**UNITED
      STATES SECURITIES AND EXCHANGE**


**COMMISSION**


**Washington,
      D.C. 20549**




**FORM
      10-Q**




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


**THE
      SECURITIES EXCHANGE ACT OF 1934**




**For
      the quarterly period ended**  **September
      30, 2006**




**1-32146**Commission
                file number





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





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





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





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





**Indicate
                by check mark whether the registrant:**


(1)
                  filed all reports required to be filed by Section 13 or 15(d) of
                  the
                  Exchange Act during the 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 o**
 Indicate
          by check mark whether the registrant is a large accelerated filer, an
          accelerated filer, or a non-accelerated filer. See definition of “accelerated
          filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
          one):
  Large accelerated filer o
                Accelerated filer o
                Non-accelerated filer xIndicate by check mark
                  whether the
                  registrant is a shell company (as defined in Rule 12b-2 of the
                  Exchange
                  Act)
 
 **Yes
          o No x**
  **Applicable
          only to corporate issuers**
  As
                  of November 10, 2006 (the most recent practicable date), there
                  were
                  12,926,989 shares of the issuer's Common Stock, $0.02 par value
                  per share,
                  outstanding.Indicate
                  by check mark whether the registrant is a shell company (as defined
                  in
                  Rule 12b-2 of the Exchange Act)**Yes
                  o   
                  No x**
 
 
  **DOCUMENT
                  SECURITY SYSTEMS, INC.**
                **FORM
                  10-Q**
                **TABLE
                  OF CONTENTS****PART
                  I****FINANCIAL
                  INFORMATION**Item
                  1
              
              Financial
                  StatementsConsolidated
                  Balance Sheets
              
              F-1Consolidated
                  Statements of Operations
              
              F-2Consolidated
                  Statements of Cash Flows
              
              F-3Notes
                  to Financial Statements
              
              F-4Item
                  2
              
              Management's
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              
              1Item
                  3
              
              Quantitative
                  and Qualitative Disclosures about Market Risk
              
              11Item
                  4
              
              Controls
                  and Procedures
              
              11**PART
                  II****OTHER
                  INFORMATION**Item
                  1
                Item
                  1a
              
              Legal
                  Proceedings
                Risk
                  Factors
              
              123Item
                  2
              
              UnregisteredSales
                  of Equity Securities and Use of Proceeds
              
              13Item
                  3
              
              Defaults
                  upon Senior Securities
              
              20Item
                  4
              
              Submission
                  of Matters to a Vote of Security Holders
              
              20Item
                  5
              
              Other
                  Information
              
              20Item
                  6
              
              Exhibits
              
              20**SIGNATURES**
  i
   **PART
        I**
   **FINANCIAL
        INFORMATION**
 ITEM
        1 -
        FINANCIAL STATEMENTS
  
 **DOCUMENT
                    SECURITY SYSTEMS, INC.  AND SUBSIDIARIES****Consolidated
                    Balance Sheets****September
                    30,**
                
                **December
                    31,****2006**
                
                **2005****(unaudited)**
                
                **(audited)****ASSETS****Current
                    assets:**Cash
                    and cash equivalents
                
                $
                1,520,360
                
                $
                3,953,482Accounts receivable, net of allowanceof
                    $25,000 ($13,000 -2005)
                
                
                719,941
                
                
                164,726Inventory
                
                
                249,438
                
                
                148,804Prepaid expenses and other current assets
                
                
                124,974
                
                
                225,114Total
                    current assets
                
                
                2,614,713
                
                
                4,492,126**Restricted
                    cash**
                
                
                —
                
                
                240,000**Fixed
                    assets, net**
                
                
                623,700
                
                
                451,195**Other
                    assets**
                
                
                159,862
                
                
                229,050**Goodwill**
                
                
                1,396,734
                
                
                711,785**Other
                    intangible assets, net**
                
                
                4,994,754
                
                
                4,208,962**Total
                    Assets**
                
                $
                9,789,763
                
                $
                10,333,118**LIABILITIES
                    AND STOCKHOLDERS' EQUITY****Current
                    liabilities:**Accounts
                    payable
                
                $
                1,298,827
                
                $
                547,512Accrued
                    expenses & other current liabilities
                
