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 MARCH 31, 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.)5
      Caufield Place, Suite 102, Newtown, PA 18940(Address
      of principal executive offices) (Zip
Code)





Registrant’s
telephone number, including area code: (215) 579-7789





Securities registered pursuant to
Section 12(b) of the Act:None





Securities
registered pursuant to Section 12(g) of the Act:





Title of each class
                Common
      Stock, par value $0.33 per share
              Name of each exchange on which
      registered
                OTC
      Bulletin Board





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 Website, 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 May 12, 2010 was 23,456,063.









PATIENT
SAFETY TECHNOLOGIES, INC.





FORM
10-Q FOR THE QUARTER


ENDED
MARCH 31, 2010





TABLE
OF CONTENTS





Page


CAUTIONARY
      NOTE REGARDING FORWARD-LOOKING STATEMENTS
                  1HELPFUL
      INFORMATION
                  1PART
      I – FINANCIAL INFORMATION
                  2ITEM
      1.  FINANCIAL STATEMENTS
                  2Condensed
      Consolidated Balance Sheets
                  2Condensed
      Consolidated Statements of Operations
                  3Condensed
      Consolidated Statements of Cash Flows
                  4ITEM
      2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
      OF OPERATIONS
                  17ITEM
      3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
    RISK
                  26ITEM
      4(T). CONTROLS AND PROCEDURES
                  26PART
      II – OTHER INFORMATION
                  27ITEM
      1. LEGAL PROCEEDINGS
                  27ITEM
      1A. RISK FACTORS
                  27ITEM
      1A. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
      PROCEEDS
                  27ITEM
      3. DEFAULTS UPON SENIOR SECURITIES
                  27ITEM
      4. (REMOVED AND RESERVED)
                  28ITEM
      5. OTHER INFORMATION
                  28ITEM
      6. EXHIBITS
                  28SIGNATURES
                  29













CAUTIONARY
NOTE REGARDING FORWARD-LOOKING STATEMENTS




Some of
the statements in this quarterly report on Form 10-Q are forward-looking
statements.  You can sometimes identify forward-looking statements by
our use of forward-looking words like “may,” “should,” “expects,” “intends,”
“plans,” “anticipates,” “believes,” “estimates,” “seeks,” “predicts,”
“potential,” or “continue” or the negative of these terms and other similar
expressions.




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





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 the medical patient safety market, the market for surgical
sponges, our market share, the cumulative number of surgical sponges used and
number 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).





1





PART
I – FINANCIAL INFORMATION





ITEM
1.  FINANCIAL STATEMENTS





PATIENT
SAFETY TECHNOLOGIES, INC.





Condensed
Consolidated Balance Sheets





March
      31,
                                    2010
                                  
                                  
                                  December
      31,
                                    2009Assets
                                  
                                  (Unaudited)Current
      assets:Cash
      and cash equivalents
                                  
                                  $
                                  1,783,029
                                  
                                  
                                  $
                                  3,446,726Accounts
      receivable
                                  
                                  
                                  1,000,533
                                  
                                  
                                  
                                  906,136Inventories,
      net
                                  
                                  
                                  606,236
                                  
                                  
                                  
                                  565,823Prepaid
      expenses
                                  
                                  
                                  170,766
                                  
                                  
                                  
                                  207,598Total current
      assets
                                  
                                  
                                  3,560,564
                                  
                                  
                                  
                                  5,126,283Property
      and equipment, net
                                  
                                  
                                  1,045,739
                                  
                                  
                                  
                                  744,646Goodwill
                                  
                                  
                                  1,832,027
                                  
                                  
                                  
                                  1,832,027Patents,
      net
                                  
                                  
                                  3,032,789
                                  
                                  
                                  
                                  3,114,025Long-term
      investment
                                  
                                  
                                  666,667
                                  
                                  
                                  
                                  666,667Other
      assets
                                  
                                  
                                  33,248
                                  
                                  
                                  
                                  43,246Total
      assets
                                  
                                  $
                                  10,171,034
                                  
                                  
                                  $
                                  11,526,894Liabilities
      and Stockholders’ DeficitCurrent
      liabilitiesAccounts
      payable
                                  
                                  $
                                  2,810,120
                                  
                                  
                                  $
                                  2,043,166Convertible
      note
                                  
                                  
                                  1,424,558
                                  
                                  
                                  
                                  1,424,558Capital
      lease-current portion
                                  
                                  
                                  18,996
                                  
                                  
                                  
                                  19,330Warrant
      derivative liability
                                  
                                  
                                  1,947,598
                                  
                                  
                                  
                                  3,666,336Deferred
      revenue
                                  
                                  
                                  7,222,216
                                  
                                  
                                  
                                  8,099,144Accrued
      liabilities
                                  
                                  
                                  1,055,104
                                  
                                  
                                  
                                  1,242,876Total
      current liabilities
                                  
                                  
                                  14,478,592
                                  
                                  
                                  
                                  16,495,410Capital
      lease, less current portion
                                  
                                  
                                  53,183
                                  
                                  
                                  
                                  58,274Deferred
      tax liability
                                  
                                  
                                  773,195
                                  
                                  
                                  
                                  805,768Total
      liabilities
                                  
                                  
                                  15,304,970
                                  
                                  
                                  
                                  17,359,452Commitments
      and contingencies (Note 16)Stockholders’
      deficit :Series
      A preferred stock, $1.00 par value, cumulative 7%
dividend:1,000,000
      shares authorized; 10,950 issued and outstanding at March 31,
      2010and
      December 31, 2009;(Liquidation
      preference of $1.2 million at March 31, 2010 and December 31,
      2009)
                                  
                                  
                                  10,950
                                  
                                  
                                  
                                  10,950Common
      stock, $0.33 par value: 100,000,000 shares authorized;23,456,063
      shares issued and outstanding at March 31, 2010 and December 31,
      2009
                                  
                                  
                                  7,740,501
                                  
                                  
                                  
                                  7,740,501Additional
      paid-in capital
                                  
                                  
                                  45,158,560
                                  
                                  
                                  
                                  44,834,321Accumulated
      deficit
                                  
                                  
                                  (58,043,947
                                  )
                                  
                                  
                                  (58,418,330
                                  )Total
      stockholders’ deficit
                                  
                                  
                                  (5,133,936
                                  )
                                  
                                  
                                  (5,832,558
                                  )Total
      liabilities and stockholders’ deficit
                                  
                                  $
                                  10,171,034
                                  
                                  
                                  $
                                  11,526,894


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





2





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








For
      the Three Months Ended March 31,2010
                      
                      
                      2009Revenues
                      
                      $
                      2,364,819
                      
                      
                      $
                      935,558Cost
      of revenue
                      
                      
                      1,088,887
                      
                      
                      
                      548,244Gross
      profit
                      
                      
                      1,275,932
                      
                      
                      
                      387,314Operating
      expenses:Research
      and development
                      
                      
                      33,331
                      
                      
                      
                      112,297Sales
      and marketing
                      
                      
                      994,116
                      
                      
                      
                      649,012General
      and administrative
                      
                      
                      1,651,861
                      
                      
                      
                      2,551,444Total
      operating expenses
                      
                      
                      2,679,308
                      
                      
                      
                      3,312,753Operating
      loss
                      
                      
                      (1,403,376
                      )
                      
                      
                      (2,925,439
                      )Other
      income (expense)Interest
      expense
                      
                      
                      (6,333
                      )
                      
