
              51
 
 * Related
party (see Note 15)
 
 (a)
              On
      September 5, 2008, the Company entered into an Amendment and Early
      Conversion of the Secured Convertible Promissory Note (the “Amendment”)
      with Ault Glazer Capital Partners, LLC (“AG Capital
      Partners”).  The Amendment allowed for the conversion,
      prior to the maturity date of December 31, 2010, of the outstanding
      principal balance of the AG Capital Partners Note (the “AGNote”)
      into 1.3 million shares of the Company’s common stock and payment of
      accrued and estimated future interest in the amount of $450 thousand in
      cash.  According to the Amendment, following the $450 thousand
      payment, which was made by the Company in connection with the signing of
      the Amendment, the AG Note could be converted into 1.3 million shares of
      common stock upon AG Capital Partners’ satisfaction of certain
      conditions.
 
 On
September 12, 2008, the parties executed an Agreement for the Advancement of
Common Stock prior to close of the Amendment and Early Conversion of Secured
Convertible Promissory Note, pursuant to which the Company issued 300 thousand
of the previously agreed upon 1.3 million shares.
 
 Additionally,
although AG Capital Partners failed to satisfy the conditions by the deadline
stated in the Amendment, the Company issued 250 thousand shares on October 10,
2008 and 250 thousand shares on November 6, 2008.   As a result
of the issuance of 800 thousand shares issued to AG Capital Partners as
described above, the principal balance of the AG Note was reduced by a total of
$656 thousand, based on the fair market value of the common stock on the date it
was issued.  Currently, under the terms of the Amendment, the Company
can settle the remaining principal balance on the AG Note upon the issuance of
500 thousand shares of common stock to AG Capital Partners.  However,
the Company does not intend to issue these shares until such time as AG Capital
Partners satisfies the conditions of the Amendment.
  12
 
 (b)
              On
      October 27, 2008 the Company entered into a Discount Convertible Debenture
      with David Spiegel in the principal amount of $65 thousand (the “Spiegel
      Note”) with a 9% original issue discount of $15 thousand, which
      matures on October 27, 2011.  The Spiegel Note is convertible at
      any time, in whole or in part, into common stock of the Company at a
      conversion price of $1.50 per common share at the option of the
      holder.  During the three and nine months ended September 30,
      2009, the Company incurred interest expense and amortization of the debt
      discount of $1 thousand and $3 thousand, respectively, on the Spiegel
      Note.
 
 
 Notes
Payable
 
 Notes
payable at September 30, 2009 and December 31, 2008 are comprised of the
following (in
thousands):
 
 September
      30,
                2009
              
              
              December
      31,
                2008Herbert
      Langsam (a)*
              
              $
              600
              
              
              $
              600Catalysis
      Offshore (b)*
              
              
              287
              
              
              
              250Catalysis
      Partners (b)*
              
              
              600
              
              
              
              250Apehelion
      Medical Fund, LP (c)
              
              
              314
              
              
              
              -JMR
      Capital Limited (c)
              
              
              208
              
              
              
              -William
      Hitchcock (c)
              
              
              1,045
              
              
              
              -Total
      Notes Payable
              
              $
              3,054
              
              
              $
              1,100Less:  unamortized
      discount
              
              
              (854
              )
              
              
              -Less:  Current
      portion
              
              
              (600
              )
              
              
              (1,100
              )Notes
      payable - long term portion
              
              $
              1,600
              
              
              $
              -
 
 * Related
party (see Note 15)
 
 (a)
              On
      May 1, 2006, the Company executed a $500 thousand Secured Promissory Note
      (the “Langsam
      Note”) due November 1, 2006, payable to the Herbert Langsam
      Irrevocable Trust.  Herbert Langsam is a Director of the
      Company, and Member of the Board of Directors of the
      Company.  The Langsam Note accrues interest at the rate of 12%
      per annum, although from November 1, 2006 through December 2008; the
      Langsam Note accrued interest at rate of 16% per annum as the Company was
      in default.  In December 2008, Mr. Langsam agreed to extend
      maturity of the Langsam Note to June 30, 2009, and then in August 2009,
      agreed to further extend maturity of this note to December 31,
      2009.  The Company also entered into a Security Agreement on May
      1, 2006, granting the Herbert Langsam Irrevocable Trust a security
      interest in all of the Company’s assets as collateral for the satisfaction
      and performance of the Company’s obligations pursuant to the Langsam
      Note.
  On
November 13, 2006, the Company executed an additional $100 thousand Secured
Promissory Note (the “Second
Langsam Note”) due May 13, 2007 payable to the Herbert Langsam
Irrevocable Trust. The Second Langsam Note accrues interest at the rate of 12%
per annum, although from May 13, 2007 through December 2008, the Second Langsam
Note accrued interest at rate of 16% per annum as the Company was in
default.  As additional consideration for entering into the Second
Langsam Note, the Company granted Mr. Langsam warrants to purchase 50 thousand
shares of the Company’s common stock at an exercise price of $1.25 per share,
which were exchanged in the first warrant exchange transaction that closed July
21, 2009.   On November 13, 2006, the Company also entered into a
Security Agreement granting the Herbert Langsam Irrevocable Trust a security
interest in all of the Company’s assets as collateral for the satisfaction and
performance of the Company’s obligations pursuant to the Second Langsam
Note.  Also, In December 2008, Mr. Langsam agreed to extend maturity
of the Second Langsam Note to June 30, 2009, and then in August, 2009, agreed to
further extend maturity of this note to December 31, 2009.
  On
December 29, 2008, in connection with his agreement to extend the maturity dates
of both the Langsam Note and Second Langsam Note to June 30, 2009, the Company
granted Mr. Langsam 25 thousand shares of the Company’s common
stock.  On August 13, 2009, in connection with the further extension
of the maturity date of these notes from June 30, 2009 to December 31, 2009, the
Company agreed to grant Mr. Langsam an additional 25 thousand shares of the
Company’s common stock.
  13
  During
the three and nine months ended September 30, 2009, the Company incurred
interest expense of $18 thousand and $54 thousand, respectively, on these
notes.  At September 30, 2009 and December 31, 2008, accrued interest
on these notes totaled $185 thousand.
 
 (b)
              Between
      February 28, 2008 and March 20, 2008, Catalysis Offshore, Ltd. and
      Catalysis Partners, LLC (collectively “Catalysis”),
      related parties, each loaned $250 thousand to the Company.  As
      consideration for the loans, the Company issued Catalysis promissory notes
      in the aggregate principal amount of $500 thousand (the “Catalysis
      Notes”). The Catalysis Notes accrued interest at the rate of 8% per
      annum and had maturity dates of May 31, 2008. The managing partner of
      Catalysis is Francis Capital Management, LLC (“Francis
      Capital”), an investment management firm. John Francis, a Director
      of the Company and President of Francis Capital, has voting and investment
      control over the securities held by Catalysis. Francis Capital, including
      shares directly held by Catalysis, beneficially owns 3.2 million shares of
      the Company’s common stock and warrants for purchase of 45 thousand shares
      of the Company’s common stock.  On January 29, 2009 the
      Catalysis Notes were converted into new notes as part of the Senior
      Secured Note and Warrant Purchase Agreement described
    below.(c)
              On
      January 29, 2009, the Company entered into a Senior Secured Note and
      Warrant Purchase Agreement, pursuant to which, the Company sold Senior
      Secured Promissory Notes (the “SeniorNotes”) in the principal amount of $2.6
      million and warrants to purchase 1.5 million shares of the Company’s
      common stock (the “January
      Warrant”), to several accredited investors (the “January
      Investors”).  The January Investors paid $2.0 million in
      cash and converted $550 thousand of existing debt and accrued interest on
      the Catalysis Notes into the Senior Notes.   The Senior
      Notes accrue interest, which is compounded to principal quarterly in
      arrears, at 10% per annum, throughout the term of the Senior Notes, and
      unless earlier converted in a Financing Round, have a maturity date of
      January 29, 2011.  As of September 30, 2009, the Company has
      added $115 thousand of accrued interest to the principal
      balance.  The January Warrants have an exercise price of $1.00
      and expire on January 29, 2014.  The Company recorded a debt
      discount in the amount of $1.3 million based on the estimated relative
      fair value allocated to the warrants.  On August 18, 2009 the
      Company converted $212 thousand of existing Senior Note and accrued
      interest owed to Arizona Bay Technology Ventures, LP into common stock at
      $0.86 per share.  For the nine months ended September 30, 2009
      the Company recognized $461 thousand in debt discount
      amortization.   During the three and nine months ended
      September 30, 2009, the Company incurred interest expense of $65 thousand
      and $178 thousand, respectively, on the Senior Notes.  At
      September 30, 2009 accrued interest on these notes totaled $64
      thousand.
  The
Senior Note holders carry conversion rights and warrant that the Senior Notes
may be convertible into the Financing Round, which shall mean as defined in the
holder’s warrant purchase agreement, the “next issuance of Securities by the
Company for cash or the exchange of debt or both taking place after the Closing
and prior to the Note’s maturity date.”  The Company has the right to
prepay the unpaid principal and interest due on the Senior Notes without any
prepayment penalty.  The Senior Notes are secured by essentially all
of the Company’s assets including but not limited to the Company’s interest in
their primary operating subsidiary, SurgiCount Medical Technologies,
Inc.
 