                
                229,692
                
                
                212,559Deferred
                    revenue
                
                
                595,783
                
                
                —Current
                    portion of capital lease obligations
                
                
                34,817
                
                
                33,374Current
                    portion of long-term debt
                
                
                —
                
                
                50,891Total
                    current liabilities
                
                
                2,159,119
                
                
                844,336**Long-term
                    debt**
                
                
                —
                
                
                167,309**Long-term
                    capital lease obligations**
                
                
                58,784
                
                
                84,931**Commitments
                    and contingencies (See Note 8)****Stockholders'
                    equity**Common
                    stock, $.02 par value;200,000,000
                    shares authorized,12,926,989 shares
                    issued and outstanding (12,698,872 in 2005)
                
                
                258,540
                
                
                253,977Additional paid-in capital
                
                
                23,114,276
                
                
                21,377,996Accumulated deficit
                
                
                (15,800,956
                )
                
                (12,395,431
                )Total
                    stockholders' equity
                
                
                7,571,860
                
                
                9,236,542**Total
                    Liabilities and Stockholders' Equity**
                
                $
                9,789,763
                
                $
                10,333,118
  See
        accompanying notes.
  F-1
 
 **DOCUMENT
                  SECURITY SYSTEMS, INC. AND
                  SUBSIDIARIES****Consolidated
                  Statements of
                  Operations****(unaudited)****Three
                  Months Ended**
              
              **Nine
                  Months Ended****September
                  30,**
              
              **September
                  30,**
              
              **September
                  30,**
              
              **September
                  30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Revenue,
                  netSecurity
                  products & printing
              
              $
              849,264
              
              $
              222,158
              
              $
              2,608,619
              
              $
              864,352Royalties
              
              
              246,528
              
              
              28,251
              
              
              343,223
              
              
              51,600Legal
                  products
              
              
              167,518
              
              
              122,714
              
              
              483,983
              
              
              381,445Total
                  Revenue
              
              
              1,263,310
              
              
              373,123
              
              
              3,435,825
              
              
              1,297,397Costs
                  of revenueSecurity
                    products & printing
              
              
              581,370
              
              
              123,936
              
              
              1,665,325
              
              
              475,285Legal
                  products
              
              
              86,355
              
              
              62,713
              
              
              267,240
              
              
              196,960Total
                  costs of revenue
              
              
              667,725
              
              
              186,649
              
              
              1,932,565
              
              
              672,245**Gross
                  profit**
              
              
              595,585
              
              
              186,474
              
              
              1,503,260
              
              
              625,152**Operating
                  expenses:**Selling,
                  general and administrative expenses
              
              
              1,435,016
              
              
              674,018
              
              
              3,919,925
              
              
              1,956,675Research
                  and development
              
              
              93,693
              
              
              79,165
              
              
              262,577
              
              
              239,750Amortization
                  of intangibles
              
              
              275,714
              
              
              135,000
              
              
              763,989
              
              
              270,000Operating expenses
              
              
              1,804,423
              
              
              888,183
              
              
              4,946,491
              
              
              2,466,425**Operating
                  loss**
              
              
              (1,208,838
              )
              
              (701,709
              )
              
              (3,443,231
              )
              
              (1,841,273
              )**Other
                  income (expense):**Interest income
              
              
              7,200
              
              
              29,797
              
              
              51,338
              
              
              67,222Interest expense
              
              
              (2,788
              )
              
              (6,494
              )
              
              (13,632
              )
              
              (20,543
              )**Loss
                  before income taxes**
              
              
              (1,204,426
              )
              
              (678,406
              )
              
              (3,405,525
              )
              
              (1,794,594
              )Income
                  taxes
              
              
              —
              
              
              —
              
              
              —
              
              
              —**Net
                  loss**
              
              $
              (1,204,426
              )
              $
              (678,406
              )
              $
              (3,405,525
              )
              $
              (1,794,594
              )**Net
                  loss per share, basic and diluted**
              
              $
              (0.09
              )
              $
              (0.06
              )
              $
              (0.26
              )
              $
              (0.15
              )**Weighted
                  average common shares outstanding, basic and
                  diluted**
              
              
              12,920,315
              
              
              12,285,029
              
              
              12,868,887
              
              
              11,856,511
  See
        accompanying notes.
  F-2
 **DOCUMENT
                  SECURITY SYSTEMS, INC. AND SUBSIDIARIES****Consolidated
                  Statements of Cash Flows****For
                  the Nine Months Ended September 30,****2006**
              
