UNITED STATES SECURITIES AND
EXCHANGE COMMISSION
 Washington, D.C.
20549
 
 FORM 10-Q/A
 
 QUARTERLY REPORT PURSUANT TO SECTION
13 OR 15(d) OF
 THE SECURITIES EXCHANGE ACT OF
1934
 
 For the quarterly period
ended  September 30,
2008
  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 1525Rochester,NY14614(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 preceding 12 months (or for such shorter period that the registrant
was required to file such reports)
 
 And
 (2) has
been subject to such filing requirements for the past 90 days.
 Yes x No  ̈
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
definition of “large accelerated filer”, “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
 Large
accelerated filer  ̈ Accelerated
filer x Non-accelerated
filer  ̈ Smaller
reporting company  ̈
 
 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
December 30, 2008 (the most recent practicable date), there were 14,472,994
shares of the issuer's Common Stock, $0.02 par value per share,
outstanding.
  
 DOCUMENT SECURITY SYSTEMS,
INC.
 FORM 10-Q/A
 TABLE OF
CONTENTS
 
 PART I
                
                FINANCIAL
      INFORMATIONItem
      1
                
                Financial
      StatementsConsolidated
      Balance Sheets
                
                3Consolidated
      Statements of Operations
                
                4Consolidated
      Statements of Cash Flows
                
                5Notes
      to Interim Consolidated Financial Statements
                
                6Item
      2
                
                Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
                
                16Item
      3
                
                Quantitative
      and Qualitative Disclosures about Market Risk
                
                23Item
      4
                
                Controls
      and Procedures
                
                23PART II
                
                OTHER
      INFORMATIONItem
      1
                
                Legal
      Proceedings
                
                23Item
      1a
                
                Risk
      Factors
                
                25Item
      2
                
                Unregistered Sales
      of Equity Securities and Use of Proceeds
                
                30Item
      3
                
                Defaults
      upon Senior Securities
                
                30Item
      4
                
                Submission
      of Matters to a Vote of Security Holders
                
                30Item
      5
                
                Other
      Information
                
                30Item
      6
                
                Exhibits
                
                31SIGNATURES
 2
  PART I
  FINANCIAL INFORMATION
 ITEM 1 -
FINANCIAL STATEMENTS
 
 DOCUMENT SECURITY SYSTEMS, INC. 
AND SUBSIDIARIES
 Consolidated Balance
Sheets
 As of
 September 30,
                
                December 31,2008
                
                2007(unaudited)
                
                (audited)ASSETSCurrent
      assets:Cash
      and cash equivalents
                
                $
                442,803
                
                $
                742,468Restricted
      cash
                
                
                157,500
                
                
                -Accounts
      receivable, net of allowance of $65,000 ($82,000 as of December 31,
      2007)
                
                
                784,668
                
                
                617,320Inventory
                
                
                230,272
                
                
                259,442Loans
      to employees
                
                
                67,781
                
                
                120,732Prepaid
      expenses and other current assets
                
                
                87,906
                
                
                487,715Total
      current assets
                
                
                1,770,930
                
                
                2,227,677Restricted
      cash
                
                
                -
                
                
                177,345Fixed assets,
      net
                
                
                1,349,230
                
                
                1,494,540Other
    assets
                
                
                258,085
                
                
                147,958Goodwill
                
                
                1,396,734
                
                
                1,396,734Other intangible assets,
      net
                
                
                3,580,285
                
                
                6,149,530Total
    assets
                
                $
                8,355,264
                
                $
                11,593,784LIABILITIES AND STOCKHOLDERS'
      EQUITYCurrent
      liabilities:Accounts
      payable
                
                $
                1,353,926
                
                $
                1,795,085Accrued
      expenses & other current liabilities
                
                
                1,112,404
                
                
                818,606Deferred
      revenue & customer deposits
                
                
                56,580
                
                
                732,355Current
      portion of capital lease obligations
                
                
                84,129
                
                
                79,948Total
      current liabilities
                
                
                2,607,039
                
                
                3,425,994Revolving notes from related
      parties
                
                
                1,858,000
                
                
                300,000Capital lease
      obligations
                
                
                215,229
                
                
                294,821Deferred
      revenue
                
                
                -
                
                
                15,938Deferred tax
      liability
                
                
                203,397
                
                
                200,000Commitments and contingencies
      (see Note 10)Stockholders'
      equityCommon
      stock, $.02 par value; 200,000,000 shares authorized, 14,359,756 shares
      issued and outstanding (13,654,364 in 2007) (325,000 subscribed in
      2008)
                
                
                287,195
                
                
                273,087Additional
      paid-in capital
                
                
                34,881,064
                
                
                31,298,571Subscriptions
      receivable
                
                
                (1,300,000
                )
                
                -Accumulated
      deficit
                
                
                (30,396,660
                )
                
                (24,214,627
                )Total
      stockholders' equity
                
                
                3,471,599
                
                
                7,357,031Total liabilities and
      stockholders' equity
                
                $
                8,355,264
                
                $
                11,593,784
 
 See
accompanying notes
  3
  DOCUMENT SECURITY SYSTEMS, INC. AND
SUBSIDIARIES
 Consolidated Statements of
Operations
 (unaudited)
 
 Three Months Ended September 30,
                
                Nine Months Ended September 30,2008
                
                2007
                
                2008
                
                2007RevenueSecurity
      printing and products
                
                $
                1,334,184
                
                $
                945,941
                
                $
                3,421,437
                
                $
                2,764,323Royalties
                
                
                181,047
                
                
                278,290
                
                
                1,401,522
                
                
                871,243Digital
      solutions
                
                
                8,220
                
                
                9,469
                
                
                24,660
                
                
                184,240Legal
      products
                
                
                150,129
                
                
                175,725
                
                
                482,561
                
                
                513,070Total
      Revenue
                
                
                1,673,580
                
                
                1,409,425
                
                
                5,330,180
                
                
                4,332,876Costs
      of revenueSecurity
      printing and products
                
                
                635,934
                
                
                635,935
                
                
                2,027,636
                
                
                1,691,473Digital
      solutions
                
                
                3,507
                
                
                3,507
                
                
                10,521
                
                
                40,521Legal
      products
                
                
                86,120
                
                
                82,575
                
                
                257,536
                
                
                276,342Total
      costs of revenue
                
                
                725,561
                
                
                722,017
                
                
                2,295,693
                
                
                2,008,336Gross profit
                
                
                948,019
                
                
                687,408
                
                
                3,034,487
                
                
                2,324,540Operating expenses:Selling,
      general and administrative
                
                
                1,789,790
                
                
                1,979,171
                
                
                5,828,136
                
                
                5,587,903Research
      and development
                
                
                72,876
                
                
                110,833
                
                
                322,106
                
                
                314,130Impairment
      of patent defense costs
                
                
                -
                
                
                -
                
                
                291,581
                
                
                -Amortization
      of intangibles
                
                
                540,934
                
                
                480,256
                
                
                1,605,104
                
                
                1,258,985Operating
      expenses
                
                
                2,403,600
                
                
                2,570,260
                
                
                8,046,927
                
                
                7,161,018Operating loss
                
                
                (1,455,581
                )
                
                (1,882,852
                )
                
                (5,012,440
                )
                
                (4,836,478
                )Other income (expense):Interest
      income
                
                
                484
                
                
                14,829
                
                
                569
                
                
                89,816Gain
      (loss) on foreign currency transactions
                
                
                7,534
                
                
                (6,378
                )
                
                (16,652
                )
                
                (10,669
                )Interest
      expense
                
                
                (41,208
                )
                
                (1,362
                )
                
                (95,098
                )
                
                (3,811
                )Loss
      on sale of patent assets
                
                
                (1,169,947
                )
                
                -
                
                
                (1,169,947
                )
                
                -Other
      Income
                
                
                -
                
                
                -
                
                
                125,795
                
                
                -Loss from continuing operations
      before income taxes
                
                
                (2,658,718
                )
                
                (1,875,763
                )
                
                (6,167,773
                )
                
                (4,761,142
                )Income
      tax expense
                
                
                4,738
                
                
                4,738
                
                
                14,260
                
                
                14,214Loss from continuing operations
                
                
                (2,663,456
                )
                
                (1,880,501
                )
                
                (6,182,033
                )
                
                (4,775,356
                )Loss from discontinued
      operations (Note 8)Gain
      on sale of discontinued assets
                
                
                
                
                
                42,905
                
                
                
                
                
                42,905Loss
      from discontinued operations
                
                
                -
                
                
                (43,807
                )
                
                -
                
                
                (59,233
                )Loss
      on discontinued operations
                
                
                -
                
                
                (902
                )
                
                -
                
                
                (16,328
                )Net loss
                
                $
                (2,663,456
                )
                $
                (1,881,403
                )
                $
                (6,182,033
                )
                $
                (4,791,684
                )Net loss per share -basic and
      diluted:Continuing
      operations
                
                $
                (0.19
                )
                $
                (0.14
                )
                $
                (0.45
                )
                $
                (0.35
                )Discontinued
      operations
                
                
                (0.00
                )
                
                0.00
                
                
                (0.00
                )
                
                0.00Net
      Loss
                
                $
                (0.19
                )
                $
                (0.14
                )
                $
                (0.45
                )
                $
                (0.35
                )Weighted average common shares
      outstanding, basic and diluted
                
                
                14,286,192
                
                
                13,676,030
                
                
                13,879,891
                
                
                13,629,241
  See
accompanying notes
  4
 
 DOCUMENT SECURITY SYSTEMS, INC. AND
SUBSIDIARIES
 Consolidated Statements of Cash
Flows
 For the Nine Months Ended September
30,
 (unaudited)
  2008
              
              2007Cash flows from operating
      activities:Net
      loss
              
              $
              (6,182,033
              )
              $
              (4,791,684
              )Adjustments
      to reconcile net loss to net cash used by operating
      activities:Depreciation
      and amortization
              
              
              1,841,975
              
              
              1,396,262Stock
      based compensation
              
              
              1,536,403
              
              
              970,829Impairment
      of patent defense costs
              
              
              291,581
              
              
              -Net
      gain on disposal of discontinued operations
              
              
              -
              
              
              (42,905
              )Loss
      on sale of patent assets
              
              
              1,169,947
              
              
              -Decrease
      in restricted cash
              
              
              19,845
              
              
              -(Increase)
      decrease in assets:Accounts
      receivable
              
              
              (167,348
              )
              
              (112,870
              )Inventory
              
              
              29,170
              
              
              4,762Prepaid
      expenses and other assets
              
              
              (43,049
              )
              
              (171,526
              )Increase
      (decrease) in liabilities:Accounts
      payable
              
              
              (65,053
              )
              
              445,334Accrued
      expenses and other liabilities
              
              
              143,914
              
              
              (25,635
              )Deferred
      revenue
              
              
              (691,713
              )
              
              (234,464
              )Net
      cash used by operating activities
              
              
              (2,116,361
              )
              
              (2,561,897
              )Cash flows from investing
      activities:Purchase
      of fixed assets
              
              
              (226,716
              )
              
              (423,918
              )Proceeds
      from the sale of discontinued operations
              
              
              -
              
              
              80,000Proceeds
      from the sale of patent assets
              
              
              500,000
              
              
              -Purchase
      of other intangible assets
              
              
              (1,144,351
              )
              
              (1,150,977
              )Net
      cash used by investing activities
              
              
              (871,067
              )
              
              (1,494,895
              )Cash flows from financing
      activities:Borrowing
      on short-term credit facility
              
              
              500,000
              
              
              -Repayment
      on short-term credit facility
              
              
              (500,000
              )
              
              -Borrowing
      on revolving note- related parties
              
              
              1,558,000
              
              
              -Repayments
      of capital lease obligations
              
              
              (75,411
              )
              
              (27,140
              )Increase
      in restricted cash
              
              
              -
              
              
              (177,345
              )Payment
      of stock issuance costs
              
              
              -
              
              
              (519,619
              )Issuance
      of common stock
              
              
              1,205,174
              
              
              355,225Net
      cash provided (used) by financing activities
              
              
              2,687,763
              
              
              (368,879
              )Net increase (decrease) in cash
      and cash equivalents
              
              
              (299,665
              )
              
              (4,425,671
              )Cash and cash equivalents
      beginning of period
              
              
              742,468
              
              
              5,802,615Cash and cash equivalents end
      of period
              
              $
              442,803
              
              $
              1,376,944
 
 See
accompanying notes.
  5
  DOCUMENT SECURITY SYSTEMS,
INC.
 NOTES TO INTERIM CONSOLIDATED
FINANCIAL STATEMENTS
 September 30,
2008
 (Unaudited)
  1.     Basis of
Presentation and Significant Accounting Policies
  The
accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with U.S. generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and Article
10 of Regulation S-X. Accordingly, these statements do not include all of the
information and footnotes required by U.S. generally accepted accounting
principles for complete financial statements. In the opinion of management, the
accompanying balance sheets and related interim statements of operations and
cash flows include all adjustments, consisting only of normal recurring items
necessary for their fair presentation in accordance with U.S. generally accepted
accounting principles. All significant intercompany transactions have been
eliminated.
 
