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, 2010




or





 ̈
            
            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.)Two
      Venture Plaza, Suite 350, Irvine, CA 92618(Address
      of principal executive offices) (Zip
Code)





Registrant’s
telephone number, including area code: (949) 387-2277





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   ̈
            Accelerated
      filer   ̈Non-accelerated
      filer   ̈
       (Do not check if smaller reporting company)
            Smaller
      Reporting Company  x





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




The
number of outstanding shares of the registrant’s common stock, par value $0.33
per share, as of November 15, 2010 was 23,456,063.









PATIENT
SAFETY TECHNOLOGIES, INC.





FORM
10-Q FOR THE QUARTER


ENDED
SEPTEMBER 30, 2010





TABLE
OF CONTENTS





PageCAUTIONARY
      NOTE REGARDING FORWARD-LOOKING STATEMENTS
              iHELPFUL
      INFORMATION
              iPART
      I – FINANCIAL INFORMATION
              1ITEM
      1.  FINANCIAL STATEMENTS
              1Condensed
      Consolidated Balance Sheets
              1Condensed
      Consolidated Statements of Operations
              2Condensed
      Consolidated Statements of Cash Flows
              3ITEM
      2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
      OF OPERATIONS
              20ITEM
      3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
    RISK
              31ITEM
      4. CONTROLS AND PROCEDURES
              31PART
      II – OTHER INFORMATION
              32ITEM
      1. LEGAL PROCEEDINGS
              32ITEM
      1A. RISK FACTORS
              32ITEM
      1A. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
      PROCEEDS
              32ITEM
      3. DEFAULTS UPON SENIOR SECURITIES
              32ITEM
      4. (REMOVED AND RESERVED)
              32ITEM
      5. OTHER INFORMATION
              32ITEM
      6. EXHIBITS
              33SIGNATURES
              34







CAUTIONARY
NOTE REGARDING FORWARD-LOOKING STATEMENTS




Some of
the statements in this quarterly report on Form 10-Q are forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as
amended.  You can sometimes identify forward-looking statements by our use
of forward-looking words like “may,” “should,” “expects,” “intends,” “plans,”
“anticipates,” “believes,” “estimates,” “seeks,” “predicts,” “potential,” or
“continue” or the negative of these terms and other similar expressions. 
Our forward-looking statements relate to future events or our future performance
and include, but are not limited to, plans, objectives, expectations and
intentions. Other statements contained in this report that are not historical
facts are also forward-looking statements.




Although
we believe that the plans, objectives, expectations and intentions 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, objectives, expectations or intentions will be
achieved.  Our actual results, performance (financial or operating) or
achievements 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, 2009
filed on March 31, 2010 and amended on April 30, 2010, including without
limitation the following:





·
            our
      need for additional financing to support our
  business;





·
            the
      early stage of adoption of our Safety-Sponge® System and the need to
      expand adoption of our Safety-Sponge®
System;





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





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





·
            any
      inability to successfully protect our intellectual property
      portfolio.





The risks
included in our filings are not exhaustive, and additional factors could
adversely affect our business and financial performance. We operate in a
competitive and rapidly changing environment. New risk factors emerge from time
to time, and it is not possible for management to predict all such risk factors,
nor can it assess the impact of all such risk factors on our business or the
extent to which any factor, or combination of factors, may cause actual results
to differ materially from those contained in any forward-looking
statements.





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, objectives, expectations and
intentions 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, objectives, expectations or
intentions change.





HELPFUL
INFORMATION





As used
throughout this quarterly report on Form 10-Q, the terms the “Company,” “the
registrant,” “we,” “us,” and “our” mean Patient Safety Technologies, Inc., a
Delaware corporation, together with its consolidated subsidiary, SurgiCount
Medical Inc., a California corporation, unless the context otherwise
requires.





Unless
otherwise indicated, all statements presented in this quarterly report on Form
10-Q regarding cumulative number of surgical sponges used and numbers of
procedures are internal estimates only.





Safety-Sponge®,
SurgiCounterTM and CitadelTM, among others, are registered or unregistered
trademarks of Patient Safety Technologies, Inc. (including its
subsidiary).




i




PART
I – FINANCIAL INFORMATION





ITEM
1.  FINANCIAL STATEMENTS





PATIENT
SAFETY TECHNOLOGIES, INC. AND SUBSIDIARY


Condensed
Consolidated Balance Sheets


(Unaudited)


September 30,
                                  2010
                                
                                
                                December 31,
                                  2009AssetsCurrent
      assets:Cash
      and cash equivalents
                                
                                $
                                2,796,742
                                
                                
                                $
                                3,446,726Restricted
      cash
                                
                                
                                223,630
                                
                                
                                
                                —Accounts
      receivable, net
                                
                                
                                679,760
                                
                                
                                
                                906,136Inventories,
      net
                                
                                
                                1,729,969
                                
                                
                                
                                565,823Prepaid
      expenses
                                
                                
                                256,057
                                
                                
                                
                                207,598Total
      current assets
                                
                                
                                5,686,158
                                
                                
                                
                                5,126,283Property
      and equipment, net
                                
                                
                                918,563
                                
                                
                                
                                744,646Goodwill
                                
                                
                                1,832,027
                                
                                
                                
                                1,832,027Patents,
      net
                                
                                
                                2,870,318
                                
                                
                                
                                3,114,025Long-term
      investment
                                
                                
                                666,667
                                
                                
                                
                                666,667Other
      assets
                                
                                
                                48,801
                                
                                
                                
                                43,246Total
      assets
                                
                                $
                                12,022,534
                                
                                
                                $
                                11,526,894Liabilities
      and Stockholders’ Equity (Deficit)Current
      liabilitiesAccounts
      payable
                                
                                $
                                1,677,252
                                
                                
                                $
                                2,043,166Accrued
      liabilities
                                
                                
                                865,608
                                
                                
                                
                                1,242,876Convertible
      note payable
                                
                                
                                1,424,558
                                
                                
                                
                                1,424,558Capital
      lease-current portion
                                
                                
                                —
                                
                                
                                
                                19,330Warrant
      derivative liability
                                
                                
                                980,757
                                
                                
                                
                                3,666,336Deferred
      revenue
                                
                                
                                4,446,647
                                
                                
                                
                                8,099,144Total
      current liabilities
                                
                                
                                9,394,822
                                
                                
                                
                                16,495,410Capital
      lease, less current portion
                                
                                
                                —
                                
                                
                                
                                58,274Deferred
      tax liability
                                
                                
                                708,049
                                
                                
                                
                                805,768Total
      liabilities
                                
                                
                                10,102,871
                                
                                
                                
                                17,359,452Commitments
      and contingencies (Note 20)Stockholders’
      equity(deficit):Series
      A preferred stock, $1.00 par value, cumulative 7%
dividend:1,000,000
      shares authorized; 10,950 issued and outstanding at September 30,
      2010and
      December 31, 2009;(Liquidation
      preference of $1.2 million at September 30, 2010 and December 31,
      2009)
                                
                                
                                10,950
                                
                                
                                
                                10,950Series
      B convertible preferred stock, $1.00 par value, cumulative 7%
      dividend:150,000
      shares authorized; 60,067 issued and outstanding at September 30,
      2010and
      0 issued and outstanding at December 31, 2009;(Liquidation
      preference of $6.0 million at September 30, 2010 and $0 at December 31,
      2009)
                                
                                
                                60,067
                                
                                
                                
                                —Common
      stock, $0.33 par value: 100,000,000 shares authorized;23,456,063
      shares issued and outstanding at September 30, 2010 and December 31,
      2009
                                
                                
                                7,740,501
                                
                                
                                
                                7,740,501Additional
      paid-in capital
                                
                                
                                51,266,092
                                
                                
                                
                                44,834,321Accumulated
      deficit
                                
                                
                                (57,157,947
                                )
                                
                                
                                (58,418,330
                                )Total
      stockholders’ equity (deficit)
                                
                                
                                1,919,663
                                
                                
                                
                                (5,832,558
                                )Total
      liabilities and stockholders’ equity (deficit)
                                
                                $
                                12,022,534
                                
                                
                                $
                                11,526,894





The
accompanying notes are an integral part of these condensed consolidated interim
financial statements.




1





PATIENT
      SAFETY TECHNOLOGIES, INC. AND SUBSIDIARYCondensed
      Consolidated Statements of Operations
              (Unaudited)





Three Months Ended
                
                
                Nine Months EndedSeptember 30,
                
                
                September 30,2010
                
                
                2009
                
                
                2010
                
                
                2009Revenues
                
                $
                4,122,560
                
                
                $
                978,461
                
                
                $
                10,252,897
                
                
                $
                2,942,066Cost
      of revenue
                
                
                1,950,573
                
                
                
                540,013
                
                
                
                4,829,821
                
                
                
                1,707,575Gross
      profit
                
                
                2,171,987
                
                
                
                438,448
                
                
                
                5,423,076
                
                
                
                1,234,491Operating
      expenses:Research
      and development
                
                
                35,246
                
                
                
                69,270
                
                
                
                166,548
                
                
                
                267,851Sales
      and marketing
                
                
                518,570
                
                
                
                609,921
                
                
                
                2,341,132
                
                
                
                1,812,146General
      and administrative
                
                
                693,235
                
                
                
                1,256,580
                
                
                
                4,849,573
                
                
                
                5,162,428Total
      operating expenses
                
                
                1,247,051
                
                
                
                1,935,771
                
                
                
                7,357,253
                
                
                
                7,242,425Operating
      income (loss)
                
                
                924,936
                
                
                
                (1,497,323
                )
                
                
                (1,934,177
                )
                
                
                (6,007,934
                )Other
      income (expense)Interest
      income (expense)
                
                
                3,598
                
                
                
                (303,580
                )
                
                
                (5,062
                )
                
                
                (744,000
                )Gain
      (loss) on change in fair value of warrant derivative
    liability
                
                
                15,631
                
                
                
                (1,762,384
                )
                
                
                2,685,579
                
                
                
                (4,332,503
                )Other
      income (expense)
                
                
                —
                
                
                
                194,447
                
                
                
                433,958
                
                
                
                194,447Total
      other income (expense)
                
                
                19,229
                
                
                
                (1,871,517
                )
                
                
                3,114,475
                
                
                
                (4,882,056
                )Income
      (loss) before income taxes
                
                
                944,165
                
                
                
                (3,368,840
                )
                
                
                1,180,298
                
                
                
                (10,889,990
                )Income
      tax benefit
                
                
                32,573
                
                
                
                31,758
                
                
                
                139,862
                
                
                
                96,477Net
      income (loss)
                
                
                976,738
                
                
                
                (3,337,082
                )
                
                
                1,320,160
                
                
                
                (10,793,513
                )Preferred
      dividends
                
                
                (14,682
                )
                
                
                (19,163
                )
                
                
                (59,777
                )
                
                
                (57,488
                )Net
      income (loss) applicable to common shareholders
                
                $
                962,056
                
                
                $
                (3,356,245
                )
                
                $
                1,260,383
                
                
                $
                (10,851,001
                )Income
      (loss) per common shareBasic
                
                $
                0.04
                
                
                $
                (0.17
                )
                
                $
                0.05
                
                
                $
                (0.60
                )Diluted
                
                $
                0.04
                
                
                $
                (0.17
                )
                
                $
                0.04
                
                
                $
                (0.60
                )Weighted
      average common shares outstanding:Basic
                
                
                23,456,063
                
                
                
                20,229,483
                
                
                
                23,456,063
                
                
                
                18,219,514Diluted
                
                
                24,031,063
                
                
                
                20,229,483
                
                
                
                35,659,766
                
                
                
                18,219,514





The
accompanying notes are an integral part of these condensed consolidated interim
financial statements.