                      
                      (219,729
                      )Gain
      (loss) on change in fair value of warrant derivative
                        liability
                      
                      
                      1,718,738
                      
                      
                      
                      (414,021
                      )Other
      income
                      
                      
                      51,944
                      
                      
                      
                      20Total
      other income (expense)
                      
                      
                      1,764,349
                      
                      
                      
                      (633,730
                      )Income
      (loss) before income taxes
                      
                      
                      360,973
                      
                      
                      
                      (3,559,169
                      )Income
      tax benefit
                      
                      
                      32,573
                      
                      
                      
                      32,360Net
      income (loss)
                      
                      
                      393,546
                      
                      
                      
                      (3,526,809
                      )Preferred
      dividends
                      
                      
                      (19,163
                      )
                      
                      
                      (19,163
                      )Net
      income (loss) applicable to common shareholders
                      
                      $
                      374,383
                      
                      
                      $
                      (3,545,972
                      )Income
      (loss) per common shareBasic
                      
                      $
                      0.02
                      
                      
                      $
                      (0.21
                      )Diluted
                      
                      $
                      0.01
                      
                      
                      $
                      (0.21
                      )Weighted
      average common shares outstanding:Basic
                      
                      
                      23,456,063
                      
                      
                      
                      17,197,872Diluted
                      
                      
                      25,199,632
                      
                      
                      
                      17,197,872





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




3




PATIENT
SAFETY TECHNOLOGIES, INC.


Condensed
Consolidated Statements of Cash Flows


(Unaudited)





For
      the Three Months Ended March 31,2010
                                            
                                            
                                            2009Operating
      activities:Net
      income (loss)
                                            
                                            $
                                            393,546
                                            
                                            
                                            $
                                            (3,526,809
                                            )Adjustments
      to reconcile net income (loss) to net cash used in operating
      activities:Depreciation
                                            
                                            
                                            136,411
                                            
                                            
                                            
                                            84,769Amortization
      of patents
                                            
                                            
                                            81,236
                                            
                                            
                                            
                                            81,235Amortization
      of debt discount
                                            
                                            
                                            −−
                                            
                                            
                                            
                                            118,258Stock
      based compensation
                                            
                                            
                                            324,239
                                            
                                            
                                            
                                            225,045Non-cash
      expense related to issuance of additional warrants
                                            
                                            
                                            −−
                                            
                                            
                                            
                                            1,297,200(Gain)
      loss on change in fair value of warrant derivative
    liability
                                            
                                            
                                            (1,718,738
                                            )
                                            
                                            
                                            414,021Change
      in deferred tax liability
                                            
                                            
                                            (32,573
                                            )
                                            
                                            
                                            (33,209
                                            )Changes
      in operating assets and liabilities:Accounts
      receivable
                                            
                                            
                                            (94,397
                                            )
                                            
                                            
                                            182,848Inventories
                                            
                                            
                                            (40,413
                                            )
                                            
                                            
                                            165,410Prepaid
      expenses
                                            
                                            
                                            36,832
                                            
                                            
                                            
                                            10,542Other
      assets
                                            
                                            
                                            9,997
                                            
                                            
                                            
                                            −−Accounts
      payable
                                            
                                            
                                            766,954
                                            
                                            
                                            
                                            (350,472
                                            )Accrued
      liabilities
                                            
                                            
                                            (187,772
                                            )
                                            
                                            
                                            (8,723
                                            )Deferred
      revenue
                                            
                                            
                                            (876,928
                                            )
                                            
                                            
                                            −−Net
      cash used in operating activities
                                            
                                            
                                            (1,201,606
                                            )
                                            
                                            
                                            (1,331,885
                                            )Investing
      activities:Purchase
      of property and equipment
                                            
                                            
                                            (437,504
                                            )
                                            
                                            
                                            (22,051
                                            )Net
      cash used in investing activities
                                            
                                            
                                            (437,504
                                            )
                                            
                                            
                                            (22,051
                                            )Financing
      activities:Proceeds
      from issuance of notes payable
                                            
                                            
                                            −−
                                            
                                            
                                            
                                            2,000,000Capital
      lease principle payments
                                            
                                            
                                            (5,424
                                            )
                                            
                                            
                                            −−Payments
      of preferred dividends
                                            
                                            
                                            (19,163
                                            )
                                            
                                            
                                            (19,163
                                            )Net
      cash (used in) provided by financing activities
                                            
                                            
                                            (24,587
                                            )
                                            
                                            
                                            1,980,837Net
      (decrease) increase in cash and cash equivalents
                                            
                                            
                                            (1,663,697
                                            )
                                            
                                            
                                            626,901Cash
      and cash equivalents at beginning of period
                                            
                                            
                                            3,446,726
                                            
                                            
                                            
                                            296,185Cash
      and cash equivalents at end of period
                                            
                                            $
                                            1,783,029
                                            
                                            
                                            $
                                            923,086Supplemental
      disclosures of cash flow information:Cash
      paid during the period for interest
                                            
                                            $
                                            −−
                                            
                                            
                                            $
                                            16,753Cash
      paid during the period for taxes
                                            
                                            $
                                            12,570
                                            
                                            
                                            $
                                            −−Non
      cash investing and financing activities:Dividends
      accrued
                                            
                                            $
                                            19,163
                                            
                                            
                                            $
                                            19,163Reclassification
      of accrued interest to notes payable
                                            
                                            $
                                            −−
                                            
                                            
                                            $
                                            50,000Debt
      discount recorded in connection with issuance of notes
    payable
                                            
                                            $
                                            −−
                                            
                                            
                                            $
                                            1,311,311Reclassification
      of warrant equities to derivative liability
                                            
                                            $
                                            −−
                                            
                                            
                                            $
                                            3,989,878





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




4




Patient
Safety Technologies, Inc.
 Notes
to Condensed Consolidated Interim Financial Statements




1.
DESCRIPTION OF BUSINESS





Patient
Safety Technologies, Inc. ("PST" or the "Company") is a Delaware
corporation. The Company’s operations are conducted through its wholly-owned
operating subsidiary, SurgiCount Medical, Inc. (“SurgiCount”), a California
corporation.





The
Company’s operating focus is the development, marketing and sales of products
and services focused in the medical patient safety markets.  The
SurgiCount Safety-SpongeTMSystem
is a patented system of bar-coded surgical sponges, SurgiCounterTM scanners, and
software applications 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 March
31, 2010, the Company has an accumulated deficit of $58,043,947 and a working
capital deficit of $10,918,028.  For the three month period ended
March 31, 2010, the Company incurred an operating loss of $1,403,376 and
generated negative cash flow from operating activities of
$1,201,606.  The most recent report dated March 31, 2010 by our
independent registered public accounting firm on our consolidated financial
statements as of and for the year ended December 31, 2009 includes an
explanatory paragraph in which they state that the significant recurring net
losses through December 31, 2009 and the significant working capital deficit as
of December 31, 2009 raise substantial doubt about the Company’s ability to
continue as a going concern.





Management
believes that existing cash resources, combined with projected cash flow from
operations, will not be sufficient to fund the Company’s working capital
requirements for the next three months, and that in order to continue to operate
as a going concern it will be necessary to raise additional funds.





If the
Company is unable to obtain the necessary financing it may have to severely
curtail or even discontinue operations within the second quarter of 2010. No
assurances, however, can be made that the Company will be successful in
obtaining a sufficient amount of financing on acceptable terms or any financing
to continue to fund its operations or that the Company will achieve profitable
operations and positive cash flow.  The accompanying condensed
consolidated interim financial statements do not include any adjustments that
might result from the outcome of this uncertainty.