 Interim
results are not necessarily indicative of results expected for a full year. For
further information regarding Document Security Systems, Inc (the “Company”)
accounting policies, refer to the audited consolidated financial statements and
footnotes thereto included in the Company's Form 10-K for the fiscal year ended
December 31, 2007.
 
 The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ materially from those estimates
and assumptions.
 
 Other Intangible
Assets – Other
intangible assets consists of costs associated with the application, acquisition
and defense of the Company’s patents, contractual rights to patents and trade
secrets associated with the Company’s technologies, a non-exclusive licensing
agreement, and customer lists obtained as a result of acquisitions. The
Company’s patents and trade secrets are for document anti-counterfeiting and
anti-scanning technologies and processes that form the basis of the Company’s
document security business. External legal costs incurred to defend the
Company’s patents are capitalized to the extent of an evident increase in the
value of the patents and an expected successful outcome. Legal costs are
expensed at the point when it is determined that the outcome is expected to be
unsuccessful. The Company capitalizes the cost of an appeal until it is
determined that the appeal will be unsuccessful. The Company’s capitalized
patent defense costs expenses are analyzed for impairment based on the expected
eventual outcome of the legal action and recoverability of proceeds or added
economic value of the patent in excess of the costs. Legal actions related to
the same patent defense case are unified into one asset group for the purposes
on the impairment analysis. The Company amortizes its other intangible assets
over their estimated useful lives. Patents are amortized over the remaining
legal life, up to 20 years. Intangible asset amortization expense is classified
as an operating expense.
 
 Recent Accounting
Pronouncements In
September 2006, the FASB issued SFAS No.157 , Fair Value
Measurements . SFAS
No. 157, as amended, defines fair value, establishes a framework for measuring
fair value in accordance with accounting principles generally accepted in the
United States of America, and expands disclosures about fair value measurements.
With respect to financial assets and liabilities, SFAS No. 157 is effective for
financial statements issued for fiscal years beginning after November 15,
2007. However, in February 2008, the FASB determined that an entity need
not apply this standard to nonfinancial assets and liabilities that are
recognized or disclosed at fair value in the financial statements on a
nonrecurring basis until 2009. Accordingly, the Company’s adoption of this
standard on January 1, 2008, is limited to financial assets and
liabilities and did not have a material effect on the Company’s financial
condition or results of operations. The Company’s still in the process of
evaluating the impact of this standard with respect to its effect on
nonfinancial assets and liabilities and has not yet determined the impact that
it will have on the consolidated financial statements upon full adoption.
 
 In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities , which
permits entities to choose to measure certain financial assets and liabilities
at fair value. SFAS No. 159 is effective for years beginning after
November 15, 2007. The Company has not adopted the fair value option
method permitted by SFAS No. 159.
  6
  In
December 2007, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 141 (revised 2007), “ Business
Combinations ” (“SFAS
141R”), which replaces SFAS 141. SFAS 141R establishes principles and
requirements for how an acquirer in a business combination recognizes and
measures in its financial statements the identifiable assets acquired, the
liabilities assumed, and any controlling interest; recognizes and measures the
goodwill acquired in the business combination or a gain from a bargain purchase;
and determines what information to disclose to enable users of the financial
statements to evaluate the nature and financial effects of the business
combination. SFAS 141R is to be applied prospectively to business combinations
for which the acquisition date is on or after an entity’s fiscal year that
begins after December 15, 2008. We are currently evaluating the potential
impact of the adoption of SFAS 141R on our consolidated financial position,
results of operations and cash flows.
 
 In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements-on Amendment of ARB No. 51 . SFAS
No. 160 establishes accounting and reporting standards for the noncontrolling
interest in a subsidiary. SFAS No. 160 is effective for financial statements
issued for fiscal years beginning after December 15, 2008, and interim
statements within those fiscal years. Among other things, SFAS No. 160 requires
noncontrolling interest to be included as a component of shareholders’ equity.
The Company does not currently have any noncontrolling interests.
 
 On
December 21, 2007, the SEC issued Staff Accounting Bulletin No. 110,
“Share-Based Payment”. SAB No. 110 addresses the use of a “simplified”
method in developing an estimate of expected term of “plain vanilla” share
options in accordance SFAS No. 123(R), “Share-Based Payment”. SAB
No. 110 allows the use of the “simplified” method of estimating expected
term where a company may not have sufficient historical exercise data. SAB
No. 110 is effective January 1, 2008 and the Company plans to
continue to use the simplified method to estimate the expected term of its plain
vanilla employee options.
  On
December 12, 2007, the Financial Accounting Standards Board (FASB) ratified the
Emerging Issues Task Force (“EITF”) opinion related to EITF Issue 07-1,
“Accounting for Collaborative Arrangements.” The Task Force reached a consensus
that a collaborative arrangement is a contractual arrangement that involves two
or more parties, all of which are both (a) involved as active participants in a
joint operating activity that is not conducted primarily through a separate
legal entity and (b) exposed to significant risks and rewards that depend on the
commercial success of the joint operating activity. This Issue also addresses
(i) the income statement classification by participants in a collaborative
arrangement for transactions with third parties and transactions between the
participants and (ii) financial statement disclosures. The consensus on EITF
Issue 07-1 is effective for fiscal years beginning after December 15, 2008, and
for interim periods within those fiscal years. Entities should apply the
consensus retrospectively to all periods presented for only those collaborative
arrangements existing as of the effective date, unless it is impractical to do
so. The Company will adopt this new accounting pronouncement effective January
1, 2009, and does not anticipate any material impact on its financial condition
or results of operations.
 
 In
April 2008, the FASB issued FSP FAS 142-3, “Determination of Useful Life of
Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends the factors that
should be considered in developing the renewal or extension assumptions used to
determine the useful life of a recognized intangible asset under FAS 142,
“Goodwill and Other Intangible Assets.” FSP FAS 142-3 also requires expanded
disclosure related to the determination of intangible asset useful lives. FSP
FAS 142-3 is effective for fiscal years beginning after December 15, 2008.
The Company is currently evaluating the potential impact the adoption of FAS FSP
142-3 will have on its financial statements.
  In
May 2008, the FASB issued FASB Staff Position (“FSP”) APB 14-1, “Accounting
for Convertible Debt Instruments That May Be Settled in Cash upon Conversion
(Including Partial Cash Settlement)” (“FSP APB 14-1”), which clarifies the
accounting for convertible debt instruments that may be settled in cash upon
conversion, including partial cash settlement. FSP APB 14-1 specifies that an
issuer of such instruments should separately account for the liability and
equity components of the instruments in a manner that reflect the issuer’s
non-convertible debt borrowing rate when interest costs are recognized in
subsequent periods. FSP APB 14-1 is effective for fiscal years beginning after
December 15, 2008, and retrospective application is required for all
periods presented. The Company is currently evaluating the potential impact of
the adoption of FSP APB 14-1 on its financial statements.
  In May
2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted
Accounting Principles. The purpose of this statement is to improve financial
reporting by providing a consistent framework for determining applicable
accounting principles to be used in the preparation of financial statements
presented in conformity with accounting principles generally accepted in the
United States of America. SFAS No. 162 will become effective 60 days after the
SEC’s approval. The Company believes that the adoption of this standard on its
effective date will not have a material effect on the consolidated financial
statements
  7
  In June
2008, the FASB issued FSP EITF 03-6-1 to address whether instruments granted in
share-based payment transactions are participating securities prior to their
vesting and therefore need to be included in the earnings per share calculation
under the two-class method described in SFAS No. 128, “Earnings per Share.” This
FSP requires companies to treat unvested share-based payment awards that have
non-forfeitable rights to dividends or dividend equivalents as participating
securities and thus, include them in calculation of basic earnings per share.
FSP EITF 03-6-1 is effective for fiscal years beginning after December 15, 2008.
The Company does not anticipate a material impact on its financial statements or
its computation of basic earnings per share upon adoption.
  During
the quarter ended June 30 2008, the Company adopted FSP 00-19-2, Accounting
for Registration Payment Arrangements. This FSP specifies that the contingent
obligation to make future payments or otherwise transfer consideration under a
registration payment arrangement, whether issued as a separate agreement or
included as a provision of a financial instrument or other agreement, should be
separately recognized and measured in accordance with FASB Statement No. 5,
Accounting for Contingencies. The Company has determined it to be remote, that
it will be required to remit payments to the investors for failing to obtain an
effective registration statement  on or
before the required time frame.
  2.     Restricted
Cash
  In July
2007, the Company established a restricted cash balance of 87,500 British
pounds, or approximately $157,500 (as of September 30, 2008), as collateral for
a deed of guarantee that was required by the English Court of Appeals in order
for the Company to pursue an appeal in that court. On March 19, 2008, the
Company was notified that its appeal was denied and that the Company owed the
European Central Bank, the successful party in the appeal, the 87,500 British
pounds. On May 14, 2008, the Company made a payment of 87,500 British pounds to
the European Central Bank as an interim payment of the appeal costs pending
final assessment by the Court which is expected in the fourth quarter of 2008.
The Company was not able to apply the funds in its restricted account to this
payment. The Company will use the restricted funds to pay additional fees due
upon final assessment of the costs by the Court, if any. Accordingly, the
Company classified the restricted cash as current as of September 30, 2008. (See
Note 10 Commitments and
Contingencies)
  3.  Inventory
  Inventory
consisted of the following:
  September 30
              
              December 31,2008
              
              2007(unaudited)
              
              (audited)Finished
      Goods
              
              $
              143,606
              
              $
              161,978Raw
      Materials
              
              
              86,666
              
              
              97,464$
              230,272
              
              $
              259,442
  8
  4.     Other
Intangible Assets
  Other
intangible assets are comprised of the following:
 
 September 30, 2008
              
              December 31, 2007Useful
                Life
              
              Gross Carrying
                Amount
              
              Accumulated
                Amortizaton
              
              Net Carrying
                Amount
              
              Gross Carrying
                Amount
              
              Accumulated
                Amortizaton
              
              Net Carrying
                AmountRoyalty
      rights
              
              
              5 years
              
              $
              90,000
              
              $
              85,500
              
              $
              4,500
              
              $
              90,000
              
              $
              72,000
              
              $
              18,000Other
      intangibles
              
              
              5
      years
              
              
              1,187,595
              
              
              508,374
              
              $
              679,221
              
              
              1,187,595
              
              
              335,304
              
              
              852,291Patent
      and contractual rights
              
              
              Varied
              (1)
              
              5,427,570
              
              
              2,531,006
              
              $
              2,896,564
              
              
              8,205,340
              
              
              2,926,101
              
              
              5,279,239$
              6,705,165
              
              $
              3,124,880
              
              $
              3,580,285
              
              $
              9,482,935
              
              $
              3,333,405
              
              $
              6,149,530
  (1)-
patent rights are amortized over their expected useful life which is generally
the legal life of the patent. As of September 30, 2008 the weighted average
remaining useful life of these assets in service was 3.0 years.
  On March
19, 2008, the Company received notification that its appeal of the invalidation
of its European Patent 455750B1 in the UK was not successful. As result of the
adverse court decision, the Company recognized an impairment loss of
approximately $292,000 associated with the U.K appeal as of March 31, 2008. The
impairment loss includes a judgment for reimbursement of estimated counterpart
legal fees. The Company may owe additional counter party legal fees associated
with the decision, which the Company will expense as soon as the amount, if any,
is estimatable.
  On August
20, 2008, the Company entered into an agreement with Trebuchet Capital Partners,
LLC (“Trebuchet”) under which Trebuchet has agreed to pay substantially all of
the litigation costs associated with pending validity proceedings initiated by
the European Central Bank (“ECB”) in eight European countries relating to the
Company’s European Patent 0 455 750B1 that the Company has claimed the ECB
infringed in printing of the Euro currency (the “Patent”). Trebuchet also agreed
to pay substantially all of the litigation costs associated with future validity
challenges filed by the ECB or other parties, provided that Trebuchet elects to
assume the defense of any such challenges, in its sole discretion, and patent
infringement suits filed against the ECB and certain other alleged infringers of
the Patent, all of which suits may be brought at the sole discretion of
Trebuchet and may be in the name of the Company, Trebuchet or both. The Company
provided Trebuchet with the sole and exclusive right to manage infringement
litigation relating to the Patent in Europe, including the right to initiate
litigation in the name of the Company, Trebuchet or both and to choose whom and
where to sue, subject to certain limitations set forth in the agreement. Under
the terms of the Agreement, the Company and Trebuchet have agreed to equally
share all proceeds generated from litigation relating to the Patent, including
judgments and licenses or other arrangements entered into in settlement of any
such litigation. Trebuchet is also entitled to recoup any litigation expenses
specifically awarded to the Company in such actions.
 
