UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549





FORM
10-Q





(Mark
One)





x
            
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





FOR THE
QUARTERLY PERIOD ENDED JUNE 30, 2009




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 Number)43460
      Ridge Park Drive, Suite 140, Temecula, CA 92590(Address
      of principal executive offices) (Zip
Code)





Registrant’s
telephone number, including area code: (951) 587-6201





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
past 12 months (or for such shorter period that the registrant was required to
file such reports), and (2) has been subject to such filing requirements for the
past 90 days.  Yes x    No   ̈.





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


Yes o   No  o





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
definitions of “accelerated filer,” “large accelerated filer,” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check
one):


Large
      accelerated filer  ̈
            
            Accelerated
      filer  ̈
            
            Non-accelerated
      filer  ̈
              (Do
      not check if a 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.





There
were 19,396,834 shares of the registrant's common stock outstanding as of August
4, 2009.









PATIENT
SAFETY TECHNOLOGIES, INC.





FORM
10-Q FOR THE QUARTER


ENDED
JUNE 30, 2009





TABLE
OF CONTENTS





PagePART
      I – FINANCIAL INFORMATIONItem
      1.       Financial
      Statements
            1Item
      2.       Management’s Discussion and
      Analysis of Financial Condition and Results of Operations
            17Item
      3.       Quantitative and Qualitative
      Disclosures About Market Risk
            27Item
      4T.     Controls and Procedures
            27PART
      II – OTHER INFORMATIONItem
      1.       Legal
    Proceedings
            29Item
      1A.    Risk Factors
            29Item
      2.       Unregistered Sales of Equity
      Securities and Use of Proceeds
            29Item
      3.       Defaults Upon Senior
      Securities
            30Item
      4.       Submission of Matters to a
      Vote of Security Holders
            30Item
      5.       Other
    Information
            30Item
      6.       Exhibits
            31SIGNATURES
            32










We
believe that it is important to communicate our plans and expectations about the
future to our stockholders and to the public.  Some of the statements
in this report are forward-looking statements about our plans and expectations
of what may happen in the future, including in particular the statements about
our plans and expectations in Part I of this report under the heading “Item 2.
Management's Discussion and Analysis of Financial Condition and Results of
Operations.”  Statements that are not historical facts are
forward-looking statements within the meaning of Section 21E of the Securities
Exchange Act of 1934, as amended (the “Exchange
Act”).    You can sometimes identify forward-looking
statements by our use of forward-looking words like “may,” “should,” “expects,”
“intends,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,”
“potential,” or “continue” or the negative of these terms and other similar
expressions.





Although
we believe that the plans and expectations reflected in or suggested by our
forward-looking statements are reasonable, those statements are based only on
the current beliefs and assumptions of our management and on information
currently available to us and, therefore, they involve uncertainties and risks
as to what may happen in the future.  Accordingly, we cannot guarantee
that our plans and expectations will be achieved.  Our actual results
and stockholder values could be very different from and worse than 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 in Part I, Item 1A of annual report on Form 10-K for the year
ended December 31, 2008 filed with the SEC on April 15, 2009, as amended on May
1, 2009 and July 13, 2009 (the “Form
10-K”), including without limitation the following:





·
            The
      early stage of adoption of our Safety-Sponge System and the
      unpredictability of our sales cycle




·
            Our
      need for additional financing to support our
  business




·
            Any
      failure of our new management team to operate
  effectively




·
            Our
      reliance on third-party manufacturers, some of whom are sole-source
      suppliers




·
            Any
      inability to successfully defend our intellectual property
      portfolio




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





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











PART
I – FINANCIAL INFORMATION





Item
1.  Financial Statements.




PATIENT
SAFETY TECHNOLOGIES, INC. AND SUBSIDIARY Condensed
Consolidated Balance Sheets (In
thousands, except par value)




June
      30,2009
              
              
              December
      31,2008(unaudited)AssetsCurrent
      assets:Cash
      and cash equivalents
              
              $
              251
              
              
              $
              296Accounts
      receivable
              
              
              188
              
              
              
              418Inventories,
      net
              
              
              657
              
              
              
              200Prepaid
      expenses
              
              
              220
              
              
              
              188Total
      current assets
              
              
              1,316
              
              
              
              1,102Restricted
      certificate of deposit
              
              
              94
              
              
              
              94Notes
      receivable
              
              
              121
              
              
              
              121Property
      and equipment, net
              
              
              474
              
              
              
              622Goodwill
              
              
              1,832
              
              
              
              1,832Patents,
      net
              
              
              3,277
              
              
              
              3,439Long-term
      investment
              
              
              667
              
              
              
              667Other
      assets
              
              
              29
              
              
              
              37Total
      assets
              
              $
              7,810
              
              
              $
              7,914Liabilities
      and Stockholders' (Deficit) EquityCurrent
      liabilitiesAccounts
      payable
              
              $
              1,770
              
              
              $
              909Current
      portion of convertible debentures
              
              
              1,425
              
              
              
              1,425Current
      portion of notes payable
              
              
              600
              
              
              
              1,100Accrued
      liabilities
              
              
              9,983
              
              
              
              3,358Total
      current liabilities
              
              
              13,778
              
              
              
              6,792Long-term
      convertible debentures, less current portion
              
              
              53
              
              
              
              51Long-term
      notes payable, less current portion
              
              
              1,530
              
              
              
              ---Deferred
      tax liability
              
              
              979
              
              
              
              1,042Total
      liabilities
              
              
              16,340
              
              
              
              7,885Stockholders'
      equity:Convertible
      preferred stock, $1.00 par value, cumulative 7% dividend:1,000
      shares authorized; 11 issued and outstanding at June 30,
    2009and
      December 31, 2008;(Liquidation
      preference of $1.2 million at June 30, 2009 and December 31,
      2008
              
              
              11
              
              
              
              11Common
      stock, $0.33 par value: 25,000 shares authorized;17,180
      shares issued and outstanding at June 30, 2009 and December 31,
      2008;
              
              
              5,675
              
              
              
              5,675Additional
      paid-in capital
              
              
              35,767
              
              
              
              36,034Accumulated
      deficit
              
              
              (49,983
              )
              
              
              (41,691
              )Total
      stockholders' (deficit) equity
              
              
              (8,530
              )
              
              
              29Total
      liabilities and stockholders' equity
              
              $
              7,810
              
              
              $
              7,914
  The
      accompanying notes are an integral part of these consolidated interim
      financial statements.




1




PATIENT
SAFETY TECHNOLOGIES, INC. AND SUBSIDIARY Condensed
Consolidated Statements of Operations (In
thousands, except per share data) (unaudited)




For
      the Quarter Ending June 30,
              
              
              For
      the Six Months Ending June 30,2009
              
              
              2008
              
              
              2009
              
              
              2008Revenues
              
              $
              1,028
              
              
              $
              557
              
              
              $
              1,964
              
              
              $
              1,057Cost
      of revenue
              
              
              619
              
              
              
              326
              
              
              
              1,168
              
              
              
              719Gross
      profit
              
              
              409
              
              
              
              231
              
              
              
              796
              
              
              
              338Operating
      expenses:Research
      and development
              
              
              86
              
              
              
              38
              
              
              
              199
              
              
              
              81Sales
      and marketing
              
              
              553
              
              
              
              682
              
              
              
              1,202
              
              
              
              1,134General
      and administrative
              
              
              1,360
              
              
              
              1,687
              
              
              
              3,911
              
              
              
              2,723Total
      operating expenses
              
              
              1,999
              
              
              
              2,407
              
              
              
              5,312
              
              
              
              3,938Operating
      loss
              
              
              (1,590
              )
              
              
              (2,176
              )
              
              
              (4,516
              )
              
              
              (3,600
              )Other
      income (expenses):Interest
      expense
              
              
              (220
              )
              
              
              (88
              )
              
              
              (440
              )
              
              
              (175
              )Change
      in fair value of warrant liability
              
              
              (2,155
              )
              
              
              (168
              )
              
              
              (2,570
              )
              
              
              (168
              )Realized
      loss on assets held for sale, net
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (25
              )Unrealized
      loss on assets held for sale, net
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (65
              )Total
      other income (expense)
              
              
              (2,375
              )
              
              
              (256
              )
              
              
              (3,010
              )
              
              
              (433
              )Loss
      from operations before income taxes
              
              
              (3,965
              )
              
              
              (2,432
              )
              
              
              (7,526
              )
              
              
              (4,033
              )Income
      tax benefit
              
              
              31
              
              
              
              32
              
              
              
              65
              
              
              
              65Net
      loss
              
              
              (3,934
              )
              
              
              (2,400
              )
              
              
              (7,461
              )
              
              
              (3,968
              )Preferred
      dividends
              
              
              (19
              )
              
              
              (19
              )
              
              
              (38
              )
              
              
              (38
              )Net
      loss applicable to common shareholders
              
              $
              (3,953
              )
              
              $
              (2,419
              )
              
              $
              (7,499
              )
              
              $
              (4,006
              )Net
      loss per common share - basic and diluted
              
              $
              (0.23
              )
              
              $
              (0.19
              )
              
              $
              (0.44
              )
              
              $
              (0.32
              )Weighted
      average common shares outstanding:Basic
      and diluted
              
              
              17,198
              
              
              
              13,054
              
              
              
              17,198
              
              
              
              12,567
  The
accompanying notes are an integral part of these consolidated interim financial
statements.
  2
  PATIENT
SAFETY TECHNOLOGIES, INC. AND SUBSIDIARY
 Condensed
Consolidated Statements of Cash Flows
 (In
thousands)
 (unaudited)
  For
      the Six Months Ending June 30,2009
                  
                  
                  2008Operating
      activities:Net
      loss
                  
                  $
                  (7,461
                  )
                  
                  $
                  (3,968
                  )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
                  
                  
                  170
                  
                  
                  
                  163Amortization
      of patents
                  
                  
                  162
                  
                  
                  
                  162Amortization
      of debt discount
                  
                  
                  247
                  
                  
                  
                  -Non-cash
      interest
                  
                  
                  61
                  
                  
                  
                  -Stock-based
      compensation to consultants
                  
                  
                  -
                  
                  
                  
                  8Stock-based
      compensation to employees and directors
                  
                  
                  572
                  
                  
                  
                  1,001Non
      cash expense related to issuance of warrants
                  
                  
                  1,297
                  
                  
                  
                  -Change
      in fair value of warrant derivative liability
                  
                  
                  2,570
                  
                  
                  
                  168Inventory
      valuation allowance
                  
                  
                  106
                  
                  
                  
                  -Loss
      on sale of property
                  
                  
                  -
                  
                  
                  
                  91Income
      tax expense (benefit)
                  
                  
                  (64
                  )
                  
                  
                  (65
                  )Changes
      in operating assets and liabilities:Accounts
      receivable
                  
                  
                  231
                  
                  
                  
                  (116
                  )Inventories
                  
                  
                  (563
                  )
                  
                  
                  (28
                  )Prepaid
      expenses
                  
                  
                  (32
                  )
                  
                  
                  (467
                  )Other
      assets
                  
                  
                  8
                  
                  
                  
                  -Accounts
      payable
                  
                  
                  860
                  
                  
                  
                  317Accrued
      liabilities
                  
                  
                  (157
                  )
                  
                  
                  250Net
      cash used in operating activities
                  
                  
                  (1,993
                  )
                  
                  
                  (2,484
                  )Investing
      activities:Purchase
      of property and equipment
                  
                  
                  (14
                  )
                  
                  
                  (264
                  )Proceeds
      from sale of assets held for sale, net
                  
                  
                  -
                  
                  
                  
                  226Net
      cash provided by investing activities
                  
                  
                  (14
                  )
                  
                  
                  (38
                  )Financing
      activities:Proceeds
      from issuance of common stock and warrants
                  
                  
                  -
                  
                  
                  
                  2,202Proceeds
      from issuance of notes payable
                  
                  
                  2,000
                  
                  
                  
                  500Payments
      on notes payable
                  
                  
                  -
                  
                  
                  
                  (101
                  )Payments
      of preferred dividends
                  
                  
                  (38
                  )
                  
                  
                  (38
                  )Net
      cash provided by financing activities
                  
                  
                  1,962
                  
                  
                  
                  2,563Net
      decrease in cash and cash equivalents
                  
                  
                  (45
                  )
                  
                  
                  41Cash
      and cash equivalents at beginning of period
                  
                  
                  296
                  
                  
                  
                  406Cash
      and cash equivalents at end of period
                  
                  $
                  251
                  
                  
                  $
                  447Supplemental
      disclosures of cash flow information:Cash
      paid during the period for interest
                  
                  $
                  36
                  
                  
                  $
                  23Non
      cash investing and financing activities:Dividends
      accrued
                  
                  $
                  38
                  
                  
                  $
                  38Issuance
      of common stock for an accrued liability
                  
                  $
                  -
                  
                  
                  $
                  135Issuance
      of common stock in payment of notes payable and accrued
      interest
                  
                  $
                  -
                  
                  
                  $
                  426Reclassification
      of accrued interest to notes payable, less current portion -
      net
                  
                  $
                  113
                  
                  
                  $
                  -Debt
      discount associated with issuance of notes payable
                  
                  $
                  1,311
                  
                  
                  $
                  -


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




3




Patient
Safety Technologies, Inc. and Subsidiary


Notes
to Condensed Consolidated Interim Financial Statements – Unaudited
 June
30, 2009
  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 turn-key system of bar-coded surgical sponges, SurgiCounterTM
scanners and software applications which integrate together to form a
comprehensive accounting and documentation system to avoid unintentionally
leaving sponges inside of patients during surgical procedures.
  2.
LIQUIDITY AND GOING CONCERN
 
 The
accompanying unaudited condensed consolidated financial statements have been
prepared assuming that the Company will continue as a going concern. At June 30,
2009, the Company has an accumulated deficit of approximately $50.0 million and
a working capital deficit of approximately $12.5 million, of which $8.6 million
represents the estimated fair value of warrant derivative liabilities (see Note
12). For the
three and six months ended June 30, 2009, the Company incurred net losses of
approximately $4.0 and $7.5 million, respectively.  For the six months
ended June 30, 2009 the Company used approximately $2.0 million in cash to fund
its operating activities.
 