 14
  9.  ACCRUED
LIABILITIES
 
 Accrued
liabilities at September 30, 2009 and December 31, 2008 are comprised of the
following (in
thousands):
 
 September
      30,
                2009
              
              
              December
      31,
                2008Interest
      (see Note 8)
              
              $
              249
              
              
              $
              237Dividends
      on preferred stock
              
              
              115
              
              
              
              134Salaries
      and severance obligations
              
              
              47
              
              
              $
              285Directors
      fees
              
              
              158
              
              
              
              145Contingent
      tax liability (see Note 16)
              
              
              722
              
              
              
              701Other
              
              
              69
              
              
              
              94$
              1,360
              
              
              $
              1,596
 
 10.  DEFERRED
REVENUE
 
 The sale
of the Company’s SurgiCounterTM scanner includes a one year maintenance agreement
covering telephone support and software upgrades.  Revenue relating to
the one year maintenance agreement is deferred at the time of sale, and is
recognized monthly over the twelve month term.
 
 As of
September 30, 2009, the Company had deferred revenue of $4 thousand, which is
included in the Other Accrued Liabilities (Note 9) on the accompanying balance
sheet, at September 30, 2009.
 
 11.  INVENTORIES,
NET
 
 Inventories
are stated at the lower of cost or market and consist of the following (in thousands):
 
 September
      30,
                2009
              
              
              December
      31,
                2008Finished
      goods
              
              $
              836
              
              
              $
              200Reserve
      for excess and obsolete
              
              
              (106
              )
              
              
              -Inventories,
      net
              
              $
              730
              
              
              $
              200
  The
Company recorded charges related to the excess and obsolete reserve to cost of
revenues of zero and $106 thousand for the three and nine months ended September
30, 2009 respectively.  There were no corresponding charges during the
2008 three and nine month periods.
  12.
EQUITY TRANSACTIONS
 
 Common
Stock
 
 On
January 2, 2009, the Company issued 2.5 million warrants to purchase shares of
the Company’s common stock to warrant holders, with anti-dilutive clauses in
their original warrants.   The warrants are exercisable through
the term of the original warrant and have an exercise price of
$0.75.
 
 On
January 29, 2009, the Company entered into a Senior Secured Note and Warrant
Purchase Agreement, pursuant to which, the Company sold Senior
Notes  in the principal amount of $2.6 million and January Warrants to
purchase 1.5 million shares of the Company’s common stock to the January
Investors in consideration for $2 million in cash proceeds and conversion of
$550 thousand owed under existing promissory notes.   The January
Warrants have an exercise price of $1.00 and expire on January 29,
2014.  (See Note 8)
  15
 
 On July
29, 2009, the Company completed the first closing of a private placement of its
common stock.  The shares were issued and sold to accredited investors
who were holders of common stock warrants of the
Company.  The shares of common stock were issued at a per share price
of $0.86,  paid by cancellation of the common stock warrants held by
these holders, and in some cases an additional cash contribution by the
holders.  Holders not making a cash investment tendered warrants to
purchase an aggregate of 1.6 million shares of common stock and received an
aggregate of 597 thousand shares of the Company’s common stock. Holders who
elected to make a cash investment tendered warrants to purchase an aggregate of
4.8 million shares of common stock and an aggregate of $1.6 million in cash, and
received an aggregate of 4.8 million shares of the Company’s common
stock.
 
 On
September 18, 2009, the Company completed the second and final closing of a
private placement of its common stock.  The shares were issued and
sold to accredited investors who were holders of common stock warrants of the
Company.  The shares of common stock were issued at a per share price
of $0.86, paid by cancellation of the common stock warrants held by these
holders, and in some cases an additional cash contribution by the
holders.  Holders not making a cash investment tendered warrants to
purchase an aggregate of 59 thousand shares of common stock and received an
aggregate of 20 thousand shares of the Company’s common stock. Holders who
elected to make a cash investment tendered warrants to purchase an aggregate of
567 thousand shares of common stock and an aggregate of $195 thousand in cash,
and received an aggregate of 567 thousand shares of the Company’s common
stock.
 
 For the
warrants classified in equity prior to the exchange, the Company accounted for
the warrants cancelled as an exchange of warrants for common shares, whereby the
repurchase price of the warrants was  considered to be the fair value
of the common shares issued in the exchange, less any cash received by the
Company from the warrant holders.  Under this treatment, the fair
value of the warrant exchanged was estimated at the date of the exchange based
on the original terms of the warrant and was compared to the repurchase price,
and additional expense was recognized by the Company to the extent that the
repurchase price exceeded the fair value of the warrant prior to the
exchange.
 
 For the
warrants classified as derivative liabilities prior to the exchange, the Company
accounted for the warrants exchanged as an issuance of common shares to
extinguish a liability, and as such, the difference between the reacquisition
price and the net carrying amount of the debt was recognized in earnings in the
period of extinguishment.  The Company determined that the value of
the common stock issued was more clearly evident than the value of the debt, and
therefore should be used in the determination of the reacquisition
price.  In exchanges of warrants classified as derivative liabilities,
whereby the Company also receives cash from the warrant holder as part of the
exchange, the amount of cash received was netted against the value of the common
shares issued to determine the reacquisition price. Warrants classified as
derivative liabilities prior to the exchange were adjusted to the then current
fair value on the date of the exchange, and the change in fair value was
recognized through earnings.  The adjusted fair value was used in the
exchange transaction to determine the gain or loss.
  13.
WARRANTS AND WARRANT DERIVATIVE LIABILITY
 
 The
following table summarizes warrants to purchase common stock activity for the
nine months ended September 30, 2009:
 
 #
      of
                Warrants
              
              
              Range
      of
                Exercise
      PriceWarrants
      outstanding December 31, 2008
              
              
              10,719,896
              
              
              $
              1.25
      - $6.05Issued
              
              
              4,106,326
              
              
              $
              0.75
      - $2.00Cancelled/Expired
              
              
              (8,072,722
              )
              
              $
              0.75
      - $5.95Warrants
      outstanding September 30, 2009
              
              
              6,753,500
              
              
              $
              0.75
      - $6.05
  The
warrants issued during the nine months ended September 30, 2009 and the year
ended December 31, 2008 were issued primarily in connection with the various
subscription and debt agreements entered into by the Company as well as payments
for services and accrued interest. The warrants outstanding as of September 30,
2009 have exercise terms of expiring on dates ranging from November 2009 through
June 2015.
 
 As of
December 31, 2008, warrants to purchase a total of 5.3 million shares, with an
estimated fair value of $1.8 million were recorded as a warrant derivative
liability based on the Company’s evaluation of criteria under FASB guidance as
codified in ASC 815-40, Derivatives and Hedging(previously EITF 00-19, Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own
Stock).  During the nine months ended September 30, 2009,
warrants to purchase 5.8 million additional shares were reclassified from equity
to derivative liability based on the evaluation under ASC 815-40.  In
addition, on August 6, 2009, the shareholders voted to approve a proposal to
increase the total number of authorized shares from 25 million to 100 million
shares of common stock and the Company amended its articles of incorporation
reflecting the increase.  Based on the revaluation of warrants in
accordance with ASC 815-40, certain warrants previously classified as
liabilities due to a lack of sufficient authorized shares outstanding were
reclassified to equity at fair value on the date of the increase in authorized
shares of common stock.  A total of 2.9 million warrants with a fair
value of $2.2 million were reclassified from liability to additional paid in
capital.
  16
 
 Effective
January 1, 2009, upon the adoption of FASB ASC 815-40, the Company reclassified
a total of 1.2 million outstanding warrants that were previously classified as
equity to a derivative liability.  This reclassification was necessary
as the Company determined that certain terms included in these warrant
agreements provided for a possible future adjustment to the warrant exercise
price, and accordingly, under the provisions of ASC 815-40, these warrants did
not meet the criteria for being considered to be indexed to the Company’s
stock.  As such, these warrants no longer qualified for the exception
to derivative liability treatment provided for in ASC 815-10.  The
estimated fair value of the warrants reclassified at January 1, 2009 pursuant to
ASC 815-40 was determined to be $707 thousand.  The cumulative effect
of the change in accounting for these warrants of $794 thousand was recognized
as an adjustment to the opening balance of accumulated deficit at January 1,
2009 based on the difference between the amounts recognized in the consolidated
balance sheet before the initial adoption of ASC 815-40 and the amounts
recognized in the consolidated balance sheet as a result of the initial
application of ASC 815-40.  The amounts recognized in the consolidated
balance sheet as a result of the initial application of ASC 815-40 on January 1,
2009 were determined based on the amounts that would have been recognized if ASC
815-40 had been applied from the issuance date of the warrants.
 
 At
September 30, 2009, warrants to purchase a total of 2.6 million shares, with an
estimated fair value of $2.4 million, are included in liabilities in the
accompanying balance sheet.  Based on the change in fair value of the
warrant derivative liability, the Company recorded a non-cash loss of $1.8
million and $4.3 million for the three and nine months ended September 30, 2009,
respectively.
 
 The
following weighted average assumptions were used to estimate the fair value
information presented with respect to warrants issued during the nine months
ended September 30, 2009 utilizing the Black-Scholes option pricing
model:
 
 Risk-free
      interest rate
              
              
              2.31
              %Average
      expected life (years)
              
              
              1.68
      – 4.31Expected
      volatility
              
              
              98
              %Expected
      dividends
              
              None
  14.
FAIR VALUE MEASUREMENTS
 
 Fair
Value Hierarchy
 
 The
Company adopted the fair value measurement and disclosure requirements of FASB
guidance as codified in ASC 820 (previously SFAS No. 157, Fair Value Measurements)
effective January 1, 2008 for financial assets and liabilities measured on a
recurring basis.  ASC 820 defines fair value, establishes a framework
for measuring fair value under generally accepted accounting principles and
expands disclosures about fair value measurements.  This standard
applies in situations where other accounting pronouncements either permit or
require fair value measurements.  ASC 820 does not require any new
fair value measurements.
 
 Fair
value is defined in ASC 820 as the price that would be received upon sale of an
asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date.  Fair value measurements are to
be considered from the perspective of a market participant that holds the assets
or owes the liability.  ASC 820 also establishes a fair value
hierarchy, which requires an entity to maximize the use of observable inputs and
minimize the use of unobservable inputs when measuring fair value.
 