3.
BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING
POLICIES





Basis
of Presentation





The
accompanying unaudited condensed consolidated interim financial statements have
been prepared in accordance with the instructions to Form 10-Q and 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 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 months ended March 31,
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.




5




Patient
Safety Technologies, Inc.
 Notes
to Condensed Consolidated Interim Financial Statements


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.  Revenue is recorded net of any discounts or trade-in
allowances given to the buyer.





·
            Hardware Cost Reimbursement
      Revenues:  During fiscal year 2009, the Company began a
      program in which the scanners and related hardware used in the
      Safety-Sponge® System are provided to the hospitals without charge for
      their use. Prior to the third quarter of 2009, the Company’s business
      model included the sale of its SurgiCounterTM scanners and related software
      used in its Safety-Sponge® System to most hospitals that adopted the
      Company’s system.  Beginning with the third quarter of 2009, the
      Company modified its business model and began to provide its SurgiCounterTM
      scanners and related software to all 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.  Because the Company
      no longer engages in direct SurgiCounterTM scanner sales, 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: As 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.  These items are considered to be separate deliverables
      within a multiple-element arrangement, and based on the fact that there is
      vendor specific objective evidence for the non-delivered element the total
      price of this arrangement is allocated to each respective deliverable
      based on the residual fair value of each element, and recognized as
      revenue as each element is delivered. For the hardware and software
      elements, delivery is 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.




6


Patient
Safety Technologies, Inc.
 Notes
to Condensed Consolidated Interim Financial Statements




·
            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.




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 reduced for any discounts or trade in allowances
given to the buyer.





Recent
Accounting Pronouncements





In
October 2009, the FASB issued 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.





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 FASB ASU 2010-06, Improving Disclosures about Fair
Value Measurementswhich clarifies certain existing disclosure
requirements in ASC 820 as well as requires disclosures related to significant
transfers between each level and additional information about Level 3 activity.
FASB ASU 2010-06 begins phasing in the first fiscal period after December 15,
2009. The Company’s adoption of this standard did not have any effect impact on
the Company’s consolidated financial statements.





4.EARNINGS (LOSS)
PER COMMON SHARE





Earnings
(loss) per common share is determined by dividing the earnings (loss) applicable
to common shareholders by the weighted average number of common shares
outstanding. The Company complies with FASB 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
period ended March 31, 2010, the shares associated with the convertible note
plus only the warrants and options that have a value in excess of the average
stock price during the three months period ending March 31, 2010 are included in
calculating diluted earnings per share. Because the effects of outstanding
options, warrants and the conversion of convertible preferred stock and
convertible note 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 period ended March 31, 2009




7


Patient
Safety Technologies, Inc.
 Notes
to Condensed Consolidated Interim Financial Statements


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





Three
      Months EndedMarch
      31,2010
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              2009BasicIncome
      (loss) available to common stockholders
                                                                                                                                                                              
                                                                                                                                                                              $
                                                                                                                                                                              374,383
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              $
                                                                                                                                                                              (3,545,972
                                                                                                                                                                              )Weighted
      average common shares outstanding (basic)
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              23,456,063
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              17,197,872Basic
      income (loss) per common share
                                                                                                                                                                              
                                                                                                                                                                              $
                                                                                                                                                                              0.02
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              $
                                                                                                                                                                              (0.21
                                                                                                                                                                              )DilutedIncome
      (loss) available to common stockholders
                                                                                                                                                                              
                                                                                                                                                                              $
                                                                                                                                                                              374,383
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              $
                                                                                                                                                                              (3,545,972
                                                                                                                                                                              )Weighted
      average common shares outstanding
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              23,456,063
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              17,197,872Assumed
      exercise of options
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              357,800
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              —Assumed
      exercise of warrants
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              885,769
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              —Assumed
      conversion of debt
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              500,000
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              —Common
      and potential common shares
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              25,199,632
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              17,197,872Diluted
      income (loss) per common share
                                                                                                                                                                              
                                                                                                                                                                              $
                                                                                                                                                                              0.01
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              $
                                                                                                                                                                              (0.21
                                                                                                                                                                              )Potentially
      dilutive securities outstanding at period endexcluded
      from diluted computation as they were anti-dilutive
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              13,005,513
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              
                                                                                                                                                                              19,687,942





5.
INVENTORY





Inventory
consists of the following:




March
      31,
                      
                      December
      31,2010
                      
                      2009Finished
      goods
                      $
                      775,232
                      
                      
                      $
                      734,819Reserve
      for obsolescence
                      
                      (168,996
                      )
                      
                      
                      (168,996
                      )Total
      inventory, net
                      $
                      606,236
                      
                      
                      $
                      565,823





6.
PROPERTY AND EQUIPMENT





Property
and equipment consists of the following:


March
      31,
                    
                    
                    December
      31,2010
                    
                    
                    2009Computer
      software and equipment
                    
                    $
                    1,100,003
                    
                    
                    $
                    1,097,181Furniture
      and equipment
                    
                    
                    298,369
                    
                    
                    
                    298,333Hardware
      for customer use
                    
                    
                    823,686
                    
                    
                    
                    394,861Property
      and equipment, gross
                    
                    
                    2,222,058
                    
                    
                    
                    1,790,375Less:
      accumulated depreciation
                    
                    
                    (1,176,319
                    )
                    
                    
                    (1,045,729
                    )Property
      and equipment, net
                    
                    $
                    1,045,739
                    
                    
                    $
                    744,646




8


Patient
Safety Technologies, Inc.
 Notes
to Condensed Consolidated Interim Financial Statements


The
furniture and equipment balance at March 31, 2010 includes $71,783 of office
furniture acquired as part of the Newtown, PA sublease, which has been recorded
as a capital lease, and which will be amortized over the term of the sublease
through April 2013. Depreciation expense for the three months ended March 31,
2010 was $136,411.





7.
GOODWILL AND PATENTS





The
Company recorded goodwill in the amount of $1,700,000 in connection with its
acquisition of SurgiCount Medical, Inc. in February 2005.  During the
year ended December 31, 2007, cumulative gross revenues of SurgiCount exceeded
$1,000,000 and as such the Company issued 100,000 shares of common stock, valued
at approximately $145,000 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 $4,700,000.




The
Company performs its annual impairment analysis of goodwill in the fourth
quarter of each year according to the provisions of ASC- 350 Valuation Analysis(formerly
SFAS 142, Goodwill and Other
Intangible Assets). This statement requires that the Company perform a
two-step impairment test on goodwill. In the first step, the Company compares
the fair value of each reporting unit to its carrying value. If the fair value
of the reporting unit exceeds the carrying value of the net assets assigned to
the reporting unit, goodwill is not impaired and the Company is not required to
perform further testing. If the carrying value of the net assets assigned to the
reporting unit exceeds the fair value of the reporting unit, then the Company
must perform the second step of the impairment testing to determine the implied
fair value of the reporting unit’s goodwill. The implied fair value of goodwill
is calculated by deducting the fair value of all tangible and intangible assets
of the reporting unit, excluding goodwill, from the fair value of the reporting
unit as determined in the first step. If the carrying value of a reporting
unit’s goodwill exceeds its implied fair value, then an impairment loss equal to
the difference would be recorded.




During
2009, the Company conducted its annual test for impairment, at year-end and
determined goodwill was not impaired.