2




PATIENT
SAFETY TECHNOLOGIES, INC. AND SUBSIDIARY


Condensed
Consolidated Statements of Cash Flows


(Unaudited)





Nine Months Ended September 30,2010
                              
                              
                              2009Operating
      activities:Net
      income (loss)
                              
                              $
                              1,320,160
                              
                              
                              $
                              (10,793,513
                              )Adjustments
      to reconcile net income (loss) to net cash used in operating
      activities:Depreciation
                              
                              
                              388,006
                              
                              
                              
                              253,496Amortization
      of patents
                              
                              
                              243,706
                              
                              
                              
                              243,706Amortization
      of debt discount
                              
                              
                              —
                              
                              
                              
                              461,000Stock
      based compensation
                              
                              
                              965,078
                              
                              
                              
                              896,326Gain
      on reduction of contingent tax liability
                              
                              
                              (427,700
                              )Warrant
      exchange
                              
                              
                              —
                              
                              
                              
                              (193,000
                              )Loss
      on abandonment of lease
                              
                              
                              151,973
                              
                              
                              
                              —Loss
      on capital lease write-off
                              
                              
                              3,917
                              
                              
                              
                              —Non-cash
      interest
                              
                              
                              —
                              
                              
                              
                              1,323,000(Gain)
      loss on change in fair value of warrant derivative
    liability
                              
                              
                              (2,685,579
                              )
                              
                              
                              4,333,136Change
      in deferred tax liability
                              
                              
                              (97,719
                              )
                              
                              
                              (97,079
                              )Changes
      in operating assets and liabilities:Accounts
      receivable
                              
                              
                              226,376
                              
                              
                              
                              232,200Inventories
                              
                              
                              (1,164,147
                              )
                              
                              
                              (530,000
                              )Prepaid
      expenses
                              
                              
                              (48,459
                              )
                              
                              
                              (10,333
                              )Other
      assets
                              
                              
                              (5,554
                              )
                              
                              
                              8,000Accounts
      payable
                              
                              
                              634,086
                              
                              
                              
                              897,022Accrued
      liabilities
                              
                              
                              (101,540
                              )
                              
                              
                              (100,649
                              )Deferred
      revenue
                              
                              
                              (3,652,497
                              )
                              
                              
                              —Net
      cash used in operating activities
                              
                              
                              (4,249,893
                              )
                              
                              
                              (3,076,688
                              )Investing
      activities:Purchase
      of property and equipment
                              
                              
                              (627,888
                              )
                              
                              
                              (89,020
                              )Net
      cash used in investing activities
                              
                              
                              (627,888
                              )
                              
                              
                              (89,020
                              )Financing
      activities:Proceeds
      from issuance of notes payable
                              
                              
                              —
                              
                              
                              
                              2,000,000Proceeds
      from issuance of convertible preferred stock and warrants
                              
                              
                              —
                              
                              
                              
                              1,706,000Proceeds
      from issuance of convertible preferred stock
                              
                              
                              5,000,000
                              
                              
                              
                              —Payments
      for stock issuance costs
                              
                              
                              (480,010
                              )Capital
      lease principle payments
                              
                              
                              (15,556
                              )
                              
                              
                              —Payments
      of preferred dividends
                              
                              
                              (53,007
                              )
                              
                              
                              (57,488
                              )Transfer
      to restricted cash in connection with tax escrow account
                              
                              
                              (223,630
                              )
                              
                              
                              —Net
      cash provided by financing activities
                              
                              
                              4,227,797
                              
                              
                              
                              3,648,512Net
      increase (decrease) in cash and cash equivalents
                              
                              
                              (649,984
                              )
                              
                              
                              482,804Cash
      and cash equivalents at beginning of period
                              
                              
                              3,446,726
                              
                              
                              
                              296,185Cash
      and cash equivalents at end of period
                              
                              $
                              2,796,742
                              
                              
                              $
                              778,989Supplemental
      disclosures of cash flow information:Cash
      paid during the period for interest
                              
                              $
                              —
                              
                              
                              $
                              36,000Cash
      paid during the period for taxes
                              
                              $
                              16,113
                              
                              
                              $
                              —Non
      cash investing and financing activities:Issuance
      of convertible preferred stock for accounts payable
                              
                              $
                              1,000,000
                              
                              
                              $
                              —Dividends
      accrued
                              
                              $
                              53,007
                              
                              
                              $
                              57,488Reduction
      of fixed assets based on write-off of capital lease
                              
                              $
                              62,048
                              
                              
                              $
                              —Payment
      of Series B preferred dividends in shares
                              
                              $
                              6,770
                              
                              
                              $
                              —Reclassification
      of accrued interest to notes payable
                              
                              $
                              —
                              
                              
                              $
                              165,000Debt
      discount recorded in connection with issuance of notes
    payable
                              
                              $
                              —
                              
                              
                              $
                              1,311,311Reclassification
      of warrant equities to derivative liability
                              
                              $
                              —
                              
                              
                              $
                              4,240,000Issuance
      of common stock in payment of notes payable and accrued
      interest
                              
                              $
                              —
                              
                              
                              $
                              (258,000
                              )Cancellation
      of warrants in connection with warrant exchange
                              
                              $
                              —
                              
                              
                              $
                              (5,722,036
                              )Reclassification
      of warrant derivative liability to equity
                              
                              $
                              —
                              
                              
                              $
                              (2,152,940
                              )





The
accompanying notes are an integral part of these condensed consolidated interim
financial statements.




3




1.
DESCRIPTION OF BUSINESS





Patient
Safety Technologies, Inc. is a Delaware corporation, conducts its operations
through its wholly-owned operating subsidiary, SurgiCount Medical, Inc. (“SurgiCount”), a California
corporation. References to the "Company" include references
Patient Safety Technologies, Inc. and SurgiCount, unless the context otherwise
requires.





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-Sponge®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.




2.
LIQUIDITY AND GOING CONCERN





The
accompanying condensed consolidated interim financial statements have been
prepared assuming that the Company will continue as a going concern. At
September 30, 2010, the Company had a working capital deficit of $3.7 million,
and for the nine-month period ended September 30, 2010, the Company incurred an
operating loss of $1.9 million and generated negative cash flow from operating
activities of $4.3 million.





In the
most recent audit report dated March 31, 2010 by the Company’s independent
registered public accounting firm, Squar Milner, included an explanatory
paragraph in which they stated that the significant recurring net losses through
December 31, 2009 and the significant working capital deficit at December 31,
2009 raised substantial doubt about the Company’s ability to continue as a going
concern.





In June
2010, the Company augmented its cash resources by completing a convertible
preferred stock financing transaction that generated gross proceeds of $5.0
million.  Starting in the most recent quarter ended September 30, 2010,
newly appointed management implemented a comprehensive restructuring effort
focused on a number of initiatives, including reducing operating expenses and
achieving positive operating income and operating cash flow.  During the
most recent quarter ended September 30, 2010, the Company reported revenue of
$4.1 million and operating income of $925 thousand, which is the first time that
the Company has reported positive operating income since the Company’s
acquisition of SurgiCount Medical in 2005.  Although cash flow from
operating activities during the quarter ended September 30, 2010 were negative
$2.1 million, this result included a payment of $2.4 million for past due
amounts owed to the primary manufacturing vendor of our sponge products, A Plus
International, Inc. (A Plus”).  Our cash flow from operating activities for
the quarter ended September 30, 2010 when adjusted to remove this payment to A
Plus, would have resulted in the quarterly operating cash flow from operating
activities being positive or adding to the cash balance on hand.  Operating
income of $925 thousand during the quarter ended September 30, 2010 included
$1.3 million of gross profit attributable to sales to Cardinal Health, our
exclusive distributor, under our agreement with them that includes provisions
for their purchase of stocking orders throughout 2010.   However,
management still considers this quarter’s positive operating profit result to be
a meaningful milestone event, given the Company’s history of reporting operating
losses.  The improvements in both cash flow and income from operations
during the third quarter of 2010 as compared to previous periods was the result
of a number of items, including the restructuring initiative recently
implemented by newly appointed management and continued growth in the Company’s
revenue, which included revenue attributable stocking orders from Cardinal
Health.  The Company’s revenue and gross profit during the first nine
months of 2010 of $10.3 million and $5.4 million respectively, have grown 248%
and 340% respectively, compared to the first nine months of 2009.





Despite
the improvements in operating performance achieved in the three and nine months
ended September 30, 2010, management believes that it will be necessary to raise
additional funds before the end of the first quarter 2011 in order to continue
to operate as a going concern.  Management believes that if necessary,
additional cost-cutting measures can be implemented to extend the Company’s
ability to operate its core business beyond the first quarter 2011 if financing
is not timely available.  Management’s plan to raise additional required
funding could include equity and or debt financings, in private transactions
with accredited investors.  The Company has historically been successful in
raising required financing in this manner, and believes that it will be able to
raise such additional financing on a timely basis.  However, no
assurances can be made that the Company will be successful in obtaining a
sufficient amount of financing on acceptable terms (or any financing) in
order to continue to fund its operations, or that it will be able to continue to
achieve profitable operating results or positive cash flow.  In addition,
no assurance can be made that additional cost cutting measures, if implemented,
will materially extend the Company’s ability to operate without procuring
additional financing.  The accompanying condensed consolidated interim
financial statements do not include any adjustments that might result from the
outcome of this uncertainty.




4




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 applicable
sections 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 and disclosures that are, in the
opinion of management, necessary to make the financial statements not
misleading. The condensed consolidated balance sheet as of December 31, 2009 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, 2009.  Results of the three and nine months
ended September 30, 2010 are not necessarily indicative of the results to be
expected for the full year ending December 31, 2010.





Principles
of Consolidation





The
accompanying condensed consolidated interim financial statements for 2010
include the accounts of the Company and its subsidiary.  All
significant intercompany balances and transactions have been eliminated in
consolidation.





Use
of Estimates





The
condensed consolidated interim financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of
America (“GAAP”). 
The preparation of these financial statements requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosures of contingent assets and liabilities at the dates of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.  These estimates and assumptions include, but are not limited
to, assessing the following: the valuation of accounts receivable and inventory,
impairment of goodwill and other intangible assets, the fair value of
stock-based compensation and derivative liabilities, valuation allowance related
to deferred tax assets, warranty obligations, provisions for returns and
allowances and the determination of assurance of the collection of revenue
arrangements.





Reclassifications





Certain
prior year amounts have been reclassified to conform to the 2010 presentation.
These reclassifications had no effect on previously reported results of
operations or accumulated deficit.





Revenue
Recognition





The
Company recognizes revenue from the sale of products to end-users and
distributors when persuasive evidence of a sale exists, the product is complete,
tested and has been shipped which coincides with transfer of title and risk of
loss, the sales price is fixed and determinable, collection of the resulting
receivable is reasonably assured, there are no material contingencies and the
Company does not have significant obligations for future performance.  When
collectability is not reasonably assured, the Company defers the revenue until
cash payment is received.Provisions for
estimated future product returns and allowances are recorded in the period of
the sale based on the historical and anticipated future rate of returns. 
The Company records shipping and handling costs charged to customers as revenue
and shipping and handling costs to cost of revenue as incurred.  Revenue is
recorded net of any discounts or trade-in allowances given to the
buyer.




5


·
            Hardware Cost Reimbursement
      Revenues:  Beginning with the third quarter of 2009, the
      Company modified its business model and began to offer its SurgiCounterTM
      scanners and related hardware and software to all hospitals at no cost
      when they adopt its Safety-Sponge® System.  Prior to the third
      quarter of 2009, the Company’s business model included the sale of its
      SurgiCounterTM scanners and related hardware and software used in its
      Safety-Sponge® System to most hospitals that adopted the Company’s
      system.  Under the supply and distribution agreement with Cardinal
      Health entered into in November 2009, the Company is reimbursed an agreed
      upon percentage of the cost of the scanners provided by the Company to
      hospitals that receive their surgical sponges and towels through Cardinal
      Health. Reimbursements received from Cardinal Health are initially
      deferred and are recognized as revenue on a pro-rata basis over the life
      of the specific hospital contract.  Because the Company no longer
      engages primarily in direct SurgiCounterTM scanner and related
      hardware sales, except in certain customer specific situations, it
      generally anticipates only recognizing revenues associated with its
      SurgiCounterTM scanners in connection with reimbursement arrangements under
      its agreement with Cardinal Health.





·
            Hardware, Software and
      Maintenance Agreement Revenues: Because the software included in
      the Company’s SurgiCounterTM scanner is not incidental to the product being
      sold, the sale of the software falls within the scope of AccountingStandardsCodification(“ASC”)ASC 985-605,
      formerly Statement of Position (“SOP”) 97-2.  The
      SurgiCounterTM scanner is considered to be a software-related element, as
      defined in ASC 985-605, because the software is essential to the
      functionality of the scanner, and the maintenance agreement, which
      provides for product support including unspecified product upgrades and
      enhancements developed by the Company during the period covered by the
      agreement, is considered to be post-contract customer support (“PCS”) as defined in ASC
      985-605.  Prior to the third quarter of 2009, our business model
      included the sale of our SurgiCounterTM scanners and related software used
      in our Safety-Sponge® System to most hospitals 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 all hospitals at no cost when they adopt our Safety-Sponge®
      System.  Because we no longer engage primarily in direct
      SurgiCounterTM scanner sales, we generally anticipate only recognizing
      revenues associated with our SurgiCounterTM scanners in connection with
      reimbursement arrangements under our agreement with Cardinal Health. 
      Therefore, we do not expect that our SurgiCounterTM scanners and related
      hardware will represent a sizable source of future revenues for us.
      Deferred scanner revenue associated with the reimbursement from Cardinal
      Health, will be recognized over the life of the specific hospital
      contract.





·
            Sales
      of our sponges and towels are generally considered to be at the time of
      shipment where terms are FOB shipping point.  In the event that terms
      of the sale are FOB customer, the delivery is considered to occur at the
      time that delivery to the customer has been completed.  Delivery with
      respect to the initial one-year maintenance agreement is considered to
      occur on a monthly basis over the term of the one-year period, and
      revenues related to this element are recognized on a pro-rata basis during
      this period.  Costs of scanners and related hardware and software are
      capitalized and depreciated to Cost of Sales with an assumed three year
      life.




·
            Surgical Sponge
      Revenues:The surgical products (sponges and towels) used in
      the Company’s Safety-Sponge® System are sold separately from the hardware
      and software described above, and those products are not considered to be
      part of a multiple-element arrangement.  Accordingly, revenues
      related to the sale of products used in the Company’s Safety-Sponge®
      System are recognized in accordance with ASC 605-25 that addresses revenue
      recognition for multiple-element arrangements. Generally revenues from the
      sale of surgical products used in the Safety-Sponge® System are recognized
      upon shipment as most surgical products used in the Safety-Sponge® System
      are sold FOB shipping point.  In the event that terms of the sale are
      FOB customer, revenue is recognized at the time delivery to the customer
      has been completed. Advanced payments are classified as deferred revenue
      and recognized as product is shipped to the
  customer.


Recent
Accounting Pronouncements
 
 In
October 2009, the Financial Accounting Standards Board (“FASB”) issued
Accounting Standards Update (“ASU”) 2009-13, Multiple Deliverable Revenue
Arrangements, which 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 consolidated financial statements has not been evaluated.


6





In
October 2009, the FASB issued ASU 2009-14, Certain Revenue Arrangements That
Include Software Elements, which 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 consolidated
financial statements has not been evaluated.