 Under the
terms of the Agreement, and in consideration for Trebuchet’s funding agreement,
the Company assigned and transferred a 49% interest of all of the Company’s
right, title and interest in the Patent to Trebuchet which allows Trebuchet to
have a separate and exclusive interest including a separate and distinct right
to exploit the Patent. Pursuant to this transaction, the Company recognized a
loss on the sale of patent assets for its assignment and transfer of 49% of its
ownership rights in the patent, which had a net book value of approximately
$1,670,000, for proceeds of $500,000. As a result, the Company recognized a loss
on sale of patent assets of approximately $1,170,000. The Company considered
this a triggering event and reviewed its remaining capitalized patent costs for
impairment as of September 30, 2008. With the assistance of Trebuchet, the
Company determined that the expected eventual outcome of the legal action and
recoverability of proceeds or added economic value of the patent was still in
excess of the current carrying amount.
  9
  5.     Revolving
Notes
  On
January 4, 2008, the Company entered into a Credit Facility Agreement with
Fagenson and Co., Inc., as agent, a related party to Robert B. Fagenson, the
Chairman of the Company's Board of Directors. Under the Fagenson Credit
Agreement, the Company can borrow up to a maximum of $3,000,000 from time to
time up to and until January 4, 2010. The advances are generally limited to
$400,000 unless otherwise mutually agreed upon by both parties per fiscal
quarter, with the exception of $600,000 that can be advanced at any time for
patent litigation related bills. Any amount borrowed by the Company pursuant to
the Fagenson Credit Agreement will have an annual interest rate of 2% above
LIBOR and will be secured by the Common Stock of Plastic Printing Professionals,
Inc., (“P3”) the Company's wholly owned subsidiary. Interest is payable
quarterly in arrears and the principal is payable in full at the end of the term
under the Fagenson Credit Agreement. In addition, on January 4, 2008, the
Company also entered into a Credit Facility Agreement with Patrick White, the
Company's Chief Executive Officer and a member of the Board of Directors. Under
the White Credit Agreement, the Company can borrow up to $600,000 from time to
time up to and until January 4, 2010. Any amount borrowed by the Company
pursuant to the White Credit Agreement will have an annual interest rate of 2%
above LIBOR and will be secured by the accounts receivable of the Company,
excluding the accounts receivable of P3. Interest is payable quarterly in
arrears and the principal is payable in full at the end of the Term under the
White Credit Agreement. Mr. White can accept common stock as repayment of the
loan upon a default. Under the terms of the agreement the Company is required to
comply with various covenants. During the year ended December 31, 2007, Patrick
White advanced the Company $300,000 while the terms of the credit facility were
being finalized. As of September 30, 2008, the Company was in technical default
of both agreements due to a failure to pay interest when due. Both Fagenson and
Co., Inc. and Patrick White have agreed to waive the defaults through January 1,
2010.
  As of
September 30, 2008, the Company had outstanding $450,000 under the White Credit
Agreement, $1,408,000 under the Fagenson Credit Agreement. Interest expense
amounted to $63,000 for the nine month period ending September 30, 2008 and is
included in accrued expenses as of September 30, 2008.
  On May 7,
2008 the Company entered into a $500,000 unsecured credit facility with Taiko
III Corp to fund the Company’s ongoing patent infringement and related lawsuits
against the European Central Bank. Interest shall accrue on the unpaid principal
amount at a 6% annual rate. The outstanding principal amount may be prepaid by
the Company, in whole but not in part and including the full interest through
the maturity of the loan, at its option so long as the Company provides Taiko
III with prior written notice of such prepayment. The term of the line of credit
is 364 days. In addition, the loan can be repaid by the Company, at the
discretion of Taiko III if the Company had defaulted under the credit facility,
by using the Company’s common stock at a discount to the market value at the
time of the repayment at 33% to market at the time of payment at no less than
$2.00 per share and no more than $5.00 per share. On August 20, 2008, the
Company entered into an agreement with Trebuchet Capital Partners, which, among
other things, called for Trebuchet to pay the Company $500,000, which the
Company used to pay in full the Company’s existing obligation owed to Taiko III
Corp. See Note 4.
  6.    
Shareholders’ Equity
  Stock Issued for Patent Defense
Costs  -  On
November 14, 2006, the Company entered into an stock payment agreement with
McDermott Will & Emery LLP (“MWE”), its lead counsel on its European Central
Bank (“ECB Litigation”) patent infringement and related cases. The agreement
with MWE allows the Company to use its common stock to eliminate the Company’s
cash requirements for MWE’s legal fees related to the ECB validity litigation,
not to exceed $1.2 million in stock. During the nine months ended September 30,
2007, 60,866 restricted common shares were issued to MWE to pay for
approximately $746,000 of legal fees incurred through September 30, 2007.
 
 Stock Issued in Private Placement - On June
25, 2008 the Company entered into two Share Purchase Agreements pursuant to
which the Company agreed to sell a total of 500,000 shares of the Company’s
common stock for an aggregate purchase price of $2,000,000. Pursuant to the
terms of the first Agreement, the Company sold 150,000 shares of Common Stock to
the Purchaser for $600,000 payable on June 25, 2008. Pursuant to the terms of
the second Agreement, the Company sold 350,000 shares of Common Stock for
$1,400,000, with $100,000 payable on June 25, 2008 and the remaining $1,300,000
payable in six-month installments over a two-year period. Pursuant to the terms
of the first Agreement, the Purchaser may not sell the 150,000 shares of Common
Stock purchased thereunder earlier than June 25, 2009. Pursuant to the terms of
the second Agreement, the Purchaser may not sell the 350,000 shares of Common
Stock purchased thereunder until the earlier of (i) one year after the Purchase
Price being paid in full to the Company, or (ii) the one-year anniversary of a
Payment Failure Termination Event (as defined in the second Agreement). (See
Note 10 -Commitments)
 
 On
January 22, 2007, the Company sold 6 units at a price of $50,000 per unit for
gross proceeds of $300,000 consisting of 35,280 unregistered shares of the
Company’s common stock and five-year warrants to purchase up to an aggregate of
17,640 shares of the Company’s common stock at an exercise price of $11.75 per
share. The fair market value of these warrants was determined using the Black
Scholes option pricing model at $107,000.
 
 On August
20, 2008, the Company entered into an agreement with Trebuchet Capital Partners,
LLC who agreed to pay substantially all of the litigation costs associated with
pending validity proceedings initiated by the ECB in eight European countries
relating to the Company’s European Patent 0 455 750B1 that the Company has
claimed the ECB infringed in printing of the Euro currency. Trebuchet has also
purchased 100,000 shares of the Company’s common stock, for an aggregate
purchase price of $400,000, the proceeds of which were used by the Company to
pay existing litigation cost.
  10
  Restricted Stock – As of
September 30, 2008, there are 42,793 unvested restricted shares granted to
employees and consultants that vest through June 2009. In addition, there are
195,000 restricted shares that will vest only upon the occurrence of certain
events over the next 4 years, which include, among other things a change of
control of the Company or other merger or acquisition of the Company, the
achievement of certain financial goals, including among other things a
successful result of the Company’s patent infringement lawsuit against the
European Central Bank. These 195,000 shares, if vested, would result in the
recording of stock based compensation expense of approximately $2,438,000, the
grant date fair value, over the period beginning when any of the contingent
vesting events is deemed to be probable over the expected requisite service
period. As of September 30, 2008, vesting is not considered probable and no
compensation expense has been recognized related to the performance grants. On
May 10, 2008, the Company accelerated the vesting of 33,333 restricted shares
and retired 250,000 of unvested restricted stock as the result of a separation
agreement with the Company’s former President. The 33,333 shares of restricted
stock, formerly set to vest pro-ratably through June 2009, were accelerated to
vest pro-ratably on a monthly basis over a ten-month vesting period ending in
March 2009. As a result of the acceleration of the 33,333 shares of restricted
stock, the Company recognized approximately $194,000 of stock based compensation
during the second quarter of 2008. (See Note 10 -Commitments)
  Stock
Options – During
the nine months ended September 30, 2008, the Company issued options to purchase
37,000 of its common shares at an exercise price of $6.31 per share to
non-employee directors pursuant to the 2004 Non-Employee Officer Director Stock
Option Plan that vest at the end of one of year of service on the Company’s
Board of Directors. The Company also issued options to purchase 50,000 of its
common shares at an exercise price of $5.68 per share to employees pursuant to
the 2004 Employee Stock Option Plan that will vest over three years. The
aggregate fair value of these options amounted to approximately $220,000
determined by utilizing the Black Scholes option pricing model. The Company
records stock-based payment expense related to these options based on the grant
date fair value in accordance with FASB 123R.
  Stock
Warrants – During
the nine months ended September 30, 2008, the Company received $100,000 in
proceeds from the exercise of warrants to purchase 50,000 shares of our common
stock. During the nine months ended September 30, 2007, the Company received
approximately $55,000 in proceeds from the exercise of warrants to purchase
12,125 shares of our common stock.
 
 Stock-Based
Compensation - Stock-based
compensation includes expense charges for all stock-based awards to employees,
directors and consultants. Such awards include option grants, warrant grants,
and restricted stock awards. During the nine months ended September 30, 2008,
the Company recognized approximately $1,536,000 ($971,000- 2007) in stock-based
compensation. Approximately $194,000 of the expense was the result of the
acceleration of vesting of restricted shares to the Company’s former President
as the result of his separation from the Company in May 2008.
 
 As of
September 30, 2008, there was approximately $816,000 of total unrecognized
compensation costs related to non-vested options and restricted stock granted
under the Company’s stock option plans which the Company expects to vest over a
period of not to exceed five years.
 
 On August
13, 2008, the Company cancelled 330,500 employee stock options with exercise
prices ranging from $6.24 to $12.50, and replaced the cancelled options with
330,500 employee stock options with an exercise price of $6.00. No other terms
of the options were modified. On the date of grant, the fair market value of the
Company’s Common Stock was $5.15. The repricing was treated as a modification
under FAS123R, and resulted in an additional aggregate fair value expense
determined using the Black- Scholes option pricing model of approximately
$225,000, of which approximately $170,000 was expensed as of the grant date for
fully vested options. The remaining fair value of the modified options will be
expensed proratably during the expected vesting period of the options thru 2010.
 
 7. Other Income
 On May
31, 2008, the Company was awarded a judgment of approximately $126,000 pursuant
to a positive judgement for the Company in its counterclaim the matter “Frank
LaLoggia v. Document Security Systems, Inc”, which the Company won in June 2006.
The Company expects to collect the full amount of the judgment.
  11
  8.    
Discontinued Operations
 
 On
September 25, 2007, the Company sold certain assets and the operations of its
retail copying and quickprinting operations to an unrelated third party for
$80,000 and the assumption of ongoing operating leases. The sale included fixed
assets with a net book value of approximately $37,000. The Company recognized a
gain on the sale of approximately $43,000. In accordance with SFAS 144, the
disposal of assets constitutes a component of the entity and has been accounted
for as discontinued operations. The operating results relating to these assets
are segregated and reported as discontinued operations in the accompanying 2007
consolidated statement of operations. The results of operations directly
attributed to the division’s operations that have been reclassified from
continuing operations are as follows:
 
 Three Months Ended
              
              Nine Months EndedSeptember 30, 2007
              
              September 30, 2007Revenues
              
              $
              72,791
              
              
              292,282Cost
      of sales
              
              
              48,720
              
              
              150,525Operating
      expenses
              
              
              67,878
              
              
              200,990Income
      from discontinued operations
              
              $
              (43,807
              )
              
              (59,233
              )
  9.     Earnings
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.  If the Company had generated earnings during the nine month
period ended September 30, 2008, 426,980 (767,887- 2007) common equivalent
shares would have been added to the weighted average shares outstanding to
compute the diluted weighted average shares outstanding.
 