Goodwill
was $1,832,027 at March 31, 2010 and December 31, 2009.





Patents,
net, consists of the following:




March
      31,
                      2010
                    
                    
                    December31,
      2009Patents
                    
                    $
                    4,684,576
                    
                    
                    $
                    4,684,576Accumulated amortization
                    
                    
                    (1,651,787
                    )
                    
                    
                    (1,570,551
                    )$
                    3,032,789
                    
                    
                    $
                    3,114,025





The patents
are subject to amortization over their estimated useful life of 14.4
years.  Amortization expense was $81,236 for the three months ended
March 31, 2010 and 2009.





8.
LONG-TERM INVESTMENTS





Long-term
investments consists of the following:





March
      31,
                      2010
                    
                    
                    December
      31, 2009Alacra
      Corporation
                    
                    $
                    666,667
                    
                    
                    $
                    666,667Total
                    
                    $
                    666,667
                    
                    
                    $
                    666,667





At March
31, 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
$666,667.  The Company has the right, to the extent that Alacra has
sufficient available capital, to have the Series F convertible preferred stock
redeemed by Alacra for face value beginning on December 31, 2006. During the
year ended December 31, 2007, Alacra redeemed one-third of the Series F
convertible preferred stock.  The Company expects to receive proceeds
from the redemption of one-half of the current carrying value in 2010 and the
remaining balance in 2011.




9


Patient
Safety Technologies, Inc.
 Notes
to Condensed Consolidated Interim Financial Statements


9.
CONVERTIBLE NOTE PAYABLE





Convertible
Note





Convertible
note consists of the following:





March
      31,
                        2010
                      
                      
                      December
      31,
                        2009Ault
      Glazer Capital Partners, LLC (a) *
                      
                      $
                      1,424,558
                      
                      
                      $
                      1,424,558Total
      convertible note
                      
                      
                      1,424,558
                      
                      
                      
                      1,424,558Less:  current
      portion
                      
                      
                      (1,424,558
                      )
                      
                      
                      (1,424,558
                      )Convertible
      note-long term portion
                      
                      $
                      —
                      
                      
                      $
                      —





* Related
Party (See Note 16)





(a)
            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”) in respect of the
AG Capital Partners Convertible Note.  The Amendment allowed for the
conversion, prior to the maturity date, of the outstanding principal balance of
the AG Capital Partners Convertible Note into 1,300,000 shares of the Company’s
common stock and $450,000 in cash payments.  According to the
Amendment, after the cash payments were made, the AG Capital Partners
Convertible Note could be converted into 1,300,000 shares of common stock upon
Ault Glazer’s satisfaction of certain conditions.  The Company made
the agreed upon $450,000 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 on September 12, 2008 to Ault Glazer in advance of the satisfaction
of the conditions in the Amendment with the understanding that Ault Glazer would
satisfy the conditions stated in the Amendment prior to September 19,
2008.  The stated purpose of the Advancement was to facilitate Ault
Glazer’s satisfaction of each of the conditions stated in the
Amendment.





Ault
Glazer failed to satisfy the conditions by the September 19, 2008 deadline as
stated in the Advancement.  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 this date, there remain 500,000 shares issuable to
Ault Glazer upon Ault Glazer meeting the conditions of the
Amendment.





During
the three months ended March 31, 2010 and the fiscal 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.




10


Patient
Safety Technologies, Inc.
 Notes
to Condensed Consolidated Interim Financial Statements


10.
ACCRUED LIABILITIES





Accrued
liabilities consists of the following:




March
      31,
                    2010
                  
                  
                  December
      31,
                    2009Accrued
      lease liability
                  
                  $
                  7,547
                  
                  
                  $
                  7,547Accrued
      dividends on preferred stock
                  
                  
                  114,976
                  
                  
                  
                  114,976Accrued
      salaries
                  
                  
                  47,449
                  
                  
                  
                  47,449Accrued
      director’s fees
                  
                  
                  162,500
                  
                  
                  
                  162,500Contingent
      tax liability
                  
                  
                  671,600
                  
                  
                  
                  740,726Accrued
      commissions
                  
                  
                  —
                  
                  
                  
                  13,200Other
                  
                  
                  51,032
                  
                  
                  
                  156,478Total
      accrued liabilities
                  
                  $
                  1,055,104
                  
                  
                  $
                  1,242,876





11.
DEFERRED REVENUE





Deferred
revenue consists of the following:





March
      31,
                      2010
                    
                    
                    December
      31,
                      2009Cardinal
      Health advance payment on purchase order
                    
                    $
                    6,925,491
                    
                    
                    $
                    8,000,000Scanner
      reimbursement revenue
                    
                    
                    292,142
                    
                    
                    
                    99,144Maintenance
      agreements
                    
                    
                    4,583
                    
                    
                    
                    —Total
                    
                    $
                    7,222,216
                    
                    
                    $
                    8,099,144





In
November 2009, the Company renewed its distribution arrangement with Cardinal
Health through the execution of a new Supply and Distribution Agreement on
November 19, 2009.  This new agreement has a five-year term and names
Cardinal Heath as the exclusive distributor in the United States, Puerto Rico
and Canada of current products used in the Company’s Safety-Sponge® System. In
connection with the execution of the new supply and distribution agreement,
Cardinal Health issued a $10,000,000 purchase order for products used in the
Company’s Safety-Sponge® System, calling for deliveries over the 12-month period
ending November 2010 and paid the Company $8,000,000 upon execution of the
agreement as partial pre-payment for such products, and agreed to pay up to
$2,000,000 directly to the Company’s supplier upon delivery of invoices for
product delivered under the purchase order.  As of March 31, 2010, the
Company shipped $1,074,509 of product covered under the $10,000,000 purchase
order from Cardinal Health.





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
provide its SurgiCounterTM scanners and related software to all 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.  Because the Company no longer engages
in direct SurgiCounterTM scanner sales, it generally anticipates only
recognizing revenues associated with its SurgiCounterTM scanners in connection
with reimbursement arrangements under its agreement with Cardinal
Health.




11


Patient
Safety Technologies, Inc.
 Notes
to Condensed Consolidated Interim Financial Statements


12.
STOCKHOLDERS’ DEFECIT





Preferred Stock
                                    
                                    
                                    Common Stock Issued
                                    
                                    
                                    Paid
      – In
                                    
                                    
                                    Accumulated
                                    
                                    
                                    Total
                                      Stockholders’Shares
                                    
                                    
                                    Amount
                                    
                                    
                                    Shares
                                    
                                    
                                    Amount
                                    
                                    
                                    Capital
                                    
                                    
                                    Deficit
                                    
                                    
                                    Equity
      (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
      dividend
                                    
                                    
                                    −−
                                    
                                    
                                    
                                    −−
                                    
                                    
                                    
                                    −−
                                    
                                    
                                    
                                    −−
                                    
                                    
                                    
                                    −−
                                    
                                    
                                    
                                    (19,163
                                    )
                                    
                                    
                                    (19,163
                                    )Stock-based
      compensation
                                    
                                    
                                    −−
                                    
                                    
                                    
                                    −−
                                    
                                    
                                    
                                    −−
                                    
                                    
                                    
                                    −−
                                    
                                    
                                    
                                    324,239
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    324,239Net
      income
                                    
                                    
                                    −−
                                    
                                    
                                    
                                    −−
                                    
                                    
                                    
                                    −−
                                    
                                    
                                    
                                    −−
                                    
                                    
                                    
                                    −−
                                    
                                    
                                    