 The
standard describes three levels of inputs that may be used to measure fair
value:
 
 Level 1:
Quoted prices in active markets for identical or similar assets and
liabilities.
 
 Level
2:  Quoted prices for identical or similar assets and liabilities in
markets that are not active or observable inputs other than quoted prices in
active markets for identical or similar assets and liabilities.
 
 Level
3:  Unobservable inputs that are supported by little or no market
activity and that are significant to the fair value of the assets or
liabilities.
  17
 
 Financial
Instruments Measured at Fair Value on a Recurring Basis
 
 ASC 820
requires disclosure of the level within the fair value hierarchy used by the
Company to value financial assets and liabilities that are measured at fair
value on a recurring basis. At September 30, 2009, the Company had outstanding
warrants to purchase common shares of its stock that are classified as warrant
derivative liabilities with a fair value of $2.4 million.  The
warrants are valued using Level 3 inputs because there are significant
unobservable inputs associated with them.
 
 The table
below sets forth a summary of changes in the fair value of the Company’s
Level 3 assets and liabilities for the nine months ended September 30, 2009
(in
thousands):
 
 December
      31,
                2008
              
              
              Transfer
      into
                Level
      3
              
              
              Transfer
      from
                Level
      3
              
              
              Net
      realized
                losses
      included
                in
      earnings
              
              
              September
      30,
                2009Warrant
      derivative liability
              
              $
              (1,762
              )
              
              $
              (4,240
              )
              
              $
              7,936
              
              
              $
              (4,333
              )
              
              $
              (2,399
              )
  Losses
included in earnings for the three and nine months ended September 30, 2009, are
reported in other income/(expense) in the amount of $1.8 million and $4.3
million, respectively.
 
 Fair
Value of Other Financial Instruments
 
 The
carrying amounts of financial instruments such as cash or cash equivalents,
restricted cash, accounts receivable and accounts payable approximate their fair
values because of the short-term nature of these financial
instruments.  Notes receivable arrangements include a market rate of
interest and their carrying values approximates fair
value.  Convertible debentures and note payable arrangements are based
on borrowing rates currently available to the Company for loans with similar
terms and maturities, and are reported at their carrying values, which the
Company believes approximates fair value.  Warrants classified as
derivative liabilities are reported at their estimated fair market value, with
changes in fair market value being reported in current period
loss.
  15.
RELATED PARTY TRANSACTIONS
 
 Convertible
Debentures and Notes Payable
 
 As of
September 30, 2009 and December 31, 2008, the Company had convertible debentures
and notes payable agreements issued to related parties with aggregate
outstanding principal balances of $2.9 million and $2.5 million, respectively
(See Note 8).
 
 September
      30, 2009
              
              
              December
      31, 2008Notes
      Payable:Herbert
      Langsam
              
              $
              600
              
              
              $
              600Catalysis
      Offshore
              
              
              287
              
              
              
              250Catalysis
      Partners
              
              
              600
              
              
              
              250Total
      Notes Payable
              
              $
              1,487
              
              
              $
              1,100Convertible
      Debentures:Ault
      Glazer Capital Partners
              
              $
              1,425
              
              
              $
              1,425Notes
      Payable and Convertible Debentures
              
              $
              2,912
              
              
              $
              2,525
 
 18
 
 A
Plus International, Inc.
 
 During
the nine months ended September 30, 2009 and 2008, the Company recognized cost
of revenues of $1.3 million and $1.1 million, respectively, in connection with
surgical sponges provided by A Plus International, Inc (“A Plus”).  At
September 30, 2009 and December 31, 2008 the Company’s accounts payable included
$1.4 million and $ 164 thousand, respectively, owed to A Plus in connection with
purchases of surgical sponges.  Effective June 1, 2009, the terms of
the Company’s agreement with A Plus relating to the supply of surgical sponges
were clarified to provide that title to surgical sponges purchased, transferred
to the Company upon receipt by A Plus at its Chino, California
warehouse.  Wenchen Lin, a Director and significant beneficial owner
of the Company is a founder and significant owner of A Plus.
 
 Health
West Marketing Inc.
 
 During
the nine months ended September 30, 2009 and 2008 Health West Marketing
Incorporated received payments for consulting services of $180 thousand in each
of the respective periods, from A Plus.  William Adams the Company’s
former Chief Executive Officer is the Chief Executive Officer and President of
Health West Marketing Inc. and is a consultant to the Company.  The
consulting arrangement between A Plus and Health West has been an ongoing
agreement between the respective parties.  The Company has not
recognized any income or expense on their financial statements relating to the
agreement between Health West Marketing Incorporated and A
Plus.
  16.  COMMITMENTS
AND CONTINGENCIES
 
 Contingent
Tax Liability
 
 In the
process of preparing the Company’s federal tax returns for prior years, the
Company’s management found there had been errors in reporting income to the
recipients and the respective taxing authorities, related to stock grants made
to those certain employees and consultant recipients.   In
addition, the Company determined that required tax withholding relating to these
stock grants had not been made, reported or remitted, as required in fiscal
years 2006 and 2007.  Due to the Company’s failure to properly report
this income and withhold/remit required amounts, the Company may be held liable
for the amounts that should have been withheld plus related penalties and
interest.  The Company has estimated its contingent liability based on
the estimated required federal and state withholding amounts, the employee and
employer portion of social security taxes as well as the possible penalties and
interest associated with the error.  Although the Company’s liability
may ultimately be reduced if it can prove that the taxes due on this income were
paid on a timely basis by some or all of the recipients, the estimated liability
including estimated interest and penalties, accrued by the Company is based on
the assumption that it will be liable for the entire amounts due to the
uncertainty with respect to whether or not the recipients made such
payments.
 
 As the
Company determined that it is probable that it will be held liable for the
amounts owed, and as the amount could be reasonably estimated, an accrual for
the estimated liability, which is included in accrued liabilities as of
September 30, 2009 and December 31, 2008, is $722 thousand and $701 thousand,
respectively.
 
 Legal
Proceedings
 
 On
October 15, 2001, Jeffrey A. Leve and Jeffrey Leve Family Partnership, L.P.
filed a lawsuit (the “Leve
Lawsuit”) against the Company, Sunshine Wireless, LLC ("Sunshine"),
and four other defendants affiliated with Winstar Communications, Inc. (“Winstar”).
On February 25, 2003, the case against the Company and Sunshine was dismissed,
however, on October 19, 2004, Jeffrey A. Leve and Jeffrey Leve Family
Partnership, L.P. exercised their right to appeal.  The initial
lawsuit alleged that the Winstar defendants conspired to commit fraud and
breached their fiduciary duty to the plaintiffs in connection with the
acquisition of the plaintiff's radio production and distribution
business.  The complaint further alleged that the Company and Sunshine
joined the alleged conspiracy. On June 1, 2005, the United States Court of
Appeals for the Second Circuit affirmed the February 25, 2003 judgment of the
district court dismissing the claims against the Company.
 
 On July
28, 2005, Jeffrey A. Leve and Jeffrey Leve Family Partnership, L.P. filed a new
lawsuit (the “New Leve
Lawsuit”) against the Company, Sunshine and four other defendants
affiliated with Winstar. The New Leve Lawsuit attempts to collect a federal
default judgment of $5 million entered against only two entities, i.e., Winstar
Radio Networks, LLC and Winstar Global Media, Inc., by attempting to enforce the
judgment against a number of additional entities who are not judgment debtors.
Further, the New Leve Lawsuit attempts to enforce the plaintiffs default
judgment against entities that were dismissed on the merits from the underlying
action in which plaintiffs obtained their default judgment. On January 29, 2009,
the Superior Court of California issued a preliminary ruling in the Company’s
favor.  On August 5, 2009, the Superior Court of California, County of
Los Angeles issued a Statement of Decision on the New Leve lawsuit finding for
the Company on all claims.  On November 6, 2009, the plaintiffs filed
a notice of appeal in the Superior Court of the State of California, County of
Los Angeles Central District.
 
 19
  17.
SUBSEQUENT EVENTS
 
 Cardinal Health Supply
Agreement.  The exclusive Supply Agreement with Cardinal Health,
which acts as the main distributor of the Company’s surgical sponges used
in the Safety-SpongeTM System in the United States,  terminated on November
14, 2009 in accordance with its terms. The Company is currently in discussions
with Cardinal Health relating to the negotiation of a successor agreement. 
The Company and Cardinal Health have orally agreed to continue under the terms
of the terminated Supply Agreement while discussions continue. The Company is
optimistic that it will enter into a successor agreement; however, if
negotiations do not result in the execution of such an agreement with
Cardinal Health, the absence of such an agreement could adversely impact the
Company’s results of operations and have a material adverse effect on the
Company's business and financial condition.




20




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




The
following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our unaudited condensed
consolidated interim
financial statements and the related notes thereto appearing elsewhere in this
Form 10-Q and our audited consolidated financial statements and related notes
thereto and the description of our business appearing in the Form
10-K.  This discussion contains forward-looking statements that
involve risks and uncertainties. See “Cautionary Note Regarding Forward-Looking
Statements.”  Known and unknown risks, uncertainties and other factors
could cause our actual results to differ materially from those projected in any
forward-looking statements.  In evaluating these statements, you
should specifically consider various factors, including, but not limited to,
those set forth under the caption “Risk Factors” in the Form 10-K.




Overview




Patient
Safety Technologies, Inc. is a Delaware corporation whose operations are
conducted through its wholly-owned operating subsidiary, SurgiCount Medical,
Inc., a California corporation.  The use of the terms “we,” “us,”
“our,” and “our company” and other similar terms in this quarterly report on
Form 10-Q means Patient Safety Technologies, Inc. and its consolidated
subsidiary, SurgiCount Medical, Inc. unless the context requires
otherwise.