 The
Company believes that existing cash resources, combined with projected cash flow
from operations, will not be sufficient to fund its working capital requirement
for the next twelve months.  In order to continue to operate as a
going concern it will be necessary to raise additional capital.
 
 The
Company expects to be able to raise sufficient additional capital to meet its
currently projected requirements.  As discussed in Note 16, subsequent
to June 30, 2009, the Company raised aggregate proceeds of approximately
$1.5  million through a private placement of common stock to holders
of the Company’s outstanding stock warrants.  We cannot be certain
that additional capital will be available when needed, or that it will be
offered on terms acceptable to the Company. The Company also cannot be certain
when, and if, the Company will achieve profitable operations and positive cash
flow.  The condensed consolidated interim financial statements do not
include any adjustments that might result from the outcome of this
uncertainty.
  3.
BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING
POLICIES
 
 Basis
of Presentation
 
 The
accompanying unaudited condensed consolidated interim financial statements have
been prepared in accordance with the instructions to Form 10-Q and Article 8-03
of Regulation S-X and do not include all the information and disclosures
required by accounting principles generally accepted in the United States of
America.  The condensed consolidated interim financial information is
unaudited but reflects all normal adjustments that are, in the opinion of
management, necessary to make the financial statements not
misleading.  The condensed consolidated interim financial statements
should be read in conjunction with the consolidated financial statements in the
Company’s Annual Report on Form 10-K for the year ended December 31,
2008.  Results of the three and six months ended June 30, 2009 are not
necessarily indicative of the results to be expected for the full year ending
December 31, 2009.
 
 Use
of Estimates
 
 The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes.  The actual results may differ from
management’s estimates.
 
 Reclassifications
 
 Certain
prior year amounts have been reclassified to conform to the 2009 presentation.
These reclassifications had no effect on previously reported results of
operations or accumulated deficit.
 
 Recent
Accounting Pronouncements
 
 In
September 2006, the Financial Accounting Standards Board (“FASB”)
issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements
(“SFAS
157”). This statement defines fair value, establishes a framework for
measuring fair value in U.S. GAAP, and expands disclosures about fair value
measurements.  This statement applies in those instances where other
accounting pronouncements require or permit fair value measurements and the
board of directors has previous concluded in those accounting pronouncements
that fair value is the relevant measurement attribute.  Accordingly,
this statement does not require any new fair value
measurements.  However for some entities, the application of this
Statement will change the current practice.  In February 2008, the
FASB issued FSP FAS 157-2 which defers the effective date of SFAS 157 for all
non-financial assets and liabilities, except those items recognized or disclosed
at fair value on an annual or more frequent recurring basis until years
beginning after November 15, 2008.   Our adoption of SFAS 157 for
its financial assets and liabilities on January 1, 2008 and FSP FAS 157-2 for
its non-financial assets and liabilities on January 1, 2009 did not have a
material impact on the Company’s consolidated financial
statements.
  4
  In
December 2007, the FASB issued Statement of Financial Accounting Standards No.
141(R), Business Combinations(“SFAS 141(R)”).  This statement requires the acquiring entity
in a business combination to record all assets acquired and liabilities assumed
at their respective acquisition-date fair values, changes the recognition of
assets acquired and liabilities assumed arising from contingencies, changes the
recognition and measurement of contingent consideration, and requires the
expensing of acquisition-related costs as incurred.  SFAS 141(R) also
requires additional disclosure of information surrounding a business
combination, such that users of the entity's financial statements can fully
understand the nature and financial impact of the business
combination.  Our adoption of SFAS No. 141(R) on January 1, 2009 did
not have a material impact on the Company’s consolidated
statements.
  In
December 2007, the FASB issued Statement of Financial Accounting Standards No.
160; Noncontrolling Interests
in Consolidated Financial Statementsan amendment of ARB5 (“SFAS
160”).  SFAS 160 establishes accounting and reporting standards for
ownership interests in subsidiaries held by parties other than the parent, the
amount of consolidated net income attributable to the parent and to the
noncontrolling interest, changes in a parent's ownership interest and the
valuation of retained noncontrolling equity investments when a subsidiary is
deconsolidated. SFAS 160 also established reporting requirements that provide
sufficient disclosures that clearly identify and distinguish between the
interests of the parent and the interests of the noncontrolling owner. Our
adoption of SFAS No. 160 on January 1, 2009 did not have a material impact on
our consolidated financial statements.
 
 In
March 2008, the FASB issued Statement of Financial Accounting Standards
No. 161, Disclosures
about Derivative Instruments and Hedging Activities—an amendment of FASB
Statement No. 133 (“SFAS 161”).  The standard requires
additional quantitative disclosures (provided in tabular form) and qualitative
disclosures for derivative instruments.  The required disclosures
include how derivative instruments and related hedged items affect an entity’s
financial position, financial performance, and cash flows; relative volume of
derivative activity; the objectives and strategies for using derivative
instruments; the accounting treatment for those derivative instruments formally
designated as the hedging instrument in a hedge relationship; and the existence
and nature of credit-related contingent features for
derivatives.  SFAS No. 161 does not change the accounting
treatment for derivative instruments.  Our adoption of SFAS
No. 161 on January 1, 2009 did not have a material impact on our
consolidated financial statements.
 
 In April
2008, the FASB issued FSP FAS 142-3, Determination of Useful Life of
Intangible Assets (“FSP FAS 142-3”).  FSP FAS 142-3 amends the
factors that should be considered in developing the renewal or extension
assumptions used to determine the useful life of a recognized intangible asset
under FAS 142, “Goodwill and Other Intangible Assets.”  FSP FAS 142-3
also requires expanded disclosure related to the determination of intangible
asset useful lives.  FSP FAS 142-3 is effective for fiscal years
beginning after December 15, 2008.  Earlier adoption is not
permitted.  Our adoption of FSP FAS 142-3 on January 1, 2009 did not
have a material impact on our consolidated financial statements.
 
 In May
2008, the FASB issued FASB Staff Position APB 14-1, Accounting for Convertible Debt
Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash
Settlement) (“FSP APB 14-1”)  FSP APB 14-1 requires recognition
of both the liability and equity components of convertible debt instruments with
cash settlement features.  The debt component is required to be
recognized at the fair value of a similar instrument that does not have an
associated equity component.  The equity component is recognized as
the difference between the proceeds from the issuance of the note and the fair
value of the liability.  FSP APB 14-1 also requires an accretion of
the resulting debt discount over the expected life of the
debt.  Retrospective application to all periods presented is required
and a cumulative-effect adjustment is recognized as of the beginning of the
first period presented.  This standard is effective for fiscal years
beginning after December 15, 2008.  Our adoption of FSP APB 14-1 on
January 1, 2009 did not have a material impact on our consolidated financial
statements.
 
 In June
2008, the FASB issued FSP No. EITF 03-6-1, Determining Whether Instruments
Granted in Share-Based Payment Transactions Are Participating Securities,
which requires entities to apply the two-class method of computing basic and
diluted earnings per share for participating securities that include awards that
accrue cash dividends (whether paid or unpaid) any time common shareholders
received dividends and those dividends do not need to be returned to the entity
if the employee forfeits the award.  FSP EITF 03-6-1 will be effective
for the Company on January 1, 2009 and will require retroactive
disclosure.  The adoption of EITF 03-6-1 did not have a material
impact on our consolidated financial statements.
  5
  In June
2008, the FASB ratified EITF Issue No. 07-5, “Determining whether an Instrument
(or Embedded Feature) is indexed to an Entity’s own Stock”(“EITF
07-5).  EITF 07-5 is effective for financial statements issued for
fiscal years beginning after December 15, 2008, and interim periods within those
fiscal years.   Early application is not
permitted.  Paragraph 11(a) of SFAS No. 133 – specifies that a
contract that would otherwise meet the definition of a derivative but is both
(a) indexed to the Company’s own stock and (b) classified in stockholders’
equity in the statement of financial position would not be consider a derivative
financial instrument.  EITF 07-5 provides a new two-step model to be
applied in determining whether a financial instrument or an embedded feature is
indexed to an issuer’s own stock and thus able to qualify for the SFAS No. 133
paragraph 11(a) scope exception.  The Company’s adoption of EITF 07-05
effective January 1, 2009, resulted in the identification of certain warrants
that were determined to be ineligible for equity classification because of
certain provisions that may result in an adjustment to their exercise
price.  Accordingly, these warrants were reclassified as liabilities
upon the effective date of EITF 07-05 and re-measured at fair value as of June
30, 2009 with changes in the fair value recognized in other income for the
quarter ended June 30, 2009 (See Note 12).
 
 In April
2009, the FASB issued FSP SFAS No. 157-4, “Determining Fair Value When the
Volume and Level of Activity for the Asset or Liability Have Significantly
Decreased and Identifying Transactions That Are Not Orderly” (“FSP SFAS
No. 157-4”). FSP SFAS No. 157-4 provides additional guidance for
estimating fair value in accordance with FASB Statement No. 157 Fair Value
Measurements, when the volume and level of activity for the asset or liability
have significantly decreased. FSP SFAS No. 157-4 also includes guidance on
identifying circumstances that indicate a transaction is not orderly. This FSP
emphasizes that even if there has been a significant decrease in the volume and
level of activity for the asset or liability and regardless of the valuation
technique(s) used, the objective of a fair value measurement remains the same.
Fair value is the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction (that is, not a forced
liquidation or distressed sale) between market participants at the measurement
date under current market conditions. This statement is effective for interim
and annual reporting periods ending after June 15, 2009. The adoption of
this pronouncement during the quarter ended June 30, 2009 did not have a
material effect on the Company’s financial statements.
 
 In April
2009, the FASB issued FSP FAS No. 107-1 and APB 28-1, “Interim Disclosures
about Fair Value of Financial Instruments” (“FSP FAS No. 107-1”). FSP FAS
No. 107-1 amends SFAS No. 107, “Disclosures about Fair Value of
Financial Instruments”, to require disclosures about fair value of financial
instruments for interim reporting periods of publicly traded companies as well
as in annual financial statements. FSP FAS No. 107-1 also amends APB
Opinion No. 28, “Interim Financial Reporting”, to require those disclosures
in summarized financial information at interim reporting periods. This statement
became effective for interim and annual reporting periods ending after
June 15, 2009. The adoption of this pronouncement during the quarter ended
June 30, 2009 did not have a material effect on the Company’s financial
statements.
 
 In May
2009, the FASB issued SFAS No. 165, “Subsequent Events” (“SFAS No. 165”).
SFAS No. 165 establishes general standards of accounting for and disclosure of
events that occur after the balance sheet date but before financial statements
are issued or are available to be issued. SFAS No. 165 was effective for fiscal
years and interim periods ending after June 15, 2009. The adoption of this
pronouncement during the quarter ended June 30, 2009 did not have a material
effect on the Company’s financial statements.
 