                                    393,546
                                    
                                    
                                    
                                    393,546BALANCES,
      March 31, 2010
                                    
                                    
                                    10,950
                                    
                                    
                                    $
                                    10,950
                                    
                                    
                                    
                                    23,456,063
                                    
                                    
                                    $
                                    7,740,501
                                    
                                    
                                    $
                                    45,158,560
                                    
                                    
                                    $
                                    (58,043,947
                                    )
                                    
                                    $
                                    (5,133,936
                                    )





13.
WARRANTS AND WARRANT DERIVATIVE LIABILITY





The
following table summarizes warrants to purchase common stock activity for the
period ended March 31, 2010:


Amount
                  
                  
                  Range
      of Exercise
                    PriceWarrants
      outstanding December 31, 2009
                  
                  
                  8,064,978
                  
                  
                  $
                  0.75
      − 6.05Issued
                  
                  
                  —
                  
                  
                  
                  −Cancelled/Expired
                  
                  
                  (295,125
                  )
                  
                  $
                  2.00
      – 5.27Warrants
      outstanding March 31, 2010
                  
                  
                  7,769,853
                  
                  
                  $
                  0.75
      − 6.05





At March
31, 2010, stock purchase warrants will expire as follows:





#
      of Warrants
                    
                    
                    Range
      of Exercise Price2010
                    
                    
                    120,000
                    
                    
                    $
                    2.00
      − 6.052011
                    
                    
                    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
                    
                    
                    854,167
                    
                    
                    $
                    1.25Total
                    
                    
                    7,769,853
                    
                    
                    $
                    0.75
      − 6.05





*
Included are certain warrants which contain anti-dilution rights if the Company
grants or issues securities for less than exercise price.





Warrants
Derivative Liability





At March
31, 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(previously EITF 07-5, Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own
Stock).





At March
31, 2010, the estimated fair value of these warrants, based on a Black-Scholes
option pricing model was $1,947,598, 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 $1,718,738 for the three months ended March 31, 2010. The warrant fair
values at March 31, 2010 were determined using the Black-Scholes valuation
model using the closing price stock price at each date, volatility rate of
112-118%, risk free interest rates of 0.53-1.69%, and contractual lives equal to
the remaining term of the warrants expiring as of each measurement
date.




12


Patient
Safety Technologies, Inc.
 Notes
to Condensed Consolidated Interim Financial Statements


14.
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.





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 March 31, 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 $1,947,598. The warrants are valued
using Level 3 inputs because there are significant unobservable inputs
associated with them (See Note 13).





The table
below sets forth a summary of changes in the fair value of the Company’s
liability for the period ended March 31, 2010:





January
      1, 2010
                      
                      
                      Gain
      on change in fair value included in earnings
                      
                      
                      March
      31, 2010Warrant
      Derivative
                        Liability
                      
                      $
                      (3,666,336
                      )
                      
                      $
                      1,718,738
                      
                      
                      $
                      (1,947,598
                      )





Other
Financial Instruments





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





The fair
value of convertible debt is estimated to be $600,000 and $950,000 at March 31,
2010 and December 31, 2009, respectively, which is less than the carrying value
of $1,424,558 at each of these dates.  As described in Note 9, the
current terms of the convertible debt agreement provide for the full settlement
of the outstanding note balance.  Accordingly, the fair values noted
above were estimated based on market value of 500,000 shares of the Company’s
common stock at March 31, 2010 and December 31, 2009.





The fair
value of long-term investments reported using the cost method for which there
are no quoted market prices has not been determined as a reasonable estimate of
fair value could not be made without incurring excessive costs.




13


Patient
Safety Technologies, Inc.
 Notes
to Condensed Consolidated Interim Financial Statements


15.
STOCK OPTION PLANS





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.
Options granted under the 2005 SOP have an exercise price equal to or greater
than the fair market value of the underlying common stock at the date of grant
and become exercisable based on a vesting schedule determined at the date of
grant. The options generally expire 10 years from the date of grant. Restricted
stock awards granted under the 2005 SOP are subject to a vesting period
determined at the date of grant.





On March
11, 2009, the Board of Directors of the Company approved the 2009 Stock Option
Plan (the “2009 SOP”)
and the Company’s stockholders approved the 2009 SOP August 6, 2009. The 2009
SOP reserves 3,000,000 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. Options granted under the 2009 SOP have an exercise price equal to or
greater than the fair market value of the underlying common stock at the date of
grant and become exercisable based on a vesting schedule determined at the date
of grant. The options generally expire 10 years from the date of grant.
Restricted stock awards granted under the 2009 SOP are subject to a vesting
period determined at the date of grant.





All
options that the Company granted during the three months ended March 31, 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:








Three
      Months Ended
                                  March
      31,2010
                                
                                
                                2009Weighted
      average risk free interest rate
                                
                                2.76%
                                
                                
                                1.67%Weighted
      average life (in years)
                                
                                6.0
      years
                                
                                
                                2.42-4.38 yearsVolatility
                                
                                123%
                                
                                
                                105%Expected
      dividend yield
                                
                                0%
                                
                                
                                0%Weighted
      average grant-date fair value per share of options granted
                                
                                $1.39
                                
                                
                                $0.76





A summary
of stock option activity for the three months ended March 31, 2010 is presented
below:


Outstanding
      OptionsNumber
      ofShares
                                                                                
                                                                                
                                                                                
                                                                                WeightedAverage
                                                                                    ExercisePrice
                                                                                
                                                                                
                                                                                
                                                                                WeightedAverageRemainingContractual
      Life
                                                                                  (years)
                                                                                
                                                                                
                                                                                
                                                                                AggregateIntrinsic
      Value(1)Balance
      at December 31, 2009(2)
                                                                                
                                                                                
                                                                                5,821,000
                                                                                
                                                                                
                                                                                $
                                                                                1.41
                                                                                
                                                                                
                                                                                
                                                                                8.96
                                                                                
                                                                                
                                                                                $
                                                                                4,301,385Options
      Granted
                                                                                
                                                                                
                                                                                680,000
                                                                                
                                                                                
                                                                                $
                                                                                1.39
                                                                                
                                                                                
                                                                                
                                                                                9.83Exercised
                                                                                
                                                                                
                                                                                —
                                                                                
                                                                                
                                                                                
                                                                                —
                                                                                
                                                                                
                                                                                
                                                                                —Forfeited
                                                                                
                                                                                
                                                                                (21,771
                                                                                )
                                                                                
                                                                                $
                                                                                1.70Cancelled
                                                                                
                                                                                
                                                                                —
                                                                                
                                                                                
                                                                                
                                                                                —Balance
      at March 31, 2010
                                                                                
                                                                                
                                                                                6,479,229
                                                                                
                                                                                
                                                                                $
                                                                                1.37
                                                                                
                                                                                
                                                                                
                                                                                8.83Vested
      and exercisable as of
                                                                                  March
      31, 2010
                                                                                
                                                                                
                                                                                2,506,832
                                                                                
                                                                                
                                                                                $
                                                                                1.72
                                                                                
                                                                                
                                                                                
                                                                                8.11
                                                                                
                                                                                
                                                                                $
                                                                                388,723Unvested
      as of March 31, 2010
                                                                                
                                                                                
                                                                                3,972,397
                                                                                
                                                                                
                                                                                $
                                                                                1.16
                                                                                
                                                                                
                                                                                
                                                                                9.27
                                                                                
                                                                                
                                                                                $
                                                                                938,562





1)
            The
      aggregate intrinsic value is calculated as the difference between the
      exercise price of the underlying awards and the closing stock price of
      $1.20 of the Company’s common stock at March 31,
  2010.