We focus
on the development, marketing and sales of products and services in the medical
patient safety markets.  Our Safety-SpongeTM System
is a patented system of bar-coded surgical sponges, SurgiCounterTM scanners, and
software applications integrated to form a comprehensive counting and
documentation system.  This system is designed to reduce the number of
retained surgical sponges unintentionally left inside of patients during
surgical procedures by allowing faster and more accurate counting of surgical
sponges.  We initially sell our SurgiCount Safety-SpongeTM System
to hospitals and other institutions through our direct sales force, but rely on
a distributor for the ongoing supply of our proprietary surgical sponge
products, manufactured for us by an exclusive supplier, to hospitals and other
institutions that have adopted our system.  Our business model
consists of selling our unique surgical sponge products on a recurring basis to
those hospitals and institutions that have adopted our SurgiCount
Safety-SpongeTM
System.




We
recently launched the SurgiCount indemnification program, whereby hospitals
using the Safety-SpongeTM System in
conjunction with our proprietary data manager, “CitadelTM,” are insured for
up to $1 million per retained foreign object (“RFO”) event. We believe that this
has the potential to increase interest in, and accelerate adoption of, our
Safety-SpongeTMSystem. As hospitals continue to embrace our solution to
RFO’s, we are actively expanding our sales and clinical presence in the
marketplace to keep pace with our growing customer base.




Sources
of Revenues and Expenses




Revenues




Surgical Sponge
Revenues.  We generate revenues primarily from the sale of our
Safety-SpongeTM sponges to our exclusive distributor, who then sells directly to
and through sub-distributors to hospitals and other institutions that have
adopted our SurgiCount Safety-SpongeTM
System.  We expect hospitals and institutions that adopt our
Safety-SpongeTM System to commit to its use and thus provide a recurring source
of revenues from ongoing sales of supplies. We recognize revenues from the sale
of surgical sponges in accordance with Staff Accounting Bulletin
104.  Because most of our surgical sponges sales are to our
distributor FOB shipping point, this means we generally recognize revenues upon
shipment to our distributor.




Hardware, Software and Maintenance
Agreement Revenues.  We also generate revenues from the sale of
related hardware and software to such hospitals and institutions.  The
sale of our SurgiCount Safety-SpongeTM System
includes hardware (the SurgiCounterTM scanners), our proprietary software and an
initial one-year maintenance agreement (which may be renewed).  All of
these items are considered to be separate deliverables within a multiple-element
arrangement and, accordingly, we allocate the total price of this arrangement
among each respective deliverable, and recognize revenue as each element is
delivered.  For the hardware and software elements of our SurgiCount
Safety-SpongeTM System,
we recognize revenues on delivery, which is the time of shipment (if terms are
FOB shipping point) or upon receipt by the customer (if terms are FOB
destination).  Delivery with respect to our initial one-year
maintenance agreements is considered to occur on a monthly basis over the term
of the one-year period; we recognize revenues related to this element on a
pro-rata basis during this period.  Because of the change in our
business model discussed below under “Factors Affecting Future Results,” we do
not expect for these sales to represent a significant portion of our revenues
going forward.




21




Cost
of revenues




Our cost
of revenues consists of direct product costs of our sponges from our contract
manufacturers and a reserve expense for obsolete and slow moving
inventory.  We also include the travel and salary expenses relating to
the software upgrades performed on our scanners under maintenance agreements in
cost of revenues.  In addition, when we provide (rather than sell)
scanners to hospitals and institutions, we include the depreciation expense in
cost of revenues over the life of the hardware, estimated to be three
years.  However, when we sell the scanners to hospitals and
institutions, our costs of revenues includes the full product cost when
shipped.




Research
and development expenses




Our
research and development expenses consist of costs associated with the design,
development, testing and enhancement of our products.  We also include
salaries and related employee benefits, research-related overhead expenses and
fees paid to external service providers in our research and development
expenses.




Sales
and marketing expenses




Our sales
and marketing expenses consist primarily of salaries and related employee
benefits, sales commissions and support cost, professional service fees, travel,
education, trade show and marketing costs.




General
and administrative expenses




Our
general and administrative expenses consist primarily of salaries and related
employee benefits, professional service fees, legal costs, expenses related to
being a public entity, depreciation and amortization expense.




Total
other income (expense)




Our total
other income (expense) primarily reflects changes in the fair value of warrants
classified as derivative liabilities.  Under applicable accounting
rules (discussed below under “Critical Accounting Policies—Warrant Derivative
Liability”), we are required to make estimates of the fair value of our warrants
each quarter, and “mark to market.”  As a result, changes in our stock
price from period to period result in other income (when our stock price
decreases) or other expense (when our stock price increases) on our income
statement.  We also record realized gain (loss) on assets held for
sale and unrealized loss on assets held for sale in total other income
(expense).




Critical
Accounting Policies and Estimates




The
preparation of financial statements in conformity with U.S. generally accepted
accounting principles requires the use of estimates and assumptions that affect
the reported amountsof assets and liabilities,
revenues and expenses, and related disclosures in the financial
statements.  Critical accounting policies are those accounting
policies that may be material due to the levels of subjectivity and judgment
necessary to account for highly uncertain matters or the susceptibility of such
matters to change, and that have a material impact on financial condition or
operating performance. While we base our estimates and judgments on our
experience and on various other factors that we believe to be reasonable under
the circumstances, actual results may differ from these estimates under
different assumptions or conditions.  We believe the following
critical accounting policies used in the preparation of our financial statements
require significant judgments and estimates.  For additional
information relating to these and other accounting policies, see Note 3 to our
consolidated financial statements, appearing in Item 1 of this quarterly report
on Form 10-Q.




22




Warrant
Derivative Liability




We
account for warrants issued in connection with financing arrangements in
accordance with Financial Accounting Standards Board (“FASB”) Accounting
Standards Codification (“ASC”) Topic 815-40 Derivatives and Hedging – Contracts
in Entity’s Own Equity (which covers former Emerging Issues Task Fork (“EITF”)
Issue No 07-5, Determining
whether an Instrument (or Embedded Feature) is indexed to an Entity’s own
Stock and the former EITF Issue No. 00-19, Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own
Stock).  In applying ASC Topic 815-40, we must estimate the
fair value of warrants classified as derivative liabilities.  Although
we use the Black-Scholes option pricing model to estimate such fair value, this
model requires the use of numerous assumptions, including, among others, the
expected life (turnover), volatility of the underlying equity security, a risk
free interest rate and expected dividends. The use of different assumptions by
management in the Black Scholes option pricing model could produce substantially
different results.  Because we record changes in the fair value of
warrants classified as derivative liabilities in total other income (expense),
materially different results could have a material effect on our results of
operations.




Goodwill




Our
goodwill represents the excess of the purchase price over the estimated fair
values of the net tangible and intangible assets of SurgiCount Medical, Inc.
acquired in February 2005. We review goodwill for impairment at least annually
in the fourth quarter, as well as whenever events or changes in circumstances
indicate its carrying value may not be recoverable in accordance with ASC Topic
350-10 (previously Statement of Financial Accounting Standards (“SFAS”) No. 142,
Goodwill and Other Intangible
Assets).  ASC Topic 350-10 requires that a two-step impairment
test be performed on goodwill. In the first step, we will compare the fair value
to its carrying value.  If the fair value exceeds the carrying value,
goodwill will not be considered impaired and we are not required to perform
further testing.  If the carrying value exceeds the fair value, then
we must perform the second step of the impairment test in order to determine the
implied fair value of goodwill and record an impairment loss equal to the
difference. Determining the implied fair value involves the use of significant
estimates and assumptions. These estimates and assumptions include revenue
growth rates and operating margins used to calculate projected future cash
flows, risk-adjusted discount rates, future economic and market conditions and
determination of appropriate market comparables. We base our fair value
estimates on assumptions we believe to be reasonable but that are unpredictable
and inherently uncertain. Actual future results may differ from those estimates.
To the extent additional events or changes in circumstances occur, we may
conclude that a non-cash goodwill impairment charge against earnings is
required, which could have an adverse effect on our financial position and
results of operations.




Stock-Based
Compensation




We
recognize compensation expense, under the provisions of ASC Topic 505-50
(previously SFAS No. 123 (R), Share-Based Payment). As a
result, we recognize compensation expense in an amount equal to the estimated
fair value of each option grant, non-vested stock award and shares issued under
the employee stock purchase plan over the estimated period of service and
vesting.  This estimation of the fair value of each stock-based grant
or issuance on the date of grant involves numerous assumptions by management.
Although we calculate the fair value under the Black Scholes option pricing
model, which is a standard option pricing model, this model still requires the
use of numerous assumptions, including, among others, the expected life
(turnover), volatility of the underlying equity security, a risk free interest
rate and expected dividends. The model and assumptions also attempt to account
for changing employee behavior as the stock price changes and capture the
observed pattern of increasing rates of exercise as the stock price
increases.  The use of different assumptions other than those used by
management in the Black Scholes option pricing model could produce substantially
different results.




23




Impairment
of Long-Lived Assets and Identifiable Intangible Assets




We
evaluate long-lived assets and identifiable intangible assets with finite useful
lives under the provisions of ASC Topic 360-10 (previously SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets), and accordingly, management reviews our
long-lived assets and identifiable intangible assets with finite useful lives
for impairment whenever events or changes in circumstances indicate that the
carrying amount of such assets may not be recoverable. We recognize an
impairment loss when the sum of the future undiscounted net cash flows expected
to be realized from the asset is less than its carrying amount. If an asset is
considered to be impaired, the impairment to be recognized is measured by the
amount by which the carrying amount of the asset exceeds its fair value.
Considerable judgment is necessary to estimate the fair value of the assets and
accordingly, actual results could vary significantly from such estimates. Our
most significant estimates and judgments relating to the long-lived asset
impairments include the timing and amount of projected future cash
flows.




