**UNITED
      STATES SECURITIES AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**




**FORM
      10-Q**




**QUARTERLY
      REPORT UNDER SECTION 13 OR 15(d) OF**


**THE
      SECURITIES EXCHANGE ACT OF 1934**




**For
      the quarterly period ended**  **March
      31, 2006**




**1-32146**Commission
                file number





**DOCUMENT
                SECURITY SYSTEMS, INC.**(Exact
                name of registrant as specified in its charter)




**New
                York**
            
            **16-1229730**(State
                of incorporation)
            
            (IRS
                Employer Identification Number)





**28
                Main Street East, Suite 1525****Rochester,****NY****14614**
              
              (Address
                of principal executive office)





**(585)
                325-3610**(Registrant's
                telephone number)





**Indicate
                by check mark whether the registrant:**(1)
                filed all reports required to be filed by Section 13 or 15(d) of
                the
                Exchange Act during the preceeding 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 is a large accelerated filer,
                an
                accelerated filer, or a non-accelerated filer. See definition of
                “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the
                Exchange Act. (Check one):
              
              Large
                accelerated filer [ ]Accelerated
                filer [ ]Non-accelerated
                filer [X]
              
              Indicate
                by check mark whether the registrant is a shell company (as defined
                in
                Rule 12b-2 of the Exchange Act)
              **Yes
                [ ] No [X]**
              
              **Applicable
                only to corporate issuers**As
                of May 12, 2006 (the most recent practicable date), there
                were 12,863,017 shares of the issuer's Common Stock, $0.02 par value
                per share, outstanding.Indicate
                by check mark whether the registrant is a shell company (as defined
                in
                Rule 12b-2 of the Exchange Act)
              **Yes
                [ ] No [X]**





**DOCUMENT
                SECURITY SYSTEMS, INC.**
              **FORM
                10-Q**
              **TABLE
                OF CONTENTS****PART
                I**
            
            **FINANCIAL
                INFORMATION**Item
                1
            
            Financial
                StatementsConsolidated
                Balance Sheets
            
            F-1Consolidated
                Statements of Operations
            
            F-2Consolidated
                Statements of Cash Flows
            
            F-3Notes
                to Financial Statements
            
            F-4Item
                2
            
            Management's
                Discussion and Analysis of Financial Condition and Results of
                Operations
            
            16Item
                3
            
            Quantitative
                and Qualitative Disclosures about Market Risk
            
            24Item
                4
            
            Controls
                and Procedures
            
            24**PART
                II**
            
            **OTHER
                INFORMATION**Item
                1
            
            Legal
                Proceedings
            
            25Item
                1a
            
            Risk
                Factors
            
            26Item
                2
            
            UnregisteredSales
                of Equity Securities and Use of Proceeds
            
            31Item
                3
            
            Defaults
                upon Senior Securities
            
            32Item
                4
            
            Submission
                of Matters to a Vote of Security Holders
            
            32Item
                5
            
            Other
                Information
            
            32Item
                6
            
            Exhibits
            
            33**SIGNATURES**
            
            34







2




**PART
      I**




**FINANCIAL
      INFORMATION**


ITEM
      1 -
      FINANCIAL STATEMENTS




**DOCUMENT
                  SECURITY SYSTEMS, INC.  AND SUBSIDIARIES****Consolidated
                  Balance Sheets****As
                  of****March
                  31,**
              
              **December
                  31,****2006**
              
              **2005****ASSETS**
              
              (unaudited)
              
              (audited)**Current
                  assets:**Cash
                  and cash equivalents
              
              $
              2,543,576
              
              $
              3,953,482Accounts receivable, net
              
              
              462,461
              
              
              164,726Inventory
              
              
              211,924
              
              
              148,804Prepaid expenses
              
              
              257,922
              
              
              225,114Total
                  current assets
              
              
              3,475,883
              
              
              4,492,126**Restricted
                  cash**
              
              
              240,000
              
              
              240,000**Fixed
                  assets, net**
              
              
              631,777
              
              
              451,195**Other
                  assets**
              
              
              161,243
              
              
              229,050**Goodwill**
              
              
              1,653,701
              
              
              711,785**Other
                  intangible assets, net**
              
              
              4,588,315
              
              
              4,208,962$
              10,750,919
              
              $
              10,333,118**LIABILITIES
                  AND STOCKHOLDERS' EQUITY****Current
                  liabilities:**Accounts
                  payable
              
              $
              1,065,938
              
              $
              547,512Accrued
                  expenses & other current liabilities
              
              
              259,822
              
              
              212,559Current
                  portion of long-term debt
              
              
              51,931
              
              
              50,891Current
                  portion of capitalized lease obligations
              
              
              34,088
              
              
              33,374Total
                  current liabilities
              
              
              1,411,779
              
              
              844,336**Long-term
                  debt**
              
              
              153,793
              
              
              167,309**Long-term
                  capital lease obligations**
              
              
              76,137
              
              
              84,931**Stockholders'
                  equity**Common
                  stock, $.02 par value;200,000,000
                  shares authorized,12,863,017
                  shares issued and outstanding (12,698,872 in 2005)
              
              
              257,260
              
              
              253,977Additional paid-in capital
              
              
              22,241,943
              
              
              21,377,996Accumulated deficit
              
              
              (13,389,993
              )
              
              (12,395,431
              )Total
                  stockholders' equity
              
              
              9,109,210
              
              
              9,236,542$
              10,750,919
              
              $
              10,333,118


See
      accompanying notes




F-1




**DOCUMENT
                  SECURITY SYSTEMS, INC. AND SUBSIDIARIES****Consolidated
                  Statements of Operations****For
                  the Three Months Ended March 31,**
  **2006**
              
              **2005****(unaudited)**
              
              **(unaudited)****Sales,
                  net**
              
              $
              862,710
              
              
              433,200Costs
                  of sales
              
              
              546,197
              
              
              225,984**Gross
                  profit**
              
              
              316,513
              
              
              207,216**Operating
                  Expenses:**Selling,
                  general and administrative expenses
              
              
              1,039,906
              
              
              691,781Research
                  and development
              
              
              72,602
              
              
              80,112Amortization
                  of intangibles
              
              
              220,000
              
              
              4,500Operating expenses
              
              
              1,332,508
              
              
              776,393**Operating
                  loss**
              
              
              (1,015,995
              )
              
              (569,177
              )**Other
                  income (expense):**Interest income
              
              
              26,896
              
              
              12,954Interest expense
              
              
              (5,463
              )
              
              (7,199
              )**Loss
                  before income taxes**
              
              
              (994,562
              )
              
              (563,422
              )Income
                  taxes
              
              
              -
              
              
              -**Net
                  loss**
              
              $
              (994,562
              )
              
              (563,422
              )**Net
                  loss per share, basic and diluted**
              
              $
              (0.08
              )
              
              (0.05
              )**Weighted
                  average common shares outstanding, basic and
                  diluted**
              
              
              12,803,861
              
              
              11,167,096


See
      accompanying notes.




F-2




**DOCUMENT
                  SECURITY SYSTEMS, INC. AND SUBSIDIARIES****Consolidated
                  Statements of Cash Flows****For
                  the Three Months Ended March 31,**
  **2006**
              
              **2005****(unaudited)**
              
              **(unaudited**)******Cash
                  flows from operating activities:**Net loss
              
              $
              (994,562
              )
              $
              (563,422
              )Adjustments
                  to reconcile net loss to net cash used by operating
                  activities:Depreciation and amortization expense
              
              
              276,647
              
              
              46,696Stock
                  based compensation
              
              
              27,329
              
              
              3,840(Increase) decrease in assets:Accounts receivable
              
              
              (131,749
              )
              
              153,865Inventory
              
              
              7,027
              
              
              (22,807
              )Prepaid expenses and other assets
              
              
              7,802
              
              
              25,888Increase (decrease) in liabilities:Accounts payable
              
              
              260,458
              
              
              15,638Accrued expenses & other current liabilities
              
              
              (50,105
              )
              
              (7,434
              )Net
                  cash used by operating activities
              
              
              (597,153
              )
              
              (347,736
              )**Cash
                  flows from investing activities:**Purchase of fixed assets
              
              
              (37,229
              )
              
              (66,387
              )Acquisiton of P3
              
              
              (1,250,000
              )
              
              -Purchase of other intangible assets
              
              
              (94,869
              )
              
              (2,909
              )Net
                  cash used by investing activities
              
              
              (1,382,098
              )
              
              (69,296
              )**Cash
                  flows from financing activities:**Repayment of long-term debt
              
              
              (12,476
              )
              
              (11,754
              )Decrease
                  (increase) in restricted cash
              
              
              -
              
              
              (4,426
              )Repayment
                  of capital lease obligations
              
              
              (8,080
              )
              
              (7,424
              )Issuance
                  of common stock, net
              
              
              589,901
              
              
              1,418,155Net
                  cash provided by financing activities
              
              
              569,345
              
              
              1,394,551**Net
                  increase (decrease) in cash and cash equivalents**
              
              
              (1,409,906
              )
              
              977,519**Cash
                  and cash equivalents beginning of period**
              
              
              3,953,482
              
              
              2,657,865**Cash
                  and cash equivalents end of period**
              
              $
              2,543,576
              
              $
              3,635,384


See
      accompanying notes.




F-3




**DOCUMENT
      SECURITY SYSTEMS, INC.**


**NOTES
      TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS**


**March
      31, 2006**


**(Unaudited)**






**1.    
      Basis of Presentation and Significant Accounting Policies**




Document
      Security Systems, Inc. (the “Company”), a New York corporation, operates in the
      market for secured documents and solutions. The Company licenses its patented
      technology and sells products that use its patented optical anti-scanning,
      anti-counterfeiting technologies. The Company’s customers include governments,
      law enforcement agencies, security printers, check and forms printers and
      corporations. In addition, the Company, through its consolidated subsidiaries,
      operates a retail printing operation and sells supplies to the legal industry.
      The Company has focused its operations in these businesses since 2002.
      Previously, the Company was named New Sky Communications and was focused on
      the
      production of motion pictures.