 The
Company has evaluated subsequent events that occurred after June 30, 2009,
through August 14, 2009, the date the Company’s financial statements were
issued.  During this period we did not have any material subsequent events that required recognition or disclosure in our
June 30, 2009 financial statements. See Note 16 for disclosure related to
unrecognized subsequent events.
  In June
2009, through the issuance of SFAS No. 168, “The FASB Accounting Standards
Codification and the Hierarchy of Generally Accepted Accounting Principles, the
FASB confirmed that the FASB Accounting Standards Codification (the
“Codification”) will become the single official source of authoritative US
generally accepted accounting principles (“US GAAP”)(other than guidance issued
by the SEC), superseding existing FASB, American Institute of Certified Public
Accountants, EITF, and related literature. After the effective date of the
Codification, only one level of authoritative US GAAP will exist. All other
literature will be considered non-authoritative. The Codification does not
change US GAAP; instead, it introduces a new structure that is organized in an
easily accessible, user-friendly online research system. The Codification
becomes effective for interim and annual periods ending on or after
September 15, 2009. The Company will apply the Codification beginning in
the quarter ending September 30 2009. The adoption of the Codification will not
have an effect on the Company’s financial statements, but will impact the
Company’s future financial statement disclosures since all future references to
authoritative accounting literature will be referenced in accordance with the
Codification.
  4.
CONCENTRATION OF CREDIT RISK
 
 From time
to time, the Company maintains its cash balances at a financial institution that
exceeds the Federal Deposit Insurance Corporation coverage of $250
thousand.  The Company has not experienced any losses in such accounts
and believes it is not exposed to any significant credit risk related to its
cash and cash equivalents.
  6
  At June
30, 2009 and 2008, due to the Company’s distribution agreement with Cardinal
Health, it had one individual customer whose receivable balance outstanding
represented 57% and 81%, respectively, of its gross accounts receivable
balance.
 
 We rely
primarily on A Plus International to supply our sponge products, but also rely
on a number of third parties to manufacture certain of our products. If any of
our third-party manufacturers cannot, or will not, manufacture our products in
the required volumes, on a cost-effective basis, in a timely manner, or at all,
we will have to secure additional manufacturing capacity. Any interruption or
delay in manufacturing could have a material adverse effect on our business and
operating results.
  5.  STOCK-BASED
COMPENSATION
 
 In
September 2005, the Board of Directors of the Company approved the Amended and
Restated 2005 Stock Option and Restricted Stock Plan (the “2005
SOP”) and the Company’s stockholders approved the Plan in November 2005.
The Plan reserves 2.5 million shares of common stock for grants of incentive
stock options, nonqualified stock options, warrants and restricted stock awards
to employees, non–employee directors and consultants performing services for the
Company. Options granted under the Plan 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 Plan are subject to a vesting
period determined at the date of grant.
 
 All
options that the Company granted during the three and six months ended June 30,
2009 and 2008 were granted at the per share fair market value on the grant date.
Vesting of options differs based on the terms of each option. The Company
utilized the Black-Scholes option pricing model and the assumptions used for
each period are as follows:
  Six
      Months ended June 30,2009
                
                2008Weighted
      average risk free interest rate
                
                2.42
                %
                
                
                3.5
                %Weighted
      average life (in years)
                
                5.99
                years
                
                
                5.00
                yearsWeighted
      average volatility
                
                149.23
                %
                
                
                106
                %Expected
      dividend yield
                
                ─
                
                
                
                ─
                %Weighted
      average grant-date fair value per share of options granted
                $
                .91
                
                
                $
                .93
  A summary
of stock option activity for the six months ended June 30, 2009 is presented
below (in thousands, except
per share data):
  Outstanding
      OptionsWeightedWeighted
                
                
                AverageNumber
                
                
                Average
                
                
                Remaining
                
                
                Aggregateof
                
                
                Exercise
                
                
                Contractual
                
                
                IntrinsicShares
                
                
                Price
                
                
                Life
                
                
                Value
      (1)Balance
      at December 31, 2008
                
                
                1,627
                
                
                $
                4.40Options
      granted (2)
                
                
                5,165
                
                
                
                .76Cancelled/forfeited
                
                
                (
      2,066
                )
                
                
                .75Balance
      at June 30, 2009
                
                
                4,726
                
                
                $
                1.28
                
                
                
                9.16
                
                
                $
                846Vested
      and exercisable as of June 30, 2009
                
                
                1,574
                
                
                $
                2.19
                
                
                
                8.19
                
                
                $
                21Unvested
      as of June 30, 2009
                
                
                3,152
                
                
                $
                0.83
                
                
                
                9.71
                
                
                $
                825
  (1) The
aggregate intrinsic value is calculated as the difference between the exercise
price of the underlying awards and the closing stock price of $1.05 of our
common stock at June 30, 2009.
  (2)
Represents options which were issued outside the 2005 SOP.
 7
  On
January 2, 2009 the Company granted 2.8 million, nonqualified stock options to
executives under the terms of their employment agreements, of which 2.0 million
were cancelled on May 6, 2009, upon the resignation of David Bruce, the former
CEO. On May 7, 2009, the Company granted 2.0 million, nonqualified stock options
to Steven Kane, the current CEO, under an employment contract. On June 22, 2009,
the Company granted 400 thousand fully vested nonqualified stock options to two
Board members under a compensation agreement for Director’s fees. The total
grant date fair value of stock options granted during the three and six months
ended June 30, 2009 was $1.9 million and $4.0 million,
respectively.
 
 During
the three and six months ended June 30, 2009, the Company recognized stock-based
compensation expense of $225 thousand and $572 thousand,
respectively.  During the three and six months ended June 30, 2008,
the Company had stock based compensation expense of $809 thousand and $1.0
million, respectively.
 
 As of
June 30, 2009, there was $2.5 million of unrecognized compensation costs related
to outstanding employee stock options.   This amount is expected
to be recognized of a weighted average period of 3.6 years.  To the
extent the forfeiture rate is different from what we have anticipated,
stock-based compensation related to these award will be different from our
expectations.
  6.  NET
LOSS PER COMMON SHARE
 
 Loss per
common share is based on the weighted average number of common shares
outstanding. The Company complies with SFAS No. 128, Earnings Per Share, which
requires dual presentation of basic and diluted earnings per share on the face
of the 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 loss per common share reflects the potential dilution that could occur
if convertible preferred stock or debentures, 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 Company.
 
 Since the
effects of outstanding options, warrants and the conversion of convertible
preferred stock and convertible debt are anti-dilutive in all periods presented,
shares of common stock underlying these instruments have been excluded from the
computation of loss per common share.  The following sets forth the
number of shares of common stock underlying outstanding options, warrants,
convertible preferred stock and convertible debt as of June 30, 2009 and 2008,
(in
thousands):
  June
      30, 2009
                
                
                June
      30, 2008Warrants
                
                
                14,563
                
                
                
                9,364Stock
      options
                
                
                4,726
                
                
                
                1,407Convertible
      promissory notes
                
                
                543
                
                
                
                1,069Convertible
      preferred stock
                
                
                246
                
                
                
                246Total
                
                
                20,078
                
                
                
                12,086
 7.
CONVERTIBLE DEBENTURES & NOTES PAYABLE
 
 Convertible
Debentures
 
 Convertible
debentures at June 30, 2009 and December 31, 2008 are comprised of the following
(in
thousands):
  8
  June 30,
                  2009
                
                
                December 31,
                  2008Ault
      Glazer Capital Partners, LLC (a) *
                
                $
                1,425
                
                
                $
                1,425David
      Spiegel (b)
                
                
                65
                
                
                
                65Total
      convertible debentures
                
                
                1,490
                
                
                
                1,490Less:  unamortized
      discount
                
                
                (12
                )
                
                
                (14
                )1,478
                
                
                
                1,476Less:  current
      portion
                
                
                (1,425
                )
                
                
                (1,425
                )Convertible
      debentures - long term portion
                
                $
                53
                
                
                $
                51
  * Related
party (see note 14)
 
 (a)
                On
      September 5, 2008, the Company entered into an Amendment and Early
      Conversion of the Secured Convertible Promissory Note (the “Amendment”)
      with Ault Glazer Capital Partners, LLC (“AG Capital
      Partners”).  The Amendment allowed for the conversion,
      prior to the maturity date of December 31, 2010, of the outstanding
      principal balance of the Note into 1.3 million shares of the Company’s
      common stock and payment of accrued and estimated future interest in the
      amount of $450 thousand in cash.  According to the Amendment,
      following the $450 thousand payment, which was made by the Company in
      connection with the signing of the Amendment, the Promissory Note could be
      converted into 1.3 million shares of common stock upon AG Capital Partners
      satisfaction of certain conditions.
 
 On
September 12, 2008, the parties executed an Agreement for the Advancement of
Common Stock prior to close of the Amendment and Early Conversion of Secured
Convertible Promissory Note, pursuant to which the Company issued 300 thousand
of the previously agreed upon 1.3 million shares.
 
 Additionally,
although Ault Glazer failed to satisfy the conditions by the deadline stated in
the Amendment,  the Company issued  250 thousand shares on
October 10, 2008 and  250 thousand shares on November 6,
2008.   As a result of the issuance of 800 thousand shares issued
to AG Capital Partners as described above, the principal balance of the
Promissory Note was reduced by a total $656 thousand, based on the fair market
value of the common stock on the date it was issued.  Currently, under
the terms of the Amendment, the Company can settle the remaining principal
balance on the Promissory note upon the issuance of 500 thousand shares of
common stock to AG Capital Partners.  However, the Company does not
intend to issue these shares until such time as AG Capital Partners satisfies
the conditions of the Amendment.
 
 (b)
                On
      October 27, 2008 we entered into a Discount Convertible Debenture with
      David Spiegel in the principal amount of $65 thousand (the “Spiegel
      Note”) with a 9% original issue discount of $15
      thousand.  The Note is convertible at any time, in whole or in
      part, into common stock of the Company at a conversion price of $1.50 per
      common share at the option of the holder.  During the three and
      six months ended June 30, 2009, the Company incurred interest expense and
      amortization of the debt discount of $1 thousand and $2 thousand,
      respectively, on the Spiegel Note.
  9
 
 Notes
Payable
 
 Notes
payable at June 30, 2009 and December 31, 2008 are comprised of the following
(in thousands):
  June
      30,
                
                
                December
      31,2009
                
                
                2008Herbert
      Langsam (a)*
                
                $
                600
                
                
                $
                600Catalysis
      Offshore (b)*
                
                
                280
                
                
                
                250Catalysis
      Partners (b)*
                
                
                585
                
                
                
                250Apehelion
      Medical Fund, LP (c)
                
                
                306
                
                
                
                -Arizona
      Bay Technology Ventures, LP (c)
                
                
                203
                
                
                
                -JMR
      Capital Limited (c)
                
                
                203
                
                
                
                -William
      Hitchcock (c)
                
                
                1,019
                
                
                
                -Total
      notes payable
                
                
                3,196
                
                
                
                1,100Less:
      unamortized discount
                
                
                (1,066
                )
                
                
                -Less:
      current portion
                
                
                (600
                )
                
                
                (1,100
                )Notes
      payable - long term portion
                
                $
                1,530
                
                
                $
                -
  * Related
party (see Note 14)
 
 (a)
                On
      May 1, 2006, Herbert Langsam, a Director of the Company, loaned the
      Company $500 thousand. The loan is documented by a $500 thousand Secured
      Promissory Note (the “Langsam
      Note”) payable to the Herbert Langsam Irrevocable Trust. The
      Langsam Note accrues interest at the rate of 12% per annum and had a
      maturity date of November 1, 2006. This note was not repaid by the
      scheduled maturity and to date has not been extended, therefore the
      Langsam Note is recorded in current liabilities. Accordingly, the note is
      currently in default and therefore accruing interest at the rate of 16%
      per annum. Pursuant to the terms of a Security Agreement dated May 1,
      2006, the Company granted the Herbert Langsam Revocable Trust a security
      interest in all of the Company’s assets as collateral for the satisfaction
      and performance of the Company’s obligations pursuant to the Langsam
      Note.
 
 On
November 13, 2006, Mr. Langsam loaned the Company an additional $100 thousand.
The loan is documented by a $100 thousand Secured Promissory Note (the “Second Langsam
Note”) payable to the Herbert Langsam Irrevocable Trust. The Second
Langsam Note accrues interest at the rate of 12% per annum and had a maturity
date of May 13, 2007. The Company is in the process of restructuring the debt
that is owed to Mr. Herbert Langsam. Mr. Langsam received warrants to purchase
50 thousand shares of the Company’s common stock at an exercise price of $1.25
per share as additional consideration for entering into the loan agreement. The
Company recorded debt discount in the amount of $17 thousand as the estimated
value of the warrants. The debt discount was amortized as non-cash interest
expense over the original term of the debt using the effective interest
method.  Pursuant to the terms of a Security Agreement dated November
13, 2006, the Company granted the Herbert Langsam Revocable Trust a security
interest in all of the Company’s assets as collateral for the satisfaction and
performance of the Company’s obligations pursuant to the Second Langsam
Note.
 
 On
December 29, 2008 Mr. Langsam received 25 thousand shares of the Company’s
common stock to extend the maturity dates of both loans to June 30,
2009.   The Company is currently in negotiations with Mr.
Langsam, and the parties have reached an agreement to extend the maturity date
of his notes from June 30, 2009 to December 31, 2009, in consideration of
issuance, by the Company, of 25,000 shares of its common
stock.   The agreement has been approved by the audit committee
and ratified by the executive committee.
 