 10.    
Commitments and Contingencies
  Legal Matters
  On August
1, 2005, the Company commenced a suit against the European Central Bank (“ECB”)
alleging patent infringement by the ECB and claimed unspecified damages. The
suit was brought in European Court of First Instance in Luxembourg. The Company
alleged that all Euro banknotes in circulation infringe the Company European
Patent 0 455 750B1 (the “Patent”), 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. The Court of
First Instance ruled on September 5, 2007 that it does not have jurisdiction to
rule on the patent infringement claim, and also ruled that the Company will be
required to pay attorneys and court fees of the ECB. The ECB formally requested
the Company to pay attorneys and court fees in the amount of Euro 93,752
($144,000), which, unless the amount is agreed will be subject to an assessment
procedure that will not likely be concluded until approximately the end of 2008,
which the Company will accrue as soon as the assessed amount, if any, is
estimatable.
 
 On March
24, 2006, the Company received notice that the ECB has filed a separate claim in
the United Kingdom and Luxembourg courts seeking the invalidation of the
Patent. Proceedings were commenced before the national courts seeking revocation
and declarations of  invalidity  of the
Patent in each of the Netherlands, Belgium, Italy, France, Spain, Germany and
Austria. On March 26, 2007, the High Court of Justice, Chancery Division,
Patents Court in London, England (the “English Court”) ruled that the Patent was
deemed invalid in the United Kingdom, and on March 19, 2008 this decision was
upheld on appeal. The English Court rejected the ECB’s allegations of invalidity
based on lack of novelty, lack of inventive step and insufficiency, but held
that the patent was invalid for added subject matter. The English Court’s
decision does not affect the validity of the Patent in other European countries.
On March 30, 2007, the English Court awarded the ECB 30% of
their costs (including legal fees) of the initial trial , of
which the Company paid 90,000 British pounds ($182,000) on April 19, 2007. We
expect that an additional 90,000 pounds ($162,000 at September 30, 2008) will
become payable by the Company for the costs of the initial trial, which is
included in accrued expenses as of September 30, 2008. In July 2007, the Company
posted a bond of 87,500 British pounds ($157,500 at September 30, 2008), as
collateral for the appeal costs which is recorded as restricted cash at
September 30, 2008. On June 19, 2008, the Company paid 87,500 British pounds
($177,000 based on the applicable exchange rate on that date) towards
the  ECB’s
costs of the English appeal. The Company may also owe additional legal fees
associated with the Court of Appeal decisions, which, unless otherwise agreed by
the parties, will be subject to an assessment procedure that will not likely be
concluded earlier than the first quarter of 2009. The Company will record the
assessed amount, if any, as soon as it is estimatable.
  12
  On March
27, 2007 the Bundespatentgericht of the Federal Republic of Germany ruled that
the German part of the Patent was valid, having considered the English Court’s
decision. As a result of this ruling, the Company expects to be awarded
reimbursements for its costs associated with the German validity case, which is
Euro 44,692 ($64,000 at September 30, 2008), which the Company will record when
the amount, if any, is received. The ECB has filed an appeal against that
decision, which is not expected to be decided before 2010. On January 9, 2008
the French Court held that the Patent was invalid in France for the same reasons
given by the English Court. The Company is required to pay de minimus attorneys’
fees of the ECB as a result of the French decision. The Company filed an appeal
against the French decision on May 7, 2008. On March 12, 2008 the Dutch Court,
having considered the English, German and French decisions, ruled that the
Patent is valid in the Netherlands. The ECB filed an appeal against the Dutch
decision on March 27, 2008. A trial was also held in Madrid, Spain on June 3 and
5, 2008 and oral and written closing submissions were made on July 19, 2008. A
judgment is expected in the fourth quarter of 2008.
  The
Patent has thus been confirmed to be valid and enforceable in two jurisdictions
(Germany and the Netherlands) that use the Euro as its national currency.
Additional trials on the validity of the Patent are expected in other European
jurisdictions in 2008 and 2009.
 
 On August
20, 2008, the Company entered into an agreement with Trebuchet Capital Partners,
LLC (“Trebuchet”) under which Trebuchet has agreed to pay substantially all of
the litigation costs associated with pending validity proceedings initiated by
the European Central Bank (“ECB”) in eight European countries relating to the
Company’s European Patent 0 455 750B1 that the Company has claimed the ECB
infringed in printing of the Euro currency (the “Patent”). Trebuchet also agreed
to pay substantially all of the litigation costs associated with future validity
challenges filed by the ECB or other parties, provided that Trebuchet elects to
assume the defense of any such challenges, in its sole discretion, and patent
infringement suits filed against the ECB and certain other alleged infringers of
the Patent, all of which suits may be brought at the sole discretion of
Trebuchet and may be in the name of the Company, Trebuchet or both. The Company
provided Trebuchet with the sole and exclusive right to manage infringement
litigation relating to the Patent in Europe, including the right to initiate
litigation in the name of the Company, Trebuchet or both and to choose whom and
where to sue, subject to certain limitations set forth in the agreement. Under
the terms of the Agreement, the Company and Trebuchet have agreed to equally
share all proceeds generated from litigation relating to the Patent, including
judgments and licenses or other arrangements entered into in settlement of any
such litigation. Trebuchet is also entitled to recoup any litigation expenses
specifically awarded to the Company in such actions.
  On
January 31, 2003, the Company 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 the
Company has an interest. The Company 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, various
business torts, including unfair competition and declaratory relief. Adler
distributes and supplies anti-counterfeit document products and Mr. McTaggert is
a principal of Adler. Adler had entered into several purported agreements with
Thomas M. Wicker Enterprises and Document Security Consultants, both of which
the Company acquired in 2002. These alleged agreements, generally, would have
authorized Adler to manufacture in Canada the Company’s “Checkmate®” patented
system for verifying the authenticity of currency and documents. Other purported
agreements were signed between these parties and Thomas Wicker regarding other
technology claimed to have been owned by Wicker and assigned to the Company.
Among other things, the Company contends that certain of the purported
agreements are not binding and/or enforceable. To the extent any of them are
binding and enforceable, the Company claims that Adler has breached these
purported agreements, failed to make an appropriate accounting and payments
under them, and may have exceeded the scope of its license. Adler has denied the
material allegations of the complaint and has counterclaimed against the
Company, claiming Adler owns or co-owns or has a license to use certain of the
Company’s technologies. In May 2005, the Company filed a first amended and
supplemental complaint adding Blanks/USA and Raymond Maxon as additional
defendants. In February 2007, the Company filed a second amended and
supplemental complaint adding Judith Wu (McTaggert’s wife) and Arcis Digital
Security, Inc. (a company in which Ms. Wu is involved) as additional defendants.
Maxon has asserted a counterclaim against the Company contending that the
Company’s purported acquisition of a certain patent from Thomas Wicker in 2002
gave rise to an alleged right on the part of Maxon to receive a portion of
Thomas Wicker’s proceeds from such acquisition. The Company has denied the
material allegations of all of the counterclaims. If Adler or Maxon is
successful, it may materially affect the Company, the Company’s financial
condition, and the Company’s ability to market and sell certain of the Company
technology and related products. This case is in discovery phase, and it is too
soon to determine how the various issues raised by the lawsuit will be
determined.
  13
  In
addition to the foregoing, the Company is 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 these legal proceedings to which the Company is a party
to will have a material adverse effect on the Company results of operations,
cash flows or the Company’s financial condition.
  Commitments
  In May
2008, the Company entered into a Separation Agreement with its former President
that, among other things, accelerated the vesting of 33,333 shares of restricted
common stock of the Company that were previously awarded to the former President
pursuant to the Company’s 2004 Employee Stock Option Plan so that such shares
vested in equal monthly installments during the immediately following ten
months. The Separation Agreement further provided that if the former President
did not realize at least $212,000 in gross proceeds from the sale of such 33,333
shares of restricted stock upon their vesting, then the Company would pay the
former President the amount that such proceeds is less than $212,000 in cash or
additional shares of common stock of the Company. As of September 30, 2008,
13,333 of such 33,333 shares had vested generating gross proceeds of
approximately $48,000.
  In June
2008, the Company entered into two Stock Purchase Agreements in which it sold
500,000 shares of its common stock to Walton Invesco Inc. for an aggregate
purchase price of $2.0 million. Pursuant to the terms of such Stock Purchase
Agreements, Walton Invesco Inc. may demand registration of such 500,000 shares
with the Securities and Exchange Commission on Form S-3 with such registration
statement to take effect no later than (i) 120 days after payment in full for
such shares under the applicable agreement or, (ii) with respect to 350,000
shares, 270 days after a Payment Failure Termination Event (as defined in the
applicable Stock Purchase Agreement).
  Pursuant
to an agreement made in December 2004, the Company is required to share the
economic benefit derived from settlements, licenses or subsequent business
arrangements that the Company obtains from any infringer of patents formerly
owned by the Wicker Family. For infringement matters involving certain U.S.
patents, the Company will be required to disburse 30% of the settlement
proceeds. For infringement matters involving certain foreign patents, including
the lawsuit against the European Central Bank described in Part II Item 1 –
Legal Proceedings, the Company will be required to disburse 14% of the
settlement proceeds. These payments do not apply to licenses or royalties to
patents that the Company has developed or obtained from persons other than the
Wicker Family. As of September 30, 2008, there have been no settlement amounts
related to these agreements.
  In May
2005, the Company made an agreement with its legal counsel in charge of the
Company’s patent infringement litigation in the Court of First Instance with the
European Central Bank which capped its fees for all matters associated with that
infringement 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.
  11   Supplemental Cash Flow
Information
  During
the nine months ended September 30, 2008, the Company issued 19,260 shares for
the payment of approximately $94,000 of marketing expenses. During the nine
months ended September 30, 2007, the Company issued 60,866 shares of Common
Stock valued at approximately $746,000 in conjunction with the payment of legal
expenses which were capitalized as other intangible assets. In addition, the
Company extended the term of previously issued warrants to a warrant holder in
exchange for a license valued at approximately $521,000. In addition, during
2007, the Company issued fully vested, nonforfeitable warrants to consultants of
approximately $525,000 that were recorded as a prepaid expense that was
recognized as stock based compensation. As of September 30, 2008, all of this
amount had been recognized as expense.
  14
  12.     Segment
Information
  The
Company's businesses are organized, managed and internally reported as three
operating segments. Two of these operating segments, Document Security Systems
and Plastic Printing Professionals, 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. For the purposes of providing segment
information, these two 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” . A
summary of the Company’s two segments is as follows:
  Document Security and
      Production
              
              License,
      manufacture and sale of document security technologies, including digital
      security print solutions and secure printed products at Document Security
      Systems and Plastic Printing Professionals divisions. In September 2007,
      the Company sold substantially all of the assets of its retail printing
      and copying division, a former component of the Document Security and
      Production segment, to an unrelated third party as this operation was not
      critical to the Company’s core operations. The results of the retail and
      copying division are reported as discontinued operations and are not a
      component of these segment results (See Note 8).Legal
      Supplies
              
              Sale
      of specialty legal supplies, primarily to lawyers and law firms located
      throughout the United States via the website
    Legalstore.com.
 