*Interim
      Financial Statements*




The
      condensed consolidated financial statements include the accounts of Document
      Security Systems, Inc and its wholly owned subsidiaries (collectively, the
      “Company”) after elimination of intercompany transactions, profits, and
      balances.  The condensed consolidated financial statements have been
      prepared from the Company’s records without audit and, in management’s opinion,
      include all adjustments (consisting of only normal recurring adjustments)
      necessary to fairly reflect the financial condition and the results for the
      periods presented. Certain information and footnote disclosures normally
      included in financial statements prepared in accordance with U.S. generally
      accepted accounting principles have been condensed or omitted under the
      Securities and Exchange Commission’s rules and regulations.




These
      condensed consolidated financial statements should be read in conjunction with
      the audited consolidated financial statements included in the Company’s Annual
      Report on Form 10-KSB for the year ended December 31, 2005. The
      results of operations for the interim periods presented in these condensed
      consolidated financial statements are not necessarily indicative of the results
      for the full year.




*Reclassifications*




Certain
      prior period amounts in the accompanying condensed consolidated financial
      statements and notes thereto have been reclassified to current period
      presentation. These classifications had no effect on the results of operations
      for the period presented. These reclassifications include the reclassification
      of state business fees from income tax to selling, general and administrative
      and amortization of intangibles from selling, general and administrative to
      a
      separate line on the statement of operations.




*Use
      of Estimates*




The
      preparation of consolidated financial statements in accordance with U.S.
      generally accepted accounting principles requires the Company to make estimates
      and judgments that affect the reported amounts of assets, liabilities, revenue
      and expenses, and related disclosure of contingent assets and liabilities.
      Certain of the Company’s accounting policies require higher degrees of judgment
      than others in their application. These include impairments and estimation
      of
      useful lives of long-lived assets, inventory valuation, reserves for
      uncollectible accounts receivable, and contingencies and litigation. The Company
      bases its estimates on historical experience and on various other assumptions
      that are believed to be reasonable under the circumstances, the results of
      which
      form the basis for making judgments about the carrying values of assets and
      liabilities that are not readily apparent from other sources. Actual results
      may
      differ from these estimates under different assumptions or
      conditions.




F-4




*Share-Based
      Payments*




Prior
      to
      January 1, 2006, the Company accounted for stock option awards granted
      under the Company’s Stock Incentive Plan in accordance with the recognition and
      measurement provisions of Accounting Principles Board Opinion No. 25,
“Accounting for Stock Issued to Employees”, (“APB 25”) and related
      Interpretations, as permitted by Statement of Financial Accounting Standards
      No. 123, “Accounting for Stock-Based Compensation”, (“SFAS 123”).
      Share-based employee compensation expense was not recognized in the Company’s
      consolidated statements of operations prior to January 1, 2006, as all
      stock option awards granted had an exercise price equal to or greater than
      the
      market value of the common stock on the date of the grant, except for
      modifications of stock option awards, which triggered compensation expense
      in
      accordance with provisions of FASB FIN 44 —“Accounting
      for
      Certain Transactions Involving Stock Compensation”. As permitted by SFAS 123,
      the Company reported pro-forma disclosures presenting results and earnings
      per
      share as if the Company had used the fair value recognition provisions of SFAS
      123 in the Notes to Consolidated Financial Statements. Stock-based compensation
      related to non-employees were accounted for based on the fair value of the
      related stock or options in accordance with SFAS 123 and its interpretations.




Effective
      January 1, 2006, the Company adopted the provisions of Statement of
      Financial Accounting Standard No. 123 (revised 2004), “Share-Based
      Payment”, (“SFAS 123(R)”) using the modified prospective transition method. See
      Note 5 for further detail on the impact of SFAS 123(R) to the Company’s
      condensed consolidated financial statements.






**2.Inventory**




Inventory
      consisted of the following:




**March
                  31,**
              
              **December
                  31,****2006**
              
              **2005****(unaudited)**
              
              **(audited)**Finished
                  Goods
              
              $
              141,777
              
              $
              148,804Materials
              
              
              70,147
              
              
              -$
              211,924
              
              $
              148,804




**3.    
      Goodwill and Other Intangible Assets**





***Other
      Intangible Assets*** -




F-5





Other
      intangible assets are comprised of the following:





**March
                  31,**
              
              **December
                  31,****Useful****Life**
              
              **2006**
              
              **2005**Royalty
                  rights
              
              
              5
                  years
              
              $
              90,000
              
              $
              90,000Other
                  Intangibles
              
              
              5
                  years
              
              
              441,000
              
              
              41,000Patent
                  and contractual rights
              
              
              Varied
                  (1
              )
              
              4,833,424
              
              
              4,634,071**5,364,424**
              
              
              **4,765,071**Less
                  accumulated amortization
              
              
              
              
              
              776,109
              
              
              556,109Net
                  carrying value
              
              
              
              
              **$**
              **4,588,315**
              ****
              **$**
              **4,208,962**




(1)-
        patent rights are amortized over their expected useful life which is generally
        the legal life of the patent. As of March 31, 2006 the weighted average
        remaining useful life of these assets in service was 6.8 years.


***Goodwill
      -*** In
      accordance with the provisions of SFAS No. 142, "Goodwill and Other Intangible
      Assets" (SFAS 142), the Company performs an annual fair value test of its
      recorded goodwill for its reporting units using a discounted cash flow and
      capitalization of earnings approach. During the first quarter of 2006, the
      Company recorded a preliminary estimate of goodwill of $942,000 associated
      with
      its acquisition of the assets of Plastic Printing Professionals. As of March
      31,
      2006, the Company’s goodwill of $1,654,000 consists of $81,000 attributable to
      the legal segment and $1,573,000 attributable to the document security segment.
      The Company plans to conduct annual impairment tests in the fourth quarter
      of
      each year, unless impairment indicators exist at an earlier date.




**4.    
      Acquisition**




On
      February 7, 2006, the Company acquired substantially all of the assets of
      Plastic Printing Professionals, Inc. ("P3") for $1.25 million in cash, 18,704
      shares of the Company’s Common Stock valued at $250,000 and the assumption of
      certain liabilities. The cash portion of the purchase price was paid using
      the
      Company’s cash on hand. P3 is a security printer specializing in plastic cards
      containing security technologies. P3 has 25 full-time employees and had sales
      of
      approximately $2.7 million in 2005.  Commencing
      on February 7, 2006, the results of P3’s operations are included in the
      consolidated financial statements of the Company. The Company accounted for
      the
      acquisition as a business combination under FASB 141 “Business Combinations”. We
      are in the process of completing the review and determination of the fair value
      of certain of the acquired assets and expect to complete that process during
      the
      second quarter of 2006. The purchase price has been preliminarily allocated
      based on the estimated fair market value of the assets acquired and liabilities
      assumed as follows:




Accounts
                  receivable
              
              $
              166,000Inventory
                  & pre-paid assets
              
              
              83,000Fixed
                  assets
              
              
              200,000Identified
                  intangible assets
              
              
              400,000Goodwill
              
              
              942,000Total
                  Assets
              
              $
              1,791,000Liabilities
                  Assumed
              
              $
              (261,000
              )Total
                  Purchase
                  Price
              
              $
              1,530,000
  F-6




Set
      forth
      below is the unaudited pro forma revenue, operating loss, net loss and loss
      per
      share of the Company as if P3 had been acquired as of January 1,
      2005:


**Three
                  Months Ended March 31,****2006**
              
              **2005****Revenue**
              
              $
              1,112,816
              
              $
              1,051,241**Operating
                  Loss**
              
              
              (1,020,765
              )
              
              (578,981
              )**Net
                  Loss**
              
              
              (998,886
              )
              
              (573,226
              )**Basic
                  and diluted loss per share**
              
              
              (0.08
              )
              
              (0.05
              )




**5.
      - Stock Based Compensation**





In
      December 2004, the Financial Accounting Standards Board issued SFAS 123R,
      Share-Based Payment (“SFAS 123R”). SFAS 123R supersedes SFAS 123, Accounting for
      Stock Based Compensation, and Accounting Principles Board Opinion 25, Accounting
      for Stock Issued to Employees (“APB 25) and its related implementation guidance.
      On January 1, 2006, the Company adopted the provisions of SFAS 123R using the
      modified prospective transition method. Under this method, the Company is
      required to record compensation expense for all stock based awards granted
      after
      the date of adoption and for the unvested portion of previously granted awards
      that remain outstanding as of the beginning of the adoption and prior periods
      have not been restated. Under SFAS 123R, compensation expense related to stock
      based payments are recorded over the requisite service period based on the
      grant
      date fair value of the awards.





Prior
      to
      the adoption of SFAS 123R, the Company accounted for employee stock options
      using the intrinsic value method in accordance with APB 25. Accordingly, no
      compensation expense was recognized for stock options issued to employees as
      long as the exercise price was greater than or equal to the market value of
      the
      common stock at the date of grant. In accordance with SFAS 123, the Company
      disclosed the summary of pro forma effects to reported net loss as if the
      Company had elected to recognize compensation costs based on the fair value
      of
      the awards at the grant date.





The
      Company has adopted The
      2004
      Employees' Stock Option Plan (the "2004 Plan") to provide for the grant of
      options to purchase up to 1,200,000 shares of Common Stock to all employees,
      including executive officers. Under the terms of the 2004 Plan, options granted
      thereunder may be designated as options which qualify for incentive stock option
      treatment ("ISOs") under Section 422A of the Internal Revenue Code, or options
      which do not so qualify ("Non-ISOs"). The
      2004
      Plan is administered by the Compensation Committee designated by the Board
      of
      Directors. The Compensation Committee has the discretion to determine the
      eligible employees to whom, and the times and the price at which, options will
      be granted; whether such options shall be ISOs or Non-ISOs; the periods during
      which each option will be exercisable; and the number of shares subject to
      each
      option. The Committee has full authority to interpret the 2004 Plan and to
      establish and amend rules and regulations relating thereto.




The
      Company also has adopted The Non-Executive Director Stock Option Plan (the
      "Director Plan"), which provides for options for up to 100,000 shares to
      non-executive directors and advisors. Under the terms of the Director Plan,
      an
      option to purchase (a) 5,000 shares of our common stock shall be granted to
      each
      non-executive director upon joining the Board of Directors (or upon the approval
      of this plan if the director joined prior to its adoption date) and (b) 5,000
      shares of our common stock shall be granted to each non-executive director
      thereafter on January 2 nd of each
      year; provided that any non-executive director, who has not served as a director
      for an entire year prior to January 2nd of each year then such non-employee
      director shall receive a pro rata number of options based on the time the
      director has served in such capacity during the previous year.