In
January 2010, the FASB issued ASU 2010-06, “Fair Value Measurements and
Disclosures (Topic 20): Improving Disclosures about Fair Value Measurements.”
This ASU provides clarification regarding existing disclosures and requires
additional disclosures regarding fair value measurements. Specifically, the
guidance now requires reporting entities to disclose the amounts of significant
transfers between levels and the reasons for the transfers. In addition, the
reconciliation should present separate information about purchases, sales,
issuances and settlements. A reporting entity should provide disclosures about
the valuation techniques and inputs used to measure fair value. The new standard
was effective for reporting periods beginning after December 15, 2009 except for
disclosures about purchases, sales, issuances and settlements, which is not
effective until reporting periods beginning after December 15, 2010. There were
no transfers into or out of Level 1 or Level 2 of the fair value hierarchy
during the nine months ended September 30, 2010. Adoption of the not yet
effective section of this guidance is not expected to have a material impact on
our Consolidated Financial Statements.





4.
RESTRICTED CASH





Restricted
cash at September 30, 2010 consists of $224 thousand of cash held in an escrow
account pursuant to the Tax Escrow Agreement, which was established during the
quarter ended June 30, 2010 in connection with the Convertible Preferred Stock
financing transaction (see Note 20).  Cash held in the escrow account is
invested in the escrow agent’s insured money market account and any income
earned on such funds is added to the balance held in escrow.  In accordance
with the terms of the Tax Escrow Agreement, funds held in the escrow account may
be released to pay tax claims by federal or state taxing authorities, or in the
event that the Company’s estimated contingent tax liability, as reflected in its
periodic reporting on either Form 10-Q or 10-K, is reduced for reasons other
than actual payment of tax claims, subject to compliance with specific
provisions of the agreement.  During the nine months ended September 30,
2010 the initial contingent tax liability of $651 thousand was reduced by $427
thousand based on the expiration of the federal statute of limitations relating
to certain 2006 income.  The Company anticipates the remaining $224
thousand balance of restricted cash will be released from the escrow account by
the second quarter of 2011 based on the expiration of the federal statute of
limitations relating to the tax year 2007.





5. EARNINGS (LOSS)
PER COMMON SHARE





Earnings
(loss) per common share are determined by dividing the earnings (loss)
applicable to common shareholders by the weighted average number of common
shares outstanding. The Company complies with FASB Accounting Standards
Codification (“ASC”) 260-10 Earnings Per Share(previously SFAS No. 128, Earnings per Share), which requires dual
presentation of basic and diluted earnings (loss) per share on the face of the
condensed consolidated statements of operations. Basic loss per common share
excludes dilution and is computed by dividing loss attributable to common
stockholders by the weighted-average common shares outstanding for the period.
Diluted earnings per common share reflects the potential dilution that could
occur if convertible preferred stock or notes, options and warrants were to be
exercised or converted or otherwise resulted in the issuance of common stock
that then shared in the earnings of the entity.





For the
three and nine months ended September 30, 2010, the shares associated with the
convertible note (see Note 10), convertible preferred stock and warrants and
options that have a conversion/exercise price in excess of the average stock
price during the three and nine month periods ending September 30, 2010,
respectively, are included in calculating diluted earnings per share. Because
the effects of outstanding options, warrants, convertible note and
convertible preferred stock that have conversion/exercise prices in excess
of the average stock price during the three and nine month periods ended
September 30, 2010, are anti-dilutive, shares of common stock underlying these
instruments as shown below have been excluded from the computation of loss per
common share for the three and nine months ended September 30, 2009,
respectively.




7




The
following table sets forth the computation of basic and diluted earnings (loss)
per share:





Three Months Ended
                
                
                Nine Months EndedSeptember 30,
                
                
                September 30,2010
                
                
                2009
                
                
                2010
                
                
                2009BasicIncome
      (loss) available to common stockholders
                
                $
                962,056
                
                
                $
                (3,356,245
                )
                
                $
                1,260,383
                
                
                $
                (10,851,001
                )Weighted
      average common shares outstanding (basic)
                
                
                23,456,063
                
                
                
                20,229,483
                
                
                
                23,456,063
                
                
                
                18,219,514Basic
      income (loss) per common share
                
                $
                0.04
                
                
                $
                (0.17
                )
                
                $
                0.05
                
                
                $
                (0.
      60
                )DilutedIncome
      (loss) available to common stockholders
                
                $
                962,056
                
                
                $
                (3,356,245
                )
                
                $
                1,260,383
                
                
                $
                (10,851,001
                )Weighted
      average common shares outstanding
                
                
                24,031,063
                
                
                
                20,229,483
                
                
                
                23,456,063
                
                
                
                18,219,514Assumed
      issuance of restricted stock
                
                
                75,000
                
                
                
                —
                
                
                
                75,000
                
                
                
                —Assumed
      exercise of options
                
                
                —
                
                
                
                —
                
                
                
                1,052,084
                
                
                
                —Assumed
      conversion of Series B preferred stock
                
                
                —
                
                
                
                —
                
                
                
                8,008,933
                
                
                
                —Assumed
      exercise of warrants
                
                
                —
                
                
                
                —
                
                
                
                2,567,686
                
                
                
                —Assumed
      conversion of debt
                
                
                500,000
                
                
                
                —
                
                
                
                500,000
                
                
                
                —Common
      and potential common shares
                
                
                24,031,063
                
                
                
                20,229,483
                
                
                
                35,659,766
                
                
                
                18,219,514Diluted
      income (loss) per common share
                
                $
                0.04
                
                
                $
                (0.17
                )
                
                $
                0.04
                
                
                $
                (0.60
                )Potentially
      dilutive securities outstanding at period end excluded from diluted
      computation as they were anti-dilutive
                
                
                16,250,850
                
                
                
                12,003,201
                
                
                
                8,896,863
                
                
                
                12,003,201





6.
INVENTORY, NET





Inventory
consists of the following:




September 30,
                  
                  
                  December 31,2010
                  
                  
                  2009Finished
      goods
                  
                  $
                  1,898,965
                  
                  
                  $
                  734,819Reserve
      for obsolescence
                  
                  
                  (168,996
                  )
                  
                  
                  (168,996
                  )Total
      inventory, net
                  
                  $
                  1,729,969
                  
                  
                  $
                  565,823




8




7.
PROPERTY AND EQUIPMENT, NET





Property
and equipment consists of the following:





September 30,
                  
                  
                  December 31,2010
                  
                  
                  2009Computer
      software and equipment
                  
                  $
                  1,100,003
                  
                  
                  $
                  1,097,181Furniture
      and equipment
                  
                  
                  226,586
                  
                  
                  
                  298,333Hardware
      for customer use
                  
                  
                  1,025,709
                  
                  
                  
                  394,861Property
      and equipment, gross
                  
                  
                  2,357,298
                  
                  
                  
                  1,790,375Less:
      accumulated depreciation
                  
                  
                  (1,433,735
                  )
                  
                  
                  (1,045,729
                  )Property
      and equipment, net
                  
                  $
                  918,563
                  
                  
                  $
                  744,646





At June
30, 2010, based on the Company’s decision to close the Newtown, PA office, the
Company wrote off the remaining capital lease of $66 thousand pertaining to
office furniture acquired as part of the Newtown, PA sublease.





8.
GOODWILL AND PATENTS





The
Company recorded goodwill in the amount of $1.7 million in connection with its
acquisition of SurgiCount in February 2005.  During the year ended December
31, 2007, cumulative gross revenues of SurgiCount exceeded $1.0 million and as
such the Company issued 100,000 shares of common stock, valued at approximately
$145 thousand to the SurgiCount founders, as contingent consideration, which was
recorded as additional goodwill.  In addition, in connection with the
SurgiCount acquisition, the Company recorded patents acquired that were valued
at $4.7 million.





Patents,
net, consists of the following:





September 30,
                    2010
                  
                  
                  December 31,
                    2009Patents
                  
                  $
                  4,684,576
                  
                  
                  $
                  4,684,576Accumulated amortization
                  
                  
                  (1,814,258
                  )
                  
                  
                  (1,570,551
                  )Patents,
      net
                  
                  $
                  2,870,318
                  
                  
                  $
                  3,114,025





The patents
are subject to amortization over their estimated useful life of 14.4
years.  Amortization expense for the three and nine months ended September
30, 2010 and 2009 was $81 thousand and $244 thousand, respectively.





9.
LONG-TERM INVESTMENTS





Long-term
investments consists of the following:





September 30,
                    2010
                  
                  
                  December 31,
                    2009Alacra, Inc.
                  
                  $
                  666,667
                  
                  
                  $
                  666,667Total
                  
                  $
                  666,667
                  
                  
                  $
                  666,667





At
September 30, 2010 and December 31, 2009, the Company had an investment in
shares of Series F convertible preferred stock of Alacra, Inc. (“Alacra”), a global provider
of business and financial information in New York, recorded at its cost of $667
thousand.  In December 2007, we received proceeds of $333 thousand from the
redemption of one-third of our initial $1.0 million investment. In accordance
with the terms of our investment, we have exercised our right to redeem our
remaining preferred stock to Alacra, however to date the Company has not
complied with our redemption rights.  We intend to exercise all of our
rights and expect to receive the full carrying value due to us from this
investment.  As there is no readily determinable fair value of the Alacra
preferred stock, we account for this investment under the cost
method.




9




10.
CONVERTIBLE NOTE PAYABLE





Effective
June 1, 2007, the Company restructured the entire unpaid principal and
interest under promissory notes issued to Ault Glazer Capital Partners, LLC
(“Ault Glazer”), into a new
Convertible Secured Promissory Note (the "AG Capital Partners Convertible
Note") in the principal amount of $2.5 million. The AG Capital Partners
Convertible Note bears interest at the rate of 7% per annum and is due on the
earlier of December 31, 2010, or the occurrence of an event of
default.





On
September 5, 2008, the Company entered into an Amendment and Early Conversion of
the Secured Convertible Promissory Note (the “Amendment”) to modify the
terms of the AG Capital Partners Convertible Note.  Under
the Amendment, the Company agreed to pay Ault Glazer $450 thousand in cash
and, contingent upon satisfaction of certain conditions by Ault Glazer, convert
the remaining balance of the convertible secured note into 1,300,000 shares of
the Company’s common stock.  One condition was that Ault Glazer transfers
certain leases from the Company’s name into its name.  The Company made the
$450 thousand cash payment on September 5, 2008.





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, dated September 5, 2008 (the “Advancement”).  Pursuant
to the Advancement, the Company agreed to issue 300,000 shares of the Company’s
common stock to Ault Glazer on September 12, 2008, in advance of the
satisfaction of the conditions for conversion in the Amendment, with the
understanding that Ault Glazer would satisfy the conditions stated in the
Amendment prior to September 19, 2008.





Ault
Glazer failed to satisfy the conditions by the September 19, 2008
deadline.  Although the conditions remained unsatisfied, the Company made
two additional issuances of shares to Ault Glazer pursuant to the Amendment as
follows: the Company issued another 250,000 shares on October 10, 2008 and
another 250,000 shares on November 6, 2008.   As of September 30, 2010
and December 31, 2009, there remain 500,000 shares issuable to Ault Glazer upon
Ault Glazer meeting the conditions of the Amendment.  During the three and
nine months ended September 30, 2010 and the year ended December 31,
2009, in light of the failure to satisfy the conditions of the
Amendment and the Advancement, the Company did not accrue interest
expense on the AG Capital Partners Convertible Note.





In
October 2010, the Company received a Notice of Levy (the “Levy”) from the US
Marshal’s Office in Los Angeles (“Levying Officer”) with an order requiring the
Company to deliver all shares of Patient Safety Technologies common stock (“PST
Stock”) that the Company owes to Ault Glazer Capital Partners, LLC to the
Levying Officer on behalf of a creditor who holds a judgment against Ault Glazer
Partners, LLC and other parties.    The Company is currently
reviewing the Levy and intends to comply with its legal obligations in regard to
the Levy (see Note 21).





11.
ACCRUED LIABILITIES





Accrued
liabilities consists of the following:




September 30,
                      2010
                    
                    
                    December 31,
                      2009Accrued
      lease liability
                    
                    $
                    98,826
                    
                    
                    $
                    7,547Accrued
      dividends on preferred stock
                    
                    
                    114,976
                    
                    
                    
                    114,976Accrued
      severance
                    
                    
                    301,371
                    
                    
                    
                    47,449Accrued
      director’s fees
                    
                    
                    —
                    
                    
                    
                    162,500Contingent
      tax liability
                    
                    
                    223,523
                    
                    
                    
                    740,726Accrued
      commissions
                    
                    
                    —
                    
                    
                    
                    13,200Other
                    
                    
                    126,912
                    
                    
                    
                    156,478Total
      accrued liabilities
                    
                    $
                    865,608
                    
                    
                    $
                    1,242,876




10




12.
DEFERRED REVENUE





Deferred
revenue consists of the following:





September 30,
                    2010
                  
                  
                  December 31,
                    2009Cardinal
      Health advance payment on purchase order
                  
                  $
                  4,131,148
                  
                  
                  $
                  8,000,000Scanner
      reimbursement revenue
                  
                  
                  311,749
                  
                  
                  
                  99,144Maintenance
      agreements
                  
                  
                  3,750
                  
                  
                  
                  —Total
                  
                  $
                  4,446,647
                  
                  
                  $
                  8,099,144





On
November 19, 2009 we entered into a Supply and Distribution Agreement with
Cardinal Health (which replaced our prior agreement with Cardinal Health) under
which Cardinal Health is the exclusive distributor of current products used in
our proprietary Safety-Sponge® System in the United States, Puerto Rico and
Canada.  In connection with the execution of this distribution agreement,
Cardinal Health issued a $10.0 million stocking purchase order ("First Forward
Order"), paid us $8.0 million in cash as a partial prepayment of the First
Forward Order and agreed to pay $2.0 million directly to A Plus International,
Inc. ("A Plus"), our exclusive manufacturer, upon delivery of product to
Cardinal Health.  We did not ship any product pursuant to the First Forward
Order in 2009, and accordingly, all $10.0 million of revenue from the First
Forward Order is expected to be recognized in 2010.  As of September 30,
2010, we had recognized $5.9 million in revenue from the First Forward
Order, and Cardinal Health has made payments totaling $2.0 million to A
Plus.  In addition, Cardinal Health had originally agreed to issue a $5.0
million stocking purchase order ("Second Forward Order") before the end of the
third quarter of 2010 if certain milestones were achieved, however both the
Company and Cardinal Health have agreed not to pursue this Second Forward
Order.  We expect to have revenue of $10.0 million in 2010 from the First
Forward Order, and $0 revenue from the First and Second Forward Orders in
2011.