Accounting
for Income Taxes




Deferred
income taxes result primarily from temporary differences between financial and
tax reporting. Deferred tax assets and liabilities are determined based on the
difference between the financial statement basis and tax basis of assets and
liabilities using enacted tax rates. Future tax benefits are subject to a
valuation allowance when management is unable to conclude that our deferred tax
assets will more likely than not be realized from the results of operations. Our
estimate for the valuation allowance for deferred tax assets requires management
to make significant estimates and judgments about projected future operating
results. If actual results differ from these projections or if management’s
expectations of future results change, it may be necessary to adjust the
valuation allowance.




Effective
January 1, 2007, we began to measure and record uncertain tax positions in
accordance with ASC Topic 740-10 (previously FASB Interpretation No. (“FIN”) 48,
Accounting for Uncertainty in
Income Taxes — an Interpretation of FASB Statement No. 109).ASC Topic
740-10 prescribes a threshold for the financial statement recognition and
measurement of a tax position taken or expected to be taken in a tax return.
Only tax positions meeting the more-likely-than-not recognition threshold at the
effective date may be recognized or continue to be recognized upon adoption of
this Interpretation. ASC Topic 740-10 also provides guidance on accounting for
de-recognition, interest and penalties, and classification and disclosure of
matters related to uncertainty in income taxes. Accounting for uncertainties in
income tax positions under ASC Topic 740-10 involves significant judgments by
management.  If actual results differ from these judgments, it may be
necessary to adjust the provision for income taxes.




Recent
Accounting Pronouncements




On July
1, 2009, the FASB released the FASB Accounting Standards Codification,TM
sometimes referred to as the “Codification” or “ASC.”  For us, this
means that instead of following the rules in a particular SFAS or FIN, we now
following the guidance in the corresponding ASC Topic.  In other
words, instead of applying SFAS No. 133, Accounting for Derivatives and
Hedging Activities, we will now follow the guidance in Topic 815, Derivatives and
Hedging.  The Codification does not change how we account for
our transactions or the nature of related disclosures made. However, when
referring to guidance issued by the FASB, we now refer to topics in the ASC
rather than SFAS or FIN.  The above change was made effective by the
FASB for periods ending on or after September 15, 2009 and accordingly, we have
updated references in this quarterly report on Form 10-Q to reflect the
Codification Topics as applicable.




For
additional discussion regarding this, and other accounting pronouncements, see
Note 3 to our consolidated financial statements, appearing in Item 1 of this
quarterly report on Form 10-Q.




24




Internal
Control Over Financial Reporting




In
connection with the audit for the year ended December 31, 2008, our independent
registered public accounting firm identified significant deficiencies in our
internal control over financial reporting that are material
weaknesses.  These material weaknesses included an ineffective general
control environment, an ineffective risk assessment processes, and ineffective
internal control policies and procedures relating to equity transactions and
share-based payments, the proper reporting of income and accounting for payroll
taxes, and the integrity of spreadsheets and other “off system” work papers used
in the financial reporting process.





To
address the weaknesses identified in our general control environment, our board
of directors hired a new Chief Executive Officer and restructured the board to
include two directors who meet the requirements of an audit committee financial
expert and have significant corporate governance experience, both of whom are
independent directors. To address the weaknesses identified relating to equity
transactions, we implemented a software program specifically designed to track
and account for share-based payments and equity transactions.  In
addition, we engaged an internal control specialist to design and help implement
effective risk assessment processes.




For
information regarding our evaluation of the effectiveness of our disclosure
controls and procedures as well as any changes in our internal control over
financial reporting, see Item 4T “Controls and Procedures” of this quarterly
report on Form 10-Q.




Factors
Affecting Future Results




Cardinal Health Supply
Agreement.  Our exclusive Supply Agreement with Cardinal Health,
which acts as the main distributor of our surgical sponges used in our
Safety-SpongeTM System in the United States,  terminated on November 14,
2009 in accordance with its terms. As we  are currently in discussions with
Cardinal Health relating to the negotiation of a successor agreement, we and
Cardinal Health have orally agreed to continue under the terms of our terminated
Supply Agreement while discussions continue. We are optimistic that we will
enter into a successor agreement; however,  if our negotiations do not
result in our executing such an agreement with Cardinal Health, the absence of
such an agreement could adversely impact our results of operations and have a
material adverse effect on our business and financial condition.




Effect of Stocking Sales and Backlog
on Revenues.  Our revenues reflect primarily the sale of
surgical sponges to our main distributor.  Because we recognize
revenues when we ship product, the timing of orders by our main distributor and
the management of its inventory may affect the comparability of revenues between
periods. Additionally, because we primarily recognize revenues when we ship our
products to our main distributor, to the extent there is a backlog in receipt of
products from our exclusive supplier of our surgical sponges, we may not always
be able to recognize revenues in the same period in which a product order is
received. In addition, our main distributor may be required to sell down its
inventory more than it anticipated, which could result in a larger than normal
product order.   Thus, certain changes in our revenues between
periods are not necessarily reflective of hospital or institutional demand for
our surgical sponge products.




Reduction in Hardware Sales – Effect
on Revenues and Cost of Revenues.  Prior to the third quarter
of 2009, our business model included the sale of our SurgiCounterTM scanners and
related software used in our SurgiCount Safety-SpongeTM System
to most hospitals and institutions that adopted our system.  Beginning
with the third quarter of 2009, we modified our business model and began to
provide our SurgiCounterTM scanners and related software to certain hospitals and
institutions at no cost to certain customers when they adopt our SurgiCount
Safety-SpongeTM
System.  Because we now engage only in limited SurgiCounterTM scanner
sales, we do not expect such sales to continue to represent sizable
revenues.  Notably, in the third quarter of 2009, Safety-SpongeTM sales
accounted for 99% of our revenues, and sales of hardware accounted for 1%,
compared to 83% and 8% for the same period in 2008, respectively.  In
addition to the effect on our revenues, this change in our business model also
affected our costs of revenues because rather than recognizing the full product
cost for all SurgiCounterTM scanners at the time of shipment in our cost of
revenues, we now recognize only the depreciation expense for those SurgiCounterTM
scanners that we have provided to certain hospitals and institutions at
cost.  This business model change is expected to lead to
a significant improvement in our gross margin based on the shift in product
mix resulting in a significantly higher percentage of surgical sponge sales
which are sold at a higher margin than our SurgiCounterTM scanners included in
our costs of revenues.




25




Results
of Operations




Three
Months Ended September 30, 2009 Compared to Three Months Ended September 30,
2008




Revenues




We had
revenues of $978 thousand for the three months ended September 30, 2009, an
increase of 11% compared to $880 thousand for the same period in
2008.  In the three months ended September 30, 2009,
Safety-SpongeTM sales
accounted for 99% of revenues, and sales of hardware accounted for 1%, compared
to 83% and 8% for the same period in 2008, respectively.  The primary
reason for the increase in revenues was an increase in Safety-SpongeTM sales
as more hospital systems select and implement our system to reduce the number of
retained sponges in surgeries.  This growth more than offset the
decline in revenues from scanner sales as a result of the shift in our business
model.




Cost
of revenues




Cost of
revenues decreased by $78 thousand or 13%, to $540 thousand for the three months
ended September 30, 2009 from $622 thousand for the same period in
2008.  The primary reason for the decrease is the change in our
business model with respect to the provision of our SurgiCounterTM scanners,
which resulted in approximately $144 thousand of cost now being depreciated and
recognized over the life of the hardware. This change in business model more
than offset other increases in cost of revenues during the quarter.




Gross
profit




We had
gross profit of $438 thousand for the three months ended September 30, 2009, an
increase of $180 thousand, or 69%, compared to $258 thousand in the same period
in 2008.  The primary reason for the increase in gross
profit during the third quarter of 2009 was the higher revenue
growth achieved combined with the shift in product mix resulting
in a significantly higher percentage of surgical sponge sales, which are sold at
a higher margin than our SurgiCounterTM scanners.  We had gross
margin of 44% for the three months ended September 30, 2009, compared to
29% for the same period in 2008, which improvement is attributable to our change
in business model.




Operating
expenses




We had
total operating expenses of $1.9 million for the three months ended September
30, 2009, an increase of $229 thousand, or 13%, compared to $1.7 million in the
same period in 2008.  The primary reason for the increase in operating
expenses was the significant increase in our general and administrative
expenses, which reflected increased costs associated with being a public
company, the reclassification of the warrant costs from additional paid in
capital offset by a decrease in personnel costs, which more than offset the
decreases in our research and development expenses and sales and marketing
expenses.




Research
and development expenses




We had
research and development expenses of $69 thousand for the three months ended
September 30, 2009, a decrease of $18 thousand, or 21%, compared to $87 thousand
in the same period in 2008.  The primary reason for the decrease in
research and development expenses was a decrease in personnel and associated
compensation costs.




26




Sales
and marketing expenses




We had
sales and marketing expenses of $610 thousand for the three months ended
September 30, 2009, a decrease of $52 thousand, or 8%, compared to $662 thousand
in the same period in 2008.  The primary reason for the decrease in
sales and marketing expenses was decrease in personnel and associated
compensation costs.




General
and administrative expenses




We had
general and administrative expenses of $1.3 million for the three months ended
September 30, 2009, an increase of $300 thousand, or 31%, compared to $958
thousand in the same period in 2008.    The primary reason
for the increase is a reclass of the warrant costs from additional paid in
capital offset by a decrease in personnel costs.