2)
            Includes
      3,150,000 non-qualified options that were issued outside the 2005 and 2009
      stock option plans.




14




Patient
Safety Technologies, Inc.
 Notes
to Condensed Consolidated Interim Financial Statements


The total
grant date fair value of stock options granted during the three months ended
March 31, 2010 and 2009 was $833,579 and $2,891,932,
respectively.  For the three months ended March 31, 2001 and 2009,
stock based compensation was $324,239 and $225,045, respectively.





As of
March 31, 2010, there was $3,434,121 of unrecognized compensation costs related
to outstanding employee stock options. This amount is expected to be recognized
over a weighted average period of 3.26 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.





16.
RELATED PARTY TRANSACTIONS





Convertible
Note





As of
March 31, 2010 and December 31, 2009, the Company had a convertible note issued
to related parties with aggregate outstanding principal balances of $1,424,558
(See Note 9 to the condensed consolidated interim financial
statements):





March
      31,
                      2010
                    
                    
                    December
      31,
                      2009Convertible Note:Ault
      Glazer Capital Partners, LLC
                    
                    $
                    1,424,558
                    
                    
                    $
                    1,424,558





A
Plus International, Inc.





During
the three months ended March 31, 2010 the Company recognized cost of revenues of
approximately $1,105,408 in connection with the manufacture of surgical products
used in the Safety-Sponge® System by A Plus International or A Plus.At March 31, 2010, the
Company’s accounts payable included $1,935,290 owed to A Plus in connection with
the purchase of surgical products used in the Safety-Sponge® System, $500,874 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.




17.MAJOR CUSTOMERS,
SUPPLIERS, SEGMENT AND RELATED INFORMATION




Major
Customers





During
the three months ended March 31, 2010 and 2009, due to its exclusive
distribution agreement with Cardinal Health, the Company had one customer that
represented in excess of 97% and 70% of total revenues,
respectively.  No other single customer accounted for more than 10% of
total revenues in either period.





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. 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,
all 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.




15




Patient
Safety Technologies, Inc.
 Notes
to Condensed Consolidated Interim Financial
Statements


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 patient safety products
on a consolidated basis.




The
following table summarizes revenues by geographic region. Revenues are
attributed to countries based on customer location:




Three Months Ended March
31,
                                      
                                      
                                      2010
                                      
                                      
                                      
                                      2009Revenues:United
      States
                                      
                                      $
                                      2,364,819
                                      
                                      
                                      $
                                      935,558Other
                                      
                                      
                                      —
                                      
                                      
                                      
                                      —Total
      revenues
                                      
                                      $
                                      2,364,819
                                      
                                      
                                      $
                                      935,558




The
following table summarizes revenues by product line.




Three Months Ended March
31,
                                      
                                      
                                      2010
                                      
                                      
                                      
                                      2009Revenues:Surgical
      sponges and towels
                                      
                                      $
                                      2,339,487
                                      
                                      
                                      $
                                      732,082Scanners
      and related products
                                      
                                      
                                      25,332
                                      
                                      
                                      
                                      203,476Total
      revenues
                                      
                                      $
                                      2,364,819
                                      
                                      
                                      $
                                      935,558





18.  COMMITMENTS
AND CONTINGENCIES





Operating
and Capital Lease





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 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 $100,000 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 (See Note
6).





Contingent
Tax Liability





In the
process of preparing the Company’s federal tax returns for prior years, the
Company’s management found there had been errors in reporting income to the
recipients and the respective taxing authorities, related to stock grants made
to those certain employees and consultant recipients. In addition, the Company
determined that required tax withholding relating to these stock grants had not
been made, reported or remitted, as required in fiscal years 2006 and 2007. Due
to the Company’s failure to properly report this income and withhold/remit
required amounts, the Company may be held liable for the amounts that should
have been withheld plus related penalties and interest. The Company has
estimated its contingent liability based on the estimated required federal and
state withholding amounts, the employee and employer portion of social security
taxes as well as the possible penalties and interest associated with the error.
Although the Company’s liability may ultimately be reduced if it can prove that
the taxes due on this income were paid on a timely basis by some or all of the
recipients, the estimated liability including estimated interest and penalties,
accrued by the Company is based on the assumption that it will be liable for the
entire amounts due to the uncertainty with respect to whether or not the
recipients made such payments.




16


Patient
Safety Technologies, Inc.
 Notes
to Condensed Consolidated Interim Financial
Statements


As the
Company determined that it is probable that it will be held liable for the
amounts owed, and as the amount could be reasonably estimated, an accrual for
the estimated liability, which is included in accrued liabilities as of March
31, 2010 and December 31, 2009, is $671,600 and $740,726,
respectively.





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.





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 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 $2,708.70 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 and intends to continue to defend the case
vigorously. As loss is not deemed to be probable, no accruals have been made as
of March 31, 2010.





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.  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
$2,364,819 for the three months ended March 31,
2010, which included $1,074,509 shipped to Cardinal Health (see “Factors
Affecting Future Results —Cardinal Health Supply Agreement”).  At March 31,
2010, we reached a milestone of having had a cumulative total of an estimated
28,750,000 sponges used in 1,150,000 procedures without a single undetected
sponge left inside a surgical patient.




17




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), 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.





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
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 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.




18




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, appearing
elsewhere in this quarterly report on Form 10-Q.




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.




19




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.




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





In
January 2010, the FASB issued guidance designed to improve disclosures about
fair value measurements as well as disclosures related to significant transfers
between each level and additional information about Level 3
activity.  This guidance begins phasing in the first fiscal period
after December 15, 2009, and is effective as of March 31, 2010. Our adoption of
this standard did not have any impact on the Company’s consolidated financial
statements.





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




20




Internal
Control Over Financial Reporting




In
connection with our assessment of the effectiveness of internal control over
financial reporting as of December 31, 2009 and 2008, we identified certain
material weaknesses in our internal control over financial
reporting.





The
material weaknesses identified in connection with our assessment at December 31,
2008 included an ineffective general control environment, ineffective risk
assessment processes, and ineffective internal control policies and procedures
relating to equity transactions and share-based payments, the proper reporting
of income and accounting for payroll taxes, and the integrity of spreadsheets
and other “off system” work papers used in the financial reporting
process.  In part, to address the weaknesses identified in our general
control environment, our board of directors hired a new Chief Executive Officer
and restructured the board to include two independent directors, one of whom
meets the requirements of an audit committee financial expert, and both of whom
have significant corporate governance experience. To address the weaknesses
identified relating to equity transactions, we implemented a new software
program specifically designed to track and account for share-based payments and
equity transactions.  In addition, we engaged an internal control
specialist to design and help implement effective risk assessment
processes.  Although we implemented these remedial actions, we
nevertheless still continued to have material weaknesses in our internal control
over financial reporting as of December 31, 2009.





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.





For
information regarding our evaluation of the effectiveness of our disclosure
controls and procedures as well as any changes in our internal control over
financial reporting, see “Controls and Procedures” below.