Because
of this arrangement, we expect that our revenues for 2010 will be significantly
higher than the actual sales of our product by Cardinal Health to end-user
hospital customers.  However, the Company’s revenue in 2011 and beyond
could be materially lower than actual sales of our product made by Cardinal
Health to end-user hospital customers.  Under the terms of the Supply and
Distribution Agreement with Cardinal Health, beginning in 2011 Cardinal Health
may adjust its inventory to more normal levels gradually over a 12 month
period.  Should Cardinal Health reduce its orders to the Company in an
effort to gradually reduce its inventory levels to more normal levels over a
12-month period, Company revenues could be materially negatively affected. 
The Company is in discussions with Cardinal Health to delay the inventory
reduction in 2011 and discuss a mutually acceptable process for Cardinal Health
to use their Forward Order inventory in satisfying customer demand, so as to
avoid having a significant negative impact, if any, on the Company’s future
revenue in 2011 and beyond as a result of this arrangement, and believes that a
mutual agreement will be reached between the Company and Cardinal Health,
however no assurances can be made that such an agreement will be
reached.





Prior to
the third quarter of 2009, the Company’s business model included the sale of its
SurgiCounterTM scanners and related software used in the Company’s Safety-Sponge®
System to most hospitals that adopted its system.  Beginning with the third
quarter of 2009, the Company modified its business model and began to offer to
provide its SurgiCounterTM scanners and related hardware and software to
hospitals at no cost when they adopt its Safety-Sponge® System.  Under the
new supply and distribution agreement with Cardinal Health entered into in
November 2009, the Company is reimbursed an agreed upon percentage of the cost
of the scanners provided by the Company to hospitals that receive their surgical
sponges and towels through Cardinal.  Reimbursements received from Cardinal
are initially deferred and are recognized as revenue on a pro-rata basis over
the life of the specific hospital contract.  The balance of the deferred
revenue to Cardinal related to scanners as of September 30, 2010 was $311
thousand.  Because the Company no longer engages primarily in
direct SurgiCounterTM scanner and related hardware sales, except in certain
customer specific situations, it generally anticipates only recognizing revenues
associated with its SurgiCounterTM scanners in connection with reimbursement
arrangements under its agreement with Cardinal Health.




11




13.
SERIES B CONVERTIBLE PREFERRED STOCK





On June
24, 2010 the Company entered into a Convertible Preferred Stock Purchase
Agreement with several accredited investors, as defined under Rule 501(a) of the
Securities Act of 1933, as amended.  The accredited investors included A
Plus International, Inc. and Catalysis Partners, LLC.  Wenchen (Wayne) Lin,
a member of the Company’s Board of Directors, is a founder and significant
beneficial owner of A Plus International, Inc and John P. Francis, a member of
the Company’s Board of Directors, has voting and investment control over
securities held by Francis Capital Management, LLC, which acts as the investment
manager for Catalysis Partners, LLC. Pursuant to the Convertible Preferred Stock
Purchase Agreement, the Company issued an aggregate of 60,000 shares of its
Series B Convertible Preferred Stock (“Series B Preferred”), at a purchase price
of $100 per share, or $6 million in the aggregate, payable in cash or as a
reduction of indebtedness or a combination of both.  Ten thousand of the
Series B preferred shares valued at $1.0 million were issued and exchanged for
$1.0 million of accounts payable balance that the Company owed A Plus
International, the primary manufacturing supplier of the Company’s sponge
products.  The Company authorized 150,000 shares of Series B Preferred,
with a par value of $1.00 per share.  Holders of the Series B Preferred are
entitled to receive quarterly cumulative dividends at a rate of 7.00% per annum,
beginning on July 1, 2010.  All dividends due on or prior to December 31,
2011 are payable in kind in the form of additional shares of Series B Preferred,
and all dividends payable after December 31, 2011 are payable solely in
cash.   On November 15, 2010 the Company’s Board of Directors declared
dividends on the Series B Preferred stock covering the period June 24, 2010 (the
date of issuance) through to September 30, 2010, totaling $110 thousand. 
The dividend will be paid to the Series B Preferred shareholders during the
quarter ended December 31, 2010 by issuing an additional 1,089 shares of Series
B Preferred shares, valued at $100 per share, and cash of $1,175, reflecting
fractional share amounts.





In
connection with the Convertible Preferred Stock Purchase Agreement, the Company
and the investors entered into a Registration Rights Agreement.  Pursuant
to the Registration Rights Agreement, the Company is required to use its
reasonable best efforts to file with the Securities and Exchange Commission a
registration statement covering the shares of common stock underlying the Series
B Preferred Stock within 90 days from the closing date of June 24, 2010, and to
cause the registration statement to be declared effective within 150 days of the
closing date, and to maintain the effectiveness of the registration statement
for the shorter of 3 years from the effective date or such time as all shares
covered under the registration statement have been sold.  Under this
agreement, if the registration statement is not declared effective within 150
days of the closing date, the Company shall be liable to pay each of the
investors in cash an amount equal to 1.5% of their respective investment. 
Based on the aggregate investment in the Series B Preferred of $6.0 million, the
Company’s exposure for penalties due to its failure to cause the registration
statement to be declared effective on a timely basis would be $90,000 per month,
unless the investors waive such penalties.  As of September 30, 2010, there
have been no penalties accrued relating to the registration requirement because
the Company believes it has or is likely to receive waivers of such requirement
through the third quarter of 2010, and deems that any such potential future
penalties are currently not probable.





14.
STOCKHOLDERS’ EQUITY:





The
following table summarizes changes in components of stockholders’ equity during
the nine months ended September 30, 2010:





Preferred Stock
                        Series A
                      
                      
                      Convertible
                        Preferred Stock
                        Series B
                      
                      
                      Common Stock Issued
                      
                      
                      Paid – In
                      
                      
                      Accumulated
                      
                      
                      Total
                        Stockholders’
                        EquityShares
                      
                      
                      Amount
                      
                      
                      Shares
                      
                      
                      Amount
                      
                      
                      Shares
                      
                      
                      Amount
                      
                      
                      Capital
                      
                      
                      Deficit
                      
                      
                      (Deficit)BALANCES,
      December 31, 2009
                      
                      
                      10,950
                      
                      
                      $
                      10,950
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      23,456,063
                      
                      
                      $
                      7,740,501
                      
                      
                      $
                      44,834,321
                      
                      
                      $
                      (58,418,330
                      )
                      
                      $
                      (5,832,558
                      )Preferred
      dividends
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      67
                      
                      
                      
                      67
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      6,703
                      
                      
                      
                      (59,777
                      )
                      
                      
                      (53,007
                      )Issuance
      of convertible preferred stock, net of transaction costs
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      60,000
                      
                      
                      
                      60,000
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      5,459,991
                      
                      
                      
                      —
                      
                      
                      
                      5,519,991Stock-based
      compensation
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      965,077
                      
                      
                      
                      
                      
                      
                      
                      965,077Net
      income
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      1,320,160
                      
                      
                      
                      1,320,160BALANCES,
      September 30, 2010
                      
                      
                      10,950
                      
                      
                      $
                      10,950
                      
                      
                      
                      60,067
                      
                      
                      $
                      60,067
                      
                      
                      
                      23,456,063
                      
                      
                      $
                      7,740,501
                      
                      
                      $
                      51,266,092
                      
                      
                      $
                      (57,157,947
                      )
                      
                      $
                      1,919,663





15.
WARRANTS AND WARRANT DERIVATIVE LIABILITY





The
following table summarizes warrants to purchase common stock activity for the
period ended September 30, 2010:




12




Amount
                
                
                Range of Exercise
                  PriceWarrants
      outstanding December 31, 2009
                
                
                8,064,978
                
                
                $
                0.75
      − 6.05Issued
                
                
                —
                
                
                
                −Cancelled/Expired
                
                
                (572,417
                )
                
                $
                1.25
      – 6.05Warrants
      outstanding September 30, 2010
                
                
                7,492,561
                
                
                $
                0.75
      – 4.50





At
September 30, 2010, stock purchase warrants will expire as follows:





#of
                    Warrants
                  
                  
                  Rangeof
                    Exercise
                    Price2010
                  
                  
                  —
                  
                  
                  
                  —2011
                  
                  
                  2,301,419
                  
                  
                  $
                  0.75
      − 4.50
                  *2012
                  
                  
                  818,000
                  
                  
                  $
                  2.002013
                  
                  
                  1,786,267
                  
                  
                  $
                  0.75
      − 1.40
                  *2014
                  
                  
                  1,890,000
                  
                  
                  $
                  1.82
      − 4.002015
                  
                  
                  696,875
                  
                  
                  $
                  1.25Total
                  
                  
                  7,492,561
                  
                  
                  $
                  0.75 – 4.50





*
Includes warrants that contain anti-dilution rights if the Company grants or
issues securities for less than the exercise price.





Warrant
Derivative Liability





At
September 30, 2010, a total of 2,567,686 warrants are classified as a derivative
liability pursuant to guidance codified in FASB ASC 815-40, Derivatives and Hedging,
Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own
Stock(previously EITF 07-5).





At
September 30, 2010, the estimated fair value of these warrants, based on a
Black-Scholes option pricing model was $981 thousand, which is included in
current liabilities in the accompanying condensed consolidated balance sheet.
Based on the change in fair value of the warrant derivative liability, the
Company recorded non-cash income of $16 thousand and $2.7 million for the three
and nine months ended September 30, 2010, respectively. The warrant fair values
at September 30, 2010 were determined using the Black-Scholes valuation
model using the closing stock price at each date, volatility rate of
129-146%, risk free interest rates of 0.22-0.56%, and contractual lives equal to
the remaining term of the warrants expiring as of each measurement
date.





16.
FAIR VALUE MEASUREMENTS





Fair
Value Hierarchy





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.




13




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.





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, 2010, the Company had outstanding
warrants to purchase common shares of its stock that are classified as warrant
derivative liabilities with a fair value of $981 thousand. The warrants are
valued using Level 3 inputs because there are significant unobservable inputs
associated with them (See Note 15).





The table
below sets forth a summary of changes in the fair value of the Company’s warrant
derivative liability for the period ended September 30, 2010:





January 1, 2010
                            
                            
                            Gain on change in
                              fair value included
                              in earnings
                            
                            
                            September 30, 2010Warrant
      DerivativeLiability
                            
                            $
                            (3,666,336
                            )
                            
                            $
                            2,685,579
                            
                            
                            $
                            (980,757
                            )





Other
Financial Instruments





The
carrying amounts of cash and cash equivalents, restricted cash, accounts
receivable, accounts payable, accrued liabilities and deferred revenue
approximate their respective fair values because of the short-term nature of
these financial instruments.





The fair
value of the Company's convertible debt is estimated to be $375 thousand and
$950 thousand at September 30, 2010 and December 31, 2009, respectively, which
is less than the carrying value of $1.42 million at each of these dates. 
As described in Note 10, the current terms of the agreements relating to the
convertible debt provides for the full settlement of the outstanding balance of
the debt.  Accordingly, the fair values noted above were estimated based on
market value of 500,000 shares of the Company’s common stock at September 30,
2010 and December 31, 2009.





The fair
value of long-term investments were reported using the cost method as there are
no quoted market prices available, and determining a reasonable estimate of fair
value can not be completed without incurring excessive costs (See Note
9).





17.
STOCK 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
2,000,000 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.  The Company has stopped granting stock options under the 2005
SOP.





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 on August 6, 2009. An
aggregate of 3,000,000 shares of common stock have been reserved under the 2009
SOP 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 and 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 2005 SOP and 2009 SOP are subject to a
vesting period determined at the date of grant.


14


In June
2010, the Company entered into a Release and Separation Agreement with the
Company’s former CEO and former members of the board of directors pursuant to
which their respective stock option grants were modified (see Note 18).  In
connection with these modifications, the Company recorded incremental stock
based compensation expense, based on the change in fair value of the modified
options, of $147 thousand during the quarter ended June 30, 2010.  In
addition, based on the continued vesting of certain of the stock options
that were modified, the Company expects to record additional stock based
compensation expense totaling approximately $112 thousand ratably over a 12
month period through June 2011.