F-7




The exercise price for options granted under the Director Plan is 100% of the
      fair market value of the common stock on the date of grant. Until otherwise
      provided in the Director Plan, the exercise price of options granted under
      the
      Director Plan must be paid at the time of exercise, either in cash, by delivery
      of shares of the common stock of the Company or by a combination of each. The
      term of each option commences on the date it is granted and unless terminated
      sooner as provided in the Director Plan, expires five years from the date of
      grant. Neither the Board nor the Compensation Committee has discretion to
      determine which non-executive director or advisory board member will receive
      options or the number of shares subject to the option, the term of the option
      or
      the exercisability of the option. However, the Committee will make all
      determinations of the interpretation of the Director Plan. Options granted
      under
      the Director Plan are not qualified for incentive stock option
      treatment.




The
      compensation cost that has been charged against income for options granted
      under
      the plans was approximately $21,000 for the three-month period ended March
      31,
      2006. The impact of this expense to basic and diluted earnings per share was
      less than $0.01 during the three-month period ended March 31, 2006. The adoption
      of SFAS 123R did not have an impact on cash flows from operating or financing
      activities. A deduction is not allowed for income tax purposes until the option
      are exercised. This amount of this deduction will be the difference between
      the
      fair value of the Company’s common stock and the exercise price at the date of
      exercise. Accordingly, there is a deferred tax asset recorded related for the
      tax effect of the financial statement expense recorded. The tax effect of the
      income tax deduction in excess of the financial statement expense will be
      recorded as an increase to additional paid-in capital. Due to the uncertainty
      of
      the Company’s ability to generate sufficient taxable income in the future to
      utilize the tax benefits of the options granted, the Company has recorded a
      valuation allowance to reduce gross deferred tax asset to zero. As a result
      for
      the three-month period ended March 31, 2006, there is no income tax expense
      impact from recording the fair value of options granted.





The
      fair
      value of each option award is estimated on the date of grant utilizing the
      Black
      Scholes Option Pricing Model that uses the assumptions noted in the following
      table.




**Three Months Ended March 31,****2006**
            
            **2005**Volatility
            
            
            42.6
            %
            
            80
            %Expected
                option term
            
            
            3
                years
            
            
            5
                yearsRisk-free
                interest rate
            
            
            4.4
            %
            
            4.0
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %





A
      summary
      of the status of the options granted under the incentive stock option plan
      is
      presented below:




F-8




**2004
                  Employee Plan**
              
              
              
              **Non-Executive
                  Director Plan****Weighted**
              
              **Weighted**
              
              
              
              **Weighted**
              
              **Weighted****Number
                  of**
              
              **Average**
              
              **Average
                  Life**
              
              **Number
                  of**
              
              **Average**
              
              **Average
                  Life****Options**
              
              **Exercise
                  Price**
              
              **Remaining**
              
              **Options**
              
              **Exercise
                  Price**
              
              **Remaining**(years)
              
              
              
              
              
              (years)Outstanding
                  at
                  December 31, 2005
              
              
              277,000
              
              
              8.05
              
              
              
              
              
              36,250
              
              
              5.47Granted
              
              
              -
              
              
              
              
              
              
              
              
              20,000
              
              
              12.65Exercised
              
              
              -
              
              
              
              
              
              
              
              
              -
              
              
              -Canceled
              
              
              30,000
              
              
              8.38
              
              
              
              
              
              -
              
              
              -Outstanding
                  at March 31, 2006:
              
              
              247,000
              
              
              8.01
              
              
              
              
              
              56,250
              
              
              8.02Exercisable
                  at March 31, 2006:
              
              
              247,000
              
              
              8.01
              
              
              
              
              
              36,250
              
              
              5.47Aggregate
                  Intrinsic Value of outstanding optionsat
                  March 31, 2006
              
              $
              1,158,230
              
              
              
              
              
              4.4
              
              $
              263,063
              
              
              
              
              
              3.8Aggregate
                  Intrinsic Value of exercisable optionsat
                  March 31, 2006
              
              $
              1,158,230
              
              
              
              
              
              4.4
              
              $
              262,063
              
              
              
              
              
              3.3


The
      weighted-average grant date fair value of options granted during the three-month
      period ended March 31, 2006 was $4.24 ($4.71 during the three-month period
      ended
      March 31, 2005). There were no options exercised during the three-month periods
      ended March 31, 2006 or March 31, 2005, respectively.





The
      following table summarizes the status of the Company’s options non-vested
      options under the incentive stock option plans is presented below:





**Number
                  of**
                  **Non-vested**
                    **Shares**
                      **Subject
                        to**
                        **Options**
              
              **Weighted-**
                  **Average
                    Grant**
                    **Date
                      Fair**
                      **Value****Non-vested
                  as of December 31, 2005**
              
              
              -
              
              $
              -**Non-vested granted- three month****period ended March 31, 2006**
              
              
              20,000
              
              $
              4.24**Vested - three month period****ended March 31, 2006**
              
              
              -
              
              $
              -**Forfeited - three month period****ended March 31, 2006**
              
              
              -
              
              $
              -**Non-vested
                  as of March 31,2006**
              
              
              20,000
              
              $
              4.24


As
      of
      March 31, 2006, there was approximately $64,000 of total unrecognized
      compensation cost related to non-vested options granted under the Non-Executive
      Director plan. That cost will be recognized over a weighted average period
      of 1
      year. The total fair value of shares vested during the three-month period ended
      March 31, 2006 was $0 ($54,600 during the three-month period ended March 31,
      2005).




F-9




***Pro-Forma
      Stock Compensation Expense:***




For
      the
      quarterly period ended March 31, 2005, the Company applied the intrinsic
      value method of accounting for stock options as prescribed by APB 25. Since
      all
      options granted during the quarterly period ended March 31, 2005 had an
      exercise price equal to the closing market price of the underlying common stock
      on the grant date, no compensation expense was recognized. If compensation
      expense had been recognized based on the estimated fair value of each option
      granted in accordance with the provisions of SFAS 123 as amended by Statement
      of
      Financial Accounting Standard 148, our net loss and net loss per share would
      have been reduced to the following pro-forma amounts (in thousands, except
      per
      share amounts):





**Three
                Months Ended March 31, 2005****$**
            ****
            **$
                per share**Net
                loss as reported
            
            $
            (563,422
            )
            $
            (0.05
            )Fair
                value method compensation expense, net of tax
            
            
            (189,148
            )
            
            (0.02
            )Pro
                forma net loss
            
            $
            (752,570
            )
            $
            (0.07
            )




**6.    
      Stockholders Equity**




***Stock
      Issued for Acquisition -*** In
      February 2006, the Company issued 18,704 of its Common Stock plus additional
      costs related to the acquisition of substantially all of the assets of Plastic
      Printing Professionals (See Note 4). The value of the shares of Common Stock
      was
      determined based upon the average closing price of the shares of the Company’s
      Common Stock on the American Stock Exchange on for 10 trading days immediately
      prior to February 7, 2005 of $13.36 per share.





***Stock
      Warrants*** - During
      the first quarter of 2006, the Company received approximately $590,000 in
      proceeds from the exercise of warrants. The following is a summary with respect
      to warrants outstanding at March 31, 2006:





**Weighted****Average****Exercise****Warrants**
              
              **Price**Shares
                  outstanding January 1
              
              
              296,783
              
              $
              4.12Granted
                  during the year
              
              
              -
              
              $
              -Exercised
              
              
              140,625
              
              $
              4.38Lapsed
              
              
              -
              
              $
              -Outstanding
                  at March 31
              
              
              156,158
              
              $
              3.94Weighted
                  average years remaining
              
              
              
              
              
              2.7


F-10




The
      following table summarizes the warrants outstanding and exercisable as of March
      31, 2006:




**Warrants
                  Outstanding**
              
              
              
              **Warrants
                  Exercisable****Weighted**
              
              
              
              **Weighted****Average**
              
              **Weighted**
              
              **Average****Range
                  of**
              
              **Remaining**
              
              **Average**
              
              **Remaining**
              
              **Weighted****Exercise**
              **Number
                  of**
              **Contractual**
              
              **Exercise**
              **Number
                  of**
              **Contractual**
              
              **Average****Prices**
              **Shares**
              **Life
                  (in years)**
              
              **Price**
              **Shares**
              **Life
                  (in years)**
              
              **Exercise
                  Price**$
              2.00-$4.99
              112,410
              2.6
              $
              3.52
              112,410
              2.6
              $
              3.52$
              5.00-$7.75
              43,748
              3.0
              $
              5.00
              43,748
              3.0
              $
              5.00156,158
              
              
              
              156,158






**7.    
      Loss per Share**




Basic earnings per share is computed by dividing net income by the
      weighted-average number of common shares, outstanding for the period. Diluted
      earnings per share is computed by including the number of additional shares
      that
      would have been outstanding if dilutive potential shares had been issued. In
      periods of losses, diluted loss per share is computed on the same basis as
      basic
      loss per share as the inclusion of any other potential shares outstanding would
      be anti-dilutive.  As of March 31, 2006, there were 459,408 (608,177 -2005)
      stock options and warrants outstanding with exercise prices below the average
      share price for the period that would have been included in the calculation
      of
      diluted earnings per share had the Company generated net income.




**8.    
      Commitments and Contigencies**




In
      May
      2005, the Company made an agreement with its legal counsel in charge of the
      Company’s litigation with the European Central Bank (“ECB”) which capped the
      fees for all matters associated with that litigation at $500,000 plus expenses,
      and a $150,000 contingent payment upon a successful ruling or settlement on
      the
      Company’s behalf in that litigation. The Company will record the $150,000 in the
      period in which the Company has determined that a successful ruling or
      settlement is probable. As discussed below, in March 2006, the Company was
      countersued by the ECB in several European nation courts. While it is the
      Company’s belief that the costs of defending these countersuits is covered under
      the litigation cap, if not, the costs of defending these suits may be
      significant.