 During
the three and six months ended June 30, 2009, the Company incurred interest
expense of $18 thousand and $36 thousand, respectively, on the Langsam
Notes.  During the three and six months ended June 30, 2008, the
Company incurred interest expense, excluding amortization of debt discount, of
$24 thousand and $48 thousand, respectively, on the Langsam Notes.  At
June, 2009 and December 31, 2008, accrued interest on the Langsam Notes totaled
$185 thousand.
 
 (b)
                Between
      February 28, 2008 and March 20, 2008, Catalysis Offshore, Ltd. and
      Catalysis Partners, LLC (collectively “Catalysis”),
      related parties, each loaned $250 thousand to the Company.  As
      consideration for the loans, the Company issued Catalysis promissory notes
      in the aggregate principal amount of $500 thousand (the “Catalysis
      Notes”). The Catalysis Notes accrue interest at the rate of 8% per
      annum and had maturity dates of May 31, 2008. The managing partner of
      Catalysis is Francis Capital Management, LLC (“Francis
      Capital”), an investment management firm. John Francis, a director
      of the Company and President of Francis Capital, has voting and investment
      control over the securities held by Catalysis. Francis Capital, including
      shares directly held by Catalysis, beneficially owns 1.3 million shares of
      the Company’s common stock and warrants for purchase of 808 thousand
      shares of the Company’s common stock.  On January 29, 2009 the
      Catalysis Notes were converted into new notes as part of the Senior
      Secured Note and Warrant Purchase Agreement described
    below.
  10
  (c)
                  On
      January 29, 2009, the Company entered into a Senior Secured Note and
      Warrant Purchase Agreement, pursuant to which, the Company sold Senior
      Secured Promissory Notes (the “Notes”) in the principal amount of $2.6
      million and warrants to purchase 1.5 million shares of the Company’s
      common stock (the “Warrant”), to several accredited investors (the
      “Investors”).  The Investors paid $2.0 million in cash and
      converted $550 thousand of existing debt and accrued interest into the new
      Notes.   The Notes accrue interest, which is compounded to
      principal quarterly in arrears, at 10% per annum, throughout the term of
      the notes, and unless earlier converted into a Financing Round, have a
      maturity date of January 29, 2011.  The Warrants have an
      exercise price of $1.00 and expire on January 29, 2014.  The
      Company recorded a debt discount in the amount of $1.3 million based on
      the estimated relative fair value allocated to the
      warrants.   For the six months ended June 30, 2009 the
      Company recognized $245 thousand in debt discount
      amortization.
 
 The Note
Holders have the option to participate in the next issuance of Securities issued
by the Company for cash or the exchange of debt, taking place after the Closing
and prior to the Note’s maturity date.  The Company has the right to
prepay the unpaid principal and interest due on the Notes without any prepayment
penalty.  The Notes are secured by essentially all of the Company’s
assets including but not limited to the Company’s interest in their primary
operating subsidiary, SurgiCount Medical Technologies, Inc.
  8.  ACCRUED
LIABILITIES
 
 Accrued
liabilities at June 30, 2009 and December 31, 2008 are comprised of the
following (in
thousands):
  June
      30,
                
                
                December
      31,2009
                
                
                2008Interest
      (see Note 7)
                
                $
                258
                
                
                $
                237Warrant
      derivative liability (see Note 12)
                
                
                8,572
                
                
                
                1,762Dividends
      on preferred stock
                
                
                134
                
                
                
                134Salaries
      and severance obligations
                
                
                95
                
                
                
                285Director's
      fees
                
                
                158
                
                
                
                145Contingent
      tax liablity (see Note 15)
                
                
                715
                
                
                
                701Other
                
                
                51
                
                
                
                94$
                9,983
                
                
                $
                3,358
  9.  DEFERRED
REVENUE
  The
      sale of our Safety- SpongeTM
      scanner includes a one year maintenance agreement covering telephone
      support and software upgrades.  Revenue relating to the one year
      maintenance agreement is deferred at the time of sale, and is recognized
      monthly over the twelve month term.
 
 As of
June 30, 2009 we had deferred revenue of $9 thousand, which is included in the
Accrued Liabilities (Note 8) on the accompanying balance sheet, June 30,
2009.
 
 11
  10.  INVENTORIES,
NET
 
 Inventories
are stated at the lower of cost or market and consist of the following (in
thousands):
  June
      30,
                  2009
                
                
                December
      31,
                  2008Finished
      goods
                
                $
                763
                
                
                $
                200Reserve
      for excess and obsolete
                
                
                (106
                )
                
                
                —Inventories,
      net
                
                $
                657
                
                
                $
                200
  The
Company recorded charges related to the excess and obsolete reserve to cost of
revenues of $106 thousand and zero for the three and six months ended June 30,
2009 and 2008, respectively.
  11.
EQUITY TRANSACTIONS
 
 Common
Stock
 
 On May
27, 2008 the Company entered into a subscription agreement with several
accredited investors in a private placement exempt from the registration
requirements of the Securities Act.  The Company issued and sold to
these accredited investors an aggregate of 2.1 million shares of its common
stock and warrants to purchase an additional 1.3 million shares of its common
stock.  The warrants are exercisable for a period of five years, have
an exercise price equal to $1.40.  These issuances resulted in
aggregate gross proceeds to the Company of $2.2 million and the extinguishment
of $426 thousand in existing debt.
 
 Between
April 2008 and June 2008, the Company issued 1.7 million warrants to officers,
directors and consultants of the Company.  The warrants were issued in
place of prior issuances of stock options with exercise prices well above market
price that were cancelled.  The exercise prices of the warrants were
$1.25 and $1.75 and vested over four years.  During this same time
period, 263 thousand warrants were issued to directors and consultants with an
exercise price of $1.25 and $1.75 that vested upon grant.
 
 On July
31, 2008, the Company issued 153 thousand shares of its common stock to Ault
Glazer Capital Partners, LLC.  The shares were issued in satisfaction
of unpaid accrued interest of $103 thousand due on the senior secured promissory
note held by Ault Glazer Capital Partners and prepaid interest of $128
thousand.  The accrued interest paid, which was in default, was
converted into shares of the Company’s common stock at a conversion price of
$1.50 per share.
 
 On August
1, 2008 the Company entered into a subscription agreement with several
accredited investors in a private placement exempt from the registration
requirements of the Securities Act.  The Company issued and sold to
these accredited investors an aggregate of 2.0 million shares of its common
stock and warrants to purchase an additional 1.2 million shares of its common
stock.  The warrants are exercisable for a period of five years and
have an exercise price equal to $1.40.  These issuances resulted in
aggregate gross proceeds to the Company of $2.4 million and $83 thousand in debt
extinguishment, which included $50 thousand, paid in common stock and $37
thousand was forgiven.
 
 Between
September 12, 2008 and November 6, 2008 the Company issued 800 thousand shares
of common stock to Ault Glazer Capital Partners, LLC.  The shares were
issued in partial satisfaction of the senior secured promissory note held by
Ault Glazer Capital Partners, LLC.    The issuance of the
Company’s common stock reduced the principal balance.
  12
  On
December 29, 2008, we issued 25 thousand shares of common stock to Herbert
Langsam, currently a director of the Company.  The shares were issued,
in return for a maturity date extension to June 30, 2009, on two loans held by
Mr. Langsam.  Prior to December 29, 2008 the loans had been in
default.
 
 On
January 2, 2009, the Company issued 2.5 million warrants to purchase shares of
the Company’s common stock to warrant holders, with anti-dilutive clauses in
their original warrants.   The warrants are exercisable through
the term of the original warrant and have an exercise price of
$0.75.
 
 On
January 29, 2009, the Company entered into a Senior Secured Note and Warrant
Purchase Agreement, pursuant to which, the Company sold Senior Secured
Promissory Notes (the “Notes”) in the principal amount of $2.6 million and
warrants to purchase 1.5 million shares of the Company’s common stock (the
“Warrant”), to several accredited investors (the “Investors”) in consideration
for $2 million in cash proceeds and conversion of $550 thousand owed under
existing promissory notes.   The Warrants have an exercise price
of $1.00 and expire on January 29, 2014.
  12.
WARRANTS AND WARRANT DERIVATIVE LIABILITY
 
 The
following table summarizes warrants to purchase common stock activity for the
six months ended June 30, 2009:
 Amount
                
                
                Range
      of Exercise PriceWarrants
      outstanding December 31, 2008
                
                
                10,719,896
                
                
                $1.25
      - $6.05Issued
                
                
                4,106,326
                
                
                $0.75
      - $2.00Cancelled/Expired
                
                
                (263,624
                )
                
                $3.26
      - $5.95Warrants
      outstanding June 30, 2009
                
                
                14,562,598
                
                
                $0.75
      - $6.05
  The
warrants issued during the six months ended June 30, 2009 and the year ended
December 31, 2008 were issued primary in connection with the various
subscription and debt agreements entered into by the Company as well as payments
for services and accrued interest. The warrants outstanding as of June 30, 2009
have exercise terms of expiring on dates ranging from June 2009 through
September 2015.
 
 As of
December 31, 2008, warrants to purchase a total of 5.3 million shares, with an
estimated fair value of $1.77 million were recorded as a warrant derivative
liability based on our evaluation of criteria under FASB Emerging Issues Task
Force Issue No. 00-19, Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own
Stock.  In addition, during the six months ended June 30, 2009,
warrants to purchase 5.8 million additional shares were reclassified from equity
to derivative liability based on the evaluation under EITF 00-19.
 
 Effective
January 1, 2009, upon the adoption of EITF 07-5, the Company reclassified a
total of 1.2 million outstanding warrants that were previously classified as
equity to a derivative liability.  This reclassification was necessary
as the Company determined that certain terms included in these warrant
agreements provided for a possible future adjustment to the warrant exercise
price, and accordingly, under the provisions of EITF 07-5, these warrants did
not meet the criteria for being considered to be indexed to the Company’s
stock.  As such, these warrants no longer qualified for the exception
to derivative liability treatment provided for in paragraph 11(a) of SFAS No.
133.  The estimated fair value of the warrants reclassified at January
1, 2009 pursuant to EITF 07-5 was determined to be $707 thousand.  The
cumulative effect of the change in accounting for these warrants of $794,000 was
recognized as an adjustment to the opening balance of accumulated deficit at
January 1, 2009 based on the difference between the amounts recognized in the
consolidated balance sheet before the initial adoption of EITF 07-5 and the
amounts recognized in the consolidated balance sheet as a result of the initial
application of EITF 07-5.  The amounts recognized in the consolidated
balance sheet as a result of the initial application of EITF 07-5 on January 1,
2009 were determined based on the amounts that would have been recognized if
EITF 07-5 had been applied from the issuance date of the
warrants.
  13
  At June
30, 2009, warrants to purchase a total of 12.3 million shares, with an estimated
fair value of $8.6 million, are included in accrued liabilities in the
accompanying balance sheet.  Based on the change in fair value of the
warrant derivative liability, the Company recorded a non-cash loss of $ 2.2
million and $2.6 million for the three and six months ended June 30, 2009,
respectively.
 
 The
following weighted average assumptions were used to estimate the fair value
information presented with respect to warrants issued during the six months
ended June 30, 2009 utilizing the Black-Scholes option pricing
model:
 
 Risk-free
      interest rate
                
                2.54%Average
      expected life (years)
                
                0.62
      – 5.94Expected
      volatility
                
                104%Expected
      dividends
                
                None
  13.
FAIR VALUE MEASUREMENTS
 
 Fair
Value Hierarchy
 
 We
adopted SFAS 157 effective January 1, 2008 for financial assets and liabilities
measured on a recurring basis.  SFAS 157 defines fair value,
establishes a framework for measuring fair value under generally accepted
accounting principles and expands disclosures about fair value
measurements.  This standard applies in situations where other
accounting pronouncements either permit or require fair value
measurements.  SFAS 157 does not require any new fair value
measurements.
 
 Fair
value is defined in SFAS 157 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.  SFAS 157 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
 
 SFAF 157
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 June 30, 2009 the Company had outstanding
warrants to purchase common shares of our stock that are classified as warrant
derivative liabilities with a fair value of $8.6 million.  The
warrants are valued using Level 3 inputs because there are significant
unobservable inputs associated with them.
 
 The table
below sets forth a summary of changes in the fair value of the Company’s
Level 3 assets and liabilities for the six months ended June 30, 2009 (in
thousands):
  December
      31,
                  2008
                
                
                Transfers
      into Level 3
                
                
                Net
      realized losses included in earnings
                
                
                June
      30, 2009Warrant
      derivative liability
                
                $
                (1,762
                )
                
                $
                (4,240
                )
                
                $
                (2,570
                )
                
                $
                (8,572
                )
  14
  Losses
included in earnings for the three and six months ended June 30, 2009, are
reported in other income/expense in the amount of $2.2 million and $2.6 million,
respectively.
 