All
options that the Company granted during the nine months ended September 30, 2010
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 30,2010
                
                
                2009Weighted
      average risk free interest rate
                
                
                1.59
                %
                
                
                2.07
                %Weighted
      average life (in years)
                
                4.26
      years
                
                
                6.02
      yearsVolatility
                
                
                118.69
                %
                
                
                114.1
                %Expected
      dividend yield
                
                
                0
                %
                
                
                0
                %Weighted
      average grant-date fair value per share of options granted
                
                $
                0.61
                
                
                $
                .75





A summary
of stock option activity for the nine months ended September 30, 2010 is
presented below:





Outstanding OptionsWeightedAverageWeighted
                        
                        
                        Remaining
                        
                        
                        AggregateNumber of
                        
                        
                        Average
                          Exercise
                        
                        
                        Contractual
                          Life
                        
                        
                        Intrinsic
                          ValueShares
                        
                        
                        Price
                        
                        
                        (years)
                        
                        
                        (1)Balance
      at December 31, 2009(2)
                        
                        
                        5,821,000
                        
                        
                        $
                        1.36
                        
                        
                        
                        6.15
                        
                        
                        $
                        4,401,385Options
      Granted
                        
                        
                        1,005,000
                        
                        
                        $
                        1.23
                        
                        
                        
                        9.46Exercised
                        
                        
                        —
                        
                        
                        
                        —
                        
                        
                        
                        —Forfeited
                        
                        
                        (1,801,928
                        )
                        
                        $
                        1.11Cancelled
                        
                        
                        —
                        
                        
                        
                        —Balance
      at September 30, 2010
                        
                        
                        5,024,072
                        
                        
                        $
                        1.43
                        
                        
                        
                        6.46Vested
      and exercisable as of September 30, 2010
                        
                        
                        2,670,978
                        
                        
                        $
                        1.65
                        
                        
                        
                        5.79
                        
                        
                        
                        —Unvested
      as of September 30, 2010
                        
                        
                        2,353,094
                        
                        
                        $
                        1.18
                        
                        
                        
                        7.23
                        
                        
                        $
                        —





1)
            The
      aggregate intrinsic value is calculated as the difference between the
      exercise price of the underlying awards and the closing stock prices of
      $0.75 and $1.90 of the Company’s common stock at September 30, 2010 and
      December 31, 2009, respectively.


2)
            Includes
      3,150,000 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, 2010 was $103 and $937 thousand, respectively. 
For the three and nine months ended September 30, 2010, stock based compensation
was $161 thousand and $965 thousand, respectively, that included $55 thousand
for 75,000 shares of restricted stock authorized but not issued to a
consultant.  For the three and nine months ended September 30, 2009, stock
based compensation was $325 thousand and $897 thousand,
respectively.





As of
September 30, 2010, there were $1.65 million of unrecognized compensation costs
related to outstanding employee stock options. This amount is expected to be
recognized over a weighted average period of 2.98 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.




15




18.
RELATED PARTY TRANSACTIONS





A
Plus International, Inc.





During
the three and nine months ended September 30, 2010, the Company recognized cost
of revenues of $1.9 million and $4.8 million respectively, relating to surgical
products used in the Safety-Sponge® System manufactured by A Plus International
or A Plus.At September
30, 2010, the Company’s accounts payable included $1.0 million owed to A Plus in
connection with the purchase of surgical products used in the Safety-Sponge®
System, $9 thousand of which will be paid directly to A Plus by Cardinal Health
pursuant to the new Supply and Distribution Agreement dated November 19,
2009.  Wenchen Lin, a Director and significant beneficial owner of the
Company is a founder and significant owner of A Plus. On June 24, 2010, A Plus
converted $1.0 million of accounts payable owed to A Plus into 10,000 shares of
Series B Convertible Preferred Stock (see Note 13).




Francis Capital
Management




On June
24, 2010, Catalysis Partners, LLC, invested $1.0 million in the Series B
Convertible Preferred Stock transaction (see Note 13).  John P. Francis, a
member of our Board of Directors, has voting and investment control over
securities held by Francis Capital Management, LLC, which acts as the investment
manager for Catalysis Partners, LLC.




Release
and Separation Agreements




In
connection with the Series B Convertible Preferred Stock financing (see Note
13), Steven H. Kane, the Company’s former CEO, resigned as a Director, President
and Chief Executive Officer, and Howard E. Chase, Loren McFarland, Eugene A
Bauer, MD, and William M. Hitchcock also resigned as members of our Board of
Directors (the “Board”) and received certain severance benefits.




In
connection with Mr. Kane’s resignation, we entered into a Separation Agreement
and Mutual General Release with Steven Kane (the “Kane Release”).  Under
the Kane Release, Mr. Kane will receive, subject to compliance with its terms,
12 months of salary and health payments, and waived his rights to any bonus
payment, or payment for excise taxes.  The Kane Release also provided for
the payment to Mr. Kane, in cash, of an aggregate $235 thousand as payment in
full for all accrued Director Fees and salary, accrued vacation, and accrued
severance benefits of $349 thousand as of June 30, 2010 as provided in his
employment agreement.  The Kane Release contains other provisions,
including provisions relating to stock options and other matters.




In
connection with the resignation of Messrs. Chase, McFarland, Hitchcock and Dr.
Bauer as members of our Board, effective as of June 24, 2010, we entered into a
Separation Agreement and Mutual General Release with such individuals (the
“Director Release”).  The Director Release provided for the payment, in
cash, of the following unpaid Director’s fees not previously approved by the
Compensation Committee:  $83.5 thousand to Mr. Chase, $64.9 thousand
to Mr. McFarland, $10.0 thousand to Mr. Hitchcock and $10.0 thousand to Dr.
Bauer.  The Director Release contains other provisions, including
provisions relating to stock options and other matters.




19.MAJOR
CUSTOMERS, SUPPLIERS, SEGMENT AND RELATED INFORMATION




Major
Customers





During
the three and nine months ended September 30, 2010, due to its exclusive
distribution agreement with Cardinal Health, the Company had one customer that
represented in excess of 97% and 98% of total revenues, respectively, compared
with 89% and 80% for the same respective periods in 2009.  No other single
customer accounted for more than 10% of total revenues in either
period.




16




Suppliers





The
Company relies primarily on a third-party supplier, A Plus, to supply all the
surgical sponges and towels used in its Safety-Sponge® System (see Note 18). The
Company also relies on a number of third parties to manufacture certain other
components of its Safety-Sponge® System.  If A Plus or any of the Company’s
other third-party manufacturers cannot, or will not, manufacture its 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
the Company’s business and operating results.





Furthermore,
the vast majority of products obtained from A Plus are manufactured in
China.  As such, the supply of product from A Plus is subject to various
political, economic, and other risks and uncertainties inherent in importing
products from this country, including among other risks, export/import duties,
quotas and embargoes; domestic and international customs and tariffs; changing
taxation policies; foreign exchange restrictions; and political conditions and
governmental regulations.




Segment
and Related Information





The
Company presents its business as one reportable segment due to the similarity in
nature of products marketed, financial performance measures, methods of
distribution and customer markets. The Company’s chief operating decision making
officer reviews financial information on the Company’s products on a
consolidated basis.  All revenues earned during the three and nine months
ended September 30, 2010 relate to customers based in the United
States.




The
following table summarizes revenues by product line.





Three Months Ended September
      30,
                                
                                2010
                                
                                
                                2009Revenues:Surgical
      sponges and towels
                                
                                $
                                4,091,407
                                
                                
                                $
                                964,264Scanners
      and related products
                                
                                
                                31,153
                                
                                
                                
                                14,198Total
      revenues
                                
                                $
                                4,122,560
                                
                                
                                $
                                978,462





Nine Months Ended September
    30,
                                
                                2010
                                
                                
                                2009Revenues:Surgical
      sponges and towels
                                
                                $
                                10,166,752
                                
                                
                                $
                                2,586,079Scanners
      and related products
                                
                                
                                86,145
                                
                                
                                
                                355,987Total
      revenues
                                
                                $
                                10,252,897
                                
                                
                                $
                                2,942,066





20. 
COMMITMENTS AND CONTINGENCIES





Operating
and Capital Leases





In
November 2007, the Company entered into a 36 month lease agreement for
approximately 4,000 square feet of office space in Temecula, CA, which expires
December 31, 2010.  Monthly lease payments for the remaining lease term of
this lease are $9,757.  In November 2010, the Company moved its corporate
headquarters to Irvine, CA, entering into a 36 month lease in September 2010 to
lease approximately 3,300 square feet of office space.  Monthly lease
payments are $5,610 a month during the first year and will increase 3% annually
each year afterwards, effective each September.  In December 2009, the
Company entered into a 40 month sublease agreement for office space in Newtown,
PA, which expires in April 2013, at a fixed monthly total lease payment for the
entire term of the lease of $11,576.  In connection with the Newtown, PA
office sublease, the Company acquired certain office furniture valued at $100
thousand from the building landlord for a nominal one-time payment. 
Accordingly, a portion of the total monthly lease payment for this facility has
been allocated to the acquisition of this furniture and recorded as a capital
lease at December 31, 2009.




17




In June
2010, the Company made the decision to close the Newtown, PA corporate
office.  Per FASB Accounting Standards Codification 420, Exit or Disposal Cost
Obligations, the Company expensed the net present value of the remaining
lease obligation along with an accrual for utilities through April 2013. 
At the time of management’s decision in June 2010, the Company did not offset
the lease accrual by any potential sublease income, as it was assumed at the
time to be unlikely that a tenant would be found during the remaining sublease
term due to local commercial real estate market conditions.  Accordingly,
in the quarter ended June 30, 2010, the Company recorded a charge of $372
thousand for the remaining facility lease obligation.  However as discussed
in Note 21, the Company did subsequently find a prospective tenant, (“Tenant”)
to sublease the Newtown property, and entered into a sub-sublease agreement with
Tenant on November 9, 2010 for the full lease period of the Company’s original
lease.  As a result, the Company reduced its recorded lease obligation by
$220 thousand in the quarter ended September 2010, representing the net present
value of expected future rent payments to be made by Tenant over the lease
term.  The sub-sublease arrangement is still subject to final approval by
the Master Landlord and Sublease Landlord, which management expects shortly,
however no assurances can be made that these required approvals will be
received.





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 certain employees and consultants.  In addition, the Company determined
that required tax withholding relating to these stock grants had not been made,
reported or remitted, as required in 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, and has submitted documentation to the
Internal Revenue Service reporting the previously unreported income. Although
the Company’s liability may ultimately be reduced based either on the expiration
of applicable statutes of limitations, or 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, originally
accrued by the Company was 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.





On June
24, 2010, in connection with the Series B Convertible Preferred Stock Purchase
Agreement, the Company entered into a Tax Escrow Agreement and transferred $651
thousand into a tax escrow account. The Tax Escrow Agreement was entered into
with the U.S. Bank National Association, a national banking association, acting
as escrow agent.   Under the Tax Escrow Agreement, the escrow agent is
required to use the escrowed funds to pay specified tax claims to taxing
authorities and/or to release escrowed funds to the extent the Company’s tax
reserve for the contingent tax liability has been reduced, subject to compliance
with certain procedures.





During
the nine months ended September 30, 2010, the Company reduced the tax escrow
account by $427 thousand based on the expiration of the statue of limitations
during the quarter for certain amounts relating the tax year 2006.  The
Company anticipates the remaining $224 thousand will be released from the escrow
account in the third quarter of 2011.  As of September 30, 2010, the
remaining contingent tax liability, which is included in accrued liabilities, is
$224 thousand.





Legal
Proceedings





On
October 15, 2001, Jeffrey A. Leve and Jeffrey Leve Family Partnership, L.P.
filed a lawsuit against the Company, Sunshine Wireless, LLC, and four other
defendants affiliated with Winstar Communications, Inc.  This 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 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.  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.




18




On July
28, 2005, Jeffrey A. Leve and Jeffrey Leve Family Partnership, L.P. filed
another lawsuit against the Company, Sunshine Wireless LLC and four other
defendants affiliated with Winstar Communications to collect a federal default
judgment of $5.0 million entered against two entities, Winstar Radio Networks,
LLC and Winstar Global Media, Inc., by attempting to enforce the judgment
against the Company and others under the doctrine of de factomerger.  The
action was tried before the Los Angeles County Superior Court in2008.On August 5, 2009, the Superior
Court issued a statement of decision in the
Company’s favor, and on October 8, 2009, the Superior Court entered
judgment in the Company’s favor, and judged
plaintiffs’ responsible for $2,709 of the
Company’s court costs.  On November 6, 2009, the plaintiff filed a notice
of appeal in the Superior Court of the State of California, County of Los
Angeles Central District. The Company has engaged
appellate counsel, believes the plaintiff’s case is without merit andintends to continue to defend the case vigorously. As loss is not deemed
to be probable in connection with this matter, no accruals have been made as of
September 30, 2010.





21.
SUBSEQUENT EVENTS





On
October 22, 2010, the Company entered into an employment agreement and appointed
David C. Dreyer as Chief Financial Officer and Vice President of the
Company.  Mr. Dreyer has over 20 years experience in financial management
in public companies, including as Chief Financial Officer at AMN Healthcare Inc.
(AHS) and Sicor Inc (now a part of Teva Pharmaceutical Industries Ltd
[TEVA]).





As
discussed in Note 10, Convertible Note Payable, in October 2010, the Company
received a Notice of Levy (the “Levy”) from the US Marshal’s Office in Los
Angeles (“Levying Officer”) with an order requiring the Company to deliver all
shares of Patient Safety Technologies common stock (“PST Stock”) that the
Company owes to Ault Glazer Capital Partners, LLC to the Levying Officer on
behalf of a creditor who holds a judgment against Ault Glazer Partners, LLC and
other parties.   The Company is currently reviewing the Levy and
intends to comply with its legal obligations in regard to the Levy (see Note
21).