On
      August
      1, 2005, we commenced a suit against the European Central Bank alleging patent
      infringement by the European Central Bank and have claimed unspecified damages.
      We brought the suit in European Court of First Instance in Luxembourg. We
      alleged that all Euro banknotes in circulation infringe our European Patent
      455750B1, which covers a method of incorporating an anti-counterfeiting feature
      into banknotes or similar security documents to protect against forgeries by
      digital scanning and copying devices. On March 24, 2006, we received notice
      that
      the ECB has filed a separate claim in the United Kingdom and Luxembourg patent
      courts (Luxembourg being the seat of the European Court of First
      Instance) seeking the invalidation of the Patent.  Claims to
      invalidity in each of the Netherlands, Belgium, Italy, and France were
      subsequently served. The main basis of the ECB’s claim is the existence of prior
      art. A second basis is that the scope of the Patent was extended in prosecution
      which in Europe is a ground of invalidity. If
      the
      ECB is successful, it may materially affect us, our financial condition,
      including the potential requirement to pay all of the ECB’s legal fees
      associated with the suit, and our ability to market certain
      technology.




F-11





In
      addition to the foregoing, we are subject to other legal proceedings that have
      arisen in the ordinary course of business and have not been finally adjudicated.
      Although there can be no assurance in this regard, in the opinion of management,
      none of the legal proceedings to which we are a party, whether discussed herein
      or otherwise, will have a material adverse effect on our results of operations,
      cash flows or our financial condition.




**9.
      Supplemental Cash Flow Information**




During
      the three months ended March 31, 20065, the Company issued18,704 shares of
      Common Stock valued at $250,000 in conjunction with the acquisition of the
      assets of P3 (See Note 4).




**10.    
      Segment Information**




The Company's businesses are organized, managed and internally reported as
      four
      operating segments. Three of these operating segments, Document Security
      Systems, Plastic Printing Professionals and Patrick Printing, respectively,
      are
      engaged in various aspects of developing and applying printing technologies
      and
      procedures to produce, or allow others to produce, documents with a wide range
      of features, including the Company’s patented technologies and trade secrets.
      Consistent with the Company’s strategic initiative to increase its focus on
      servicing the end-user of secure documents, the Company has reorganized Patrick
      Printing, which was formerly considered a separate reportable segment, to
      concentrate its internal printing capabilities for these end-users. While
      Patrick Printing continues to offset its costs and utilize its capacity with
      retail copying and printing work, the Company determined that it was appropriate
      to aggregate this segment with its other document production and security
      companies because of the similarities in the nature of their products and
      production and sales processes and types of customers. Thus, for the purposes
      of
      providing segment information, these three operating segments have been
      aggregated into one reportable segment in accordance with Financial Accounting
      Standards Board (“FASB”) Statement No. 131- *“Disclosures
      about Segments of an Enterprise and Related Information”* .
      Prior
      period amounts have been reclassified to reflect the change in reporting
      segments and all inter-company transactions are eliminated. A summary of the
      two
      segments is as follows:




**Document
                Security and Production**
            License,
                manufacture and sale of document security technologies and secure
                printed
                products at its Document Security Systems, Plastic Printing Professionals
                and Patrick Printing divisions. Also, includes revenues from copying
                services and residual royalties from motion picture
                operations.**Legal
                Supplies**
            Sale
                of specialty legal supplies via the Internet to lawyers and law firms
                located throughout the United States as
                Legalstore.com.




Approximate information concerning the operations by reportable segment for
      the
      three months ended March 31, 2006 and 2005 is as follows. The Company relies
      on
      intersegment cooperation and management does not represent that these segments,
      if operated independently, would report the results contained herein:




F-12




**Document****2006**
              
              **Legal
                  Supplies**
              
              **Security
                  & Production**
              
              **Corporate**
              
              **Total**Revenues
                  from external customers
              
              
              171,000
              
              
              692,000
              
              
              -
              
              
              863,000Depreciation
                  and amortization
              
              
              1,000
              
              
              247,000
              
              
              28,000
              
              
              276,000Segment
                  profit or (loss)
              
              
              (13,000
              )
              
              (499,000
              )
              
              (483,000
              )
              
              (995,000
              )**2005**Revenues
                  from external customers
              
              
              133,000
              
              
              300,000
              
              
              -
              
              
              433,000Depreciation
                  and amortization
              
              
              -
              
              
              28,000
              
              
              18,000
              
              
              46,000Segment
                  profit or (loss)
              
              
              5,000
              
              
              (175,000
              )
              
              (393,000
              )
              
              (563,000
              )










**ITEM
      2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
      OF
      OPERATIONS**




***FORWARD-LOOKING
      STATEMENTS***




Certain
      statements contained herein constitute “forward-looking statements” within the
      meaning of the Private Securities Litigation Reform Act of 1995 (the “1995
      Reform Act”). Document Security Systems, Inc. desires to avail itself of certain
“safe harbor” provisions of the 1995 Reform Act and is therefore including this
      special note to enable us to do so. Except for the historical information
      contained herein, this report contains forward-looking statements (identified
      by
      the words "estimate," "project," "anticipate," "plan," "expect," "intend,"
      "believe," "hope," "strategy" and similar expressions), which are based on
      our
      current expectations and speak only as of the date made. These forward-looking
      statements are subject to various risks, uncertainties and factors, including,
      without limitation, those contained in our Form 10-KSB for the year ended
      December 31, 2005 and those described herein that could cause actual results
      to
      differ materially from the results anticipated in the forward-looking
      statements.




**Overview**




We
      are a supplier of advanced optical anti-scanning, anti-counterfeiting, and
      verification technologies and products for all forms of printed media. We
      provide document security technology to security printers, corporations and
      governments worldwide. Our technology can be used in securing sensitive and
      critical documents such as currency, automobile titles, spare parts forms for
      the aerospace industry, psychological examinations, gift certificates, permits,
      checks, licenses, receipts, prescription and medical forms, engineering
      schematics, ID cards, labels, original music, coupons, homeland security
      manuals, consumer product and pharmaceutical packaging, tickets, and school
      transcripts. In addition, we sell legal supplies on the Internet services at
      a
      non-core division.





Generally,
      we generate revenue from our document production and security business in three
      ways. We produce document security products for the end-user market including
      pre-packaged security paper. We license our patented technology to security
      printers so that they can provide their customers with anti-counterfeiting
      capabilities, and finally, we design, produce and consult for customized
      anti-counterfeiting solutions for corporate and government customers, including
      custom documents printed on paper, plastic or various other materials or
      delivered via electronic means.





**Security
      Paper** : Our
      primary product for the end-user market is AuthentiGuard Security Paper.
      AuthentiGuard Security Paper is a paper which reveals hidden warning words,
      logos or images when a clear plastic viewer is placed over the paper or when
      the
      paper is faxed, copied, scanned or re-imaged in any form. The hidden words
      appear on the duplicate copy or the computer digital file and essentially
      prevent important documents from ever being counterfeited. We market and sell
      our Security Paper primarily through two major paper distributors: Boise White
      Paper and PaperlinX Limited. Since 2005, Boise markets our Security Paper under
      its Boise Beware brand name in North America, primarily through its network
      of
      commercial paper sales group, and in OfficeMax and CopyMax stores. In late
      2005,
      we entered into an agreement with PaperlinX to market and sell our Security
      Paper under the name SecurelinX in Europe, Australia and New Zealand. The
      initial orders under this agreement are expected to be shipped during the second
      quarter of 2006. In
      addition, our licensee, PyroTech, has the marketing rights to manufacture and
      sell our Security Paper in the continent of Africa.   We retain
      the rights to sell the same Security Paper direct to end users anywhere in
      the
      world. Pricing for the Security Paper is determined on mark-up from cost.





16


Currently,
      our Security Paper is manufactured and stored for us by a third-party printer
      which has sufficient capacity to meet our foreseeable demand for Safety Paper. We
      are
      seeking to increase profit margins by developing manufacturing capabilities
      through strategic mergers and acquisitions that will allow us to service larger
      and a wider range of potential customers while eliminating a layer of costs
      by
      reducing our reliance on third party printers.





**Technology
      Licensing:** We
      license our anti-counterfeiting technology and trade secrets through licensing
      arrangements with security printers. We seek licensees that have a broad
      customer base that can benefit from our technologies. Licensees generally pay
      on
      a usage basis with royalties of up to 5% of each job in which our technologies
      are used. In the second half of 2005, we decided to selectively seek strategic
      licensees pursuant to our plan to increase our internal security printing
      capabilities.





We
      also
      believe that some of our technologies are being used on an un-authorized basis.
      By aggressively defending our intellectual property rights, we believe that
      we
      will be able to secure a potentially significant amount of additional and
      ongoing revenue by securing licensing agreements with those persons, companies
      or governments that we believe are infringing our patents. We also anticipate
      that we may be required to commence litigation in some cases and that we will
      need to spend a significant amount of money and time on these matters.





**Custom
      Document Security Solutions** :
      Our
      technology portfolio allows us to create custom secure documents that are unique
      to the industry. We target end-users such as governments, agencies and
      corporations which require anti-counterfeiting and authentication features
      in a
      wide range of vital records such as driver’s licenses, birth certificates,
      receipts, manuals and identification materials and corporations creating
      entertainment tickets, coupons, parts tracking forms, as well as product
      packaging including pharmaceutical and a wide range of consumer goods.





In
      February of 2006, we acquired San Francisco-based Plastic Printing
      Professionals, Inc. ("P3"), a privately held, security printer specializing
      in
      plastic cards containing security technologies. P3's primary focus is
      manufacturing composite, laminated and surface printed cards which can include
      magnetic stripes, bar codes, holograms, signature panels, invisible ink, micro
      fine printing, guilloche patterns, DNA and a patent pending watermark
      technology. P3's products are marketed through an extensive dealer network
      that
      covers North America, Europe and South America. Its product and client list
      includes the Grammy Awards, the Country Music Association awards, Super Bowl
      media cards, ID cards for major airports and Latin American driver’s licenses.





During
      2005, we also began to expand our marketing efforts to the end-user of custom
      secure documents. Whereas in the past, we typically sought to license our
      technology to the printer of the end-user, we have determined that significant
      advantages exist in the market if we are able to own the end-user relationship
      from the design phase through the production phase. Therefore, we have shifted
      our focus to utilize more of our internal printing capabilities towards the
      custom security document market.





17


In
      March
      2006, we entered into a license to provide a technology for the internet
      delivery of secure, verifiable documents that can be transmitted and printed
      over the internet using a customized web-hosting site for the securitization
      process. This is the first application of a covert method we developed for
      producing secure documents, such as financial instruments, at multiple
      locations. Although anticipated revenue from this project is not significant,
      DSS anticipates that this initial prototype could develop into a major new
      product offering.