 Fair
Value of Other Financial Instruments
 
 The
carrying amounts of financial instruments such as cash or cash equivalents,
restricted cash, accounts receivable and accounts payable approximate their fair
values because of the short-term nature of these financial
instruments.  Notes receivable arrangements include a market rate of
interest and their carrying values approximates fair
value.   Convertible debentures and note payable arrangements are
based on borrowing rates currently available to the Company for loans with
similar terms and maturities, are reported at their carrying values, which the
Company believes approximates fair value.  Warrants classified as
derivative liabilities are reported at their estimated fair market value, with
changes in fair market value being reported in current period
loss.
  14.
RELATED PARTY TRANSACTIONS
 
 Convertible
Debentures and Notes Payable
 
 As of
June 30, 2009 and December 31, 2008, the Company had convertible debentures and
notes payable agreements issued to related parties with aggregate outstanding
principal balances of $2.9 million and $2.5 million, respectively (See Note
7).
 
 A
Plus International, Inc.
 
 During
the six months ended June 30, 2009 and 2008, the Company recognized cost of
goods sold of $819 thousand and $593 thousand, respectively, in connection with
surgical sponges provided by A Plus International, Inc (“A Plus”).  At
June 30, 2009 and December 31, 2008 the Company’s accounts payable included $1.2
million and $ 164 thousand, respectively, owed to A Plus in connection with
purchases of surgical sponges.  Effective June 1, 2009,  the
terms of the Company’s agreement with A Plus relating to the supply of surgical
sponges were clarified to provide that title to surgical sponges
purchased,  transferred to the Company upon receipt by A Plus at their
Chino, California warehouse.  Wenchen Lin, a director and significant
beneficial owner of the Company is a founder and significant owner of A
Plus.
 
 Health
West Marketing Inc.
 
 During
the six months ended June 30, 2009 and 2008 Health West Marketing Incorporated
received payments for consulting services, of $120 thousand and $120 thousand,
respectively, from A Plus International, Inc.  William Adams the
Company’s former Chief Executive Officer is the Chief Executive Officer and
President of Health West Marketing Inc. and is a consultant with the
Company.  The consulting arrangement between A Plus and Health West
has been an ongoing agreement between the respective parties.  The
Company has not recognized any income or expense on their financial statements
relating to the agreement between Health West Marketing Incorporated and A Plus
International, Inc.
  15.  COMMITMENTS
AND CONTINGENCIES
 
 Contingent
Tax Liability
 
 In the
process of preparing our federal tax returns for prior years, the Company’s
management found there had been errors in reporting income related to stock
grants made to certain employees and consultants to the recipients and the
respective taxing authorities.   In addition, the Company
determined that required tax withholding relating to these stock grants had not
been made 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 is 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 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.
  15
  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 was included in accrued liabilities as of December 31,
2008.  As of June 30, 2009 and December 31, 2008 the estimated
liability is $715 thousand and $701 thousand, respectively.
 
 Legal
Proceedings
 
 On
October 15, 2001, Jeffrey A. Leve and Jeffrey Leve Family Partnership, L.P.
filed a lawsuit (the “Leve
Lawsuit”) against the Company, Sunshine Wireless, LLC ("Sunshine"),
and four other defendants affiliated with Winstar Communications, Inc. (“Winstar”).
On February 25, 2003, the case against the Company and Sunshine was dismissed,
however, on October 19, 2004, Jeffrey A. Leve and Jeffrey Leve Family
Partnership, L.P. exercised their right to appeal.  The initial
lawsuit alleged that the Winstar defendants conspired to commit fraud and
breached their fiduciary duty to the plaintiffs in connection with the
acquisition of the plaintiff's radio production and distribution
business.  The complaint further alleged that the Company and Sunshine
joined the alleged conspiracy. On June 1, 2005, the United States Court of
Appeals for the Second Circuit affirmed the February 25, 2003 judgment of the
district court dismissing the claims against the Company.
 
 On July
28, 2005, Jeffrey A. Leve and Jeffrey Leve Family Partnership, L.P. filed a new
lawsuit (the “new Leve
Lawsuit”) against the Company, Sunshine Wireless, LLC ("Sunshine"),
and four other defendants affiliated with Winstar Communications, Inc. (“Winstar”).
The new Leve Lawsuit attempts to collect a federal default judgment of
$5,014,000 entered against only two entities, i.e., Winstar Radio Networks, LLC
and Winstar Global Media, Inc., by attempting to enforce the judgment against a
number of additional entities who are not judgment debtors. Further, the new
Leve Lawsuit attempts to enforce the plaintiffs default judgment against
entities that were dismissed on the merits from the underlying action in which
plaintiffs obtained their default judgment. An unfavorable outcome in the
lawsuit may have a material adverse effect on the Company's business, financial
condition and results of operations.  The Company believes the lawsuit
is without merit and intends to vigorously defend itself.  These
condensed consolidated interim financial statements do not include any
adjustments for the possible outcome of this uncertainty.  On January
29, 2009 the Superior Court of California issued a preliminary ruling in the
Company’s favor.   On August 5, 2009, the Superior Court of
California, County of Los Angeles issued a Statement of Decision on the “new Leve
lawsuit” finding for the Company on all claims.
  16.
SUBSEQUENT EVENTS
 
 Private
Placement
 
 On July
29, 2009, the Company completed the first closing of a private placement of its
common stock.  The shares were issued and sold to accredited investors
who were holders of common stock warrants of the Company.  The shares
of common stock were issued at a per share price of $0.86, paid by cancellation
of the common stock warrants held by these holders, and in some cases an
additional cash contribution by the holders.
 
 Holders
not making a cash investment tendered warrants to purchase an aggregate of
1,774,994 shares of common stock and received an aggregate of 687,235 shares of
the Company’s common stock. Holders who elected to make a cash investment
tendered warrants to purchase an aggregate of 4,780,990 shares of common stock
and an aggregate of $1,511,727 in cash, and received an aggregate of 4,780,990 shares of the Company’s common stock.
 
 The
issuances of common stock solely in exchange of warrants were effected pursuant
to the terms and conditions set forth in an Exchange Agreement among the Company
and the applicable holders; the issuances of common stock in exchange for
warrants and cash were effected pursuant to the terms and conditions set forth
in a Purchase Agreement between the Company and the applicable
holders.
 
 Legal
Proceedings
 
 On August
5, 2009, the Superior Court of California, County of Los Angeles issued a
Statement of Decision on the “new Leve lawsuit” finding for the Company on all
claims..
 
 Annual
Meeting
 
 On August
6, 2009, the Company’s stockholders approved an amendment and restatement of the
Company charter to increase the number of authorized shares of Common Stock from
25 million to 100 million, and to eliminate classification of the Board of
Directors and provide for annual election of all directors.  The amendment
and restatement of the Company’s charter had not yet become effective as of
August 14, 2009.  The Company’s stockholders also approved the adoption of
the Company’s 2009 Stock Option Plan, pursuant to which options to purchase up
to 3,000,000 shares of Common Stock may be granted to officers, employees,
directors and consultants.
  16






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 financial statements and the
related notes thereto contained elsewhere in this Form 10-Q and the
description of our business appearing in our Annual report on  Form
10-K and amendments thereto.  This discussion contains forward-looking
statements that involve risks and uncertainties.  All statements
regarding future events, our future financial performance and operating results,
our business strategy and our financing plans are forward-looking
statements.  In many cases, you can identify forward-looking
statements by terminology, such as “may,” “should,” “expects,” “intends,”
“plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or
“continue” or the negative of such terms and other comparable
terminology.  These statements are only predictions.  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, the risk factors set
forth in Part I, Item 1A of our Form 10-K and elsewhere in this report on Form
10-Q.





The
following “Overview” section is a brief summary of the significant issues
addressed in Management’s Discussion and Analysis of Financial Condition and
Results of Operations (“MD&A”).  Investors
should read the relevant sections of the MD&A for a complete discussion of
the issues summarized below.  The entire MD&A should be read in
conjunction with Item 1 of Part I of this report, “Financial
Statements.”





Overview





Patient
Safety Technologies, Inc.("PST"or the"Company", “we”,
“us,and“our”)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.  SurgiCount’s Safety-SpongeTM System
is designed to reduce the number of retained sponges and towels unintentionally
left inside of  patients during surgical procedures by allowing faster
and more accurate counting of surgical sponges and towels. The SurgiCount
Safety-SpongeTMSystem
is a patented turn-key line of modified surgical sponges, SurgiCounterTM
scanners, and software file and database elements integrated to form a
comprehensive counting and documentation system.  Our business model
consists of selling our unique surgical sponge products and selling or renting
the scanners and software to hospitals.  We use an exclusive supplier
to manufacture our sponge products and we sell mainly through a direct sales
force for initial hospital use and through distributor organizations for the
ongoing supply of sponge products to customers.





The
Safety-SpongeTMSystem
works much like a grocery store checkout process: Every surgical sponge and
towel is affixed with a unique inseparable two-dimensional data matrix bar code
and is scanned with a SurgiCounter scanner to record the sponges at the initial
and final counts of a surgical procedure. Because each sponge is identified with
a unique code, a SurgiCounter will not allow the same sponge to be counted more
than once. When counts have been completed at the end of a procedure, the system
stores a documented electronic record of all sponges used and removed and that
can be printed or uploaded to a hospital electronic records system. The
Safety-SpongeTMSystem
is the first computer assisted sponge counting system to receive a Section
510(k) clearance from the US Food & Drug Administration.





Our
principal executive offices are located at 43460 Ridge Park Drive, Suite 140,
Temecula, CA 92590. Our telephone number is (951) 587-6201.




Revenue
and Expense Components





The
following is a description of the primary components of our revenues and
expenses:





Revenues.  We
derive our revenue primarily from the sale of our Safety-SpongeTM sponges and
surgical towels to our exclusive distributor who sells directly to and through
sub-distributors and from the sale of related hardware and software to
institutions.   Demand for our products is generated by our
direct sales force and independent distributors.  Our products are
typically ordered directly by the hospitals through distributors who ship and
bill directly. We expect that once a hospital adopts our system, it will be
committed to its use and, therefore, will provide a recurring source of revenues
for sales of Safety-SpongeTM supplies.




17




·
            Surgical Sponge
      Revenues:Revenues related to the sale of sponges are
      recognized in accordance with SAB 104.  Generally, revenues from
      the sale of sponges are recognized upon shipment to our distributors, as
      most sponge sales are  FOB shipping point.  When terms
      of the sale are FOB customer, revenue is recognized at the time delivery
      to the customer has been completed.





·
            Hardware, Software and
      Maintenance Agreement Revenues: For the hardware and software
      elements, revenues are recognized on delivery, considered to be at the
      time of shipment when terms are FOB shipping point, and upon receipt by
      the customer when terms of the sale are FOB destination.  As the
      software included in our scanners is not incidental to the product being
      sold, the sale of the software falls within the scope of SOP
      97-2.  The scanner is considered to be a software-related
      element, as defined in SOP 97-2, since the software is essential to the
      functionality of the scanner. The maintenance agreement, which provides
      for product support, including such 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 SOP
      97-2.  These items are considered to be separate deliverables
      within a multiple-element arrangement and, accordingly, the total price of
      this arrangement is allocated among each respective deliverable, and
      recognized as revenue as each element is delivered. 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; revenues related to
      this element are recognized on a pro-rata basis during this
      period.




SurgiCount
sells its products primarily through an exclusive Supply Agreement with Cardinal
Health 200, Inc. (“Cardinal”).  Pursuant to the agreement, Cardinal
acts as the main distributor of SurgiCount's products in the United
States.   Either we, or Cardinal Health, may terminate the
existing agreement in November 2009.  If that agreement is not
extended or replaced, with a successor agreement containing similar terms or
terms more favorable to the Company, termination of our relationship with
Cardinal could adversely impact our results of operations.  Ongoing
discussions are currently taking place on a successor agreement with Cardinal
and other national distributors, and management is cautiously optimistic that a
new agreement can be negotiated with terms equally favorable to the
Company.  Should a new contract not be executed with Cardinal or
another national distributor, the results could have a material impact on the
Company.  SurgiCount employs a direct sales force to secure initial
customer commitments from hospitals.





Cost of
revenues.  Cost of revenues consists of direct product costs of
our sponges and scanners shipped to customers from our contract manufacturers,
reserve expense for obsolete and slow moving inventory, and the travel and
salary expenses relating to the software upgrades performed on our scanners
under maintenance agreements.





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





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





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





Other income
(expense).  Total other income (expense) includes interest
income, interest expense, change in fair value of warrant liability, realized
gain (loss) on assets held for sale and unrealized loss on assets held for
sale.