Factors
Affecting Future Results




Cardinal Health Supply
Agreement.   On November 19, 2009 we entered into a new
exclusive Supply and Distribution Agreement with Cardinal
Health.  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 the new
supply and distribution agreement, Cardinal Health issued a $10,000,000 stocking
purchase order or First Forward Order, paid us $8,000,000 in cash as a partial
prepayment of the First Forward Order and agreed to pay $2,000,000 directly to A
Plus, our exclusive manufacturer, upon delivery of product to Cardinal
Health.  Because we did not ship any product pursuant to the First
Forward Order in 2009, all $10,000,000 of incremental revenue from the First
Forward Order is expected to be recognized in 2010.  In addition,
Cardinal Health agreed to issue a $5,000,000 stocking purchase order or Second
Forward Order before the end of the third quarter 2010 if certain milestones are
achieved.  If the Second Forward Order is issued, Cardinal Health will
pay us $4,000,000 in cash as a partial prepayment of the Second Forward Order
and pay $1,000,000 directly to A Plus upon delivery of product to Cardinal
Health.  Assuming the Second  Forward Order is issued and we
can meet our delivery requirements, we expect to have minimum incremental
revenue of $10,500,000 in 2010, with the remaining $4,500,000 from the
Second  Forward Order recognized when product is shipped in 2011 in
accordance with the agreement.  Because of this arrangement, we expect
that our reported revenues for 2010 will be at a significantly higher level than
that which would be reflected based on sales by our exclusive distributors’ to
its end-user hospital customers.  In contrast, we anticipate that our
revenues for 2011 and 2012 will be at levels below actual sales by our exclusive
distributors’ to its end-user hospital customers because we anticipate that
Cardinal Health will satisfy customer demand, in part, by working down this
inventory.




21




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




Reduction in Hardware Sales – Effect
on Revenues and Cost of Revenues.  Prior to the third quarter
of 2009, our business model included the sale of our SurgiCounterTM scanners and
related software used in our 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
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. Notably, for the
three months ended March 31, 2010, surgical sponge sales accounted for 98.9% of
our revenues, and sales of hardware accounted for 1.1%, compared to 78.3% and
21.7% for the same period in 2009, respectively.  In addition to its
effect on our revenue, this change in our business model also affected our costs
of revenues because rather than recognizing the full product cost for all
SurgiCounterTM scanners at the time of shipment in our cost of revenues, we now
recognize only the depreciation expense for those SurgiCounterTM scanners that we
have provided to certain hospitals 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 March 31, 2010 Compared to Three Ended March 31, 2009




Revenues




We had
revenues of $2,364,819, which included $1,074,509 shipped to Cardinal Health
under the First Forward Order (see “Factors Affecting Future Results —Cardinal
Health Supply Agreement”) for the three months ended March 31,
2010.  Therefore, actual hospital consumption revenue which is defined
as total revenue less the First Forward Order was $1,290,310 for the three
months ended March 31, 2010, an increase of 37.9% compared to $935,558 for the
same period in 2009.   In the three months ended March 31, 2010,
surgical sponge sales accounted for 98.9% of revenues, and sales of hardware
accounted for 1.1%, compared to 78.3% and 21.7% for the same period in 2009,
respectively.  The primary reason for the increase in revenues was an
increase in sales of surgical sponges used in our Safety-Sponge® System and the
shipment of product to Cardinal Health. The increase in sales activity was
attributable to an upgraded sales force and changes made in our sales program,
including the indemnification program and providing scanners and associated
software at no additional cost to our end-user hospital customers.




Cost
of revenues




Cost of
revenues increased by $540,643 or 98.6%, to $1,088,887 for the three months
ended March 31, 2010 from $548,244 for the same period in
2009.  The primary reason for the increase in costs was 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 $500,874 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
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 $824,000 of cost now being depreciated
and recognized over the life of the hardware.




22




Gross
profit




We had
gross profit of $1,275,932 for the three months ended March 31, 2010, an
increase of $888,618, or 229.4%, compared to $387,314 in the same period in
2009.  The primary reason for the increase in gross profit during
the three months ended March 31, 2010, was the higher revenue
growth achieved, combined with the shift in product mix,
resulting in a significantly higher percentage of surgical sponge sales, which
are sold at a higher margin than our SurgiCounterTM scanners.  We
had gross margin of 53.9% for the three months ended March 31, 2010,
compared to 41.4% for the same period in 2009, which improvement is primarily
attributable to our change in business model, and partially offset by the
increase in customer rebates that did not exist in the same period in
2009.




Operating
expenses




We had
total operating expenses of $2,679,308 for the three months ended March 31,
2010, a decrease of $633,445, or 19.1%, compared to $3,312,753 in the same
period in 2009.  The decrease in operating expense was due to
$1,297,200 of warrant expense relating to the January 2009 debt financing
included in the three months ended March 31, 2009 not present in the current
period, offset by an increase in sales and marketing expenses, which include
clinical implementation related expenses in connection with expanded adoption of
our Safety-Sponge® System.  A portion of the increase is also due to
increased general and administrative expenses, which increased primarily as a
result of increased personnel-related expenses and warrant and stock based
compensation expenses.





Research
and development expenses





We had
research and development expenses of $33,331 for the three months ended March
31, 2010, a decrease of $78,966, or 70.3%, compared to $112,297 in the same
period in 2009.  The primary reason for the decrease was a reduction
in third party development expenses and a reclassification of certain
personnel-related expenses into sales and marketing expenses.





Sales
and marketing expenses





We had
sales and marketing expenses of $994,116 for the three months ended March 31,
2010, an increase of $345,104, or 53.2%, compared to $649,012 in the same period
in 2009.  The primary reason for the increase in sales and marketing
expenses was an increase in personnel, travel and trade show related expenses,
along with increased clinical implementation related expenses, which increased
in connection with expanded adoption of our Safety-Sponge® System.




General
and administrative expenses




We had
general and administrative expenses of $1,651,861 for the three months ended
March 31, 2010, a decrease of $899,583, or 35.3%, compared to $2,551,444 in the
same period in 2009.  The decrease in general and administrative
expense was due to $1,297,200 warrant expense relating to the January 2009 debt
financing, offset by an increase in personnel related expenses, such as
salaries, benefits, travel and equity based compensation expenses, along with an
increase in legal and other professional services.




Total
other income (expense)




We had
total other income of $1,764,349 for the three months ended March 31, 2010,
compared to total other expense of $633,730 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
$1,718,738 in the three months ended March 31, 2010, compared to a loss of
$414,021 in 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
reduction in our outstanding indebtedness at March 31, 2010 compared to the same
period in 2009.




23




Provision
for Income Taxes





We had a
$32,573 tax benefit for the three months ended March 31, 2010, compared to a
$32,360 tax benefit for the same period in 2009.  The tax benefit
relates to the amortization of the Company’s patent portfolio.




Net
income (loss)




For the
foregoing reasons, we had net income of $393,546 for the three months ended
March 31, 2010 compared to a net loss of $3,526,809 for the same period in
2009.





Financial
Condition, Liquidity and Capital Resources




We had
cash and cash equivalents of $1,783,029 at March 31, 2010 compared to $3,446,726
at December 31, 2009, and total current liabilities of $14,478,592 at March 31,
2010 compared to $16,495,410 at December 31, 2009. As of March 31, 2010 we had a
working capital deficit of approximately $10,918,028, of which $6,925,491 and
$1,947,598 are associated with deferred revenue relating to the partial
prepayment from Cardinal Health and the warrant derivative liability,
respectively.