The
      three-year agreement includes implementation and initial set-up fees for the
      Bank's website, as well as annual licensing and infrastructure maintenance
      fees.
      This is the first application of this covert method for producing secure
      documents, such as financial instruments, at multiple locations. Although
      anticipated revenue from this project is not significant, DSS anticipates that
      this initial prototype could develop into a major new product
      offering.





Currently,
      we primarily outsource the production of our custom security print orders to
      strategic printing vendors. The
      acquisition of P3 marked the initial execution of our strategy to expand our
      manufacturing capabilities through acquisitions in order to service our custom
      security printing business.





**Other** :
      Revenues we receive from the sale of legal supplies, our copying operations
      and
      from our former motion picture operations, are considered revenue sources that
      are unrelated to our core business operation.







***Results
      of Operations for the Three Months Ended***  ***March
      31, 2006***




The following discussion and analysis provides information that our management
      believes is relevant to an assessment and understanding of our results of
      operations and financial condition. The discussion should be read in conjunction
      with the financial statements and footnotes in this quarterly report and in
      our
      annual report on Form 10-KSB for the year ended December 31, 2005.


18


**Summary**


**Three
                  Months Ended 2006****$**
              ****
              **%
                  change vs. 2005**Sales,
                  net
              
              
              863,000
              
              
              99
              %Costs
                  of sales
              
              
              546,000
              
              
              142
              %Gross
                  profit
              
              
              317,000
              
              
              53
              %Total operating expenses
              
              
              1,333,000
              
              
              73
              %Operating
                  loss
              
              
              (1,016,000
              )
              
              81
              %Other
                  income (expense):Interest income
              
              
              27,000
              
              
              108
              %Interest expense
              
              
              (5,000
              )
              
              -29
              %Loss
                  before income taxes
              
              
              (994,000
              )
              
              79
              %Income
                  taxes
              
              
              0
              
              
              0
              %Net
                  loss
              
              
              (994,000
              )
              
              79
              %




**Sales**


**Three
                    Months Ended 2006****$**
                ****
                **%
                    change vs. 2005**Sales,
                    netDocument
                    Security
                
                $
                692,000
                
                
                131
                %Legal
                    supplies
                
                
                171,000
                
                
                29
                %Total
                    Revenue
                
                
                863,000
                
                
                99
                %






Document
      Security




Document
      security sales increased 131% during the first quarter of 2006 as compared
      to
      the first quarter of 2005. The increase was solely the result of $415,000 of
      sales included in the 2006 results from the Company’s P3 division, which was
      acquired on February 7, 2006. The acquisition of P3 provides the Company with
      production capabilities for printed plastic products that can include the
      Company’s patented technologies. Absent the acquisition of P3 during the first
      quarter of 2006, Document Security sales decreased slightly by 2% compared
      to
      the first quarter of 2005. During the first quarter of 2005, the Company
      experience strong initial orders from Boise related to the initial rollout
      of
      the Boise Beware security paper. During the first quarter of 2006, the Company
      received purchase orders for approximately $180,000 for the initial rollout
      of
      PaperlinX’s security paper which, if shipped, would have favorably impacted 2006
      first quarter results. However, these orders were not ready for shipment by
      March 31, 2006. Furthermore, while the Company has signed several licensing
      agreements in late 2005 and early 2006, none of these licensing agreements
      produced significant revenues during the first quarter of 2006 as revenue under
      these agreements is generally not due to the Company until the licensee has
      delivered the products using our technology to their customers. We expect that
      licensing revenue under these agreements will gradually become more significant
      to our results as these licensees grow comfortable with the technology and
      are
      able to promote it to their customers. Due to the lack of control over the
      timing of this revenue, the Company generally reports license revenue on a
      cash
      basis, unless license fees are received in advance in which the Company
      recognizes revenue over the period covered by the advance.




19




In
      addition, we began to focus our sales efforts on driving the end-user demand
      for
      our technologies. While we have not seen significant revenues from these efforts
      as of yet, we have bid on several secure print jobs that, if we are awarded
      the
      order, will significantly increase our revenue and allow us to quickly gain
      the
      sales level that will be commensurate with the size of our organization. We
      expect to outsource the fulfillment of these orders with our strategic licensees
      and printing vendors.




Legal
      supplies




Revenue
      from our legal supplies business grew 29% during the first quarter of 2006
      compared to the first quarter of 2005. While we view our legal supplies business
      segment as a non-core part of our company, we have experienced steady growth
      in
      its operations as it continues to expand it product catalog and customer reach
      though various keyword advertising campaigns.




**Gross
      profit**


**Three
                  Months Ended 2006****$**
              ****
              **%
                  change vs. 2005**Gross
                  profitDocument
                  Security
              
              
              250,000
              
              
              57
              %Legal
                  supplies
              
              
              67,000
              
              
              40
              %Total
                  gross profit
              
              
              317,000
              
              
              53
              %




**Three
                  Months Ended 2006****%**
              
              **%
                  change vs. 2005**Gross
                  profit percentage:Document
                  Security
              
              
              36
              %
              
              -32
              %Legal
                  supplies
              
              
              39
              %
              
              9
              %Total
                  gross profit percentage
              
              
              37
              %
              
              -23
              %




Document
      Security




The
      57%
      increase in gross profit in the first quarter of 2006 compared to the first
      quarter of 2005 was the result of the inclusion of the Company’s P3 division in
      2006 results. The gross profit percentage decrease reflects the impact of P3’s
      gross profit margin of approximately 35% which was consistent with its
      historical gross profit margin, but is less than the document security
      division’s historical profit margin. As mentioned above, the Company expects
      that its license revenue will increase as the result of recent license
      agreements. License revenue carries a high profit margin (approximately 90%)
      and
      therefore favorably impacts our gross profit margins. In addition, the Company
      expects to be able to increase profit margins at P3 with improvements in
      inventory management and pricing gained by larger order quantities which the
      Company expects to generate.




20




Legal
      supplies




Legal
      supplies gross profit margins increased primarily due to a change in product
      mix
      resulting in a greater percentage of wholesale sales versus drop shipment sales.
      We generally generate higher gross margins on products that we purchase on
      a
      wholesale basis and resell to our customers versus products that we sell as
      a
      dealer for a larger legal supply company.




**Expenses**




**Operating
      expenses**


**Three
                  Months Ended 2006****$**
              ****
              **%
                  change vs. 2005**Selling,
                  general and administrative expenses:Compensation
              
              
              414,000
              
              
              90
              %Stock
                  based compensation
              
              
              27,000
              
              
              -Professional
                  fees
              
              
              359,000
              
              
              55
              %Sales
                  and marketing
              
              
              85,000
              
              
              -41
              %Depreciation
                  and amortization
              
              
              29,000
              
              
              142
              %Other
              
              
              126,000
              
              
              43
              %Research
                  and development
              
              
              73,000
              
              
              -9
              %Amortization
                  of intangibles
              
              
              220,000
              
              
              4789
              %Total operating expenses
              
              
              1,333,000
              
              
              72
              %






**Selling,
      General and Administrative**




Our
      selling, general and administrative costs increases reflect increases to the
      size of our organization that were initiated during the latter half of 2005
      to a
      level that we feel necessary to execute our business plan. Increases in
      compensation costs are primarily due to the additions in sales, service and
      finance personnel, as well as the addition of executive and administrative
      personnel at P3 during the first quarter of 2006.






Professional
      fees include legal, accounting, shareholder services, investor relations, and
      consulting costs. During the first quarter of 2006, we experienced approximately
      $100,000 in legal fees for general corporate governance matters and work on
      it
      two non-European Central Bank lawsuits (regarding Adlertech and F. Laloggia,
      respectively- See *Part
      II -Legal Proceedings* ), and
      approximately $129,000 of accounting and shareholder costs associated with
      the
      filing and mailing of the Company’s annual report. The Company does not expect
      that its general legal and accounting expenses will continue at the level
      experienced in the first three months of the year. ** These
      legal costs do not include legal costs associated with the application and
      defense of our patents which the company capitalizes and amortizes over the
      expected life of the patent. Consulting fees are primarily directed towards
      efforts to help the Company develop contacts and market opportunities with
      government and large multinational corporations.




21




Sales
      and
      marketing expenses decreased in the first quarter of 2006 as compared to the
      first quarter of 2005 primarily due to the high level of costs incurred in
      first
      quarter of 2005 associated with the roll-out of the Company’s “AuthentiGuard”
brandname. We expect that sales and marketing expenses will continue to
      fluctuate as we incur costs incidental with our sales volume.




Other
      expenses are primarily rent and utilities, office supplies, IT support, and
      insurance costs. Increases in the first quarter of 2006 reflect higher rent
      and
      utility costs associated with the move of Legalstore.com into a new facility
      and
      the addition of P3, and increases in office expenses and general and insurance
      associated with the addition of P3 during the quarter.




**Research
      and Development**




We
      continue to invest in research and development to improve our existing
      technologies and develop new technologies that will enhance our position in
      the
      document security market. Research and development costs consists primarily
      of
      compensation costs for our four persons who spend all or at least half of their
      time on developing our technology for new uses and new technologies. In
      addition, we incur costs for the use of third party printers’ facilities test
      our technologies on equipment that we do not have access to internally. We
      expect that our research and development costs will continue at current levels
      for the foreseeable future as we continue to research new technologies and
      different uses of our current technologies.




**Amortization
      of intangibles**




Commencing
      in the second quarter of 2005, we began to amortize the costs associated with
      the patents that we acquired in 2005 and the legal costs associated with the
      development and defense of our patents, including the costs associated with
      our
      suit against the European Central Bank for patent infringement. In addition,
      we
      amortize our acquired intangibles from business combinations. Our amortizable
      asset base at March 31, 2006 was approximately $4.6 million and will generate
      approximately $800,000 in non-cash expense each year for the approximately
      the
      next 6 years.






**Net
      loss**


**Three
                  Months Ended 2006****$**
              ****
              **%
                  change vs. 2005**Net
                  loss
              
              
              (994,000
              )
              
              79
              %






During
      the first three months of 2006 we continued to experience a net loss. While
      we
      have experienced growth in our net sales and our gross profit, these increases
      have not offset our increases in our operating expense, especially significant
      increases in amortization expense of $215,000 as compared to the first quarter
      of 2005 and increases in professional fees of $128,000 as compared to the first
      quarter of 2005, which accounted for nearly 90% of the increase in net loss
      during the first quarter of 2006 versus the first quarter of 2005. We believe
      that we will not continue to sustain losses at the levels we have thus far
      experienced as we continue to grow our revenue in the future.