Total
other income (expense)




We had
total other expense of $1.9 million for the three months ended September 30,
2009, compared to total other income of $1.6 million in the same period in
2008.  The primary reason for the change was a significant increase in
the fair value of our warrant derivative liability, which resulted in expense of
$1.8 million in the three months ended September 30, 2009, compared to income of
$1.7 million in the same period in 2008.  This liability, and the
related expense, increases and decreases as a direct result of fluctuations in
the price of our common stock, which trades on the over the counter
market.




Net
income (loss)




For the
foregoing reasons, we had a net loss of $3.4 million for the three months ended
September 30, 2009 compared to net income of $205 thousand for the three months
ended September 30, 2008.




Nine
Months Ended September 30, 2009 Compared to Nine Months Ended September 30,
2008




Revenues




We had
revenues of $2.9 million for the nine months ended September 30, 2009, an
increase of 52% compared to $1.9 million for the same period in
2008.  In the nine months ended September 30, 2009, Safety-SpongeTM sales
accounted for 88% of revenues, and sales of hardware accounted for 7% compared
to 83% and 8% for the same period in 2008, respectively.  The primary
reason for the increase in revenues was an increase in Safety-SpongeTM sales
as more hospital systems select and implement our system to reduce the number of
retained sponges in surgeries




Cost
of revenues




Cost of
revenues increased by $366 thousand, or 27%, to $1.7 million for the nine months
ended September 30, 2009 from $1.3 million for the same period in
2008.  This increase is primarily attributable to higher volume of
Safety-SpongeTM sales
and an allowance for slow moving inventory, which was only partially offset by
the change in our business model with respect to the provision of our
SurgiCounterTM scanners.




Gross
profit




We had
gross profit of $1.2 million for the nine months ended September 30, 2009, an
increase of $639 thousand, or 108%, compared to $595 thousand in the same period
in 2008.  The primary reason for the increase in gross profit was that
we experienced both revenue growth due to increased sales of our Safety-
SpongeTM System,
combined with the shift in product mix resulting in a higher percentage of
surgical sponge sales, which are sold at a higher margin than
our SurgiCounterTM scanners.




27




We had
gross margin of 42% for the nine months ended September 30, 2009, compared
to 31% for the same period in 2008.  The improvement in our gross
margin is primarily attributable to our change in business model and its effects
on our cost of revenues.




Operating
expenses




We had
total operating expense of $7.2 million for the nine months ended September 30,
2009, an increase of $1.6 million, or 28%, compared to $5.6 million in the same
period in 2008.  The primary reasons for the increase in operating
expenses was $1.3 million cost in satisfaction of contractual obligations under
warrants with trigger events, and, to a lesser extent, increased costs
associated with being a public company.




Research
and development expenses




We had
research and development expenses of $268 thousand for the nine months ended
September 30, 2009, an increase of $100 thousand, or 60%, compared to $168
thousand in the same period in 2008.  The primary reason for the
increase in research and development expenses was an increase in software
development costs associated with our system hardware.




Sales
and marketing expenses




Our sales
and marketing expenses were flat at $1.8 million for the nine months ended
September 30, 2009, and for the same period in 2008.  The primary
reason these sales and marketing expenses were relatively flat was that we had a
decrease in personnel and related salary and benefit expense offset by an
increase in hospital placements compared to the 2008 period, as well as the
associated consulting and travel expenses.




General
and administrative expenses




We had
general and administrative expenses of $5.2 million for the nine months ended
September 30, 2009, an increase of $1.5 million, or 41%, compared to $3.7
million in the same period in 2008.  The primary reason for the
increase in general and administrative expenses was the $1.3 million cost of
non-dilutive warrants issued on January 2, 2009 in satisfaction of contractual
obligations under warrants with trigger events.




Total
other income (expense), net




We had
total other expense of $4.8 million for the nine months ended September 30,
2009, compared to total other income of $1.2 million in the same period in
2008.  The primary reason for the change was a significant increase in
the fair value of our warrant derivative liability, which resulted in expense of
$4.3 million in the nine months ended September 30, 2009 compared to income of
$1.5 million in the same period in 2008.  This liability, and the
related expense, increases and decreases as a direct result of fluctuations in
the price of our common stock, which trades on the over the counter
market.




Net
loss




For the
foregoing reasons, we had a net loss of $10.9 million for the nine months ended
September 30, 2009 compared to $3.8 million for the nine months ended September
30, 2008.




Financial
Condition, Liquidity and Capital Resources




We had
cash and cash equivalents of $779 thousand at September 30, 2009 compared to
$296 thousand at December 31, 2008, and total current liabilities of $7.6
million at September 30, 2009 compared to $6.8 million at December 31, 2008. As
of September 30, 2009 we had a working capital deficit of approximately $5.7
million, of which $2.4 million is associated with our warrant derivative
liability.




28




Our
principal sources of cash have included the issuance of equity and debt
securities. We expect that, as our revenues grow, our operating expenses will
continue to grow and, as a result, we will need to generate significant
additional net revenues to achieve profitability.  We do not believe
that our current cash and cash equivalents will be adequate to fund our
projected operating requirements for the next 12 months.  Although we
engaged in a financing transaction in July 2009 that resulted in the receipt of
approximately $1.5 million in cash and in $195 thousand in September 2009, and
successfully extended the maturity of certain notes to December 31, 2009 (see
“—Description of Indebtedness” below), we must still obtain additional financing
and achieve profitable operations in order to repay our existing short-term and
long-term debt and to provide a sufficient source of operating
capital.  If we are unable to obtain this additional financing, the
absence of capital will have a material adverse impact on our business and
operations by year-end 2009.




Operating
activities




We used
$3.1 million of cash for operating activities in the nine months ended September
30, 2009.  Changes in our working capital requirements provided $553
thousand of cash during the nine months ended September 30, 2009, primarily due
to an increase in accounts payable.




We used
$3.0 million of cash for operating activities in the nine months ended September
30, 2008. Changes in our working capital requirements used $222 thousand of cash
during the nine months ended September 30, 2008.





Investing
activities




We used
net cash of $89 thousand in investing activities for the nine months ended
September 30, 2009, primarily for the purchase of scanners and related hardware
provided to our customers as part of the sale of our Safety SpongeTM
System.




We used
net cash of $93 thousand in investing activities for the nine months ended
September 30, 2008, primarily consisting of capitalized costs of $319 thousand,
of which $251 thousand related to the ongoing development of purchased software
related to our Safety-SpongeTM System, offset by the sale of our undeveloped land
in Alabama for $226 thousand.




Financing
activities




We
generated net cash of $3.6 million from financing activities during the nine
months ended September 30, 2009, primarily from net proceeds from the July and September 2009 sales of
stock and warrants in exchange for warrants and the January 2009 issuance of
$2.0 million in debt.




We
generated $3.8 million of cash from financing activities during the nine months
ended September 30, 2008, primarily from net proceeds of $3.9 million from the
issuance of common stock and warrants and $500 thousand from short-term debt
financings, offset by the repayment of a promissory note of $551 thousand and
the payment of preferred dividends of $57 thousand.




Description
of Indebtedness




At
September 30, 2009 we had outstanding promissory notes in the aggregate
principal amount of $3.1 million and convertible debt instruments in the amount
of $1.5 million as detailed below.




Senior
Secured Convertible Notes




On
January 29, 2009, we entered into a Senior Secured Note and Warrant Purchase
Agreement pursuant to which we sold $2.6 million of Senior Secured Convertible
Promissory Notes and warrants to purchase 1.5 million shares of our common stock
at $1.00 per share to several accredited investors.  These investors
paid $2.0 million in cash and converted $550 thousand of existing debt and
accrued interest into the new Senior Secured Convertible Promissory
Notes.  The Senior Secured Convertible Promissory Notes accrue
interest at a rate of 10% per annum and unless earlier converted into equity,
mature on January 29, 2011.  The warrants expire on January 29,
2014.




29




During
the three and nine month periods ended September 30, 2009, we incurred interest
expense of $84 thousand and $238 thousand, respectively, on these
notes.  At September 30, 2009, accrued interest on these notes totaled
$64 thousand.  Because we capitalize interest that is not paid in the
quarter, $115 thousand has been added to the principle balance as of September
30, 2009.




Langsam
Notes




On May 1,
2006, we executed a $500 thousand Secured Promissory Note (the “Langsam Note”)
due November 1, 2006 payable to the Herbert Langsam Irrevocable
Trust.  Herbert Langsam is a Director of our company.  The
Langsam Note accrues interest at the rate of 12% per annum, although from
November 1, 2006 through December 2008, the Langsam Note accrued interest at
rate of 16% per annum as we were in default.  In December 2008, Mr.
Langsam agreed to extend maturity of the Langsam Note to June 30, 2009, and then
in August 2009, agreed to further extend maturity of this note to December 31,
2009.  We also entered into a Security Agreement on May 1, 2006,
granting the Herbert Langsam Irrevocable Trust a security interest in all of our
assets as collateral for the satisfaction and performance of our obligations
pursuant to the Langsam Note.




On
November 13, 2006, we executed an additional $100 thousand Secured Promissory
Note (the “Second Langsam Note”) due May 13, 2007 payable to the Herbert Langsam
Irrevocable Trust. The Second Langsam Note accrues interest at the rate of 12%
per annum, although from May 13, 2007 through December 2008, the Second Langsam
Note accrued interest at rate of 16% per annum as we were in
default.  In December 2008, Mr. Langsam agreed to extend maturity of
the Second Langsam Note to June 30, 2009, and then in August 2009, agreed to
further extend maturity of this note to December 31, 2009.  As
additional consideration for entering into the Second Langsam Note, we granted
Mr. Langsam warrants to purchase 50 thousand shares of our common stock at an
exercise price of $1.25 per share.  These warrants were exchanged in
the first warrant exchange transaction that closed July 21, 2009 (see Part II,
Item 2 “Unregistered Sales of Equity Securities and Use of Proceeds” of this
quarterly report on Form 10-Q).  On November 13, 2006, we also entered
into a Security Agreement granting the Herbert Langsam Irrevocable Trust a
security interest in all of our assets as collateral for the satisfaction and
performance of our obligations pursuant to the Second Langsam Note.