On
November 15, 2010 Zealous Asset Management LLC (“ZAM”), Managing General Partner
for the hedge funds Zealous Partners and Ault Glazer Capital Partners filed a
lawsuit in the Superior Court of California, County of Orange, Central Justice
Center against the Company, Dr. Louis Glazer, one of our directors, and his
spouse Melanie Glazer, as well as Steven Bodnar, a shareholder of the Company
for breach of contract, breach of good faith, fraud and other claims (the “ZAM
Suit”), The ZAM Suit alleges, among other things, that the Company’s former
management and the Glazers misrepresented the financial strength of the Company
when re-negotiating terms of various loan agreements that the Company entered
into with Zealous Partners and Ault Glazer Capital Partners in 2005 and 2006 and
allegedly “forced” Ault Glazer Capital Partners to agree to such renegotiated
terms.   The ZAM Suit also contains allegations regarding dividends
allegedly unpaid with respect to 2,600 shares of the Company’s Series A
Preferred Stock allegedly owned by an affiliate of ZAM.  Management is
still reviewing the ZAM Suit.  The Company’s preliminary analysis is that
the ZAM Suit is without merit.  The Company intends to vigorously defend
the ZAM Suit and believes that this matter will not have any material impact to
the financials statements of the Company.





As
discussed in Note 20, Commitments and Contingencies, the Company made a decision
in June 2010 to close its Newtown, PA corporate office.  Per FASB
Accounting Standards Codification 420, Exit or Disposal Cost
Obligations, the Company expensed the net present value of the remaining
lease obligation along with an accrual for utilities through April 2013,
totaling $372 thousand.  The Company did not offset the lease accrual by
any potential sublease, as it was assumed at the time to be unlikely that a
tenant would be found during the remaining sublease term due to local commercial
real estate market conditions.  The Company did find a prospective tenant,
(“Tenant”) to sublease the Newtown property, and entered into a sub-sublease
agreement with the Tenant on November 9, 2010 for the remaining lease
period of the Company’s original lease.  As a result, the Company reduced
its recorded lease obligation by $220 thousand in the quarter ended September
30, 2010, representing the net present value of expected future rent payments to
be made by Tenant over the lease term. The sub-sublease arrangement is still
subject to final approval by the Master Landlord and Sublease Landlord, which is
expected shortly, however no assurances can be made that these required
approvals will be received.








19


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 quarterly report on Form 10-Q and our audited
consolidated financial statements and related notes thereto and the description
of our business appearing in our annual report on Form 10-K for the year ended
December 31, 2009.    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 our annual
report on Form 10-K for the year ended December 31, 2009.





Overview




We focus
on the development, marketing and sales of products and services in the medical
patient safety markets. Our proprietary Safety-Sponge® 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 eliminate the possibility of retained
surgical sponges being unintentionally left inside of patients during surgical
procedures by allowing faster and more accurate counting of surgical
sponges.  As of September 30, 2010, we reached a milestone of having had a
cumulative total of over an estimated 36,625,000 of our sponges used in more
than 1,450,000 procedures without a single undetected sponge left inside a
surgical patient in all cases where our solution was utilized.  We sell our
Safety-Sponge® System to hospitals through our direct sales force, but rely on
an exclusive distributor for the ongoing supply of our proprietary surgical
sponge products to hospitals that have adopted our system.  Our business
model consists of selling our unique surgical sponge products, which are
manufactured for us by an exclusive supplier, on a recurring basis to those
hospitals that have adopted our Safety-Sponge® System.  One of the ways in
which we differentiate our products from other competing products is by working
closely with hospital personnel through education and implementation
services.  We currently sell our Safety-Sponge® System only in the United
States and we had revenues of $4.1 millionand $10.3 million for the
three and nine months ended September 30, 2010, which included $2.5 millionand
$5.9 million,respectively, shipped to
Cardinal Health under the First Forward Order which does not necessarily
represent sales of that product to end user hospitals (see “Factors Affecting
Future Results —Cardinal Health Supply Agreement”).





Sources
of Revenues and Expenses




Revenues




Surgical Sponge Revenues.We generate revenues primarily from the sale of surgical sponges used in
our Safety-Sponge® System to our exclusive distributor, who then sells directly
and through sub-distributors to hospitals that have adopted our Safety-Sponge®
System.  We expect hospitals that adopt our Safety-Sponge® System to commit
to its use and thus provide a recurring source of revenues from ongoing sales of
surgical sponges and other products used in our system. We recognize revenues
from the sale of surgical sponges upon shipment to our distributor because most
of our surgical sponge sales are to our distributor, FOB shipping point. 
Note that because of the way our sales cycle works there is a gap between the
time we begin incurring costs associated with our new customer arrangements and
when we begin generating revenues from such arrangements.




Hardware, Software and Maintenance
Agreement Revenues.  We also generate revenues from the sale of
related hardware and software to hospitals that have adopted our Safety-Sponge®
System.  The sale of our Safety-Sponge® System includes hardware (the
SurgiCounterTM scanners and certain related hardware), our proprietary file
management software (CitadelTM) 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 Safety-Sponge® 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 these sales to represent a significant portion of our revenues
going forward.


20


Prior to
the third quarter of 2009, our business model included the sale of our
SurgiCounterTM scanners and related software used in our Safety-Sponge® System to
most hospitals 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 all hospitals at no cost when they adopt our
Safety-Sponge® System.  Because we no longer engage primarily in direct
SurgiCounterTM scanner sales, we generally anticipate only recognizing revenues
associated with our SurgiCounterTM scanners in connection with reimbursement
arrangements under our agreement with Cardinal Health.  Therefore, we do
not expect that our SurgiCounterTM scanners and related hardware will represent a
sizable source of future revenues for us. Deferred scanner revenue associated
with the reimbursement from Cardinal Health, will be recognized over the life of
the specific hospital contract.




Cost
of revenues





Our cost
of revenues consists primarily of our direct product costs for surgical sponges
and products from our exclusive third-party manufacturer.  We also include
a reserve expense for obsolete and slow moving inventory in cost of
revenues.  In addition, when we provide scanners to hospitals for their use
(rather than sell), we include only the depreciation expense of the scanners in
cost of revenues (not the full product cost).  We estimate the useful life
of the scanners to be three years.  However, should we sell the scanners to
hospitals, our cost of revenues include 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.  There was a reclassification starting in 2010 of certain
personnel-related expenses to sales and marketing expenses.





Sales
and marketing expenses





Our sales
and marketing expenses consist primarily of salaries and related employee
benefits, sales commissions and support costs, 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, expenses related to being a public
entity, and 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 to record the change in fair value each period in our
statement of operations.  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.




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 amounts of 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
condensed consolidated interim financial
statements.


21


Warrant
Derivative Liability





Under
applicable accounting guidance, an evaluation of outstanding warrants is made to
determine whether warrants issued are required to be classified as either equity
or a liability. Because certain warrants we have issued in connection with past
financings contain certain provisions that may result in an adjustment to their
exercise price, we classify them as derivative liabilities, and accordingly, we
are then required to estimate the fair value of such warrants, at the end of
each fiscal quarter.  We use the Black-Scholes option pricing model to
estimate such fair value, which requires the use of numerous assumptions,
including, among others, expected life (turnover), volatility of the underlying
equity security, a risk-free interest rate and expected dividends. The use of
different values by management in connection with these assumptions 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.,
which we 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.  We are
required to perform a two-step impairment test 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 condition and
results of operations.




Stock-Based
Compensation




We
recognize compensation expense in an amount equal to the estimated grant date
fair value of each option grant, or stock award 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 values by management in connection with
these assumptions in the Black Scholes option pricing model could produce
substantially different results.




Impairment
of Long-Lived Assets




Our
management reviews our long-lived 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.


22




Since
January 1, 2007, we have measured and recorded uncertain tax positions in
accordance with rules that took effect on such date that prescribe a threshold
for the financial statement recognition and measurement of a tax position taken
or expected to be taken in a tax return.  Accordingly, we now only
recognize (or continue to recognize) tax positions meeting the
more-likely-than-not recognition threshold (or that met such threshold on the
effective date).  Accounting for uncertainties in income tax positions
involves significant judgments by management.  If actual results differ
from management’s estimates, we may need to adjust the provision for income
taxes.





Recent
Accounting Pronouncements





For
additional discussion regarding these, and
otherrecent accounting pronouncements, see
Note 3 to our condensed consolidated interim financial statements, appearing
elsewhere in this quarterly report on Form 10-Q.





Internal
Control Over Financial Reporting




In
connection with our assessment of internal controls over financial reporting as
of December 31, 2009, we identified the following material weaknesses in our
internal control over financial reporting due to:





·
            Ineffective
      control environment due to the following identified
      weaknesses:


o
            Failure
      to retain individuals competent in the application of generally accepted
      accounting principles (“GAAP”) to complex accounting
      transactions.


o
            Failure
      to establish sufficiently detailed accounting policies and procedures and
      to properly train accounting department
staff.


·
            Ineffective
      internal control policies and procedures relating to the period end close
      process including lack of controls relating to journal entries, post
      closing adjustments and management review of conclusions regarding
      accounting and financial reporting
matters.


·
            Ineffective
      internal control policies and procedures designed to provide reasonable
      assurance regarding the accuracy and integrity of spreadsheets used in the
      financial reporting system.





To remedy
these material weaknesses, we are implementing policies and procedures to
formalize our period end close process as well as to address the application of
our accounting policies to ensure conformity with GAAP.  We are also
seeking to hire qualified personnel, or engage outside resources, as applicable,
with appropriate knowledge/experience in the application of GAAP to complex
accounting transactions and we are strengthening internal policies and
procedures designed to ensure the accuracy and integrity of spreadsheets used in
the financial reporting system.  As discussed in Note 21, Subsequent
Events, the Company hired a new Chief Financial Officer, Mr. Dreyer effective
October 22, 2010.  Mr. Dreyer is a Certified Public Accountant (CPA) with
over 20 years experience in financial management of public companies. 
Management is fully committed to remediating the material weaknesses identified
during last year’s assessment of internal controls.





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 as of the end of the period covered by this report, see
“Controls and Procedures” below.





Factors
Affecting Future Results




Cardinal Health Supply
Agreement.   On November 19, 2009 we entered into a Supply and
Distribution Agreement with Cardinal Health (which replaced our prior agreement
with Cardinal Health) under which Cardinal Health is the exclusive distributor
of current products used in our proprietary Safety-Sponge® System in the United
States, Puerto Rico and Canada.  In connection with the execution of this
distribution agreement, Cardinal Health issued a $10.0 million stocking purchase
order ("First Forward Order"), paid us $8.0 million in cash as a partial
prepayment of the First Forward Order and agreed to pay $2.0 million directly to
A Plus International, Inc. ("A Plus"), our exclusive manufacturer, upon delivery
of product to Cardinal Health.  We did not ship any product pursuant to the
First Forward Order in 2009, and accordingly, all $10.0 million of revenue from
the First Forward Order is expected to be recognized in 2010.  As of
September 30, 2010, we had recognized $5.9 million in revenue from the
First Forward Order, and Cardinal Health has made payments totaling $2.0 million
to A Plus.  In addition, Cardinal Health had originally agreed to issue a
$5.0 million stocking purchase order ("Second Forward Order") before the end of
the third quarter of 2010 if certain milestones were achieved, however both the
Company and Cardinal Health have agreed not to pursue this Second Forward Order.
We expect to have
revenue of $10.0 million in 2010 from the First Forward Order, and $0 revenue
from the First and Second Forward Orders in 2011.


23





Because
of this arrangement, we expect that our revenues for 2010 will be significantly
higher than the actual sales of our product by Cardinal Health to end-user
hospital customers.  However, the Company’s revenue in 2011 and beyond
could be materially lower than actual sales of our product made by Cardinal
Health to end-user hospital customers.  Under the terms of the Supply and
Distribution Agreement with Cardinal Health, beginning in 2011 Cardinal Health
may adjust its inventory to more normal levels gradually over a 12 month
period.  Should Cardinal Health reduce its orders to the Company in an
effort to gradually reduce its inventory levels to more normal levels over a
12-month period, Company revenues could be materially negatively affected. 
The Company is in discussions with Cardinal Health to delay the reduction in
2011 and discuss a mutually acceptable process for Cardinal Health to use their
Forward Order inventory in satisfying customer demand, so as to avoid having a
significant negative impact if any, on the Company’s future revenue in 2011 and
beyond as a result of this arrangement, and believes that a mutual agreement
will be reached between the Company and Cardinal Health, however no assurances
can be made that such an agreement will be reached.




Effect of Stocking Sales and Backlog
on Revenues.  Our revenues reflect primarily the sale of surgical
sponges to our exclusive distributor.  Because we recognize revenues when
we ship product, (1) the timing of orders by our distributor and the management
of its inventory may affect the comparability of revenues between periods and
(2) 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 exclusive distributor may sell down its stocking inventory more
than it anticipated, which could result in lower than anticipated Company
revenue.  Thus, certain changes in our revenues between periods are not
necessarily reflective of actual hospital demand for our surgical sponge
products during the period reported.




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 hardware and software used in our Safety-Sponge® System to most
hospitals that adopted our system.  Beginning with the third quarter of
2009, we modified our business model and began to offer to provide our
SurgiCounterTM scanners and related hardware and software to hospitals at no cost
when they adopt our Safety-Sponge® System.  Because we no longer
engage primarily in direct SurgiCounterTM scanner
sales and generally anticipate only recognizing revenues associated
with our SurgiCounterTM scanners in connection with reimbursement arrangements
under our agreement with Cardinal Health, we do not expect our
SurgiCounterTM scanners to continue to represent a sizable source of
revenues for our company.  For the three and nine months ended
September 30, 2010, surgical sponge sales accounted for 99.2% and 99.1%,
respectively, compared to 98.3% and 91.6%, respectively, for the same period in
2009.  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 and
related hardware that we have provided to certain hospitals for their use at no
cost.  This business model change led to a significant
improvement in our gross margin in the year ended December 31, 2009 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 cost of revenue.  Going forward, we anticipate that
the shift in product mix and anticipated increase in volume of surgical
sponge sales will more than offset the effects of including depreciation expense
for the scanners in cost of revenue without generating the
corresponding revenue from the sale of the scanner.