Income tax (benefit)
provision.  The income tax (benefit) expense consists primarily
of incomes taxes and the tax effect of changes in deferred tax liabilities
associated with goodwill.





18





Critical
accounting policies and estimates





The
following discussion and analysis of our financial condition and results of
operations is based upon the accompanying financial statements.  The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements.  Critical accounting policies are those that are both
important to the presentation of our financial condition and results of
operations and require management's most difficult, complex, or subjective
judgments, often as a result of the need to make estimates of matters that are
inherently uncertain.  Our most critical accounting policies relate to
revenue recognition as described under Revenue and Expense Components above,
valuation of warrant derivative liability, valuation of our intangible assets,
stock based compensation and impairment of long-lived assets and intangibles.





Warrant
Derivative Liability





The
Company accounts for warrants issued in connection with financing arrangements
in accordance with EITF Issue No 07-5, Determining whether an Instrument
(or Embedded Feature) is indexed to an Entity’s own Stock (“EITF 07-05”)
and pursuant to EITF Issue No. 00-19, Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock (“EITF
00-19”).  Pursuant to EITF 07-5, a two-step model is applied in
determining whether a financial instrument or an embedded feature is indexed to
an issuer’s own stock and is thus able to qualify for an exemption from
derivative liability classification provided for under the scope exception in
SFAS No. 133.  The estimated fair value of warrants classified as
derivative liabilities is determined using the Black-Scholes option pricing
model.  The fair value of warrants classified as derivative
liabilities is adjusted for changes in fair value at each reporting period, and
the corresponding non-cash gain or loss is recorded in current period
earnings.  There is no limit on the number of times a contract may be
reclassified.





Pursuant
to EIFT 00-19, an evaluation of specifically identified conditions is made to
determine whether warrants issued are required to be classified as either equity
or a liability.  If the classification required under EITF 00-19
changes as a result of events during a reporting period, the instrument is
reclassified as of the date of the event that caused the
reclassification.  In the event that this evaluation results in a
partial reclassification, our policy is to first reclassify warrants with the
latest date of issuance.





Valuation
of Intangible Assets





We assess
the impairment of intangible assets annually or when events or changes in
circumstances indicate that the carrying value of the assets or the asset
grouping may not be recoverable.  Factors that we consider in deciding when
to perform an impairment review include significant under-performance of a
product line in relation to expectations, significant negative industry or
economic trends, and significant changes or planned changes in our use of the
assets.  Recoverability of intangible assets that will continue to be used
in our operations is measured by comparing the carrying amount of the asset
grouping to our estimate of the related total future net cash flows.  If an
asset grouping’s carrying value is not recoverable through the related cash
flows, the asset grouping is considered to be impaired.  The impairment is
measured by the difference between the asset grouping’s carrying amount and its
fair value, based on the best information available, including market prices or
discounted cash flow analysis.  Impairments of intangible assets are
determined for groups of assets related to the lowest level of identifiable
independent cash flows.  Due to our limited operating history and the early
stage of development of some of our intangible assets, we must make subjective
judgments in determining the independent cash flows that can be related to
specific asset groupings.  To date we have not recognized impairments
on any of our intangible assets related to the Safety SpongeTM
System.





Stock-Based
Compensation





We have
adopted the provisions of SFAS No. 123(R), Share-Based Payment. The fair
value of each option grant, non-vested stock award and shares issued under the
employee stock purchase plan were estimated on the date of grant using the
Black-Scholes option pricing model and various inputs to the model. Expected
volatilities were based on historical volatility of our stock. The expected term
represents the period of time that grants and awards are expected to be
outstanding. The risk-free interest rate approximates the U.S. treasury
rate corresponding to the expected term of the option, and dividends were
assumed to be zero. These inputs are based on our assumptions, which include
complex and subjective variables. Other reasonable assumptions could result in
different fair values for our stock-based awards.
  19





Stock-based
compensation expense, as determined using the Black-Scholes option pricing
model, is recognized on a straight line basis over the service period, net of
estimated forfeitures.  Forfeiture estimates are based on historical
data. To the extent actual results or revised estimates differ from the
estimates used; such amounts will be recorded as a cumulative adjustment in the
period that estimates are revised.





Impairment
of Long-Lived Assets and Intangibles





In
accordance with SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets, we test long-lived assets with finite
lives for impairment whenever events or changes in circumstances indicate that
their carrying value may not be recoverable.  A significant decrease
in the fair value of a long-lived asset, an adverse change in the extent or
manner in which a long-lived asset is being used or in its physical condition or
an expectation that a long-lived asset will be sold or disposed of significantly
before the end of its previously estimated life are among several of the factors
that could result in an impairment charge.





We
measure recoverability of assets to be held and used in operations by a
comparison of the carrying amount of an asset to the future net cash flows,
expected to be generated, by the assets.  If such assets are
considered to be impaired, we measure the impairment to be recognized by the
amount by which the carrying amount of the assets exceeds the fair value of the
assets.  Assets to be disposed of are reported at the lower of the
carrying amount or fair value less selling costs.





Recent
Accounting Pronouncements





In
September 2006, the Financial Accounting Standards Board (“FASB”)
issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements
(“SFAS
157”). This statement defines fair value, establishes a framework for
measuring fair value in U.S. GAAP, and expands disclosures about fair value
measurements.  This statement applies in those instances where other
accounting pronouncements require or permit fair value measurements and the
board of directors has previous concluded in those accounting pronouncements
that fair value is the relevant measurement attribute.  Accordingly,
this statement does not require any new fair value
measurements.  However for some entities, the application of this
Statement will change the current practice.  In February 2008, the
FASB issued FSP FAS 157-2 which defers the effective date of SFAS 157 for all
non-financial assets and liabilities, except those items recognized or disclosed
at fair value on an annual or more frequent recurring basis until years
beginning after November 15, 2008.   Our adoption of SFAS 157 for
its financial assets and liabilities on January 1, 2008 and FSP FAS 157-2 for
our non-financial assets and liabilities on January 1, 2009 did not have a
material impact on the Company’s consolidated financial statements.





In
December 2007, the FASB issued Statement of Financial Accounting Standards No.
141(R), Business Combinations(“SFAS 141(R)”).  This statement requires the acquiring entity
in a business combination to record all assets acquired and liabilities assumed
at their respective acquisition-date fair values, changes the recognition of
assets acquired and liabilities assumed arising from contingencies, changes the
recognition and measurement of contingent consideration, and requires the
expensing of acquisition-related costs as incurred.  SFAS 141(R) also
requires additional disclosure of information surrounding a business
combination, such that users of the entity's financial statements can fully
understand the nature and financial impact of the business
combination.  Our adoption of SFAS No. 141(R) on January 1, 2009 did
not have a material impact on the Company’s consolidated
statements.




In
December 2007, the FASB issued Statement of Financial Accounting Standards No.
160; Noncontrolling Interests
in Consolidated Financial Statementsan amendment of ARB5 (“SFAS
160”).  SFAS 160 establishes accounting and reporting standards for
ownership interests in subsidiaries held by parties other than the parent, the
amount of consolidated net income attributable to the parent and to the
noncontrolling interest, changes in a parent's ownership interest and the
valuation of retained noncontrolling equity investments when a subsidiary is
deconsolidated. SFAS 160 also established reporting requirements that provide
sufficient disclosures that clearly identify and distinguish between the
interests of the parent and the interests of the noncontrolling owner. Our
adoption of SFAS No. 160 on January 1, 2009 did not have a material impact on
our consolidated financial statements.




20





In
March 2008, the FASB issued Statement of Financial Accounting Standards
No. 161, Disclosures
about Derivative Instruments and Hedging Activities—an amendment of FASB
Statement No. 133 (“SFAS 161”).  The standard requires
additional quantitative disclosures (provided in tabular form) and qualitative
disclosures for derivative instruments.  The required disclosures
include how derivative instruments and related hedged items affect an entity’s
financial position, financial performance, and cash flows; relative volume of
derivative activity; the objectives and strategies for using derivative
instruments; the accounting treatment for those derivative instruments formally
designated as the hedging instrument in a hedge relationship; and the existence
and nature of credit-related contingent features for
derivatives.  SFAS No. 161 does not change the accounting
treatment for derivative instruments.  Our adoption of SFAS
No. 161 on January 1, 2009 did not have a material impact on our
consolidated financial statements.





In April
2008, the FASB issued FSP FAS 142-3, Determination of Useful Life of
Intangible Assets (“FSP FAS 142-3”).  FSP FAS 142-3 amends the
factors that should be considered in developing the renewal or extension
assumptions used to determine the useful life of a recognized intangible asset
under FAS 142, “Goodwill and Other Intangible Assets.”  FSP FAS 142-3
also requires expanded disclosure related to the determination of intangible
asset useful lives.  FSP FAS 142-3 is effective for fiscal years
beginning after December 15, 2008.  Earlier adoption is not
permitted.  Our adoption of FSP FAS 142-3 on January 1, 2009 did not
have a material impact on our consolidated financial statements.





In May
2008, the FASB issued FASB Staff Position APB 14-1, Accounting for Convertible Debt
Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash
Settlement) (“FSP APB 14-1”)  FSP APB 14-1 requires recognition
of both the liability and equity components of convertible debt instruments with
cash settlement features.  The debt component is required to be
recognized at the fair value of a similar instrument that does not have an
associated equity component.  The equity component is recognized as
the difference between the proceeds from the issuance of the note and the fair
value of the liability.  FSP APB 14-1 also requires an accretion of
the resulting debt discount over the expected life of the
debt.  Retrospective application to all periods presented is required
and a cumulative-effect adjustment is recognized as of the beginning of the
first period presented.  This standard is effective for fiscal years
beginning after December 15, 2008.  Our adoption of FSP APB 14-1 on
January 1, 2009 did not have a material impact on our consolidated financial
statements.





In June
2008, the FASB issued FSP No. EITF 03-6-1, Determining Whether Instruments
Granted in Share-Based Payment Transactions Are Participating Securities,
which requires entities to apply the two-class method of computing basic and
diluted earnings per share for participating securities that include awards that
accrue cash dividends (whether paid or unpaid) any time common shareholders
received dividends and those dividends do not need to be returned to the entity
if the employee forfeits the award.  FSP EITF 03-6-1 became effective
for the Company on January 1, 2009 and will require retroactive
disclosure.  The adoption of EITF 03-6-1 did not have a material
impact on our consolidated financial statements.





In June
2008, the FASB ratified EITF Issue No. 07-5, “Determining whether an Instrument
(or Embedded Feature) is indexed to an Entity’s own Stock”(“EITF
07-5).  EITF 07-5 is effective for financial statements issued for
fiscal years beginning after December 15, 2008, and interim periods within those
fiscal years.   Early application is not
permitted.  Paragraph 11(a) of SFAS No. 133 – specifies that a
contract that would otherwise meet the definition of a derivative but is both
(a) indexed to the Company’s own stock and (b) classified in stockholders’
equity in the statement of financial position would not be consider a derivative
financial instrument.  EITF 07-5 provides a new two-step model to be
applied in determining whether a financial instrument or an embedded feature is
indexed to an issuer’s own stock and thus able to qualify for the SFAS No. 133
paragraph 11(a) scope exception.  The Company’s adoption of EITF 07-05
effective January 1, 2009, resulted in the identification of certain warrants
that were determined to be ineligible for equity classification because of
certain provisions that may result in an adjustment to their exercise
price.  Accordingly, these warrants were reclassified as liabilities
upon the effective date of EITF 07-05 and re-measured at fair value as of June
30, 2009 with changes in the fair value recognized in other income for the
quarter ended June 30, 2009 (See Note 12).




21





In April
2009, the FASB issued FSP SFAS No. 157-4, “Determining Fair Value When the
Volume and Level of Activity for the Asset or Liability Have Significantly
Decreased and Identifying Transactions That Are Not Orderly” (“FSP SFAS
No. 157-4”). FSP SFAS No. 157-4 provides additional guidance for
estimating fair value in accordance with FASB Statement No. 157 Fair Value
Measurements, when the volume and level of activity for the asset or liability
have significantly decreased. FSP SFAS No. 157-4 also includes guidance on
identifying circumstances that indicate a transaction is not orderly. This FSP
emphasizes that even if there has been a significant decrease in the volume and
level of activity for the asset or liability and regardless of the valuation
technique(s) used, the objective of a fair value measurement remains the same.
Fair value is the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction (that is, not a forced
liquidation or distressed sale) between market participants at the measurement
date under current market conditions. This statement is effective for interim
and annual reporting periods ending after June 15, 2009. The adoption of
this pronouncement during the quarter ended June 30, 2009 did not have a
material effect on the Company’s financial statements.