On
December 29, 2008, in connection with his agreement to extend the maturity dates
of both the Langsam Note and Second Langsam Note to June 30, 2009, we granted
Mr. Langsam 25 thousand shares of our common stock.  On August 13,
2009, in connection with the further extension of the maturity date of both
notes from June 30, 2009 to December 31, 2009, we agreed to grant Mr. Langsam an
additional 25 thousand shares of our common stock, which shares were issued in
the fourth quarter 2009.




During
the three and nine months ended September 30, 2009, we incurred interest expense
of $18 thousand and $54 thousand, respectively, on these notes.  At
September 30, 2009 and December 31, 2008, accrued interest on these notes
totaled $185 thousand.




Spiegel
Discount Convertible Debenture




On
October 27, 2008 we entered into a Discount Convertible Debenture with David
Spiegel in the principal amount of $65 thousand at a 9% (or $15 thousand)
original issue discount with a maturity date of October 27,
2011.  This debenture is convertible at any time, in whole or in part,
into our common stock at a conversion price of $1.50 per common share at the
option of the holder.




During
the three and nine months ended September 30, 2009, we incurred interest expense
and amortization of the debt discount of $1 thousand and $3 thousand,
respectively, on this debenture.  At September 30, 2009 and December
31, 2008, accrued interest on this debenture totaled $1 thousand and $4
thousand, respectively.




30




AG
Capital Partners




On
September 5, 2008, we entered into an agreement with Ault Glazer Partners LLC
(“AG Capital Partners”) to modify the terms of our then outstanding $2.5 million
Convertible Secured Promissory Note effective as of June 1, 2007 payable to AG
Capital Partners (the “AG Capital Note”).  The AG Capital Note, which
was to have matured December 31, 2010, bore interest at a rate of 7% per annum,
was convertible into shares of our common stock at $2.50 per share in certain
circumstances, and was secured by all of our assets.  As amended, we
agreed to pay AG Capital Partners $450 thousand in cash and, contingent upon
satisfaction of certain conditions by AG Capital Partners, convert the remaining
balance of the note into 1.3 million shares of our common
stock.  Notably, AG Capital Partners is required to transfer certain
leases from our name into its name.  Following the amendment, on
September 12, 2008, we agreed to issue shares of common stock in advance of
conversion of the AG Capital Note.  As of the date of this quarterly
report on Form 10-Q, we have paid AG Capital Partners the $450 thousand cash as
agreed, and issued an aggregate 800 thousand shares of our common stock to AG
Capital Partners in settlement in advance of conversion.  AG Capital
Partners has not yet satisfied the conditions of the amendment and the issuance
of the remaining shares of our common stock to AG Capital Partners remains
contingent upon its satisfaction of the conditions of the
amendment.  In light of the settlement agreement, we are no longer
incurring interest expense on the AG Capital Note.




AG
Capital Partners is controlled by Milton “Todd” Ault III, our former Chairman
and Chief Executive Officer, and Louis Glazer, a Director of our company, both
of whom currently have a significant beneficial ownership interest in our common
and preferred stock.




Related
Party Transactions




Herbert
Langsam is a member of our Board of Directors.  As described above
under “—Description of Indebtedness—Langsam Notes,” Mr. Langsam has provided
financing to our company in exchange for equity and interest payments and a
security interest in our assets.




AG
Capital Partners is controlled by Milton “Todd” Ault III, our former Chairman
and Chief Executive Officer, and Louis Glazer.  Louis Glazer is a
member of our Board of Directors. Both Mr. Ault and Mr. Glazer currently have a
significant beneficial ownership interest in our common and preferred
stock.  .




Catalysis
Offshore Ltd and Catalysis Partners, LLC (collectively, “Catalysis”)
participated in the Senior Secured Note Offering described above under
“Description of Indebtedness—Senior Secured Note Offering,” and hold notes with
an aggregate principal amount of $865 thousand as at September 30,
2009.  John Francis, a member of our Board of Directors, is President
of Francis Capital Management, LLC, which is the managing partner of
Catalysis.




We have
an exclusive supply agreement for our surgical sponges with A Plus
International, Inc. Wenchen Lin, a member of our Board of Directors, is a
founder and significant beneficial owner of A Plus.  During the three
and nine months ended September 30, 2009, our cost of revenue includes $490
thousand and $1.3 million, respectively, in connection with our this supply
arrangement, and our accounts payable included $1.4 million  and $164
thousand at September 30, 2009 and December 31, 2008, respectively, payable to A
Plus under this supply agreement.  During the quarter the Company
purchased $455 thousand from A Plus International.




For
additional information relating to these and other related party transactions,
see Note 15 to our consolidated financial statements appearing in Item 1 of this
quarterly report on Form 10-Q.




Off-Balance
Sheet Arrangements




As of
September 30, 2009, we had no off-balance sheet arrangements.




31




Commitments
and Contingencies




As of
September 30, 2009, other than our office lease and employment agreements with
key executive officers, we had no material commitments other than the
liabilities reflected in our consolidated financial statements.




Item
3. Quantitative and Qualitative Disclosures About Market Risk




As a
smaller reporting company as defined by Rule 12b-2 of the Exchange Act and in
item 10(f)(1) of Regulation S-K, we are electing scaled disclosure reporting
obligations a-d; therefore are not required to provide the information requested
by this item.




Item
4T. Controls and Procedures.




Limitations
on the Effectiveness of Controls




We seek
to improve and strengthen our control processes to ensure that all of our
controls and procedures are adequate and effective.  We believe that a
control system, no matter how well designed and operated, can only provide
reasonable, not absolute, assurance that the objectives of the control system
are met.  In reaching a reasonable level of assurance, management
necessarily was required to apply its judgment in evaluating the cost-benefit
relationship of possible controls and procedures.  In addition, the
design of any system of controls also is based in part upon certain assumptions
about the likelihood of future events, and there can be no assurance that any
design will succeed in achieving its stated goals under all potential future
conditions.  Over time, a control may become inadequate because of
changes in conditions, or the degree of compliance with policies or procedures
may deteriorate.  No evaluation of controls can provide absolute
assurance that all control issues and instances of fraud, if any, within a
company will be detected.




Evaluation
of Disclosure Controls and Procedures




As of the
end of the period covered by this report, we conducted an evaluation, under the
supervision and with the participation of our chief executive officer and
interim chief financial officer of the effectiveness of the design and operation
of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule
15d-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange
Act”).  In designing and evaluating the disclosure controls and
procedures, management recognizes that any controls and procedures, no matter
how well designed and operated, can provide only reasonable assurance of
achieving the desired control objectives and management necessarily is required
to apply its judgment in evaluating the cost-benefit relationship of possible
controls and procedures.  Based upon that evaluation, our chief
executive officer and interim chief financial officer concluded that, as of the
end of the period covered by this report, our disclosure controls and procedures
were effective at the reasonable assurance level discussed above.




A
material weakness is a deficiency, or a combination of deficiencies, in internal
control over financial reporting, such that there is a reasonable possibility
that a material misstatement of our annual or interim financial statements will
not be presented or detected on a timely basis.  Although we believe
we have our previously identified material weaknesses, complete testing of the
controls implemented had not yet been completed as of September 30,
2009.  We expect to have fully tested the implemented controls by
December 31, 2009 for the following material weaknesses:




1.
 Our General Control Environment was ineffective due to the following
identified weaknesses:




a. We
had not established an adequate tone at the top by management and the board of
directors concerning the importance of, and commitment to, internal controls and
generally accepted business practices.   To correct this
weakness, we hired a new Chief Executive Officer, restructured the board of
directors to include two additional independent directors and established an
audit committee that includes a financial expert and a corporate governance
expert.




32




b. We
had not designed and implemented policies and procedures to ensure effective
oversight by our board of directors and consistent operation by the board of
directors in accordance with committee charters.   To correct
this weakness, we implemented policies and procedures to ensure effective
oversight by our board of directors and established committees in accordance
with their charters.




c. We
had not designed and implemented policies and procedures to ensure effective
monitoring by management of financial and operational activities and to measure
actual results against expected results and planned objectives.  To
correct this weakness, we implemented policies and procedures to ensure
effective monitoring by management of financial and operations activities,
established budgets and now measure actual results against expected results and
planned objectives.




2. We
had not designed and implemented policies and procedures to ensure effective
risk assessment processes by management and the board of directors designed to
identify and mitigate internal and external risks that could impact our ability
to achieve our objectives.  To correct this weakness, we engaged an
internal control specialist to design and help to implement effective risk
assessment processes.




3. We
had not designed and implemented effective internal control policies and
procedures relating to equity transactions and share-based
payments.  To correct these deficiencies we implemented policies and
procedures to formalize procedures relating to transactions of this nature and
ensure that such transactions are entered into and issued in accordance with
board of director approvals.  Further, we implemented a software
program specifically designed to track and account for share-based
payments.  We are in the process of testing this control.




4. We
had not designed and implemented effective internal control policies and
procedures to ensure the proper reporting of income and accounting for payroll
taxes related to certain stock grants to employees and consultants. This
weakness resulted in the need for a restatement of previously issued financial
statements due to the correction of an error for the cumulative effect of the
understatement of payroll taxes and the related accrued liability for stock
awards issued in 2005 and 2006, as of the beginning of the year ended December
31, 2007, and for the effect of the understatement in these accounts for the
year ended December 31, 2007.  We had not fully resolved this issue
with the taxing authorities as of September 30, 2009,  To correct
these deficiencies we designed and implemented policies and procedures to ensure
that all reporting obligations and required withholdings related to stock grants
to employees and consultants are processed and reported on a timely
basis.