              **2005****(unaudited)**
              
              **(unaudited)****Cash
                  flows from operating activities:**Net loss
              
              $
              (3,405,525
              )
              $
              (1,794,594
              )Adjustments to reconcile net loss to net cash used by operating
                  activities:Depreciation and amortization expense
              
              
              927,635
              
              
              404,960Stock
                  based compensation
              
              
              591,684
              
              
              29,521(Increase) decrease in assets:Accounts
                  receivable
              
              
              (389,229
              )
              
              235,226Inventory
              
              
              (30,487
              )
              
              (77,176
              )Prepaid expenses and other assets
              
              
              (20,541
              )
              
              (73,238
              )Increase in liabilities:Accounts
                  payable and accrued expenses
              
              
              234,719
              
              
              58,179Deferred
                  revenue
              
              
              595,783
              
              
              —Net
                  cash used by operating activities
              
              
              (1,495,961
              )
              
              (1,217,122
              )**Cash
                  flows from investing activities:**Purchase
                  of fixed assets
              
              
              (78,204
              )
              
              (83,941
              )Acquisition
              
              
              (1,301,670
              )
              
              —Purchase
                  of other intangible assets
              
              
              (453,542
              )
              
              (185,283
              )Net
                  cash used by investing activities
              
              
              (1,833,416
              )
              
              (269,224
              )**Cash
                  flows from financing activities:**Repayment of long-term debt
              
              
              (218,200
              )
              
              (35,663
              )Decrease
                  in restricted cash
              
              
              240,000
              
              
              51,000Repayment
                  of capital lease obligations
              
              
              (24,704
              )
              
              (22,714
              )Issuance
                  of common stock, net
              
              
              899,159
              
              
              2,555,664Net
                  cash provided by financing activities
              
              
              896,255
              
              
              2,548,287**Net
                  increase (decrease) in cash and cash equivalents**
              
              
              (2,433,122
              )
              
              1,061,941**Cash
                  and cash equivalents beginning of period**
              
              
              3,953,482
              
              
              2,657,865**Cash
                  and cash equivalents end of period**
              
              $
              1,520,360
              
              $
              3,719,806




See
        accompanying notes.
  F-3
 **DOCUMENT
        SECURITY SYSTEMS, INC.**
 **NOTES
        TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS**
 **September
        30, 2006**
 **(Unaudited)**
   **1.    
        Basis of Presentation and Significant Accounting Policies**
  Document
        Security Systems, Inc. (the “Company”), a New York corporation, operates in the
        market for secured documents and solutions. The Company licenses its patented
        technology and sells products that use its patented optical anti-scanning,
        anti-counterfeiting technologies. The Company’s customers include governments,
        law enforcement agencies, security printers, check and forms printers and
        corporations. In addition, the Company, through its consolidated subsidiaries,
        operates a retail printing operation and sells supplies to the legal industry.
 