22




**Loss
      per share**


**Three
                  Months Ended 2006****$**
              ****
              **%
                  change vs. 2005**Net
                  loss
              
              $
              (995,000
              )
              
              77
              %Net
                  loss per share, basic and diluted
              
              
              (0.08
              )
              
              60
              %Weighted
                  average common shares outstanding, basic and diluted
              
              
              12,803,861
              
              
              15
              %






Our
      basic
      and diluted loss per share has increased due to the increased dollar value
      of
      our loss partially offset by an increase in the weighted average common shares
      outstanding in 2006 compared to 2005. Our shares have increased as we have
      used
      our common shares for an acquisition and to purchase patent assets. In addition,
      we have issued shares as the result of exercises of warrants by some of our
      investors as well as to pay certain legal fees.




**LIQUIDITY
      AND CAPITAL RESOURCES**




The
      Company’s cash flows and other key indicators of liquidity are summarized as
      follows:


**Three
                  Months
                  Ended****March
                  31,**
              
              **March
                  31,**
              
              **%****2006**
              
              **2005**
              
              **Change**Operating
                  activities cash flows
              
              $
              (597,000
              )
              $
              (348,000
              )
              
              -72
              %Investing
                  activities cash flows:
              
              
              (1,382,000
              )
              
              (69,000
              )
              
              -1903
              %Financing
                  activities cash flows
              
              
              569,000
              
              
              1,395,000
              
              
              -59
              %Working
                  capital
              
              
              2,064,000
              
              
              3,496,000
              
              
              -41
              %Current
                  ratio
              
              
              2.46
              x
              
              8.13
              x
              
              -70
              %




During
      the first three months of 2006, we used cash for operations as a result of
      our
      operating loss, less non-cash amortization and stock based compensation
      expenses. We anticipate that we will continue to use cash for operations until
      we increase our revenues by a significant amount. While we believe that we
      will
      be able to increase our revenues significantly during 2006, there is no
      guarantee that we will be able to do so. If we do not achieve the revenue levels
      necessary to sustain our current cost structure we expect to initiate cost
      reductions to align our costs with our revenue levels.




23




During
      the first three months of 2006, we invested a significant amount of our cash
      for
      the acquisition of P3, a producer of plastic printed cards in San Francisco,
      California. In addition, we continued to invest in our patent portfolio,
      including the payment of legal costs associated with patent applications and
      the
      defense of our patents. During 2005, we were able to use our common stock to
      pay
      for investments in patents and contractual rights which we may not have
      otherwise been able to had we been required to pay in cash. The use of equity
      for our investments has allowed us to retain cash needed for operations during
      the early stages of our business without sacrificing the investments needed
      to
      secure our competitiveness in the future.




The
      above
      cash outflows were partially offset by cash received from our warrant holders
      who paid approximately $590,000 for the exercise of 140,625 warrants. The
      proceeds from these investors support our operations. Since entering the
      document security business, we have funded a significant portion of our cash
      needs by issuing our securities.




At
      March
      31, 2006, we had cash and cash equivalents of approximately $2,544,000 along
      with restricted cash of $240,000. Our restricted cash is held as collateral
      for
      our current and long-term debt obligation which was approximately $206,000
      at
      March 31, 2006. Our working capital as of March 31, 2006 was approximately
      $2,064,000 which was $1,432,000 or 41% lower than working capital at March
      31,
      2005. The decrease reflects our use of cash for operations and investments
      during the past twelve months. Our working capital position is expected to
      deteriorate as long as we continue to lose money from operations. In order
      to
      support our existing and proposed operations, we may need additional financing.
      Although we have outstanding warrants to purchase our common stock with exercise
      prices below the current market price that can generate approximately $615,000
      in cash financing for the Company, there is no assurance that all or any of
      the
      warrants will be exercised. If the warrants are not exercised, we may be
      required to raise additional funds by borrowing or selling stock to meet our
      cash needs, and there is no guarantee that we will be able to raise such
      additional funds.




**ITEM
      3:   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK**




Our
      market risk exposures are related to our cash, cash equivalents and investments.
      We invest our excess cash in certificates of deposits with maturities of 90
      days
      or less. Changes in interest rates affect the investment income we earn and
      therefore impact our cash flows and results of operations.




We
      mitigate our foreign currency risks principally by contracting primarily in
      U.S.
      dollars. For the quarter ended March 31, 2006, all of our billings, were
      denominated in our functional currency, which is the U.S. dollar.




**ITEM
      4 - CONTROLS AND PROCEDURES**




Evaluation
      of Disclosure Controls and Procedures. Our
      management, with the participation of our principal executive officer and
      principal accounting officer, has evaluated the effectiveness of our disclosure
      controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the
      Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of the end
      of the period covered by this Quarterly Report on Form 10-Q. Based on that
      evaluation, our principal executive officer and principal accounting officer
      have concluded that as of that date, our disclosure controls and procedures
      were
      effective to provide reasonable assurance that information required to be
      disclosed in reports filed or submitted under the Exchange Act is recorded,
      processed, summarized and reported with the time periods specified in the SEC’s
      rules and forms, and to provide reasonable assurance that information required
      to be disclosed by the Corporation in such reports is accumulated and
      communicated to the Corporation’s management, including its principal executive
      officer and principal accounting officer, as appropriate to allow timely
      decisions regarding required disclosure.





24


There
      were no change in the Corporation’s “internal control over financial reporting”
(as such term is defined in Rule 13a-15(f) under the Exchange Act) that occurred
      during the quarter ended March 31, 2005, that has materially affected, or is
      reasonably likely to materially affect, the Corporation’s internal control over
      financial reporting, other than those controls deemed necessary to accommodate
      our material acquisition of the assets and operations of Plastic Printing
      Professionals.







**PART
      II**


**OTHER
      INFORMATION**




**ITEM
      1 - LEGAL PROCEEDINGS**




There
      were no significant developments during the first three months of 2006 in
      connection with our litigation against Adler Technologies and Andrew McTagger.
      This litigation is described in our Form 10-KSB Annual Report for the year
      ended
      December 31, 2005.




There
      were no significant developments during the first three months of 2006 in
      connection with our litigation against Frank
      LaLoggia .
      This
      litigation is described in our Form 10-KSB Annual Report for the year ended
      December 31, 2005.




On
      August
      1, 2005, we commenced a suit against the European Central Bank alleging patent
      infringement by the European Central Bank and have claimed unspecified damages.
      We brought the suit in European Court of First Instance in Luxembourg. We
      alleged that all Euro banknotes in circulation infringe our European Patent
      455750B1, which covers a method of incorporating an anti-counterfeiting feature
      into banknotes or similar security documents to protect against forgeries by
      digital scanning and copying devices. We will seek all remedies available to
      us
      under the law. In November 2005, the European Central Bank filed its answer
      to
      our complaint asserting mostly procedural and jurisdictional arguments. The
      ECB
      contended that it could not be sued for patent infringement, but rather each
      individual country that comprises the ECB should be sued on an individual
      nation-by-nation basis. We responded to the European Central Bank’s answer in
      late December 2005. On March 24, 2006, we received notice that the ECB has
      filed
      a separate claim in the United Kingdom and Luxembourg patent courts (Luxembourg
      being the seat of the European Court of First Instance) seeking the
      invalidation of the Patent.  Claims to invalidity in each of the
      Netherlands, Belgium and France were subsequently served. The main basis of
      the
      ECB’s claim is the existence of prior art. A second basis is that the scope of
      the Patent was extended in prosecution which in Europe is a ground of
      invalidity. If
      the
      ECB is successful, it may materially affect us, our financial condition, and
      our
      ability to market certain technology.





In
      addition to the foregoing, we are subject to other legal proceedings that have
      arisen in the ordinary course of business and have not been finally adjudicated.
      Although there can be no assurance in this regard, in the opinion of management,
      none of the legal proceedings to which we are a party, whether discussed herein
      or otherwise, will have a material adverse effect on our results of operations,
      cash flows or our financial condition.





25




**ITEM
      1a - RISK FACTORS**




An
      investment in our securities is subject to numerous risks, including the Risk
      Factors described below. Our business, operating results or financial condition
      could be materially adversely affected by any of the following risks. The risks
      described below are not the only ones we face. Additional risks we are not
      presently aware of or that we currently believe are immaterial may also
      materially affect our business. The trading price of our Common Stock could
      decline due to any of these risks. In assessing these risks, you should also
      refer to the other information contained or incorporated by reference in this
      Form 10-Q, including our financial statements and related notes.







***We
      have a limited operating history with our business model, which limits the
      information available to you to evaluate our
      business.***




Since
      our
      inception in 1984, we have accumulated deficits from historical operations
      of
      approximately $9,550,000 at December 31, 2004, which has increased to
      approximately $13,355,000 at March 31, 2006. In 2002, we changed our business
      model and chose to strategically focus on becoming a developer and marketer
      of
      secure technologies for all forms of print media. Since 2002, we have had
      approximately $1,500,000 in revenues generated to date from our current document
      security technology. We have continued to incur losses since we began our new
      business model. Also, we have limited operating and financial information
      relating to this new business to evaluate our performance and future prospects.
      Due to the change in our business model, we do not view our historical
      financials as being a good indication of our future. We face the risks and
      difficulties of a company going into a new business including the uncertainties
      of market acceptance, competition, cost increases and delays in achieving
      business objectives. There can be no assurance that we will succeed in
      addressing any or all of these risks, and the failure to do so could have a
      material adverse effect on our business, financial condition and operating
      results.







***Current
      litigation may affect our technology rights and plan of
      operation.***




On
      August
      1, 2005, we filed a patent infringement suit in the European Court of First
      Instance against the European Central Bank (“ECB”) alleging that the Euro
      banknotes infringe our European Patent No 0455750B1 (the “Patent”).   On
      October 20, 2005, the ECB challenged the venue of the lawsuit to which we
      formally responded to the court in December, 2005.  The ECB contended that
      it could not be sued for patent infringement, but rather each individual country
      that comprises the ECB should be sued on an individual nation-by-nation basis.
      On March 24, 2006, we received notice that the ECB has filed a separate counter
      claim in the United Kingdom and Luxembourg patent courts (Luxembourg being
      the
      seat of the European Court of First Instance) seeking the invalidation of
      the Patent.  Claims to invalidity in each of the Netherlands, Belgium and
      France were subsequently served. The main basis of the ECB’s claim is the
      existence of prior art. A second basis is that the scope of the Patent was
      extended in prosecution which in Europe is a ground of invalidity. If
      the
      ECB is successful, it may materially affect us, our financial condition, and
      our
      ability to market certain technology.