5. We
had not designed and implemented effective internal control policies and
procedures to provide reasonable assurance regarding the accuracy and integrity
of spreadsheets and other “off system” work papers used in the financial
reporting process.  To correct this weakness, we implemented internal
control policies and procedures to provide reasonable assurance that “off
system” work papers and spreadsheets are accurate.  We are in the
process of testing this control.




Changes
in Internal Control over Financial Reporting




There
have not been any changes in our internal control over financial reporting (as
such term is defined in Rules 13a-15(f) and 15d-15(f) of the Securities Exchange
Act of 1934, as amended) during the most recent fiscal quarter that have
materially affected or are reasonably likely to materially affect our internal
control over financial reporting.




See also
the discussion regarding our internal control over financial reporting included
in Item 2 of this quarterly report on Form 10-Q under “Management’s Discussion
and Analysis of Results of Operations—Internal Control Over Financial
Reporting.”




33




PART
II – OTHER INFORMATION




Item
1. Legal Proceedings




On
October 15, 2001, Jeffrey A. Leve and Jeffrey Leve Family Partnership, L.P.
filed a lawsuit (the “Leve Lawsuit”)
against us, Sunshine Wireless, LLC ("Sunshine"), and four other defendants
affiliated with Winstar Communications, Inc. (“Winstar”). On February 25, 2003, the case
against us and Sunshine was dismissed, however, on October 19, 2004, Jeffrey A.
Leve and Jeffrey Leve Family Partnership, L.P. exercised their right to
appeal.  The initial lawsuit alleged that the Winstar defendants
conspired to commit fraud and breached their fiduciary duty to the plaintiffs in
connection with the acquisition of the plaintiff's radio production and
distribution business.  The complaint further alleged that we and
Sunshine joined the alleged conspiracy. On June 1, 2005, the United States Court
of Appeals for the Second Circuit affirmed the February 25, 2003 judgment of the
district court dismissing the claims against us.




On July
28, 2005, Jeffrey A. Leve and Jeffrey Leve Family Partnership, L.P. filed a new
lawsuit (the “New Leve
Lawsuit”) against us, Sunshine and four other defendants
affiliated with Winstar. The New Leve Lawsuit attempts to collect a federal
default judgment of $5 million entered against only two entities, i.e., Winstar Radio Networks, LLC and Winstar
Global Media, Inc., by attempting to enforce the judgment against a number of
additional entities who are not judgment debtors. Further, the New Leve Lawsuit
attempts to enforce the plaintiffs default judgment against entities that were
dismissed on the merits from the underlying action in which plaintiffs obtained
their default judgment. On January 29, 2009, the Superior Court of California
issued a preliminary ruling in our favor.  On August 5, 2009, the
Superior Court of California, County of Los Angeles issued a Statement of
Decision on the New Leve lawsuit finding for us on all claims.  On
November 6, 2009, the plaintiffs filed a notice of appeal in the Superior Court
of the State of California, County of Los Angeles Central District.




Item
1A. Risk Factors




Intentionally
omitted.




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




On July
29, 2009, we issued an aggregate 5.4 million shares of our common stock in the
first closing of a private placement to accredited investors who were holders of
warrants to purchase shares of our common stock.  Warrant holders
could tender their warrants for shares of our common stock pursuant to the
Exchange Agreement dated as of July 29, 2009 (the “Exchange Agreement”) or
acquire additional shares of our common stock at a price per share of $0.86
pursuant to the Purchase Agreement dated as of July 29, 2009 (the “Purchase
Agreement”) in exchange for their warrants for shares of our common stock and
cash.




Holders
not making a cash investment tendered warrants to purchase an aggregate 1.6
million shares of our common stock in exchange for an aggregate 597 thousand
shares of our common stock pursuant to the Exchange Agreement. Holders who
elected to make a cash investment tendered warrants to purchase an aggregate 4.8
million shares of our common stock and an aggregate $1.5 million in cash, and
received an aggregate 4.8 million shares of our common stock pursuant to the
Purchase Agreement.




On
September 18, 2009, we issued an aggregate 587 thousand shares of our common
stock in the second and final closing of a private placement to accredited
investors who were holders of warrants to purchase shares of our common
stock.  Warrant holders could tender their warrants for shares of our
common stock pursuant to the Exchange Agreement or acquire additional shares of
our common stock at a price per share of $0.86 pursuant to the Purchase
Agreement in exchange for their warrants to purchase our common stock and
cash.




34




Holders
not making a cash investment tendered warrants to purchase an aggregate 59
thousand shares of our common stock in exchange for an aggregate 20 thousand
shares of our common stock pursuant to the Exchange Agreement. Holders who
elected to make a cash investment tendered warrants to purchase an aggregate 567
thousand shares of our common stock and an aggregate $195 thousand in cash, and
received an aggregate 567 thousand shares of our common stock pursuant to the
Purchase Agreement.




Item
3. Defaults Upon Senior Securities




Not
applicable.




Item
4. Submission of Matters to a Vote of Security Holders




Our
Annual Meeting of Stockholders was held on August 6, 2009 in Los Angeles,
California.  Five matters were submitted to a vote of our
stockholders: (i) the election of three Class I Directors to hold office
for a term expiring in 2010, the election of two Class II Directors to hold
office for a term expiring in 2011 (one of whom was elected by preferred
stockholders voting as a separate class) and the election of two Class III
Directors to hold office for a term expiring in 2012 (one of whom was elected by
preferred stockholders voting as a separate class), the term in each case
subject to the approval of (v) below; (ii) the ratification of the
appointment of Squar, Milner, Peterson, Miranda & Williamson, L.L.P. as our
independent registered public accounting firm for the fiscal year ending
December 31, 2009, (iii) the approval of the amendment and restatement of our
certificate of incorporation to increase the authorized number of shares of
common stock from 25 million  to 100 million, (iv) the approval of the
Patient Safety Technologies, Inc. 2009 Stock Option Plan and (v) the approval of
an amendment to our certificate of incorporation to provide for the annual
election of all directors.





At the
Annual Meeting, the following individuals were elected to the Board of
Directors, upon the following vote:




Votes
              For
            
            
            Votes
              Against
            
            
            Votes
              AbstainedSteven
      H. Kane
            
            
            9,459,292
            
            
            
            1,992,854
            
            
            
            3,292John
      P. Francis
            
            
            11,427,778
            
            
            
            24,368
            
            
            
            3,292Howard
      E. Chase
            
            
            10,640,408
            
            
            
            811,738
            
            
            
            3,292Herbert
      Langsam*
            
            
            8,150
            
            
            
            0
            
            
            
            2,350Wenchen
      Lin
            
            
            9,146,002
            
            
            
            2,306,144
            
            
            
            3,292Louis
      Glazer, M.D., Ph.G.*
            
            
            8,150
            
            
            
            0
            
            
            
            2,350Loren
      L. McFarland
            
            
            10,604,858
            
            
            
            811,288
            
            
            
            3,292




*
      Elected by preferred stockholders voting as a separate
    class




Because
of the passage of the amendment to our certificate of incorporation (as
described below), each of these Directors will serve until our next annual
meeting of stockholders.




11,447,337
votes were cast in favor of the ratification of the appointment of Squar,
Milner, Peterson, Miranda & Williamson, L.L.P. as our independent registered
public accounting firm for the fiscal year ending December 31, 2009, 312 votes
were cast against ratification and 7,7900 votes abstained.




10,574,895
votes were cast in favor of the amendment and restatement of our certificate of
incorporation to increase the authorized number of shares of common stock from
25,000,000 to 100,000,000, 871,867 votes were cast against amendment and
restatement and 8,672 votes abstained.




2,312,007
votes were cast in favor of the Patient Safety Technologies, Inc. 2009 Stock
Option Plan, 1,654,171 votes were cast against and 641,929 votes
abstained.




35




11,434,954
votes were cast in favor of the amendment of our certificate of incorporation to
provide for the annual election of all directors, 17,282 votes were cast against
amendment and 3,202 votes abstained.





Item
5. Other Information.




None.




Item
6. Exhibits.




Exhibit
              Number
            
            Description3.1
            
            Amended
      and Restated Certificate of Incorporation (incorporated by reference to
      Appendix A to our Definitive Proxy Statement on Schedule 14A, filed with
      the Securities and Exchange Commission on July 13,
2009)10.1
            
            Exchange
      Agreement dated as of July 29, 2009 (incorporated by reference to Exhibit
      99.2 to our Current Report on Form 8-K filed with the Securities and
      Exchange Commission on August 3, 2009)10.2
            
            Purchase
      Agreement dated as of July 29, 2009 (incorporated by reference to Exhibit
      99.2 to our Current Report on Form 8-K filed with the Securities and
      Exchange Commission on August 3, 2009)31.1*
            
            Certification
      of Principal Executive Officer required by Rule 13a-14(a) or Rule
      15d-14(a)31.2*
            
            Certification
      of Principal Financial Officer required by Rule 13a-14(a) or Rule
      15d-14(a)32.1*
            
            Certifications
      of Chief Executive Officer and Chief Financial Officer required by Rule
      13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of
      the United States Code





* Filed
herewith




36




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.




PATENT
      SAFETY TECHNOLOGIES, INCDate:
      November  17, 2009
              By:
              /s/
      Steven H. KaneSteven
      H. KaneChief
      Executive Officer


Date:
      November  17, 2009
              By:
              /s/
      Mary A. LayMary
      A. LayInterim
      Chief Financial Officer and
                Principal
      Accounting Officer




37