In April
2009, the FASB issued FSP FAS No. 107-1 and APB 28-1, “Interim Disclosures
about Fair Value of Financial Instruments” (“FSP FAS No. 107-1”). FSP FAS
No. 107-1 amends SFAS No. 107, “Disclosures about Fair Value of
Financial Instruments”, to require disclosures about fair value of financial
instruments for interim reporting periods of publicly traded companies as well
as in annual financial statements. FSP FAS No. 107-1 also amends APB
Opinion No. 28, “Interim Financial Reporting”, to require those disclosures
in summarized financial information at interim reporting periods. This statement
became effective for interim and annual reporting periods ending after
June 15, 2009. The adoption of this pronouncement during the quarter ended
June 30, 2009 did not have a material effect on the Company’s financial
statements.





In May
2009, the FASB issued SFAS No. 165, “Subsequent Events” (“SFAS No. 165”).
SFAS No. 165 establishes general standards of accounting for and disclosure of
events that occur after the balance sheet date but before financial statements
are issued or are available to be issued. SFAS No. 165 was effective for fiscal
years and interim periods ending after June 15, 2009. The adoption of this
pronouncement during the quarter ended June 30, 2009 did not have a material
effect on the Company’s financial statements.





The
Company has evaluated subsequent events that occurred after June 30, 2009,
through August 14, 2009, the date the Company’s financial statements were
issued.  During this period, we did not have any material subsequent events that required recognition or disclosure in our
June 30, 2009 financial statements. See Note 16 for disclosure related to
unrecognized subsequent events.




In June
2009, through the issuance of SFAS No. 168, “The FASB Accounting Standards
Codification and the Hierarchy of Generally Accepted Accounting Principles, the
FASB confirmed that the FASB Accounting Standards Codification (the
“Codification”) will become the single official source of authoritative U.S.
generally accepted accounting principles (“US GAAP”)(other than guidance issued
by the SEC), superseding existing FASB, American Institute of Certified Public
Accountants, EITF, and related literature. After the effective date of the
Codification, only one level of authoritative US GAAP  will
exist. All other literature will be considered non-authoritative. The
Codification does not change US GAAP; instead, it introduces a new structure
that is organized in an easily accessible, user-friendly online research system.
The Codification becomes effective for interim and annual periods ending on or
after September 15, 2009. The Company will apply the Codification beginning
in the quarter ending September 30, 2009. The adoption of the Codification will
not have an effect on the Company’s financial statements, but will impact the
Company’s future financial statement disclosures since all future references to
authoritative accounting literature will be referenced in accordance with the
Codification.





22




Results
of Operations





Revenues





We
recognized revenues of $1.0 million and $557 thousand for the three months ended
June 30, 2009 and 2008, respectively.  Revenues during the three
months ended June 30, 2009 consisted of Safety-SpongeTM sales
of $993 thousand and sales of hardware and supplies of $35
thousand.  Revenues during the three months ended June 30, 2008
consisted of Safety-SpongeTM sales
of $547 thousand and sales of hardware and supplies of $10
thousand.





We
recognized revenues of $2.0 million and $1.1 million for the six months ended
June 30, 2009 and 2008, respectively.  Revenues during the six months
ended June 30, 2009 consisted of Safety-SpongeTM sales
of $1.7 million and sales of hardware and supplies of $241
thousand.  Revenues during the six months ended June 30, 2008
consisted of Safety-SpongeTM sales
of $951 thousand and sales of hardware and supplies of $106
thousand





We
attribute the significant increase in sales generated by our Safety-SpongeTM System
to increased product awareness and demand.  Several major institutions
have adopted the Safety-SpongeTM System
over the past 12 months and we expect this trend to continue.





Cost
of revenues





Cost of
revenues increased by $293 thousand, or 90%, to $619 thousand for the three
months ended June 30, 2009 from $326 thousand for the same period in
2008.  This reflects an increase in sales of our Safety-SpongeTM System
and a reserve account for obsolete and slow moving inventory in the amount of
$106 thousand.





Cost of
revenues increased $448 thousand, or 62%, to $1.2 million for the six months
ended June 30, 2009 from $719 thousand for the same period in
2008.  This reflects an increase in sales of our Safety-SpongeTM System
and a reserve account for obsolete and slow moving inventory in the amount of
$106 thousand.


Gross
profit





For the
three months ended June 30, 2009, our gross profit increased by $178 thousand or
77%, to $409 thousand from $231 thousand for the same period in
2008.  Our gross margin percentage was 40% for the three months ended
June 30, 2009, compared to 41% for the same period in 2008.  The
decrease in gross profit was primarily the result of  an inventory
reserve for obsolete inventory in the 2009 period.





For the
six months ended June 30, 2009, our gross profit increased by $458 thousand or
136% to $796 thousand from $338 thousand for the same period in
2008.  Our gross margin percentage was 41% for the six months ended
June 30, 2009, compared to 32% for the same period in 2008.  The
increase in gross margin percentage was primarily of increased sales of our
Safety-SpongeTM System in the 2009 period and a write off for obsolete inventory
in the 2008 period and discounts provided in connection with hardware sales
during that period.





Research
and development





Research
and development expenses were $86 thousand and $38 thousand, respectively, for
the three month period ended June 30, 2009 and June 30, 2008.  The
additional expense is primarily due to an increase in software development costs
associated with our system hardware.





Research
and development costs were $199 thousand and $81 thousand, respectively, for the
six month period  ended June 30, 2009 and June 30,
2008.  The additional expense is also primarily due to an increase in
software development costs.





Sales
and marketing


We had
sales and marketing expenses of $553 thousand and $682 thousand, respectively,
for the three month period ended June 30, 2009 and June 30, 2008.  The
decrease is primarily due to a decrease in new hospital placements in the 2009
period compared to the comparable 2008 period,  as well as the
associated consulting and travel expenses.




23





We had
sales and marketing expenses of $1.2 million and $1.1 million, respectively, for
the six month period ended June 30, 2009 and June 30, 2008.  The
increase is primarily due to the addition of sales and clinical representatives
in the field and the associated salary, commission, benefits and travel
expenses, partially offset by a decrease in implementation costs and related
expenses for the three month period ended June 30, 2009.





General
and administrative





General
and administrative costs were $1.4 million and $1.7 million, respectively, for
the three month period ended June 30, 2009 and June 30, 2008.  The
decrease is primarily due to a decrease in stock based compensation expense and
legal fees.





General
and administrative costs were $3.9 million and $2.7 million, respectively, for
the six month period ended June 30, 2009 and June 30, 2008.  The
increase is primarily due to warrant expense of $1.3 million for the six months
ended June 30, 2009.





Total
other income (expense), net





Total
other expenses  were $2.4 million and  $256 thousand,
respectively, for the three month period ended June 30, 2009 and June 30,
2008.  This increase was mainly due to an increase in the fair market
value of our warrant derivative liability resulting in an expense  of
$2.2 million and the increase in interest expense due to the  increase
in our long term debt in early 2009 and an associated increase in debt discount
amortization resulting in an expense of $220 thousand for the three month period
ended June 30,2009.





Total
other expenses were $3.0 million and $433 thousand, respectively, for the six
month period ended June 30, 2009 and June 30, 2008.  This increase was
mainly due to an increase in the fair market value of our warrant derivative
liability resulting in an expense of $2.6 million and the increase in interest
expense due to the increase in our long term debt in early 2009 and an
associated increase in debt discount amortization resulting in an expense of
$440 thousand for the six month period ended June 30, 2009.





Income
tax benefit.





We
recorded a tax benefit of $31 thousand for the three months ended June 30, 2009
compared to $32 thousand for the three months ended June 30, 2008.  We
recorded a tax benefit of $65 thousand for the six months ended June 30, 2009
and 2008, respectively.





As of
December 31, 2008, we had net operating loss carryforward of approximately $30
million to offset future taxable income for federal income tax
purposes.  The future utilization of the loss carryforwards to reduce
any future income taxes will depend on our ability to generate sufficient
taxable income prior to the expiration of the net operating loss
carryforwards.  In addition, the future utilization of loss
carryforwards may be subject to an annual limitation as a result of ownership
changes that may have occurred previously or that could occur in the
future.  The loss carryforwards begin expiring in 2016.





Financial
Condition, Liquidity and Capital Resources





Our
principal sources of cash have included the issuance of equity and debt
securities.  Principal uses of cash have included cash used in
operations, capital expenditures and working capital.  We expect that
our principal uses of cash in the future will be for operations, working
capital, capital expenditures and research and development.  We expect
that, as our revenues grow, our sales and marketing and research and development
expenses will continue to grow and, as a result, we will need to generate
significant net revenues to achieve profitability.  We do not believe
that our current cash and cash equivalents will be adequate to fund our
projected operating requirements.  In order to ensure the continued
viability of the Company, additional financing must be obtained and profitable
operations must be achieved in order to repay our existing short-term and
long-term debt and to provide a sufficient source of operating
capital.  The sale of additional equity or convertible debt securities
could result in dilution to our stockholders.    Additional
financing may not be available in amounts or on terms reasonably acceptable to
us, if at all.  If we are unable to obtain this additional financing,
the absence of capital will have a material adverse impact on our business and
operations by year-end 2009.




24





As of
June 30, 2009 we had a working capital deficit of approximately $12.5 million,
of which $8.6 million is associated with our warrant derivative
liability.





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





Operating
activities





We used
net cash of $2.0 million in operating activities for the six months ended June
30, 2009.  During this period, net cash used in operating activities
primarily consisted of a net loss of $7.5 million,  an increase in
inventory of $563 thousand and an increase in accrued liabilities of $157
thousand, offset by a $2.6 million non-cash, unrealized loss on our warrant
derivative liability caused by an increase in the market value of our common
stock, $1.3 million non-cash expense related to the issuance of warrants, an
increase in accounts payable of $860 thousand, amortization and depreciation
expense of $332 thousand, amortization of debt discount of $247 thousand, stock
based compensation of $572 thousand, and a decrease of $231 thousand in accounts
receivable.





We used
net cash of $2.5 million in operating activities for the six months ended June
30, 2008.  During this period net cash used in operating activities
primarily consisted of a net loss of $4.0 million,  a $116 thousand
increase in account receivable and a $467 thousand increase in prepaid expenses,
offset by amortization and depreciation of $325 thousand, stock based
compensation of $1.0 million, $168 thousand non-cash, unrealized loss $2.2
million on our warrant derivative liability caused by an increase in the market
value of our common stock, a $317 thousand increase in accounts payable and $250
thousand increase in accrued liabilities.





Investing
activities





We used
net cash of $14 thousand in investing activities for the six months ended June
30, 2009, primarily for the purchase of computer hardware and related
software.





We used
net cash of $38 thousand in investing activities for the six months ended June
30, 2008, primarily consisting of $264 thousand used in the ongoing development
of purchased software related to our Safety-SpongeTMSystem,
partially offset by $226 thousand received from the sale of undeveloped land in
Alabama.





Financing
activities





We
generated net cash of $2.0 million from financing activities during the six
months ended June 30, 2009, primarily from net proceeds from the issuance of
debt and warrants of $2.6 million, offset by repayments of notes payable of $550
thousand and preferred stock dividends of $19 thousand.





We
generated net cash of $2.6 million from financing activities during the six
months ended June 30, 2008, primarily from net proceeds of $2.2 million from the
issuance of common stock and warrants and net proceeds from short-term debt
financings of $500 thousand, offset by the repayment of a promissory note of
$101 thousand and payment of preferred stock dividends of $38
thousand.





2008
Private Placements





During
the period May 20, 2008 to August 29, 2008, we sold $5.1 million in equity
securities to accredited investors in a series of private
placements.





During
that period, the Company entered into securities purchase agreements with
several accredited investors, in private placements exempt from the registration
requirements of the Securities Act and issued and sold to these investors an
aggregate of 4.1 million shares of its common stock and warrants to purchase an
additional 2.5 million shares of its common stock.





25





Promissory
Notes





On
January 29, 2009, the Company entered into a Senior Secured Note and Warrant
Purchase Agreement, pursuant to which, the Company sold Senior Secured
Promissory Notes (the “Notes”) in the principal
amount of $2.6 million and warrants to purchase 1.5 million shares of the
Company’s common stock (the “Warrants”), to several
accredited investors (the “Investors”).  The Investors paid $2.0
million in cash and converted $550 thousand of existing debt and accrued
interest into the new Notes.   The Notes accrue interest at 10%
per annum and unless earlier converted into equity, have a maturity date of
January 29, 2011.  The Warrants have an exercise price of $1.00 and
expire on January 29, 2014.