 Approximate information concerning the operations by reportable segment for the
three and nine months ended September 30, 2008 and 2007 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:
  DocumentSecurity
      &Legal Supplies
                  
                  Production
                  
                  Corporate
                  
                  Total3 months ended
      September 30, 2008:Revenues
      from external customers
                  
                  $
                  151,000
                  
                  $
                  1,523,000
                  
                  $
                  -
                  
                  $
                  1,674,000Depreciation
      and amortization
                  
                  
                  4,000
                  
                  
                  615,000
                  
                  
                  1,000
                  
                  
                  620,000Segment
      profit (loss) from continuing operations
                  
                  
                  (6,000
                  )
                  
                  (2,046,000
                  )
                  
                  (611,000
                  )
                  
                  (2,663,000
                  )Identifiable
      assets
                  
                  
                  328,000
                  
                  
                  7,479,000
                  
                  
                  548,000
                  
                  
                  8,355,0003 months
      ended September 30, 2007:Revenues
      from external customers
                  
                  $
                  176,000
                  
                  $
                  1,233,000
                  
                  $
                  -
                  
                  $
                  1,409,000Depreciation
      and amortization
                  
                  
                  4,000
                  
                  
                  521,000
                  
                  
                  1,000
                  
                  
                  526,000Segment
      profit (loss) from continuing operations
                  
                  
                  (13,000
                  )
                  
                  (799,000
                  )
                  
                  (1,069,000
                  )
                  
                  (1,881,000
                  )Identifiable
      assets
                  
                  
                  255,000
                  
                  
                  10,564,000
                  
                  
                  1,562,000
                  
                  
                  12,381,000
  DocumentSecurity
      &Legal
      Supplies
                  
                  Production
                  
                  Corporate
                  
                  Total9 months ended
      September 30, 2008:Revenues
      from external customers
                  
                  $
                  483,000
                  
                  $
                  4,847,000
                  
                  $
                  -
                  
                  $
                  5,330,000Depreciation
      and amortization
                  
                  
                  12,000
                  
                  
                  1,827,000
                  
                  
                  3,000
                  
                  
                  1,842,000Segment
      profit (loss) from continuing operations
                  
                  
                  29,000
                  
                  
                  (4,293,000
                  )
                  
                  (1,918,000
                  )
                  
                  (6,182,000
                  )Identifiable
      assets
                  
                  
                  328,000
                  
                  
                  7,479,000
                  
                  
                  548,000
                  
                  
                  8,355,0009 months
      ended September 30, 2007:Revenues
      from external customers
                  
                  $
                  513,000
                  
                  $
                  3,820,000
                  
                  $
                  -
                  
                  $
                  4,333,000Depreciation
      and amortization
                  
                  
                  10,000
                  
                  
                  1,356,000
                  
                  
                  30,000
                  
                  
                  1,396,000Segment
      profit (loss) from continuing operations
                  
                  
                  (11,000
                  )
                  
                  (2,217,000
                  )
                  
                  (2,547,000
                  )
                  
                  (4,775,000
                  )Identifiable
      assets
                  
                  
                  255,000
                  
                  
                  10,564,000
                  
                  
                  1,562,000
                  
                  
                  12,381,000
 13.    
Subsequent Events
  On
November 6, 2008 the Company entered into an asset purchase agreement to acquire
the assets of DPI of Rochester, LLC (“DPI”), which agreement is subject to court
approval in DPI’s pending Chapter 11 bankruptcy case. DPI is a full service
digital and commercial offset printer located in Rochester, NY with
approximately $7.6 Million in annual sales in 2007. The
estimated purchase price is $1,000,000 plus the assumption of certain equipment
leases, and the Company
may provide debtor-in-possession financing, subject to United States Bankruptcy
Court approval, to DPI during its Chapter 11 reorganization process to prevent
any disruption of service to DPI’s customers. The purchase of assets is expected
to be completed in the quarter ended December 31, 2008 and is subject to the
United States Bankruptcy Court approval and an opportunity for other parties to
overbid for DPI’s assets. The obligations under the agreement are conditioned
upon the negotiation of real and personal property leases, the approval of the
bankruptcy court and other matters. There can be no assurance that the
transaction contemplated by the purchase agreement will be approved by the
bankruptcy court or that the conditions to closing will be met. Upon court
approval of the transaction, the purchase price, once known, will be allocated
to the assets acquired based on their respective fair values.
  15


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-K for the year ended December
31, 2007 and those described herein that could cause actual results to differ
materially from the results anticipated in the forward-looking
statements.




Overview




Document
Security Systems, Inc. (referred to in this report as “Document Security,” “we,”
“us,” “our” or “Company”) markets and sells products designed to protect
valuable information from unauthorized scanning, copying, and digital imaging.
We develop sophisticated security technologies that are applied during the
normal printing process and by virtually all printing methods including
traditional offset, gravure, flexo, digital or via the Internet on paper,
plastic, or packaging. We believe we are a leader of customized document
protection solutions for companies and governments worldwide. We hold eight
patents that protect our technology and have over a dozen patents in process or
pending. Our technologies and products are used by federal, state and local
governments, law enforcement agencies and are also applied by a broad variety of
industries,, including financial institutions, high technology and consumer
goods, entertainment and gaming, healthcare/pharmaceutical, defense and genuine
parts industries.  Our
customers use our technologies where there is a need for enhanced security for
protecting and verification of critical financial instruments and vital records,
or where there are concerns of counterfeiting, fraud, identity theft, brand
protection and liability.





Our core
business is counterfeit prevention, brand protection and validation of authentic
print media, including government-issued documents, currency, private corporate
record and, securities. We believe we are a world leader in the research and
development of optical deterrent technologies and have commercialized these
technologies with a broad suite of products that offer our customers a wide
array of document security solutions to satisfy their specific
anti-counterfeiting requirements. Our technology can be used in securing
sensitive and critical documents such as currency, automobile titles, spare
parts forms for the aerospace industry, 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 have developed a digital product to implement our technologies in
Internet-based environments utilizing standard desktop printers. We believe that
our digital technology greatly expands the reach and potential market for our
technologies and solutions.





Technologies





We have
developed or acquired over 30 technologies that provide to our customers a wide
spectrum of solutions. Our primary anti-counterfeiting products and technologies
are marketed under the AuthentiGuard trade names.





Products and
Services





Document Security Solutions and
Production : Our
technology portfolio allows us to create unique custom secure paper, plastic,
packaging and Internet-based solutions. We market to end-users that require
anti-counterfeiting and authentication features in a wide range of printed
materials like documents, vital records, driver’s licenses, birth certificates,
receipts, manuals, identification materials, entertainment tickets, coupons,
parts tracking forms, as well as product packaging including pharmaceutical and
a wide range of consumer goods. We manufacture plastic ID cards at our wholly
owned subsidiary called Plastic Printing Professionals, in San Francisco, CA,
and we produce our custom security paper products either internally at our small
printing facility in Rochester, NY, or outsourced at our various licensees.
Through our strategic licensee program, we can offer our customers a wide range
of production capabilities to meet the customized requirements.


16





Security Paper : Our
primary product for the retail end-user market is AuthentiGuard Security Paper.
AuthentiGuard Security Paper uses our Pantograph 4000 technology, and is a paper
that reveals hidden warning words, logos or images using The Authenticator - our
proprietary viewing lens – or when the paper is faxed, copied, scanned or
re-imaged. The hidden warning words appear on the duplicate or the computer
digital file and essentially prevents important documents from being
counterfeited. We market and sell our Security Paper primarily through two major
paper distributors: Boise Cascade and PaperlinX Limited.





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 or have unique and
strategic capabilities that expand the capabilities that we can offer our
potential customers. Revenue from licensing can take several forms. Licenses can
be for a single technology or for a package of technologies.





Digital Solutions:  We also
offer our technologies in digital forms that are deliverable via internet and
intranet environments. In October 2008, we launched our first branded digital
solution called AuthentiGuard® DX. AuthentiGuard® DX is a networked appliance
that allows the author of any Microsoft Office document (Outlook, Word, Excel,
or PowerPoint) to secure nearly any of its alphanumeric content when it is
printed or digitally stored. AuthentiGuard® DX prints selected content using our
patented technology so that it cannot be read by the naked eye. Reading the
hidden content or authenticating the document is performed with a proprietary
viewing device or software.





Additionally,
we sell custom hosted or server-based digital solutions for our customers.
Depending on our customer’s specific requirements, we host a secure server that
accepts user inputs and delivers custom, variable secure documents for output at
the user location, or offer a bundled server solution that allows for the
production of custom, variable secure documents within the user’s network
environment.





Legal Products : We also
own and operate Legalstore.com, an Internet company which sells legal supplies
and documents, including security paper and products for the users of legal
documents and supplies in the legal, medical and educational fields. While not a
component of our core business strategy, we continuously seek to maximize the
revenue and profitability of this operation.




Results of Operations for the Three
and Nine Months Ended  September 30,
2008




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-K for the year ended December 31, 2007. On September
25, 2007, the Company sold its copying and quick-printing business to an
unrelated third party. In accordance with FASB 144, the Company accounts for the
revenue and expenses of this operation, which was a component of its security
printing segment, as a discontinued operation. All amounts have been adjusted to
reflect the Company’s results after the effect of discontinued
operations.




Revenue




Three Months
              Ended September
              30, 2008
            
            Three Months
              Ended September
              30, 2007
            
            % change vs.
              2007
            
            Nine Months
              Ended September
              30, 2008
            
            Nine Months
              Ended September
              30, 2007
            
            % change vs.
              2007RevenueSecurity
      printing & products
            
            $
            1,334,000
            
            $
            946,000
            
            
            41
            %
            $
            3,421,000
            
            $
            2,765,000
            
            
            24
            %Royalties
            
            
            181,000
            
            
            278,000
            
            
            -35
            %
            
            1,402,000
            
            
            871,000
            
            
            61
            %Digital
      solutions
            
            
            8,000
            
            
            9,000
            
            
            -11
            %
            
            25,000
            
            
            184,000
            
            
            -86
            %Legal
      products
            
            
            150,000
            
            
            176,000
            
            
            -15
            %
            
            483,000
            
            
            513,000
            
            
            -6
            %Total
      Revenue
            
            
            1,673,000
            
            
            1,409,000
            
            
            19
            %
            
            5,331,000
            
            
            4,333,000
            
            
            23
            %




For the
three months ended September 30, 2008, revenue increased 19% from the same
period in 2007. The increase in revenue was primarily the result of strong
growth in sales of our security products. The Company has sought to become a
full-service provider of printing and production for its customers. During the
quarter, the Company saw 20% sales growth at its Plastic Printing division as
that division began to see the benefit of recent capital investments that
increased its production capacity and expanded its production capabilities.
Sales for paper based security products grew 30% from the same quarter of 2007,
as the Company benefited from increased sales of its safety paper for
prescriptions, and custom projects, including voter registration paper used for
a foreign election, and coupons for a Fortune 500 customer.


17




Royalty
revenue decreased primarily due to the absence of royalty revenue as a result of
the new agreement with the Ergonomics Group in the second quarter of 2008, as
described below, which previously had contributed approximately $60,000 per
quarter of royalty revenue. Otherwise, royalty revenue reflected reductions in
technology usage reported by its remaining licensing customers.




Legalstore.com
saw an approximately 15% decline in orders from the 2007 quarter, which we
believe was due to slowing conditions in the general economy along with the
effects of an issue with its adword placements on one of the major search engine
sites. The Company addressed its adword issue at the end of the quarter, and
expects legal products to return to historical levels in the fourth quarter of
2008.




For the
first nine months of 2008, revenue increased 23% compared to the first nine
months of 2007 primarily as a the result of the significant impact of royalty
revenue recognized in the second quarter of 2008 along with a 24% growth in the
company’s sales of its security printing and products. During the second quarter
of 2008, the Company recognized approximately $542,000 of previously deferred
royalty revenue as the result of a new agreement with the Ergonomic Group in
April 2008. Under a previous agreement with the Ergonomic Group, the Company
received $1,000,000 in non-refundable license and royalty fees, of which
$500,000 was recognized as royalty revenue pro-ratably over a two year license
period and the remaining $500,000 was considered a prepaid royalty, to be
recognized as revenue when sales of products using the licensed technology were
made. This agreement was cancelled and a new agreement with the Ergonomic Group
that covers the Company’s newest digital technologies was established. As a
result, the non refundable license and royalty payment no longer met the
criteria for deferral and was recognized in the second quarter of
2008.




These
growth areas were partially offset by a significant decline in digital solutions
sales during the first nine months of 2008 as compared to the first nine months
of 2007 due to the absence of any digital solutions implementations during 2008.