Results
of Operations




Three
Months Ended September 30, 2010 Compared to Three Months Ended September 30,
2009




Revenues




We had
revenues of $4.1 million, which included $2.5 million shipped to Cardinal Health
under the First Forward Order (see “Factors Affecting Future Results —Cardinal
Health Supply Agreement” above) for the three months ended September 30,
2010.  Estimated hospital consumption revenue, which is defined as total
revenue less the First Forward Order was $1.6 million for the three months ended
September 30, 2010, an increase of 69.6% compared to $978 thousand for the same
period in 2009.   In the three months ended September 30, 2010,
surgical sponge sales accounted for 99.2% of revenue, and sales of hardware
accounted for 0.8%, compared to 98.3% and 1.7% for the same period in 2009,
respectively.  The primary reason for the increase in revenues was an
increase in the number of hospitals implementing the Safety-Sponge® System and the
shipment of Forward Order inventory to Cardinal Health (see “Factors Affecting
Future Results —Cardinal Health Supply Agreement”.  New hospital
implementations were driven by a number of factors, including increasing
industry awareness of our product offering and growing evidence of its clinical
effectiveness.


24


Cost
of revenues




Cost of
revenues increased by $1.4 million or 261%, to $1.95 million for the three
months ended September 30, 2010 from $540 thousand for the same period in
2009.  The increase was primary due to an increase in sales of our products
used in our Safety-Sponge® System, reflecting an increase in the number of
hospitals that have adopted and implemented our system, along with $ 940
thousand, associated with the shipment of product to Cardinal Health (see
“Factors Affecting Future Results —Cardinal Health Supply Agreement”). 
The increase in costs associated with the increase
in product sales more than offset the decrease in costs that resulted
from the change in our business model with respect to the provision of
our SurgiCounterTM scanners, which resulted in approximately $1.0 million of cost
now being depreciated and recognized over the life of the hardware.




Gross
profit





We had
gross profit of $2.2 million for the three months ended September 30, 2010, an
increase of $1.7 million, or 395%, compared to $438 thousand in the same period
in 2009.  The primary reason for the increase in gross profit during
the three months ended September 30, 2010, was the higher revenue
growth achieved with both Forward Order inventory sales to Cardinal
Health and hospital customers.  We had gross margin of 52.7% for the three
months ended September 30, 2010, compared to 44.8% for the same period in 2009.
This improvement in gross margin was primarily attributable to a product mix
shift away from lower margin scanning hardware and increased pricing on the sale
of our sponge products to new customers.




Operating
expenses





We had
total operating expenses of $1.2 million for the three months ended September
30, 2010, a decrease of $689 thousand, or 35.6%, compared to $1.9 million for
the same period in 2009.  This reduction in operating expenses is primarily
due to the impact of a comprehensive restructuring program implemented by new
management during the third quarter of 2010 focused on a number of initiatives,
including reducing operating expenses and achieving positive operating income
and operating cash flow.  Restructuring activities included the elimination
of certain job positions, lowering executive and employee cash compensation
levels, refining and enforcing expense and travel policies and initiating spend
measurement systems and accountability across various functional areas.  As
a result of a number of factors, primarily the continued growth of the Company’s
revenues from both delivery of the Cardinal Health’s stocking inventory (as
discussed in Note 12) and hospital consumption, and the impact on operating
expenses from the restructuring initiative, the Company reported positive
operating income of $925 thousand during the most recent quarter ended September
30, 2010, the first period of positive reported operating income in the history
of the Company’s ownership of SurgiCount since 2005.




Research
and development expenses




We had
research and development expenses of $35 thousand for the three months ended
September 30, 2010, a decrease of $34 thousand, or 49.1%, compared to $69
thousand in the same period in 2009.  The primary reason for the decrease
was management prioritizing the level of spending on research and development
activities to those that lend themselves to product enhancements and extensions
to the Company’s current core product focus.




Sales
and marketing expenses




We had
sales and marketing expenses of $519 thousand for the three months ended
September 30, 2010, a decrease of $91 thousand, or 15%, compared to $610
thousand in the same period in 2009.  The primary reason for the decrease
in sales and marketing expenses were expense reductions including travel and
entertainment.


25


General
and administrative expenses





We had
general and administrative expenses of $693 thousand for the three months ended
September 30, 2010, a decrease of $563 thousand, or 45%, compared to $1.3
million in the same period in 2009.  The decrease in general and
administrative expense was primarily due to the elimination of certain
positions, the reduction of cash compensation, refining and enforcing expense
and travel policies and the reduction of consulting expenses. Additionally,
during the three months ended 2009 general and administrative expenses also
included a $214 thousand charge for amortization of debt discount, which is $0
in the third quarter of this year as the debt discount was fully amortized at
the end of 2009.




Total
other income (expense)




We had
total other income of $19 thousand for the three months ended September 30,
2010, compared to total other expense of $1.9 million in the same period in
2009.  The primary reason for the change was a decrease in the fair value
of our warrant derivative liability, which resulted in income of $16 thousand in
the three months ended September 30, 2010, compared to a loss of $1.8 million in
the same period last year, when the fair value of our warrant liability went
up.  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.  Excluding the effects of the changes in the
fair value of our warrant derivative liability, we only had a slight amount
interest income this quarter, whereas it was interest expense of $304 thousand
in the same period last year.





Provision
for income taxes





We had a
$33 thousand tax benefit for the three months ended September 30, 2010, compared
to a $32 thousand tax benefit for the same period in 2009.  Despite the
fact that the company generated positive net income before taxes of $944
thousand during the current quarter, the tax benefit relates to the amortization
of the Company’s patent portfolio.  An in-depth tax provision calculation
will be prepared at yearend, based on the Company’s final taxable income amount
reported.





Net
income




Due to a
number of factors, including the increases in this quarter’s revenue and gross
profit, along with the significant reductions in operating expenses, we had net
income of $962 thousand for the three months ended September 30, 2010 compared
to a net loss of $3.4 million for the same period in 2009.





Nine
Months Ended September 30, 2010 Compared to Nine Months Ended September 30,
2009




Revenues




We had
revenues of $10.3 million, which included $5.9 million shipped to Cardinal
Health under the First Forward Order (see “Factors Affecting Future Results
—Cardinal Health Supply Agreement”) for the nine months ended September 30,
2010.  Therefore, estimated hospital consumption revenue (defined as total
revenue less amounts shipped to Cardinal Health under the First Forward Order)
was $4.4 million for the nine months ended September 30, 2010, an increase of
49% compared to $2.9 million for the same period in 2009.   In the
nine months ended September 30, 2010, surgical sponge sales accounted for 99.2%
of revenues, and sales of hardware accounted for 0.8%, compared to 98.3% and
1.7% for the same period in 2009, respectively.  The primary reason for the
increase in revenues was an increase in the number of hospitals implementing the
Safety-Sponge® System and the
shipment of Forward Order inventory to Cardinal Health.  New hospital
implementations were driven by a number of factors, including increasing
industry awareness of our product offering and growing evidence of its clinical
effectiveness.





Cost
of revenues




Cost of
revenues increased by $3.1 million or 182.8%, to $4.8 million for the nine
months ended September 30, 2010 from $1.7 million for the same period in
2009.  This increase was primarily due to an increase in sales of our
products used in our Safety-Sponge® System from mostly new customer business as
well as growth in usage by existing customers, reflecting an increase in the
number of hospitals that have adopted and implemented our system.  The cost
of sales increase also reflects $2.8 million in costs associated with the
shipment of $5.9 million of Forward Inventory product to Cardinal Health (see
“Factors Affecting Future Results —Cardinal Health Supply Agreement”). 
The increase in costs associated with the increase
in sales of products more than offset the decrease in costs that resulted
from the change in our business model with respect to the provision of
our SurgiCounterTM scanners, which resulted in approximately $1.0 million of cost
now being depreciated and recognized over the life of the
hardware.


26


Gross
profit




We had
gross profit of $5.4 million for the nine months ended September 30, 2010, an
increase of $4.2 million, or 339%, compared to $1.2 million during the same
period in 2009.  The primary reason for the increase in gross profit during
the nine months ended September 30, 2010, was higher revenue
growth achieved, with both hospital customers and Forward Order inventory
sales to Cardinal Health.  We had gross margin of 52.9% for the nine months
ended September 30, 2010, compared to 42.0% for the same period in 2009.
This improvement in gross margin was primarily attributable to a product mix
shift away from lower margin scanning hardware and increased pricing on the sale
of our sponge products to new customers.




Operating
expenses




We had
total operating expenses of $7.4 million for the nine months ended September 30,
2010, an increase of $115 thousand, or 1.6%, compared to $7.2 million for the
same period in 2009.  The increase in operating expense was generally
insignificant as the Company held its spending on operating expenses generally
in line with last years spending levels, even though hospital consumption
revenue which is defined as total revenue less the First Forward Order sales to
Cardinal grew by $1.5 million or 49% compared to last year.  Management
initiated a comprehensive restructuring program during the third quarter of 2010
focused on a number of initiatives, including reducing operating expenses and
achieving positive operating income and operating cash flow.  Restructuring
activities included the elimination of certain job positions, lowering executive
and employee cash compensation levels, refining and enforcing expense and travel
policies and initiating spend measurement systems and accountability across
various functional areas.




Research
and development expenses





We had
research and development expenses of $167 thousand for the nine months ended
September 30, 2010, a decrease of $101 thousand, or 37.8%, compared to $268
thousand in the same period in 2009.  The primary reason for this decrease
was the reprioritization of spending to research and development activities to
those that lend themselves to product enhancements and extensions to the
Company’s existing core product focus during the third quarter of 2010 and a
reclassification of certain personnel-related expenses to sales and marketing
expenses.





Sales
and marketing expenses





We had
sales and marketing expenses of $2.3 million for the nine months ended September
30, 2010, an increase of $529 thousand, or 29.2%, compared to $1.8 million in
the same period in 2009.  The primary reason for the increase in sales and
marketing expenses was an increase in personnel, travel, entertainment and trade
show related expenses during the first and second quarters of 2010, in addition
to increased clinical implementation related expenses, which supported new
customer growth with expanded adoption of our Safety-Sponge®
System.




General
and administrative expenses




We had
general and administrative expenses of $4.8 million for the nine months ended
September 30, 2010, a decrease of $313 thousand, or 6.1%, compared to $5.2
million for the same period in 2009.  This decrease was due to lower
expenses in stock compensation, depreciation and other G&A expenses as a
result of management’s recent efforts to lower spending during the third quarter
2010, offset by higher expenses for severance, rent and legal expenses due to
severance accrued for former employees, rent costs from closing our Newtown
office location, and legal expenses associated with the recent recapitalization,
all of which occurred in June 2010 as a part of the Company’s
restructuring.  While the general and administrative expenses for the nine
months ended September for both this year and 2009 appear generally comparable,
the trends of the third quarter 2010 suggest the Company is running at an
annualized spending level that is significantly lower than the prior
year.


27


Total
other income (expense)





We had total other income of $3.1
million for the nine months ended September 30, 2010, compared to total other
expense of $4.9 million in the same period in 2009.  The primary reason for
the change was a significant decrease in the fair value of our warrant
derivative liability, which resulted in income of $2.7 million in the nine
months ended September 30, 2010, compared to a loss of $4.3 million during the same period in
2009.  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.   Excluding the effects of the changes
in the fair value of our warrant derivative liability, our other expense
decreased, primarily due to a significant decrease in our interest expense,
which decreased due to the settlement of our outstanding indebtedness in the
fourth quarter 2009.





Provision
for income taxes





We had a
$140 thousand tax benefit for the nine months ended September 30, 2010, compared
to a $96 thousand tax benefit for the same period in 2009.  Despite the
fact that the company generated positive net income before taxes of $1.2 million
for the nine months ended September 30, 2010, the tax benefit assumes
amortization of the Company’s patent portfolio.  An in-depth tax provision
calculation will be prepared at yearend, based on the Company’s final taxable
income amount reported.





Net
income (loss)




As a
result of the foregoing results discussed above, we had net income of $1.3
million for the nine months ended September 30, 2010 compared to a net loss of
$10.9 million for the same period in 2009.





Financial
Condition, Liquidity and Capital Resources




We had
cash and cash equivalents totaling $3.0 million at September 30, 2010 compared
to $3.4 million at December 31, 2009.  The cash balance as of September 30,
2010 included restricted cash of $224 thousand compared to $0 restricted cash at
December 31, 2009.  The restricted cash balance is due to the establishment
of the Tax Escrow Account (see Note 20, Commitments and Contingencies to our
condensed consolidated interim financial statements).  As of September 30,
2010 we had a working capital deficit of $3.7 million, of which $4.4 million is
associated with deferred revenue related to the partial prepayment from Cardinal
Health and $981 thousand relates to the warrant derivative liability (see
explanations at Notes 12 and 15 to our condensed consolidated interim
financial statements).





Our
principal sources of cash have historically included the issuance of equity and
debt securities.  Starting in the most recent quarter ended September 30,
2010, newly appointed management implemented a comprehensive restructuring
effort focused on a number of initiatives, including reducing operating expenses
and achieving positive operating income and operating cash flow (see Item 2
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS).  During the most recent quarter ended September 30, 2010, the
Company reported positive operating income of $925 thousand, which is the first
period of reported positive operating income since the Company’s
acquisition of SurgiCount in 2005. The operating income of $925 thousand
during the quarter ended September 30, 2010 included $1.3 million of gross
profit attributable to sales to Cardinal Health, our exclusive distributor,
under our agreement with them that includes provisions for their purchase of
inventory stocking orders throughout 2010. Also
during the most recent quarter ended September 30, 2010 the Company had negative
cash flow from operations of $2.0 million, however, excluding a one-time payment
of $2.4 million to the provider of our sponge products, A Plus International,
Inc., for significantly past due amounts owed for previously delivered
inventory, adjusted cash flow from operations would have been a positive $315
thousand.  The improvement in operating income and cash flow from
operations in the third quarter of 2010 compared to previous periods was the
result of a number of items, including the restructuring initiative recently
implemented by newly appointed management and the continued growth in the
Company’s revenue, which included inventory sales to Cardinal Health
attributable to stocking orders.