On
      January 31, 2003, we commenced an action, unrelated to the above ECB litigation,
      entitled *New
      Sky Communications, Inc., As Successor-In-Interest To Thomas M. Wicker, Thomas
      M.Wicker Enterprises, Inc. And Document Security Consultants V. Adler
      Technologies, Inc. N/K/A Adlertech International, Inc. And Andrew Mctaggert
      (United States District Court, Western District Of New York Case
      No.03-Cv-6044t(F))* regarding
      certain intellectual property in which our company has an interest. We commenced
      this action alleging various causes of action against Adler Technologies, Inc.
      and Andrew McTaggert for breach of contract, breach of the duty of good faith
      and fair dealing and various business torts. Adler distributes and supplies
      anti-counterfeit currency devices and McTaggert is a principal of, and the
      primary contact at, Adler. Adler had entered into several agreements with Thomas
      M. Wicker Enterprises and Document Security Consultants, both of which we
      acquired in 2002. These agreements, generally, authorized Adler to manufacture
      in Canada our “Checkmate ® ”
      patented system for verifying the authenticity of currency and documents. Other
      agreements were entered into between the parties and Thomas Wicker regarding
      other technology owned by Wicker and assigned to us including “Archangel,” an
      anti-copy technology, and “Blockade,” which creates a wave pattern on documents
      when they are reproduced or scanned. It is our contention that Adler has
      breached these agreements, failed to make an appropriate accounting, and may
      have exceeded the scope of its license. Adler has denied the material
      allegations of the complaint and has counterclaimed against our company,
      claiming Adler owns or co-owns or has a license to use certain technologies
      of
      ours, including several U.S. patents. If Adler is successful, it may materially
      affect us, our financial condition, and our ability to market certain
      technology.




26




In
      addition to the foregoing, we are subject to other legal proceedings that have
      arisen in the ordinary course of business and have not been finally adjudicated.
      Although there can be no assurance in this regard, in the opinion of management,
      none of the legal proceedings to which we are a party, whether discussed herein
      or otherwise, will have a material adverse effect on our results of operations,
      cash flows or our financial condition .




***If
      we are unable to adequately protect our intellectual property, our competitive
      advantage may disappear*** .




Our
      success will be determined in part by our ability to obtain United States and
      foreign patent protection for our technology and to preserve our trade secrets.
      Because of the substantial length of time and expense associated with developing
      new document security technology, we place considerable importance on patent
      and
      trade secret protection. Our ability to compete and the ability of our business
      to grow could suffer if these rights are not adequately protected. There can
      be
      no assurance that our patent applications will result in patents being issued
      or
      that current or additional patents will afford protection against competitors.
      We also rely on trade secrets that are not patented. No guarantee can be given
      that others will not independently develop substantially equivalent proprietary
      information or techniques, or otherwise gain access to our proprietary
      technology.






***We
      may face intellectual property infringement or other claims against us or our
      customers that could be costly to defend and result in our loss of significant
      rights.***




Although
      we have received U.S. Patents and a European Patent with respect to certain
      technologies of ours, there can be no assurance that these patents will afford
      us any meaningful protection. We intend to rely primarily on a combination
      of
      patent protection, trade secrets, technical measures, copyright protection
      and
      nondisclosure agreements with our employees to establish and protect the ideas,
      concepts and documentation of software and trade secrets developed by us. Such
      methods may not afford complete protection, and there can be no assurance that
      third parties will not independently develop such technology or obtain access
      to
      the software we have developed. Although we believe that our use of the
      technology and products we developed and other trade secrets used in our
      operations does not infringe upon the rights of others, our use of the
      technology and trade secrets we developed may infringe upon the patents or
      intellectual property rights of others. In the event of infringement, we could,
      under certain circumstances, be required to obtain a license or modify aspects
      of the technology and trade secrets we developed or refrain from using same.
      We
      may not have the necessary financial resources to defend any infringement claim
      made against us or be able to successfully terminate any infringement in a
      timely manner, upon acceptable terms and conditions or at all. Failure to do
      any
      of the foregoing could have a material adverse effect on us. Moreover, if the
      patents, technology or trade secrets we developed or use in our business are
      deemed to infringe upon the rights of others, we could, under certain
      circumstances, become liable for damages, which could have a material adverse
      effect on us. As we continue to market our products, we could encounter patent
      barriers that are not known today. A patent search will not disclose
      applications that are currently pending in the United States Patent Office;
      and
      there may be one or more such pending applications that would take precedence
      over our applications.





27


Furthermore,
      since the date of invention (and not the date of application) governs under
      U.S.
      patent law, future applications could be filed by another party, which would
      preempt our position. While we have taken and continue to take steps to become
      aware of related technical developments, there can be no assurance that we
      will
      not encounter an unfavorable patent situation. Other parties may assert
      intellectual property infringement claims against us or our customers, and
      our
      products may infringe the intellectual property rights of third parties. If
      we
      become involved in litigation, we could lose our proprietary rights, be subject
      to damages and incur substantial unexpected operating expenses. Intellectual
      property litigation is expensive and time-consuming, even if the claims are
      subsequently proven unfounded, and could divert management's attention from
      our
      business. If there is a successful claim of infringement, we may not be able
      to
      develop non-infringing technology or enter into royalty or license agreements
      on
      acceptable terms, if at all. This could prohibit us from providing our products
      and services to customers.




***If
      our products and services do not achieve market acceptance, we may not achieve
      our revenue and net income goals in the time prescribed or at
      all.***




We
      are at
      the early stage of introducing our document security technology and products
      to
      the market. If we are unable to operate our business as contemplated by our
      business model or if the assumptions underlying our business model prove to
      be
      unfounded, we could fail to achieve our revenue and net income goals within
      the
      time we have projected, or at all, which could have a material adverse effect
      on
      our business. As a result, the value of your investment could be significantly
      reduced or completely lost.




We
      cannot
      assure you that a sufficient number of such companies will demand our products
      or services or other document security products. In addition, we cannot predict
      the rate of market's acceptance of our document security solutions. Failure
      to
      maintain a significant customer base may have a material adverse effect on
      our
      business.




***The
      results of our research and development efforts are uncertain and there can
      be
      no assurance of the commercial success of our
      products.***




We
      believe that we will need to continue to incur research and development
      expenditures to remain competitive. The products we currently are developing
      or
      may develop in the future may not be technologically successful. In addition,
      the length of our product development cycle may be greater than we originally
      expect and we may experience delays in future product development. If our
      resulting products are not technologically successful, they may not achieve
      market acceptance or compete effectively with our competitors'
      products.




***Changes
      in document security technology and standards could render our applications
      and
      services obsolete.***




The
      market for document security products, applications, and services is fast moving
      and evolving. Identification and authentication technology is constantly
      changing as we and our competitors introduce new products, applications, and
      services, and retire old ones as customer requirements quickly develop and
      change. In addition, the standards for document security are continuing to
      evolve. If any segments of our market adopt technologies or standards that
      are
      inconsistent with our applications and technology, sales to those market
      segments could decline.




***The
      market in which we operate is highly competitive, and we may not be able to
      compete effectively, especially against established industry competitors with
      greater market presence and financial resources.***




Our
      market is highly competitive and characterized by rapid technological change
      and
      product innovations. Our competitors may have advantages over us because of
      their longer operating histories, more established products, greater name
      recognition, larger customer bases, and greater financial, technical and
      marketing resources. As a result, they may be able to adapt more quickly to
      new
      or emerging technologies and changes in customer requirements, and devote
      greater resources to the promotion and sale of their products. Competition
      may
      also force us to decrease the price of our products and services. We cannot
      assure you that we will be successful in developing and introducing new
      technology on a timely basis, new products with enhanced features, or that
      these
      products, if introduced, will enable us to establish selling prices and gross
      margins at profitable levels. Although several potential competitors have
      expressed an interest to us in forming marketing alliances, there can be no
      assurance that we will undertake such efforts or if undertaken, such efforts
      will prove profitable.




28




***Our
      growth strategy depends, in part, on our acquiring complementary businesses
      and
      assets and expanding our existing operations to include manufacturing
      capabilities, which we may be unable to do.***




Our
      growth strategy is based, in part, on our ability to acquire businesses and
      assets that are complimentary to our existing operations and expanding our
      operations to include manufacturing capabilities. We may also seek to acquire
      other businesses. The success of this acquisition strategy will depend, in
      part,
      on our ability to accomplish the following:




·
            identify
                suitable businesses or assets to buy;


·
            complete
                the purchase of those businesses on terms acceptable to us;


·
            complete
                the acquisition in the time frame we expect;
                and


·
            improve
                the results of operations of the businesses that we buy and successfully
                integrate their operations into our
                own.




There
      can
      be no assurance that we will be successful in pursuing any or all of these
      steps. Our failure to implement our acquisition strategy could have an adverse
      effect on other aspects of our business strategy and our business in general.
      We
      may not be able to find appropriate acquisition candidates, acquire those
      candidates that we find or integrate acquired businesses effectively or
      profitably.




Our
      acquisition program and strategy may lead us to contemplate acquisitions of
      companies in bankruptcy, which entail additional risks and uncertainties. Such
      risks and uncertainties include, without limitation, that, before assets may
      be
      acquired, customers may leave in search of more stable providers and vendors
      may
      terminate key relationships. Also, assets are generally acquired on an “as is”
basis, with no recourse to the seller if the assets are not as valuable as
      may
      be represented. Finally, while bankrupt companies may be acquired for
      comparatively little money, the cost of continuing the operations may
      significantly exceed expectations.




We
      have
      in the past used, and may continue to use, our Common Stock as payment for
      all
      or a portion of the purchase price for acquisitions. If we issue significant
      amounts of our Common Stock for such acquisitions, this could result in
      substantial dilution of the equity interests of our stockholders.