Cost of Sales and Gross Profit




Three Months
              Ended September
              30, 2008
            
            Three Months
              Ended September
              30, 2007
            
            % change vs.
              2007
            
            Nine Months
              Ended September
              30, 2008
            
            Nine Months
              Ended September
              30, 2007
            
            % change vs.
              2007Costs of
      revenueSecurity
      printing & products
            
            $
            636,000
            
            $
            636,000
            
            
            0
            %
            $
            2,028,000
            
            $
            1,691,000
            
            
            20
            %Digital
      solutions
            
            
            4,000
            
            
            3,000
            
            
            33
            %
            
            11,000
            
            
            41,000
            
            
            -73
            %Legal
      products
            
            
            86,000
            
            
            83,000
            
            
            4
            %
            
            258,000
            
            
            276,000
            
            
            -7
            %Total cost of
      revenue
            
            
            726,000
            
            
            722,000
            
            
            1
            %
            
            2,297,000
            
            
            2,008,000
            
            
            14
            %Gross
      profitSecurity
      printing & products
            
            
            698,000
            
            
            310,000
            
            
            125
            %
            
            1,393,000
            
            
            1,074,000
            
            
            30
            %Royalties
            
            
            181,000
            
            
            278,000
            
            
            -35
            %
            
            1,402,000
            
            
            871,000
            
            
            61
            %Digital
      solutions
            
            
            4,000
            
            
            6,000
            
            
            -33
            %
            
            14,000
            
            
            143,000
            
            
            -90
            %Legal
      products
            
            
            64,000
            
            
            93,000
            
            
            -31
            %
            
            225,000
            
            
            237,000
            
            
            -5
            %Total gross
      profit
            
            
            947,000
            
            
            687,000
            
            
            38
            %
            
            3,034,000
            
            
            2,325,000
            
            
            30
            %




Three Months
              Ended September
              30, 2008
            
            Three Months
              Ended September
              30, 2007
            
            % change vs.
              2007
            
            Nine Months
              Ended September
              30, 2008
            
            Nine Months
              Ended September
              30, 2007
            
            % change vs.
              2007Gross profit
      percentage:Gross
      profit percentage:
            
            
            57
            %
            
            49
            %
            
            16
            %
            
            57
            %
            
            54
            %
            
            6
            %




Gross
profit increased 38% to $947,000 in the thrid quarter of 2008 as compared to the
$687,000 of gross profit realized in the third quarter of 2007, primarily the
result of stong sales of the company’s security printing and products and the
ability of the Company to increase its margins through operating efficiencies
and material cost savings that the Company was able to generate at its plastics
division’s new facility. The increase in gross profits of this group was
partially offset by decreases in royalty, digital solution and legal products
profits, respectively, for reasons discussed above. For the nine months ended
September 30, 2008, the Company’s gross profit increased at a slightly higher
rate as the Company’s gross profit percentage increased 6 percentage points as
compared to the 2007 period.




18




Operating Expenses




Three Months
              Ended September
              30, 2008
            
            Three Months
              Ended September
              30, 2007
            
            % change vs.
              2007
            
            Nine Months
              Ended September
              30, 2008
            
            Nine Months
              Ended September
              30, 2007
            
            % change vs.
              2007Selling, general and
      administrativeGeneral
      and administrative compensation
            
            $
            539,000
            
            $
            514,000
            
            
            5
            %
            $
            1,622,000
            
            $
            1,310,000
            
            
            24
            %Professional
      Fees
            
            
            206,000
            
            
            352,000
            
            
            -41
            %
            
            780,000
            
            
            1,036,000
            
            
            -25
            %Sales
      and marketing
            
            
            204,000
            
            
            466,000
            
            
            -56
            %
            
            892,000
            
            
            1,525,000
            
            
            -42
            %Depreciation
      and amortization
            
            
            42,000
            
            
            20,000
            
            
            110
            %
            
            126,000
            
            
            61,000
            
            
            107
            %Other
            
            
            319,000
            
            
            289,000
            
            
            10
            %
            
            902,000
            
            
            685,000
            
            
            32
            %Research
      and development
            
            
            73,000
            
            
            111,000
            
            
            -34
            %
            
            322,000
            
            
            314,000
            
            
            3
            %Stock
      based payments
            
            
            480,000
            
            
            338,000
            
            
            42
            %
            
            1,506,000
            
            
            971,000
            
            
            55
            %Impairment
      of patent defense costs
            
            
            -
            
            
            -
            
            
            
            
            
            292,000
            
            
            -Amortization
      of intangibles
            
            
            541,000
            
            
            480,000
            
            
            13
            %
            
            1,605,000
            
            
            1,259,000
            
            
            27
            %Total Operating
      Expenses
            
            
            2,404,000
            
            
            2,570,000
            
            
            -6
            %
            
            8,047,000
            
            
            7,161,000
            
            
            12
            %




Selling, General and
Administrative




General and administrative
compensation costs
were 5% higher in the third quarter of 2008 as compared to the third quarter of
2007 which was primarily due to the impact of a bonus reversal of approximately
$41,000 in the 2007 period, which offset the impact of salary reductions made by
the Company during 2008. In addition, the 2008 amount reflects an increase in
the cash compensation of the non-employee members of the Company’s board of
directors.




Professional fees - The
decrease in professional fees during the third quarter and first nine months of
2008 reflect significant decreases in non-patent related legal fees, accounting
fees, and stock transfer and investor relations fees. These costs savings
reflect reduced SEC compliance costs and decreased legal activity, along with
the impact of the Company’s cost-cutting program it initiated in March 2008. For
the nine months ended September 30, 2008, these cost savings were partially
offset by increases in the use of consultants for sales and business development
efforts during the first three months of 2008.




Three Months
              Ended September
              30, 2008
            
            Three Months
              Ended September
              30, 2007
            
            % change vs.
              2007
            
            Nine Months
              Ended September
              30, 2008
            
            Nine Months
              Ended September
              30, 2007
            
            % change vs.
              2007Professional Fees
      DetailAccounting
      and auditing
            
            $
            40,000
            
            $
            71,000
            
            
            -44
            %
            $
            213,000
            
            $
            236,000
            
            
            -10
            %Consulting
            
            
            79,000
            
            
            95,000
            
            
            -17
            %
            $
            341,000
            
            
            292,000
            
            
            17
            %Legal
      Fees
            
            
            43,000
            
            
            120,000
            
            
            -64
            %
            $
            94,000
            
            
            255,000
            
            
            -63
            %Stock
      Transfer, SEC and Investor Relations
            
            
            44,000
            
            
            66,000
            
            
            -33
            %
            $
            132,000
            
            
            253,000
            
            
            -48
            %$
            206,000
            
            $
            352,000
            
            
            -41
            %
            $
            780,000
            
            $
            1,036,000
            
            
            -25
            %




Sales and
marketing expenses, including sales and marketing personnel costs, decreased in the third
quarter and the first nine months of 2008 as the Company reduced sales and
marketing headcount by four, reduced public relations and marketing costs and
significantly reduced the amount spent on travel and entertainment. The Company
reduced these costs as it realigned its sales process in order to maximize the
results of its sales and marketing efforts with the goal of focusing of near
term revenue opportunities.




Other operating
expenses are
primarily rent and utilities, office supplies, IT support, bad debt expense and
insurance costs. Increases in the third quarter an first nine months of 2008
reflect costs increases associated with an increase in rent costs and one time
costs associated with the move of the Company’s plastic printing division to a
larger facility, higher utility costs, and an increase in insurance
costs.


19




Stock-Based
Compensation. Stock-based compensation includes expense charges for all stock-based awards to
employees, directors and consultants. Such awards include option grants, warrant
grants, and restricted stock awards. Stock-based compensation increases in the
three and nine month periods ended September 30, 2008 reflect equity-based
payments made to employees, directors, and third-party consultants, including
approximately $194,000 of expense as the result of the acceleration of vesting
of restricted shares and $18,000 due to the modification of options to the
Company’s former President as the result of his separation from the Company in
May 2008. In addition, on August 13, 2008, the Company cancelled 330,500
employee stock options with exercise prices ranging from $6.24 to $12.50, and
replaced the cancelled options with 330,500 employee stock options with an
exercise price of $6.00. No other terms of the options were modified. On the
date of grant, the fair market value of the Company’s Common Stock was $5.15.
The repricing was treated as a modification under FAS123R, and resulted
additional aggregate fair value expense determined using the Black- Scholes
option pricing model of approximately $225,000, of which approximately $170,000
was expensed as of the grant date for fully vested options. The remaining fair
value of the modified options will be expense proratably during the expected
vesting period of the options thru 2010.




Research and
Development




We 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 consist primarily of compensation costs, and
costs for the use of third-party printers’ facilities to test our technologies
on equipment that we do not have access to internally. During the third quarter
of 2008, the Company reduced its research and development by one person who was
replaced on October 1, 2008.




Impairment of Patent Defense
Costs




On March
19, 2008, the Company received notification that its appeal of the invalidation
of its European Patent 455750B1 in the UK was not successful. As result of the
adverse court decision, the Company recognized an impairment loss of $292,000
associated with the U.K appeal as of March 31, 2008. The impairment loss
includes a judgment for reimbursement of estimated counterpart legal fees. The
Company may be obligated to pay additional counter party legal fees associated
with the decision, which the Company will expense as soon as the amount, if any,
is estimatable.




Amortization of
Intangibles




Amortization
of intangibles expense increased 13% in the third quarter of 2008 as compared to
the third quarter of 2007 which was primarily the result of an increase of $1.1
million in the Company’s capitalized patent defense costs from December 2007 to
September 2008. We amortize the costs associated with patent rights that we
acquired in 2005 and legal costs associated with the registration and defense of
our patents, including the costs associated with our lawsuit against the ECB for
patent infringement and the related ECB countersuits for patent validity. A
significant portion of these assets were acquired by the issuance of
equity-based instruments. On August 20, 2008, the Company entered into an
agreement with Trebuchet Capital Partners which agreed to pay substantially all
of the litigation costs associated with its ECB litigation. Under the terms of
the agreement the Company transferred and assigned a 49% interest of all of the
Company’s rights, title and interest in its European Patent 0455750B1 and the
two parties agreed to equally share all proceeds generated from litigation
relating to the Patent, including judgments and licenses or other arrangements
entered into in settlement of any such litigation. The Company considered this a
triggering event and reviewed its remaining capitalized patent costs related to
the Patent for impairment as of September 30, 2008. With the assistance of
Trebuchet, the Company determined that the expected eventual outcome of the
legal action and recoverability of proceeds or added economic value of the
patent was still in excess of the current carrying amount.




As a
result of the Trebuchet agreement, and the transfer and assignment of our 49%
interest in the patent, or $1,670,000, our net amortizable patent asset base at
September 30, 2008 was approximately $2.9 million and will generate
approximately $1.0 million in annual amortization expense during the next 3
years, as compared to approximately $2.0 million in annual amortization expense
the Company was recognizing prior to the Trebuchet transaction.




In
addition, the Company has approximately $683,000 of net other intangible assets
as of September 30, 2008 that consist of a royalty right, a non-exclusive
marketing right, as well as acquired intangibles including customer lists and a
trade name. These assets will generate approximately $250,000 of annual
amortization expense during the next 2.5 years. In addition, the Company has
approximately $1,397,000 in goodwill derived from acquisitions. Goodwill is not
amortized, but could become a component of expense if an impairment is
determined. The Company reviews these assets for impairment annually or if a
triggering event occurs. If an impairment, such as unfavorable ruling in the
Company’s patent validity or infringement lawsuits or an assessment of
non-commerciability of certain of its patents, then the Company would write-off
a portion of these assets, which could be a significant expense in the period
incurred.


20





Other Income and
Expense




On May
31, 2008, the Company was awarded a judgment of approximately $126,000 pursuant
to a counterclaim by the Company in the matter “Frank LaLoggia v. Document
Security Systems, Inc”, which the Company won in June 2006. The Company expects
to collect the full amount of the judgment.




On August
20, 2008, the Company entered into an agreement with Trebuchet Capital Partners,
LLC. Pursuant to the Agreement, Trebuchet has agreed to pay substantially all of
the litigation costs associated with pending validity proceedings initiated by
the European Central Bank in eight European countries relating to the Company’s
European Patent 0 455 750B1 that the Company has claimed the European Central
Bank ("ECB") infringed in printing of the Euros currency. Under the terms of the
Agreement, and in consideration for Trebuchet’s funding obligations, the Company
assigned and transferred a 49% interest of the Company’s rights, title and
interest in the Patent to Trebuchet which allows Trebuchet to have as a separate
and exclusive interest including a separate and distinct right to exploit the
Patent. Pursuant to this transaction, the Company recognized a loss on the sale
of patent assets for its assignment and transfer of 49% of its ownership rights
in the patent, which had a net book value of approximately $1,670,000, for
proceeds of $500,000, As a result, the Company recognized a loss on sale of
patent assets of approximately $1,170,000.