Our sales
cycle typically requires that we incur expenses in advance of the time we
generate revenues from our new customer arrangements.  Such expenses
include sales and marketing costs, funding product trials, purchasing scanning
hardware and funding new hospital implementations and education. Thus, as our
business grows and we expand our customer base, our cash needs tend to increase
prior to the time we generate cash from such new customer arrangements.  We
entered into a financing transaction in June 2010 that resulted in the receipt
of $4.5 million of cash, net of transaction costs and a $1.0 million reduction
in accounts payable (by A Plus International, Inc., our exclusive
supplier).  Although management believes its existing cash resources, as
augmented by the financing last June, combined with improved projected cash flow
from operations, will be sufficient to fund the Company’s working capital
requirements at least through the first quarter of 2011.  In order to
continue to operate as a going concern and make investments in product
development and sales and marketing to facilitate future sales growth, it will
be necessary to raise additional funds during 2011.  Management believes
that it will be able to obtain such financing at reasonable terms and
that, if necessary, additional cost-cutting measures can be implemented to
extend our ability to operate our core business even if financing is not
timely available.  However, no assurances can be made that we will be
successful in obtaining a sufficient amount of financing on acceptable terms (or
any financing), or that we will be able to continue to fund our operations or
achieve consistent profitable results and positive cash flow.  In addition,
no assurance can be made that additional cost cutting measures, in addition to
what management has already implemented, will be successful in extending the
Company’s ability to operate effectively without procuring additional
financing.


28


Finally,
although the Company believes it will be able to reach an arrangement with
Cardinal Health to delay or avoid reductions of its stocking inventory levels
beginning in 2011, which could materially impact the Company’s future revenues,
no assurance can be made that an agreement will be reached, or reached in a
timely manner.





Operating
activities




We used
$4.3 million of net cash from operating activities in the nine months ended
September 30, 2010.  Non-cash adjustments to reconcile net income to net
cash used in operating activities plus changes in operating assets and
liabilities used $5.6 million of cash for the nine months ended September 30,
2010.  These significant non-cash adjustments primarily reflect adjustments
to reflect the change in fair value of our warrant derivative liability,
deferred revenue adjustments relating to shipments to Cardinal Health, and
increased inventory balances.




Investing
activities




We used
$628 thousand of net cash in investing activities during the nine months ended
September 30, 2010, primarily for the purchase of scanners and related hardware
used in our Safety Sponge® System.




Financing
activities




We
generated $4.2 million of net cash from financing activities in the nine months
ended September 30, 2010, primarily from the net proceeds of the $6.0 million
issuance of Series B Convertible Preferred Stock in June 2010 ($5.0 million in
cash proceeds and $1.0 million in reductions of our accounts payable), offset
with the write-off of capital lease obligations following the closure of the
Newtown, PA office, and the payment of preferred stock dividends.  See Note
20 to our condensed consolidated interim financial statements for further
discussion.





On June
24, 2010, in connection with the Convertible Preferred Stock Purchase Agreement,
the Company entered into a Tax Escrow Agreement and transferred $651 thousand
into a tax escrow account.  Under the Tax Escrow Agreement, the escrow
agent, U.S. Bank National Association, is required to use the escrowed funds to
pay specified tax claims to taxing authorities and/or to release escrowed funds
to the extent the Company’s tax reserve for the contingent tax liability has
been reduced, subject to compliance with certain procedures.  During the
quarter ended September 2010, $428 thousand of the restricted cash balance was
released due to the statue of limitations passing on certain of the tax claims
that were initially held in escrow, leaving a balance of $224 thousand as of
September 30, 2010.





Description
of Indebtedness




At
September 30, 2010, we had aggregate indebtedness of $1.4 million pertaining to
the Ault Glazer Capital Partners LLC note as described below.




Ault
Glazer Capital Partners, LLC




On
September 5, 2008, we entered into an Amendment and Early Conversion of Secured
Convertible Promissory Note ("Amendment"), with Ault Glazer Capital
Partners, LLC, or Ault Glazer, to modify the terms of our outstanding $2.5
million convertible secured promissory note (issued to Ault Glazer
effective as of June 1, 2007). This convertible secured note was to have matured
on 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.  Under the Amendment, we agreed to pay
Ault Glazer $450 thousand in cash and, contingent upon satisfaction of certain
conditions by Ault Glazer, to convert the remaining balance of the convertible
secured note into 1,300,000 shares of our common stock.  Notably, one
condition was that Ault Glazer transfers certain leases from our name into its
name.  On September 12, 2008, we entered into an Agreement for the
Advancement of Common Stock Prior to Close of the Amendment and Early Conversion
of Secured Convertible Promissory Note ("Advancement"), whereby we agreed to
issue shares of our common stock to Ault Glazer in advance of its
satisfaction of the conditions for the conversion of the convertible secured
note that were set out in the Amendment.  As of the date of this quarterly
report on Form 10-Q, we have paid Ault Glazer $450 thousand in cash and issued
Ault Glazer aggregate 800,0000 shares of our common stock in settlement of the
promissory note in advance of conversion of the note.  Ault Glazer has not
yet satisfied the conditions set out in the Amendment, and the
issuance of the remaining shares of our common stock to Ault Glazer remains
contingent upon its satisfaction of such conditions.  In light of the
Amendment and issuance of shares pursuant to the Advancement and Ault Glazer’s
failure to satisfy the conditions, we are no longer incurring interest expense
on this convertible secured promissory note.  As of September 30, 2010, the
outstanding principal balance on this note was $1.4 million.  For further
information relating to this note, see Note 10 to our condensed consolidated
interim financial statements.


29


As
discussed in Note 21 Subsequent Events, the Company received a Notice of Levy
(the “Levy”) from the US Marshal’s Office in Los Angeles (“Levying Officer”)
with an order requiring the Company to deliver all shares of Patient Safety
Technologies stock (“PST Stock”) that the Company owes to Ault Glazer Capital
Partners, LLC to the Levying Officer as settlement of a creditor judgment
against Ault Glazer Partners, LLC and other parties. The Company is currently
reviewing the Levy and intends to comply with the associated legal
obligations.





Investment
Portfolio





At
September 30, 2010, we had an investment in preferred stock of Alacra, Inc.,
with a carrying value of $667 thousand, which represented 5.5% of our total
assets at September 30, 2010.  In December 2007, we received proceeds of
$333 thousand from the redemption of one-third of our initial $1.0 million
investment. In accordance with the terms of our investment, we have exercised
our right to redeem our remaining preferred stock to Alacra, however to
date Alacra has not complied with our redemption rights. We intend to
exercise all of our rights and expect to receive the full carrying value due to
us from this investment. As there is no readily determinable fair value of the
Alacra preferred stock, we account for this investment under the cost
method.  For additional information relating to this investment, see Note 9
to our condensed consolidated interim financial statements.





Related
Party Transactions




We have
an exclusive supply agreement for surgical sponges used in our Safety-Sponge®
System with A Plus International Inc. Wenchen Lin, a member of our Board of
Directors, is a founder and significant beneficial owner of A Plus.  In
addition, Mr. Lin has participated in prior equity financings of our
company.  During the three and nine months ended September 30, 2010, our
cost of revenue included $1.9 million and $4.6 million in connection with this
supply arrangement, and our accounts payable included $1.0 million at September
30, 2010, payable to A Plus under this supply agreement, which includes $9
thousand that will be paid directly to A Plus by Cardinal Health (see “—Factors
Affecting Future Results—Cardinal Health Supply Agreement” above). On June 24,
2010, A Plus converted $1,000,000 of accounts payable owed to A Plus into 10,000
shares of Series B Convertible Preferred Stock (see Note 13).




On June
24, 2010, John P. Francis, a member of our Board of Directors, who has voting
and investment control over securities held by Francis Capital Management, LLC,
which acts as the investment manager for Catalysis Partners, LLC, invested $1.0
million in the Series B Convertible Preferred Stock transaction.





In the past, we used the services of an aircraft owning
partnership principally owned by Steven H. Kane, our former Chief Executive
Officer for air travel.During the three and nine months ended
September 30, 2010, there were $0 and $19 thousand, respectively, in expenses
related to the use suchair travel services.  During the three and nine months
ended September 30, 2009, there were no expenses related to the use suchair travel services.





For
additional information relating to these and other related party transactions,
see Note 18 to our condensed consolidated interim financial
statements.




Off-Balance
Sheet Arrangements




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





Commitments
and Contingencies




As of
September 30, 2010, other than our office leases and employment agreements with
key executive officers and the litigation described in Item 1of Part II of this
Form 10Q, we had no material commitments or contingencies other than the
liabilities reflected in our condensed consolidated interim financial
statements.


30


ITEM
3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





Not
applicable.





ITEM
4. 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 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.





As
discussed in Note 21, Subsequent Events, on October 22, 2010, the Company
entered into an employment agreement and appointed David C. Dreyer as Chief
Financial Officer and Vice President of the Company.  Mr. Dreyer has over
20 years experience in financial management of public companies, including as
Chief Financial Officer at AMN Healthcare Inc. (AHS) and Sicor Inc (acquired by
Teva Pharmaceutical Industries Ltd [TEVA]).





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 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 Exchange Act.  Based upon that evaluation, our chief
executive officer and chief financial officer concluded that, as of the end of
the period covered by this report, our disclosure controls and procedures were
not effective because the material weaknesses in our internal control over
financial reporting described below identified in our assessment of internal
control over financial reporting as of December 31, 2009 had not been fully
remediated.





Material
Weaknesses in Internal Control Over Financial Reporting




In
connection with our assessment of internal controls over financial reporting as
of December 31, 2009, we identified the following material weaknesses in our
internal control over financial reporting due to:





·
            Ineffective
      control environment due to the following identified
      weaknesses:


o
            Failure
      to retain individuals competent in the application of generally accepted
      accounting principles (“GAAP”) to complex accounting
      transactions.


o
            Failure
      to establish sufficiently detailed accounting policies and procedures and
      to properly train accounting department
staff.


·
            Ineffective
      internal control policies and procedures relating to the period end close
      process including lack of controls relating to journal entries, post
      closing adjustments and management review of conclusions regarding
      accounting and financial reporting
matters.


·
            Ineffective
      internal control policies and procedures designed to provide reasonable
      assurance regarding the accuracy and integrity of spreadsheets used in the
      financial reporting system.





To remedy
these material weaknesses, we are implementing policies and procedures to
formalize our period end close process as well as to address the application of
our accounting policies to ensure conformity with GAAP.  We are also
seeking to hire qualified personnel, or engage outside resources, as applicable,
with appropriate knowledge/experience in the application of GAAP to complex
accounting transactions and we are strengthening internal policies and
procedures designed to ensure the accuracy and integrity of spreadsheets used in
the financial reporting system.  As discussed in Note 21 “Subsequent
Events”, the Company recently hired a new Chief Financial Officer, is fully
committed to remedying the material weaknesses identified during last year’s
assessment of internal controls.


31


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.





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 against us, Sunshine Wireless, LLC, and four other defendants
affiliated with Winstar Communications.  This 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 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.  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
another lawsuit against the Company, Sunshine and four other defendants
affiliated with Winstar.  That lawsuit attempted to collect a federal
default judgment of $5.0 million entered against two entities, Winstar Radio
Networks, LLC and Winstar Global Media, Inc., by attempting to enforce the
judgment against the Company and others under the doctrine of de factomerger.  The
action was tried before a Los Angeles County Superior Court judge, without a
jury, in 2008.On August 5, 2009, the
Superior Court issued a statement of decision in the Company’s favor, and on October 8, 2009, the
Superior Court entered judgment in the Company’s
favor, and judged plaintiffs’ responsible for $2,709 of the Company’scourt
costs.  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. The Company has engaged appellate
counsel, believes the plaintiff’s case to be without merit andintends to
continue to defend the case vigorously.





ITEM
1A.  RISK FACTORS





Refer to
the risk factors discussed in the Company’s 2009 Annual Report on Form 10K,
filed on March 31, 2010.





ITEM
2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
PROCEEDS





Not
applicable.





ITEM
3.  DEFAULTS UPON SENIOR SECURITIES





Not
applicable





ITEM
4.  (REMOVED AND RESERVED)







ITEM
5.  OTHER INFORMATION





Not
applicable


32


ITEM
6.  EXHIBITS





Exhibit
                                  Number
                                
                                Description10.1
                                
                                Employment
      Agreement dated August 9, 2010 between Patient Safety Technologies, Inc.
      and Jack A. Hamilton (incorporated by reference to
      our current report on Form 8-K filed with the Securities and Exchange
      Commission ("SEC") on August 9, 2010)31.1*
                                
                                Certification
      of Chief Executive Officer required by Rule 13a-14(a) or Rule
      15d-14(a)*31.2*
                                
                                Certification
      of Chief Financial Officer required by Rule 13a-14(a) or Rule
      15d-14(a)*32.1*
                                
                                Certification
      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.


33





SIGNATURES





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





PATIENT
      SAFETY TECHNOLOGIES, INC.Date:
      November 19, 2010
              By: /s/ Brian E. StewartBrian
      E. Stewart, President and ChiefExecutive
      OfficerDate:
      November 19, 2010
              By:/s/ David C. DreyerDavid
      C. Dreyer, Vice President,Chief
      Financial Officer, and
Treasurer


34