***If
      we fail to retain our key personnel and attract and retain additional qualified
      personnel, we might not be able to pursue our growth
      strategy.***




Our
      future success depends upon the continued service of our executive officers
      and
      other key sales and research personnel who possess longstanding industry
      relationships and technical knowledge of our products and operations. The loss
      of any of our key employees, in particular, Patrick White, our President, Chief
      Executive Officer and Chief Financial Officer; Thomas Wicker, our Vice-President
      of Research and Development; and David Wicker, our Vice-President of Operations,
      could negatively impact our ability to pursue our growth strategy and conduct
      operations. Although we believe that our relationship with these individuals
      is
      positive, there can be no assurance that the services of these individuals
      will
      continue to be available to us in the future. We have extended our employment
      agreements with Patrick White to June 2009. We have also extended our employment
      agreements with Thomas Wicker and David Wicker to June 2007. There can be no
      assurance that these persons will continue to agree to be employed by us after
      such dates.




29




We
      intend
      to hire a Chief Financial Officer for our company and believe that our ability
      to obtain a qualified Chief Financial Officer is material to our future success.
      We also must continue to hire other highly qualified individuals. Our failure
      to
      attract, train and retain management and technical personnel could adversely
      affect our company's ability to grow and to develop new products or product
      enhancements now and in the future.




***If
      we do not successfully expand our sales force, we may be unable to increase
      our
      revenues.***




We
      must
      expand the size of our marketing activities and sales force to increase
      revenues. We continue to evaluate various methods of expanding our marketing
      activities, including the use of outside marketing consultants and
      representatives and expanding our in-house marketing capabilities. Going
      forward, we anticipate an increasing percentage of our revenues to come from
      the
      licensing of our newer technologies, where profit margins are significantly
      higher than those provided by Safety Paper. If we are unable to hire or retain
      qualified sales personnel, if newly hired personnel fail to develop the
      necessary skills to be productive, or if they reach productivity more slowly
      than anticipated, our ability to increase our revenues and grow could be
      compromised. The challenge of attracting, training and retaining qualified
      candidates may make it difficult to meet our sales growth targets. Further,
      we
      may not generate sufficient sales to offset the increased expense resulting
      from
      expanding our sales force or we may be unable to manage a larger sales
      force.




***Future
      growth in our business could make it difficult to manage our
      resources.***




Our
      anticipated business expansion could place a significant strain on our
      management, administrative and financial resources. Significant growth in our
      business may require us to implement additional operating, product development
      and financial controls, improve coordination among marketing, product
      development and finance functions, increase capital expenditures and hire
      additional personnel. There can be no assurance that we will be able to
      successfully manage any substantial expansion of our business, including
      attracting and retaining qualified personnel. Any failure to properly manage
      our
      future growth could negatively impact our business and operating
      results.




***We
      cannot predict our future capital needs and we may not be able to secure
      additional financing.***




We
      may
      need to raise additional funds in the future to fund more aggressive expansion
      of our business, complete the development, testing and marketing of our
      products, or make strategic acquisitions or investments. We may require
      additional equity or debt financings, collaborative arrangements with corporate
      partners or funds from other sources for these purposes. No assurance can be
      given that these funds will be available for us to finance our development
      on
      acceptable terms, if at all. Such additional financings may involve substantial
      dilution of our stockholders or may require that we relinquish rights to certain
      of our technologies or products. In addition, we may experience operational
      difficulties and delays due to working capital restrictions. If adequate funds
      are not available from operations or additional sources of financing, we may
      have to delay or scale back our growth plans.







**Risks
      Related to Our Stock**






***Provisions
      of our certificate of incorporation and agreements could delay or prevent a
      change in control of our company.***




Certain
      provisions of our certificate of incorporation may discourage, delay, or prevent
      a merger or acquisition that a shareholder may consider favorable. These
      provisions include:







·
            the
                authority of the Board of Directors to issue preferred stock;
                and


·
            a
                prohibition on cumulative voting in the election of directors.





30




***We
      have a large number of authorized but unissued shares of common stock, which
      our
      management may issue without further stockholder approval, thereby causing
      dilution of your holdings of our common stock.***




As
      of
      May 1, 2006, there are approximately 186,677,575 million shares of
      authorized but unissued shares of our common stock. Our management will continue
      to have broad discretion to issue shares of our common stock in a range of
      transactions, including capital-raising transactions, mergers, acquisitions,
      for
      anti-takeover purposes, and in other transactions, without obtaining stockholder
      approval, unless stockholder approval is required for a particular transaction
      under the rules of the American Stock Exchange, New York law, or other
      applicable laws. We currently have no specific plans to issue shares of our
      common stock for any purpose. However, if our management determines to issue
      shares of our common stock from the large pool of such authorized but unissued
      shares for any purpose in the future without obtaining stockholder approval,
      your ownership position would be diluted without your further ability to vote
      on
      that transaction.






***The
      exercise of our outstanding options and warrants may depress our stock price.***






As
      of May
      1, 2006, there were outstanding stock options to purchase an aggregate of
      303,250 shares of our Common Stock at exercise prices ranging from $2.20 to
      $12.91 per share, most of which are immediately exercisable. As of May 1, 2006,
      there were outstanding immediately exercisable warrants to purchase an aggregate
      of 156,158 shares of our Common Stock at exercise prices ranging from $2.00
      to
      $5.00 per share. To the extent that these securities are exercised, dilution
      to
      our shareholders will occur. Moreover, the terms upon which we will be able
      to
      obtain additional equity capital may be adversely affected, since the holders
      of
      these securities can be expected to exercise or convert them at a time when
      we
      would, in all likelihood, be able to obtain any needed capital on terms more
      favorable to us than the exercise and conversion terms provided by those
      securities.




Sales
      of
      these shares in the public market, or the perception that future sales of these
      shares could occur, could have the effect of lowering the market price of our
      common stock below current levels and make it more difficult for us and our
      shareholders to sell our equity securities in the future.




Sale
      or
      the availability for sale of shares of common stock by stockholders could cause
      the market price of our common stock to decline and could impair our ability
      to
      raise capital through an offering of additional equity securities.




***We
      do not intend to pay cash dividends.***




We
      do not
      intend to declare or pay cash dividends on our common stock in the foreseeable
      future. We anticipate that we will retain any earnings and other cash resources
      for investment in our business. The payment of dividends on our common stock
      is
      subject to the discretion of our Board of Directors and will depend on our
      operations, financial position, financial requirements, general business
      conditions, restrictions imposed by financing arrangements, if any, legal
      restrictions on the payment of dividends and other factors that our Board of
      Directors deems relevant.






**ITEM
      2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
      PROCEEDS**




On
      February 7, 2006, the Company issued 18,704 shares of the Company’s Common Stock
      valued at $250,000 in connection with an acquisition. The shares issued in
      the
      transaction were not registered under the Securities Act of 1933.




31




We
      did
      not purchase any shares of our common stock during the three months ended March
      31, 2006.




**ITEM
      3 - DEFAULTS UPON SENIOR SECURITIES**




None




**ITEM
      4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS**




Our
      annual meeting of shareholders was held on May 4, 2006. The matters before
      our
      shareholders for vote, as described in our Proxy Statement, dated as of March
      30, 2006, were:





1.
      The
      election of six persons to our Board of Directors;





2.
      The ratification
      of Freed Maxick & Battaglia, CPAs PC as our independent public accountants
      for the fiscal year ending December 31, 2006.





Shareholders
      of record as of March 17, 2006 were entitled to attend and vote at the meeting.
      As of the record date of March 17, 2006, 12,844,313 shares of our Common Stock
      were outstanding. Shareholders representing 7,209,863 shares were present for
      quorum purposes in person or by proxy.





Our
      shareholders approved all of the matters before the meeting. The results of
      the
      voting were as follows:





1.
      Election of Directors


**Name
                of Nominee**
            
            **Votes**
              **For**
            
            **Votes**
              **Withheld**Patrick
                White
            
            7,202,817
            
            7,036Thomas
                Wicker
            
            7,202,840
            
            7,013Alan
                E. Harrison
            
            7,194,795
            
            15,058Timothy
                Ashman
            
            7,194,854
            
            14,999Robert
                Fagenson
            
            7,205,002
            
            4,851Ira
                A. Greenstein
            
            7,195,585
            
            14,268





The
      directors were elected for terms of one year. The Board is comprised of a total
      of six persons.







4.
      R atification
      of Freed Maxick & Battaglia, CPAs PC as the Company’s independent public
      accountants for the fiscal year ending December 31, 2005


**Votes**
              **For**
            
            **Votes**
              **Against**
            
            **Votes**
              **Withheld**7,189,597
            
            10,064
            
            10,192




**ITEM
      5 - OTHER INFORMATION**




32




None




**ITEM
      6 - EXHIBITS**




The
      Exhibits listed below designated by an * are incorporated by reference to the
      filings by Document Security Systems, Inc. under the Securities Act of 1933
      or
      the Securities and Exchange Act of 1934, as indicated. All other exhibits are
      filed herewith.


(a)
            
            Exhibits
              Item
                3.1 Articles of Organization, as amended (incorporated by reference
                to
                exhibit 3.1 to the Company's Registration Statements No. 2-98684-NY
                on
                Form S-18).*
              Item
                3.2 By-laws, as amended (incorporation by reference to exhibit 3.2
                to the
                Company's Registration Statement No. 2-98684-NY on Form
                S-18).*
              
              Item
                31.1Certifications
                of Chief Executive Officer Pursuant to Section 302 of the Sarbanes
                Oxley
                Act
              
              Item
                31.2Certifications
                of Principal Accounting Officer Pursuant to Section 302 of the Sarbanes
                Oxley Act
              
              Item
                32.1Certification
                of Chief Executive Officer Pursuant to Section 906 of the Sarbanes
                Oxley
                Act
              
              Item
                32.2Certification
                of principal Accounting Officer Pursuant to Section 906 of the Sarbanes
                Oxley Act






33


**SIGNATURES**




In accordance with the requirements of the Exchange Act, the registrant caused
      this report on Form 10-Q to be signed on its behalf by the undersigned,
      thereunto duly authorized.




**DOCUMENT
                SECURITY SYSTEMS, INC.**May
                15, 2006
            
            By:
            /s/
                Patrick WhitePatrick
              WhitePresident,
                Chief Executive Officer and
              Acting
                Chief Financial OfficerMay
                15, 2006
            
            By:
            /s/
                Philip JonesPhilip JonesController/Principal
                Accounting Officer





34