Net Loss and Loss Per
Share




Three Months
              Ended September
              30, 2008
            
            Three Months
              Ended September
              30, 2007
            
            % change vs.
              2007
            
            Nine Months
              Ended September
              30, 2008
            
            Nine Months
              Ended September
              30, 2007
            
            % change vs.
              2007Net
      loss
            
            
            (2,664,000
            )
            
            (1,881,000
            )
            
            42
            %
            
            (6,182,000
            )
            
            (4,792,000
            )
            
            29
            %Net
      loss per share, basic and diluted
            
            $
            (0.19
            )
            $
            (0.14
            )
            
            36
            %
            $
            (0.45
            )
            $
            (0.35
            )
            
            29
            %Weighted
      average common shares outstanding, basic and diluted
            
            
            14,286,192
            
            
            13,676,030
            
            
            4
            %
            
            13,879,891
            
            
            13,629,241
            
            
            2
            %




During
the third quarter of 2008, the Company experienced a net loss of $2.7 million, a
42% increase from the net loss of the third quarter of 2007. The increase in net
loss during the quarter was primarily the result of the Company’s recognition of
a one-time loss on the sale of patent assets of $1.2 million. Otherwise, net
loss for the third quarter of 2008 quarter without the impact of this one time
loss would have been approximately $1.5 million, a decrease of approximately 20%
from the third quarter of 2007. The improvement in net loss, other than the
effect of the one-time loss on sale of patent, was due the Company’s ability to
increase its sales and gross profits while reducing its operating expenses.




LIQUIDITY AND CAPITAL
RESOURCES




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


21




As Of And For The Nine Months Ended:September 30,
              2008
            
            September 30,
              2007
            
            % change vs.
              2007Cash
      flows from:Operating
      activities
            
            $
            (2,116,000
            )
            $
            (2,562,000
            )
            
            17
            %Investing
      activities
            
            
            (871,000
            )
            
            (1,495,000
            )
            
            42
            %Financing
      activities
            
            
            2,688,000
            
            
            (369,000
            )
            
            828
            %Working
      capital
            
            
            (836,000
            )
            
            352,000
            
            
            -338
            %Current
      ratio
            
            
            0.68
            x
            
            1.12
            x
            
            -39
            %Cash
      and cash equivalents
            
            $
            443,000
            
            $
            1,377,000
            
            
            -68
            %Revolving
      credit notes
            
            $
            1,858,000
            
            $
            -Funds
      Available from Open Credit Facilities
            
            $
            1,742,000
            
            $
            -




As of
September 30, 2008, our cash and cash equivalents were approximately $443,000,
down from approximately $742,000 at December 31, 2007. The decrease was
primarily due to the use of cash for operations and the use of cash to defend
the Company’s patent rights offset by the receipt of $2,358,000 from the
Company’s three credit facilities. During the third quarter of 2008, the Company
used $500,000 proceeds from the sale and assignment of certain of its patent
rights to a third party to pay down one of its credit facilities. As of
September 30, 2008, the Company had approximately $1.9 million outstanding under
two credit agreements, which are due and payable over the next two years. As of
September 30, 2008, the Company was in default of both agreements due to a
failure to pay interest when due. Both Fagenson and Co., Inc. and Patrick White
have agreed to waive the defaults through January 1, 2010.




Payment Due by PeriodTotal
            
            Less than 1
              year
            
            1-3 years
            
            3-5 years
            
            More than 5
              yearsCredit Facilities
            
            $
            1,858,000
            
            $
            -
            
            $
            1,858,000
            
            $
            -
            
            $
            -




The
Company expects to continue to use cash for its operations and the remainder of
2008. In March 2008, the Company initiated a cost reduction program in order to
bring its cash expenditures to a level closer to its current revenue base. As a
result of these cost cuts, the Company has reduced its annual cash operating
expense base by approximately $1.5 million. In addition, in August 2008, the
Company sold 49% of its patent related to its ECB litigation to a third party in
exchange for the third party’s commitment to fund nearly all of the remaining
costs associated with pending litigation efforts. This agreement, while reducing
the potential proceeds that the Company could receive upon a successful outcome
of litigation by half, essentially eliminates the Company’s cash requirements
for its ECB litigation efforts, which has historically been a significant use of
cash for the Company.




As of
September 30, 2008, the Company has an aggregate of $1,742,000 remaining
available under two revolving notes that terminate on January 4, 2010. In
addition, the Company has $1,300,000 in subscriptions receivable which it
expects to receive in six-month installments over the next two years. Based on
these funding sources, the Company believes that it has sufficient available
funds to meet is cash needs for the at least the next twelve months.


22




ITEM 3:   QUANTITATIVE AND
QUALITATIVE DISCLOSURES ABOUT MARKET RISK




The
market risk disclosures as set forth in Item 7A of our Annual Report on Form
10-K for the year ended December 31, 2007 have not changed
materially.




ITEM 4 - CONTROLS AND
PROCEDURES




Evaluation of Disclosure Controls and
Procedures





Management
is responsible for establishing and maintaining effective disclosure controls
and procedures. Our Chief Executive Officer and Chief Financial Officer
participated with our management in evaluating the effectiveness of our
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)).
Based on this evaluation, and in light of the material weaknesses in our
internal control over financial reporting that are discussed in our Annual
Report on Form 10-K for the fiscal year ended December 31, 2007 these officers
have concluded that our disclosure controls and procedures were not effective.
To address the material weaknesses described in Annual Report on Form 10-K for
the fiscal year ended December 31, 2007, we performed additional analyses and
other post-closing procedures to ensure our consolidated financial statements
were prepared in accordance with accounting principles generally accepted in the
United States of America (U.S. GAAP). Accordingly, management believes that the
financial statements included in this Quarterly Report on Form 10-Q fairly
present, in all material respects, our financial condition, result of operations
and cash flows for the periods presented.





Changes in Internal Control Over
Financial Reporting





During
the second quarter of 2008, the Company eliminated the use of an outside
consultant formerly used to enhance the segregation of duties for financial
reporting. Concurrently, the Company modified and expanded one of its existing
internal positions to accommodate some of the control objectives affected by the
elimination of the outside consultant role. The Company will evaluate the effect
of its changes in internal controls during its annual assessment of its internal
controls.




PART II


OTHER INFORMATION




ITEM 1 - LEGAL PROCEEDINGS




Information
concerning pending legal proceedings is incorporated herein by reference to Note
10 to the Condensed Consolidated Financial Statements (Unaudited) in Part I of
this Form 10-Q.





On August
1, 2005, we commenced a suit against the European Central Bank (“ECB”) alleging
patent infringement by the ECB and claimed unspecified damages. We brought the
suit in European Court of First Instance in Luxembourg. We alleged that all Euro
banknotes in circulation infringe the Company European Patent 0 455 750B1 (the
“Patent”), 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. The Court of First Instance ruled on
September 5, 2007 that it does not have jurisdiction to rule on the patent
infringement claim, and also ruled that we will be required to pay attorneys and
court fees of the ECB. The ECB formally requested the Company to pay attorneys
and court fees in the amount of Euro 93,752 ($144,000), which, unless the amount
is agreed will be subject to an assessment procedure that will not likely be
concluded until approximately the end of 2008, which the Company will accrue as
soon as the assessed amount, if any, is estimatable.





On March
24, 2006, we received notice that the ECB has filed a separate claim in the
United Kingdom and Luxembourg courts seeking the invalidation of the
Patent. Proceedings were commenced before the national courts seeking revocation
and declarations of  invalidity  of the
Patent in each of the Netherlands, Belgium, Italy, France, Spain, Germany and
Austria. On March 26, 2007, the High Court of Justice, Chancery Division,
Patents Court in London, England (the “English Court”) ruled that the Patent was
deemed invalid in the United Kingdom, and on March 19, 2008 this decision was
upheld on appeal. The English Court rejected the ECB’s allegations of invalidity
based on lack of novelty, lack of inventive step and insufficiency, but held
that the patent was invalid for added subject matter. The English Court’s
decision does not affect the validity of the Patent in other European countries.
On March 30, 2007, the English Court awarded the ECB 30% of
their costs (including legal fees) of the initial trial , of
which the Company paid 90,000 British pounds ($182,000) on April 19, 2007. We
expect that an additional 90,000 pounds ($162,000 at September 30, 2008) will
become payable by the Company for the costs of the initial trial, which is
included in accrued expenses as of September 30, 2008. In July 2007, the Company
posted a bond of 87,500 British pounds ($157,500 at September 30, 2008), as
collateral for the appeal costs which is recorded as restricted cash at
September 30, 2008. On June 19, 2008, the Company paid 87,500 British pounds
($177,000 based on the applicable exchange rate on that date) towards
the  ECB’s
costs of the English appeal. The Company may also owe additional legal fees
associated with the Court of Appeal decisions, which, unless otherwise agreed by
the parties, will be subject to an assessment procedure that will not likely be
concluded earlier than the first quarter of 2009. The Company will record the
assessed amount, if any, as soon as it is estimatable.


23


On March
27, 2007 the Bundespatentgericht of the Federal Republic of Germany ruled that
the German part of the Patent was valid, having considered the English Court’s
decision. As a result of this ruling, the Company expects to be awarded
reimbursements for its costs associated with the German validity case, which is
Euro 44,692 ($64,000 at September 30, 2008), which the Company will record when
the amount, if any, is received. The ECB has filed an appeal against that
decision, which is not expected to be decided before 2010. On January 9, 2008
the French Court held that the Patent was invalid in France for the same reasons
given by the English Court. The Company is required to pay de minimus attorneys’
fees of the ECB as a result of the French decision. The Company filed an appeal
against the French decision on May 7, 2008. On March 12, 2008 the Dutch Court,
having considered the English, German and French decisions, ruled that the
Patent is valid in the Netherlands. The ECB filed an appeal against the Dutch
decision on March 27, 2008. A trial was also held in Madrid, Spain on June 3 and
5, 2008 and oral and written closing submissions were made on July 19, 2008. A
judgment is expected in the fourth quarter of 2008.




The
Patent has thus been confirmed to be valid and enforceable in two jurisdictions
(Germany and the Netherlands) that use the Euro as its national currency.
Additional trials on the validity of the Patent are expected in other European
jurisdictions in 2008 and 2009.


On August
20, 2008, the Company entered into an agreement with Trebuchet Capital Partners,
LLC (“Trebuchet”) under which Trebuchet has agreed to pay substantially all of
the litigation costs associated with pending validity proceedings initiated by
the European Central Bank (“ECB”) in eight European countries relating to the
Company’s European Patent 0 455 750B1 that the Company has claimed the ECB
infringed in printing of the Euro currency (the “Patent”). Trebuchet also agreed
to pay substantially all of the litigation costs associated with future validity
challenges filed by the ECB or other parties, provided that Trebuchet elects to
assume the defense of any such challenges, in its sole discretion, and patent
infringement suits filed against the ECB and certain other alleged infringers of
the Patent, all of which suits may be brought at the sole discretion of
Trebuchet and may be in the name of the Company, Trebuchet or both. The Company
provided Trebuchet with the sole and exclusive right to manage infringement
litigation relating to the Patent in Europe, including the right to initiate
litigation in the name of the Company, Trebuchet or both and to choose whom and
where to sue, subject to certain limitations set forth in the agreement. Under
the terms of the Agreement, the Company and Trebuchet have agreed to equally
share all proceeds generated from litigation relating to the Patent, including
judgments and licenses or other arrangements entered into in settlement of any
such litigation. Trebuchet is also entitled to recoup any litigation expenses
specifically awarded to the Company in such actions.


On
January 31, 2003, the Company 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 the
Company have an interest. The Company 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, various
business torts, including unfair competition and declaratory relief. Adler
distributes and supplies anti-counterfeit document products and Mr. McTaggert is
a principal of Adler. Adler had entered into several purported agreements with
Thomas M. Wicker Enterprises and Document Security Consultants, both of which
the Company acquired in 2002. These alleged agreements, generally, would have
authorized Adler to manufacture in Canada the Company’s “Checkmate®” patented
system for verifying the authenticity of currency and documents. Other purported
agreements were signed between these parties and Thomas Wicker regarding other
technology claimed to have been owned by Wicker and assigned to the Company.
Among other things, the Company contends that certain of the purported
agreements are not binding and/or enforceable. To the extent any of them are
binding and enforceable, the Company claims that Adler has breached these
purported agreements, failed to make an appropriate accounting and payments
under them, and may have exceeded the scope of its license. Adler has denied the
material allegations of the complaint and has counterclaimed against the
Company, claiming Adler owns or co-owns or has a license to use certain of the
Company’s technologies. In May 2005, the Company filed a first amended and
supplemental complaint adding Blanks/USA and Raymond Maxon as additional
defendants. In February 2007, the Company filed a second amended and
supplemental complaint adding Judith Wu (McTaggert’s wife) and Arcis Digital
Security, Inc. (a company in which Ms. Wu is involved) as additional defendants.
Maxon has asserted a counterclaim against the Company contending that the
Company’s purported acquisition of a certain patent from Thomas Wicker in 2002
gave rise to an alleged right on the part of Maxon to receive a portion of
Thomas Wicker’s proceeds from such acquisition. The Company has denied the
material allegations of all of the counterclaims. If Adler or Maxon is
successful, it may materially affect the Company, the Company’s financial
condition, and the Company’s ability to market and sell certain of the Company
technology and related products. This case is in discovery phase, and it is too
soon to determine how the various issues raised by the lawsuit will be
determined.