Our
principal sources of cash have included the issuance of equity and debt
securities. We expect that as our revenues grow, our operating expenses will
continue to grow and, as a result, we will need to generate significant
additional net revenues to achieve profitability and cash flow from
operations.  Our sales cycle requires that we incur significant
expenses in advance of the time we generate revenues from our new customer
arrangements. Thus, as our business grows and we expand our customer base, our
cash needs will increase prior to the time we generate cash from such new
customer arrangements.  As such, we do not believe that our current
cash and cash equivalents will be adequate to fund our projected operating
requirements for the next three months.  Although we engaged in a
financing transaction in July 2009 that resulted in the receipt of $1,706,143 in
cash in the third quarter of 2009, and repaid a significant amount of
indebtedness in December 2009 following receipt of $8,000,000 in cash in
November 2009 from Cardinal Health in connection with its prepayment of a
$10,000,000 purchase order (see “—Factors Affecting Future Results—Cardinal
Health Supply Agreement” above), we must still obtain additional financing in
order to  achieve profitable operations of the scale required to
provide a sufficient source of operating capital.  If we are unable to
obtain this additional financing, the absence of capital will have a material
adverse impact on our business and operations during the second quarter of 2010,
which may include a severe curtailment or even discontinued
operations.  No assurances, however, can be made that we will be
successful in obtaining a sufficient amount of financing on acceptable terms or
any financing to continue to fund our operations or that we will achieve
profitable operations and positive cash flow.





Operating
activities




We used
$1,201,606 of net cash from operating activities in the three months ended March
31, 2010.  Non-cash adjustments to reconcile net income to net cash
used in operating activities plus changes in operating assets and liabilities
used $1,595,150 of cash for the three months ended March 31,
2010.  These significant non-cash adjustments primarily reflect the
stock and warrant based compensation to employees and directors and adjustments
to reflect the change in fair value of our warrant derivative liability, along
with activity relating to shipments to Cardinal Health




Investing
activities




We used
$437,504 of net cash in investing activities during the three months ended March
31, 2010, primarily for the purchase of scanners and related hardware used in
our Safety Sponge® System.




Financing
activities




We used
$24,587 of net cash from financing activities in the three months ended March
31, 2010, for the payment of preferred stock dividends and our capital lease
obligations.




Description
of Indebtedness




At March
31, 2009, we had aggregate indebtedness of $1,424,558 pertaining to the Ault
Glazer Capital Partners LLC note as described below.


Ault
Glazer Capital Partners, LLC




24




On
September 5, 2008, we entered into an Amendment and Early Conversion of Secured
Convertible Promissory Note or Amendment, with Ault Glazer Capital
Partners, LLC, or Ault Glazer, to modify the terms of our outstanding
$2,530,558 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 $450,000 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 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 or 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
agreement. As of the date of this quarterly report on Form 10-Q, we have
paid Ault Glazer $450,000 in cash and issued Ault Glazer an aggregate 800,0000
shares of our common stock, valued at $656,000 in settlement of the 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
agreement and issuance of shares pursuant to the Advancement, we are no longer
incurring interest expense on this convertible secured promissory note.  As
of March 31, 2010, the outstanding principal balance on this note was
$1,424,558.  For further information relating to this note, see
Note 9 to our condensed consolidated interim financial statements appearing
elsewhere in this quarterly report on Form 10-Q.




Ault
Glazer is controlled by Milton “Todd” Ault III, our former Chairman and Chief
Executive Officer, and Louis Glazer, M.D. Ph.G, a Director of our company. Dr.
Glazer currently has a significant beneficial ownership interest in our common
and preferred stock.





Investment
Portfolio





At March
31, 2010, we had an investment in preferred stock of Alacra Corporation, with a
carrying value of $666,667, which represented 6.5% of our total assets at March
31, 2010.  In December 2007, we received proceeds of $333,000 from the
redemption of one-third of our initial $1,000,000 investment.  In
accordance with the terms of our investment, we have exercised our right to put
back our remaining preferred stock to Alacra, and based on discussions with
Alacra management, we anticipate redemption and subsequent receipt of funds in
the fourth quarters of 2010 and 2011, respectively. 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 8 to our condensed consolidated interim financial
statements appearing elsewhere in this quarterly report on Form
10-Q.





Related
Party Transactions




Ault
Glazer Capital Partners, LLC is controlled by Milton “Todd” Ault III, our former
Chairman and Chief Executive Officer, and Louis Glazer, M.D.
Ph.G.  Dr. Glazer is a member of our Board of Directors and currently
has a significant beneficial ownership interest in our common and preferred
stock. For further information relating to this note, see Note 9 to our
condensed consolidated interim financial statements appearing elsewhere in this
quarterly report on Form 10-Q.





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 equity financings of
our company.  During the three months ended March 31, 2010, our cost
of revenue included $1,105,408in connection with this supply arrangement, and
our accounts payable included $1,935,290 at March 31, 2010, payable to A Plus
under this supply agreement, which includes $500,874 that will be paid directly
to A Plus by Cardinal Health (see “—Factors Affecting Future Results—Cardinal
Health Supply Agreement” above).





From time
to time, we may use the services of an aircraft owning partnership principally
owned by Steven H. Kane, our Chief Executive Officer for air
travel.  During the three months ended March 31, 2010 and 2009, there
were no expenses related to the use such air travel services.




25




For
additional information relating to these and other related party transactions,
see Note 16 to our condensed consolidated interim financial statements appearing
elsewhere in this quarterly report on Form 10-Q.




Off-Balance
Sheet Arrangements




As of
March 31, 2010, we had no off-balance sheet arrangements.





Commitments
and Contingencies




As of
March 31, 2010, other than our office leases and employment agreements with key
executive officers, we had no material commitments other than the liabilities
reflected in our condensed consolidated interim financial
statements.





ITEM
3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





Not
applicable.





ITEM
4(T). CONTROLS AND PROCEDURES





Limitations
on the Effectiveness of Controls





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





Evaluation
of Disclosure Controls and Procedures




As of the
end of the period covered by this report, we conducted an evaluation, under the
supervision and with the participation of our Chief Executive Officer and 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.  In designing and evaluating the
disclosure controls and procedures, management recognizes that any controls and
procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives and management
necessarily is required to apply its judgment in evaluating the cost-benefit
relationship of possible controls and procedures. Based upon that evaluation,
our chief executive officer and chief financial officer concluded that, as of
the end of the period covered by this report, our disclosure controls and
procedures were not effective at the reasonable assurance level discussed above
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.





Notwithstanding
the conclusion that our disclosure controls and procedures were not effective as
of the end of the period covered by this report, the Chief Executive Officer and
the Chief Financial Officer believe that the consolidated financial statements
and other information contained in this quarterly report present fairly, in all
material respects, our business, financial condition and results of
operations.





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:




26




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.





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 Exchange Act)
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 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.





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 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 $2,708.70 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 and intends to continue to defend the case
vigorously.





ITEM
1A.  RISK FACTORS





Intentionally
omitted.





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





Not
applicable





ITEM
3.  DEFAULTS UPON SENIOR SECURITIES





Not
applicable




27





ITEM
4.  (REMOVED AND RESERVED)





ITEM
5.  OTHER INFORMATION





Not
applicable





ITEM
6.  EXHIBITS





Exhibit
                  Number
                
                Description31.1*
                
                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.





28





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:
      May 14, 2010
              
              By:
      /s/ Steven H. KaneSteven
      H. Kane, President and ChiefExecutive
      Officer
  Date:
      May 14, 2010
                
                By:
      /s/ Marc L. RoseMarc
      L. Rose, Vice President,Chief
      Financial Officer, Treasurerand
      Corporate Secretary




29