At June
30, 2009 we had additional outstanding promissory notes in the aggregate
principal amount of $600 thousand and convertible debt instruments in the amount
of $1.5 million as detailed below:





On
      May 1, 2006, Herbert Langsam, a Director of the Company, loaned the
      Company $500 thousand. The loan is documented by a $500 thousand Secured
      Promissory Note (the “Langsam
      Note”) payable to the Herbert Langsam Irrevocable Trust. The
      Langsam Note accrues interest at the rate of 12% per annum and had a
      maturity date of November 1, 2006. This note was not repaid by the
      scheduled maturity and to date has not been extended, therefore the
      Langsam Note is recorded in current liabilities. Accordingly, the note is
      currently in default and therefore accruing interest at the rate of 16%
      per annum. Pursuant to the terms of a Security Agreement dated May 1,
      2006, the Company granted the Herbert Langsam Revocable Trust a security
      interest in all of the Company’s assets as collateral for the satisfaction
      and performance of the Company’s obligations pursuant to the Langsam
      Note.





On
November 13, 2006, Mr. Langsam loaned the Company an additional $100 thousand.
The loan is documented by a $100 thousand Secured Promissory Note (the “Second Langsam
Note”) payable to the Herbert Langsam Irrevocable Trust. The Second
Langsam Note accrues interest at the rate of 12% per annum and had a maturity
date of May 13, 2007. The Company is in the process of restructuring the debt
that is owed to Mr. Herbert Langsam. Mr. Langsam received warrants to purchase
50 thousand shares of the Company’s common stock at an exercise price of $1.25
per share as additional consideration for entering into the loan agreement. The
Company recorded debt discount in the amount of $17 thousand as the estimated
value of the warrants. The debt discount was amortized as non-cash interest
expense over the original term of the debt using the effective interest
method.  Pursuant to the terms of a Security Agreement dated November
13, 2006, the Company granted the Herbert Langsam Revocable Trust a security
interest in all of the Company’s assets as collateral for the satisfaction and
performance of the Company’s obligations pursuant to the Second Langsam
Note.





On
December 29, 2008 Mr. Langsam received 25 thousand shares of the Company’s
common stock to extend the maturity dates of both loans to June 30,
2009.  The Company is currently in negotiations with Mr. Langsam, and
the parties have reached an agreement to extend the maturity date of his notes
from June 30, 2009 to December 31, 2009, in consideration of issuance, by the
Company, of 25,000 shares of its common stock.   The agreement
has been approved by the audit committee and ratified by the executive
committee.


On
September 5, 2008, the Company entered into an Amendment and Early Conversion of
the Secured Convertible Promissory Note (the“Amendment”) with Ault Glazer Capital
Partners, LLC (“AG Capital
Partners”).  The Amendment
allowed for the conversion, prior to the maturity date, of the outstanding
principal balance of this Note into 1.3 million shares of Patient Safety common
stock and $450 thousand in cash prepayments.  According to the
Amendment, after the prepayments were made, the Note could be converted into 1.3
million shares of common stock upon AG Capital Partners’ satisfaction of certain
conditions.





On
September 12, 2008, the parties executed an Agreement for the Advancement of
Common Stock Prior to close of the Amendment and Early Conversion of Secured
Convertible Promissory Note, with AG Capital Partners.





AG
Capital Partners failed to satisfy the conditions by the deadline stated in the
Amendment.  Although the conditions remained unsatisfied, the Company
made two additional issuances of shares to AG Capital Partners pursuant to the
Amendment.  The Company issued another 250 thousand shares on October
10, 2008 and another 250 thousand shares on November 6,
2008.   As of this date, there remain 500 thousand shares
issuable to AG Capital Partners upon meeting the conditions of the
Amendment.





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





26




Item
3.  Quantitative and Qualitative Disclosures About Market
Risk.





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





Item
4T.  Controls and Procedures.





Limitations
on the Effectiveness of Controls





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





Management’s
Report on Internal Control Over Financial Reporting





Evaluation
of Disclosure Controls and Procedures





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





Based
upon that evaluation, our chief executive officer and chief financial officer
concluded that, as of the end of the period covered by this report, our
disclosure controls and procedures were effective at the reasonable
assurance level discussed above and that the previously identified material
weaknesses have been fully addressed as of June 30, 2009.





27





A
material weakness is a deficiency, or a combination of deficiencies, in internal
control over financial reporting, such that there is a reasonable possibility
that a material misstatement of the Company’s annual or interim financial
statements will not be presented or detected on a timely basis.





The
following previously identified material weaknesses have been addressed, but
complete testing, of the controls implemented, has not yet been complete as of
June 30, 2009:





1.
            The
      Company’s General Control Environment was ineffective due to the following
      identified weaknesses:





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


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


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





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





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





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





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





28




Changes
in Internal Control over Financial Reporting





We have
made the following changes during our most recently completed fiscal quarter
that have materially affected, or are reasonably likely to materially affect,
our internal control over financial reporting, as defined in
Rules 13a-15(f) and 15d-15(f) under the Exchange
Act.





To
correct weaknesses identified in the Company’s General Control Environment, the
board of directors has hired a new Chief Executive Officer and has restructured
the board to include a financial expert and a corporate governance expert, both
of whom are independent directors. In addition, the Company
has  established an oversight committee to review and monitor
managements’ business practices.





To
address the weaknesses identified relating to equity transactions, the Company
has implemented a software program specifically designed to track and account
for share-based payments and equity transactions.  In addition, the
Company has engaged an internal control specialist to design and help implement
effective risk assessment processes.




PART
II – OTHER INFORMATION





Item
1.  Legal Proceedings.





On August
5, 2009, the Superior Court of California, County of Los Angeles issued a
Statement of Decision on the “new Leve lawsuit” finding for the Company in all
claims..





Item
1A.  Risk Factors.





There
have been no material changes from risk factors previously disclosed in
Item 1A included in our Form 10-K





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





On
January 29, 2009, the Company entered into a Senior Secured Note and Warrant
Purchase Agreement, pursuant to which, the Company sold Senior Secured
Promissory Notes (the “Notes”) in the principal
amount of $2.6 million and warrants to purchase 1.5 million shares of the
Company’s common stock (the “Warrants”) to several
accredited investors (the “Investors”).  The
Investors paid $2.0 million in cash and converted $550 thousand of existing debt
and accrued interest into the new Notes.   The Notes accrue
interest at 10% per annum, throughout the term of the notes, unless earlier
converted into a equity.  The Notes, have a maturity date of January
29, 2011.  The Warrants have an exercise price of $1.00 and expire on
January 29, 2014.We
intend to use the net proceeds from this transaction primarily for general
corporate purposes and repayment of existing liabilities. These securities were
sold in reliance upon the exemption provided by Section 4(2) of the Securities
Act and the safe harbor of Rule 506 under Regulation D promulgated under the
Securities Act.  No advertising or general solicitation was employed
in offering the securities, the sales were made to a limited number of persons,
all of whom represented to the Company that they are accredited investors, and
transfer of the securities is restricted in accordance with the requirements of
the Securities Act.





Pursuant
to the employment agreement entered into with David Bruce on January 5, 2009,
the Company granted stock options to purchase 2,000,000 shares of the Company’
common stock.  The exercise price of the options is the average
selling price of the Company’s common stock on the date of grant, which was
$0.75.  Upon the six-month anniversary of the effective date of the
employment agreement, 250,000 options were to vest and become exercisable and
thereafter, the remaining shares were to vest over a forty-two month period at
the rate of 1/48th of the
total shares per month.  Mr. Bruce resigned from the Company effective
May 6, 2009 and all stock options granted were cancelled on the date of
termination.




29





The board
of directors also approved a stock option grant to purchase 750,000 shares of
the Company’s common stock for Brian Stewart, relating to his employment with
the Company.  The options were granted on January 5, 2009, Mr.
Stewart’s date of hire.  The exercise price of the options is the
average selling price of the Company’s common stock on the date of grant, which
was $0.75.  Upon the six-month anniversary of the effective date of
the employment agreement, 93,750 s options shall vest and become exercisable and
thereafter, the remaining shares will vest over a forty-two month period at the
rate of 1/48th of the
total shares per month.





Pursuant
to the employment agreement entered into with Steven Kane as Chief Executive
Officer on May 7, 2009, the Company granted stock options to purchase 2,000,000
shares of the Company’ common stock.  The exercise price of the
options is the average selling price of the Company’s common stock on the date
of grant, which was $0.75.  Upon the six-month anniversary of the
effective date of the employment agreement, 250,000 options shall vest and
become exercisable and thereafter, the remaining options will vest over a
forty-two month period at the rate of 1/48th of the
total shares per month.





The board
of directors granted stock options to purchase 200,000 shares of the Company’s
common stock to each of Loren McFarland and Howard Chase on June 22, 2009 in
connection with their joining the Board of Directors.  The exercise
price of the options is the average selling price of the Company’s common stock
on the date of grant, which was $0.99.  All Options were fully
exercisable upon grant.




Item 3.  Defaults Upon
Senior Securities.





The
Company is currently in negotiations with Herbert Langsam, and the parties have
reached an agreement to extend the maturity date of his notes from June 30, 2009
to December 31, 2009, in consideration of issuance, by the Company, of 25,000
shares of its common stock.   The agreement has been approved by
the audit committee and ratified by the executive committee.





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





None.





Item
5.  Other Information.





None.




30





Item
6.  Exhibits.





Exhibit
      Number
            
            Description4.01
            
            Form
      of Securities Purchase Agreement entered into May 20, 2008 between Patient
      Safety Technologies, Inc. and several accredited investors (Incorporated
      by reference to the Company’s current report on Form 8-K filed with the
      Securities and Exchange Commission on June 2, 2008)4.02
            
            Form
      of Registration Rights Agreement entered into May 20, 2008 between Patient
      Safety Technologies, Inc. and several accredited investors (Incorporated
      by reference to the Company’s current report on Form 8-K filed with the
      Securities and Exchange Commission on June 2, 2008)4.03
            
            Form
      of Warrant Agreement entered into May 20, 2008 between Patient Safety
      Technologies, Inc. and several accredited investors (Incorporated by
      reference to the Company’s current report on Form 8-K filed with the
      Securities and Exchange Commission on June 2, 2008)4.04
            
            Form
      of Securities Purchase Agreement entered into August 1, 2008 between
      Patient Safety Technologies, Inc. and several accredited investors
      (Incorporated by reference to the Company’s current report on Form 8-K
      filed with the Securities and Exchange Commission on August 14,
      2008)4.05
            
            Form
      of Registration Rights Agreement entered into August 1, 2008 between
      Patient Safety Technologies, Inc. and several accredited investors
      (Incorporated by reference to the Company’s current report on Form 8-K
      filed with the Securities and Exchange Commission on August 14,
      2008)4.06
            
            Form
      of Warrant Agreement entered into August 1, 2008 between Patient Safety
      Technologies, Inc. and several accredited investors (Incorporated by
      reference to the Company’s current report on Form 8-K filed with the
      Securities and Exchange Commission on August 14, 2008)4.07
            
            Form
      of Warrant Agreement entered into January 29, 2009 between Patient Safety
      Technologies, Inc. and several accredited investors (Incorporated by
      reference to the Company’s current report on Form 8-K filed with the
      Securities and Exchange Commission on February 3, 2009)10.01
            
            Form
      of Senior Secured Note and Warrant Purchase Agreement entered into January
      29, 2009 between Patient Safety Technologies, Inc. and several accredited
      investors (Incorporated by reference to the Company’s current report on
      Form 8-K filed with the Securities and Exchange Commission on February 3,
      2009)10.02
            
            Form
      of Senior Secured Note issued January 29, 2009 by Patient Safety
      Technologies, Inc. to several accredited investors (Incorporated by
      reference to the Company’s current report on Form 8-K filed with the
      Securities and Exchange Commission on February 3, 2009)10.03
            
            Form
      of Security Agreement entered into January 29, 2009 between Patient Safety
      Technologies, Inc. and several accredited investors (Incorporated by
      reference to the Company’s current report on Form 8-K filed with the
      Securities and Exchange Commission on February 3, 2009)10.04
            
            Employment
      Agreement dated January 5, 2009 between Patient Safety Technologies, Inc.
      and David Bruce.10.05*
            
            Separation
      and General Release Agreement dated May 6, 2009 between Patient Safety
      Technologies, Inc. and David Bruce.10.06*
            
            Employment
      Agreement dated May 7, 2009 between Patient Safety Technologies, Inc. and
      Steven H. Kane.31.1*
            
            Certification
      of Chief Executive Officer required by Rule 13a-14(a) or Rule
      15d-14(a)31.2*
            
            Certification
      of Chief Financial Officer required by Rule 13a-14(a) or Rule
      15d-14(a)32.1*
            
            Certification
      of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(b)
      and Section 1350 of Chapter 63 of Title 18 of the United States
      Code32.2*
            
            Certification
      of 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.




31




SIGNATURES





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





PATIENT
      SAFETY TECHNOLOGIES, INC.Date:  August
      14, 2009
            By:
            /s/
      Steven H. KaneSteven
      H. KaneChief
      Executive OfficerDate:  August
      14, 2009
            By:
            /s/
      Mary A. LayMary
      A. LayInterim
      Chief Financial Officer and
              Principal
      Accounting Officer





32