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 these legal proceedings to which we are a party will have a material
adverse effect on our results of operations, cash flows or our financial
condition.


24




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 and information
contained in our Form 10-K for the year ended December 31, 2007.





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 $30,397,000 at September 30, 2008. 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. 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.





We have secured credit facilities
that have large principal payments due and if we are unable to repay them with
cash we may be forced to repay, in whole on in part, with each credit facility’s
applicable collateral, which would have a material adverse effect on our
financial position.




On
January 4, 2008, we entered into two credit facilities with and aggregate
borrowing capacity of $3.6 million that is repayable in full on January 4, 2010.
One of these credit facilities has a borrowing limit of $3.0 million and is
secured by our stock in our Plastic Printing Professionals, Inc. subsidiary
(“P3”), and the other credit facility has a borrowing limit of $600,000 and is
secured by our accounts receivable, excluding the accounts receivable of P3. As
of September 30, 2008, the Company was in default of both agreements due to a
failure to pay interest when due. Both Fagenson and Co., Inc. and Patrick White
have agreed to waive the default through January 1, 2010. If we cannot generate
sufficient cash from operations or raise cash from other sources, including
without limitation, fund-raising through sales of equity, and if we cannot
refinance the credit facilities, we may have to repay, in whole or in part, one
or both of the credit facilities with each credit facility’s applicable
collateral, which would have a material adverse effect on our financial
position.





Due to our low cash balance and
negative cash flow, we may have to further reduce our costs by curtailing future
operations.





We have
incurred significant net losses this year and previous years. Our ability to
fund our capital requirements out of our available cash and cash generated from
our operations depends on a number of factors. Some of these factors include our
ability to (i) increase paper and plastic card sales and (ii) increase sales of
our digital products. If we cannot generate positive cash flow from operations,
we will have to continue to reduce our costs and raise working capital from
other sources. These measures could include selling or consolidating certain
operations or assets, and delaying, canceling or scaling back product
development and marketing programs. These measures could materially and
adversely affect our ability to operate profitably.





Our ability to effect a financing
transaction to fund our operations could adversely affect the value of your
stock.





If we
seek additional financing through raising additional capital through public or
private equity offerings or debt financing, such additional capital financing
may not be available to us on favorable terms and our stockholders will likely
experience substantial dilution. Material shortage of capital will require us to
take steps such as reducing our level of operations, disposing of selected
assets, effecting financings on less than favorable terms or seeking protection
under federal bankruptcy laws.


25





Our limited cash resources may not
be sufficient to fund continuing losses from operations and the expenses of the
current patent validity and patent infringement
litigations.





The cost
to defend and prosecute current and future patent litigation may be significant.
We cannot assure you that the ultimate cost of current known or future unknown
litigation and claims will not exceed our current expectations and/or our
ability to pay such costs and it is possible that such litigation costs could
have a material adverse effect on our business, financial condition and
operating results. In addition, litigation is time consuming and could divert
management attention and resources away from our business, which could adversely
affect our business, financial condition and operating results.





If we lose our current litigation,
we may lose certain of our technology rights, which may affect our business
plan.





We are
subject to litigation and alleged litigation, including without limitation our
litigation with the European Central Bank, in which parties allege, among other
things, that certain of our patents are invalid. For more information regarding
this litigation, see Part II Item 1- Legal Proceedings. If the ECB or other
parties are successful in invalidating any or all of our patents, it may
materially affect us, our financial condition, and our ability to market and
sell certain of our products based on any patent that is invalidated.
Furthermore, we have granted nearly all control over our ECB Litigation a third
party, Trebuchet Capital Partners, LLC., who may or may not have the resources
or capabilities to successfully defend our patent rights.





If we lose our current validity or
infringement litigation we may be liable for significant legal costs of our
counterparts.




We have
been able to mitigate the cash outlays that we have been required to make for
legal costs of our current invalidity cases against the European Central Bank
by, among other things, negotiating legal fee caps and using shares of our
common stock for payments. However, if we receive adverse rulings in any of our
infringement or related invalidity cases against the European Central Bank, we
will likely be responsible for a large portion of the legal costs that were
expended by the European Central Bank in such case, which would likely be
significant, with our current estimates of between $1,000,000 to $2,000,000. The
payment of these amounts could have a material adverse impact on our operations,
cash available and liquidity.




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. We intend to continue to rely primarily on a
combination of patent protection, trade secrets, technical measures, copyright
protection and nondisclosure agreements with our employees and customers to
establish and protect the ideas, concepts and documentation of software and
trade secrets developed by us. Our ability to compete and the ability of our
business to grow could suffer if these intellectual property 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 rely on a combination of patents,
copyrights, trademarks and trade secret protection and contractual rights to
establish and protect our intellectual property. Failure of our patents,
copyrights, trademarks and trade secret protection, non-disclosure agreements
and other measures to provide protection of our technology and our intellectual
property rights could enable our competitors to more effectively compete with us
and have an adverse effect on our business, financial condition and results of
operations. In addition, our trade secrets and proprietary know-how may
otherwise become known or be independently discovered by others. 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.





In
addition, we may be required to litigate in the future to enforce our
intellectual property rights, to protect our trade secrets, to determine the
validity and scope of the proprietary rights of others, or to defend against
claims of infringement or invalidity. Any such litigation could result in
substantial costs and diversion of resources and could have a material adverse
effect on our business, financial condition or results of operations, and there
can be no assurances of the success of any such litigation.





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





Although
we have received or applied for U.S., European and International Patents with
respect to certain technologies of ours, there can be no assurance that these
patents will afford us any meaningful protection. Although we believe that our
use of the technology and products we developed and other trade secrets used in
our operations do 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 an 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 and our financial
condition. 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 and our financial condition. 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 any or all of our
applications.


26


Furthermore,
third parties may assert that our intellectual property rights are invalid,
which could result in significant expenditures by us to refute such assertions.
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. If we are unsuccessful in
defending claims that our intellectual property rights are invalid, we may not
be able to enter into royalty or license agreements on acceptable terms, if at
all. This could prohibit us from providing our products and services to
customers, which could have a material adverse effect on us and our financial
condition.





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 companies will purchase 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.





Certain of our recently developed
products are not yet commercially accepted and there can be no assurance that
those products will be accepted, which would adversely affect our financial
results.





Over the
past one to two years, we have spent significant funds and time to create new
products by applying our technologies onto media other than paper, including
plastic and cardboard packaging, and delivered our technologies digitally. We
have had limited success in selling our products that are on cardboard packaging
and those that are delivered digitally. If we are not able to successfully sell
these new products, our financial results will be adversely affected.





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, which could have a material adverse effect on us and our
financial condition.


27


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.





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.





Although
we were able to successfully acquire our Plastic Printing Professionals, Inc.
subsidiary in February 2006, there can be no assurance that we will be
successful in pursuing any or all of these steps on future transactions. 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 Chief Executive
Officer 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. Our employment agreement with David Wicker
expires in June 2009. There can be no assurance that these persons will continue
to agree to be employed by us after such dates.





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.


28





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. In June 2008, we sold 350,000
shares for an aggregate purchase price of $1.4 million, with $100,000 payable at
closing and the remaining $1.3 million payable in six-month installments over
two years. If the Purchaser of such 350,000 does not pay some or all of such
remaining $1.3 million purchase price, we will have limited, if any, recourse
against the purchaser other than recouping a pro-rata amount of the 350,000
shares. If we do not receive the remaining $1.3 million of the purchase price on
schedule, our financial position and financing resources may be materially
adversely affected.





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 stockholder 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.





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
September 30, 2008, there are approximately 185 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 and vesting of restricted stock awards may depress our
stock price.





As of
September 30, 2008, there were outstanding stock options and warrants to
purchase an aggregate of 1,306,343 shares of our Common Stock at exercise prices
ranging from $2.20 to $12.65 per share and a weighted average exercise price of
$10.24. In addition, as of September 30, 2008, there were 237,793 restricted
shares of our common stock that are subject to various vesting terms. To the
extent that these securities vest, dilution to our stockholders 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
stockholders 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.


29





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 August
20, 2008, the Company entered into an agreement with Trebuchet Capital Partners,
LLC which agreed to pay substantially all of the litigation costs associated
with pending validity proceedings initiated by the ECB in eight European
countries relating to the Company’s European Patent 0 455 750B1 that the Company
has claimed the ECB infringed in printing of the Euro currency. Trebuchet has
also purchased 100,000 shares of the Company’s common stock, subject to the
American Stock Exchange approving the listing of such shares, for an aggregate
purchase price of $400,000, the proceeds of which will be used by the Company to
pay existing, accrued costs related to the Litigation. On July
18, 2008, the Company issued 19,266 shares to a vendor as payment for $94,000 of
the vendor’s outstanding bills.




ITEM 3 - DEFAULTS UPON SENIOR
SECURITIES




On
January 4, 2008, the Company entered into a Credit Facility Agreement with
Fagenson and Co., Inc., as agent, a related party to Robert B. Fagenson, the
Chairman of the Company's Board of Directors. Under the Fagenson Credit
Agreement, the Company can borrow up to a maximum of $3,000,000 from time to
time up to and until January 4, 2010. The advances are generally limited to
$400,000 unless otherwise mutually agreed upon by both parties per fiscal
quarter, with the exception of $600,000 that can be advanced at any time for
patent litigation related bills. Any amount borrowed by the Company pursuant to
the Fagenson Credit Agreement will have an annual interest rate of 2% above
LIBOR and will be secured by the Common Stock of Plastic Printing Professionals,
Inc., (“P3”) the Company's wholly owned subsidiary. Interest is payable
quarterly in arrears and the principal is payable in full at the end of the term
under the Fagenson Credit Agreement. In addition, on January 4, 2008, the
Company also entered into a Credit Facility Agreement with Patrick White, the
Company's Chief Executive Officer and a member of the Board of Directors. Under
the White Credit Agreement, the Company can borrow up to $600,000 from time to
time up to and until January 4, 2010. Any amount borrowed by the Company
pursuant to the White Credit Agreement will have an annual interest rate of 2%
above LIBOR and will be secured by the accounts receivable of the Company,
excluding the accounts receivable of P3. Interest is payable quarterly in
arrears and the principal is payable in full at the end of the Term under the
White Credit Agreement. Mr. White can accept common stock as repayment of the
loan upon a default. Under the terms of the agreement the Company is required to
comply with various covenants. During the year ended December 31, 2007, Patrick
White advanced the Company $300,000 while the terms of the credit facility were
being finalized. As of September 30, 2008, the Company was in default of both
agreements due to a failure to pay interest when due. Both Fagenson and Co.,
Inc. and Patrick White have agreed to waive the default through January 1,
2010.




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




None




ITEM 5 - OTHER
INFORMATION




None


30




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 of the Registrant, 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
of the Registrant, as amended (incorporation by reference to exhibit 3.2 to the
Company's Registration Statement No. 2-98684-NY on Form S-18).*




Item
10.1  Agreement, dated August 20, 2008, between Document Security Systems,
Inc. and Trebuchet Capital Partners, LLC. Portions of this exhibit have been
omitted pursuant to a request for confidential treatment filed separately with
the Securities and Exchange Commission.





Item 31.1  Certifications
of Chief Executive Officer Pursuant to Section 302 of the Sarbanes Oxley
Act




Item 31.2  Certifications
of Acting Chief Financial Officer Pursuant to Section 302 of the Sarbanes Oxley
Act





Item
32.1  Certification
of Chief Executive Officer Pursuant to Section 906 of the Sarbanes Oxley
Act





Item
32.2  Certification
of Acting Chief Financial Officer Pursuant to Section 906 of the Sarbanes Oxley
Act




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.December
      30, 2008
            
            By:
            /s/
      Patrick WhitePatrick
      White
              Chief
      Executive OfficerDecember
      30, 2008
            
            By:
            /s/
      Philip JonesPhilip
      JonesActing
      Chief Financial Officer
              (Vice
      President of Finance)


31