 *Interim
        Financial Statements*
  The
        consolidated financial statements include the accounts of Document Security
        Systems, Inc and its wholly owned subsidiaries (collectively, the “Company”)
        after elimination of intercompany transactions, profits, and balances.  The
        consolidated financial statements have been prepared from the Company’s records
        without audit and, in management’s opinion, include all adjustments (consisting
        of only normal recurring adjustments) necessary to fairly reflect the financial
        condition and the results for the periods presented. Certain information
        and
        footnote disclosures normally included in financial statements prepared in
        accordance with U.S. generally accepted accounting principles have been
        condensed or omitted under the Securities and Exchange Commission’s
        rules and regulations.
  These
        consolidated financial statements should be read in conjunction with the
        audited
        consolidated financial statements included in the Company’s Annual Report on
        Form 10-KSB for the year ended December 31, 2005. The results of
        operations for the interim periods presented in these consolidated financial
        statements are not necessarily indicative of the results expected for the
        year
        ended December 31, 2006.
  *Reclassifications*
  Certain
        prior period amounts in the accompanying consolidated financial statements
        and
        notes thereto have been reclassified to current period presentation. These
        classifications had no effect on the results of operations for the period
        presented. These reclassifications include the reclassification of state
        business fees from income tax to selling, general and administrative and
        amortization of intangibles from selling, general and administrative to a
        separate line on the statement of operations.
  *Use
        of Estimates*
  The
        preparation of consolidated financial statements in accordance with U.S.
        generally accepted accounting principles requires the Company to make estimates
        and judgments that affect the reported amounts of assets, liabilities, revenue
        and expenses, and related disclosure of contingent assets and liabilities.
        Certain of the Company’s accounting policies require higher degrees of judgment
        than others in their application. These include impairments and estimation
        of
        useful lives of long-lived assets, inventory valuation, reserves for
        uncollectible accounts receivable, and contingencies and litigation. The
        Company
        bases its estimates on historical experience and on various other assumptions
        that are believed to be reasonable under the circumstances, the results of
        which
        form the basis for making judgments about the carrying values of assets and
        liabilities that are not readily apparent from other sources. Actual results
        may
        differ from these estimates under different assumptions or
        conditions.
  F-4
 *Share-Based
        Payments*
  Prior
        to
        January 1, 2006, the Company accounted for stock option awards granted
        under the Company’s Stock Incentive Plans in accordance with the recognition and
        measurement provisions of Accounting Principles Board Opinion No. 25,
“Accounting for Stock Issued to Employees”, (“APB 25”) and related
        Interpretations, as permitted by Statement of Financial Accounting Standards
        No. 123, “Accounting for Stock-Based Compensation”, (“SFAS 123”).
        Share-based employee compensation expense was not recognized in the Company’s
        consolidated statements of operations prior to January 1, 2006, as all
        stock option awards granted had an exercise price equal to or greater than
        the
        market value of the common stock on the date of the grant, except for
        modifications of stock option awards, which triggered compensation expense
        in
        accordance with provisions of FASB FIN 44 -“Accounting for Certain Transactions
        Involving Stock Compensation”. As permitted by SFAS 123, the Company reported
        pro-forma disclosures presenting results and earnings per share as if the
        Company had used the fair value recognition provisions of SFAS 123 in the
        Notes
        to Consolidated Financial Statements. Stock-based compensation related to
        non-employees were accounted for based on the fair value of the related stock
        or
        options in accordance with SFAS 123 and its interpretations.
  Effective
        January 1, 2006, the Company adopted the provisions of Statement of
        Financial Accounting Standard No. 123 (revised 2004), “Share-Based
        Payment”, (“SFAS 123(R)”) using the modified prospective transition method. See
        Note 5 for further detail on the impact of SFAS 123(R) to the Company’s
        consolidated financial statements.
  *Revenue
        Recognition*
  Sales
        of
        custom document security products amd printing, retail printing and legal
        products are recognized when a product or service is delivered, shipped or
        provided to the customer and all material conditions relating to the sale
        have
        been substantially performed. We
        also
        enter into arrangements under which we provide hosted software applications.
        We
        recognize revenue for these arrangements based on the provisions of EITF
        No.
        00-3, Application of AICPA SOP 97-2 to Arrangements That Include the Right
        to
        Use Software Stored on Another Entity's Hardware ("EITF 00-3"), and the
        provisions of Staff Accounting Bulletin No. 101, Revenue Recognition in
        Financial Statements, as amended by SAB No. 104, when there is persuasive
        evidence of an arrangement, collection of the resulting receivable is probable,
        the fee is fixed or determinable and acceptance has occurred. Our revenues
        related to these arrangements consist of system implementation service fees
        and
        software subscription fees. We have determined that the system implementation
        services represent set-up services that do not qualify as separate units
        of
        accounting from the software subscriptions as the customer would not purchase
        these services without the purchase of the software subscription. As a result,
        we recognize system implementation fees ratably over a period of time from
        when
        the core system implementation services are completed and accepted by the
        customer over the remaining customer relationship life, which we have determined
        is the contractual life of the customer's subscription agreement. We recognize
        software subscription fees, which typically commence upon completion of the
        related system implementation, ratably over the applicable subscription period.
        Amounts billed and/or collected prior to satisfying our revenue recognition
        policy are reflected as deferred revenue.
  We
        recognize revenue from technology licenses once
        all the following criteria for revenue recognition have been met: (1) persuasive
        evidence of an agreement exists; (2) the right and ability to use the product
        or
        technology has been rendered; (3) the fee is fixed and determinable and not
        subject to refund or adjustment; and (4) collection of the amounts due is
        reasonably assured.
  F-5
  **2.
        Inventory**
  Inventory
        consisted of the following:
 **September
                    30,**
                
                **December
                    31,****2006**
                
                **2005****(unaudited)**
                
                **(audited)**Finished
                    Goods
                
                $
                178,745
                
                $
                148,804Materials
                
                
                70,693
                
                
                -$
                249,438
                
                $
                148,804
  **3.    
        Goodwill and Other Intangible Assets**
  ***Other
        Intangible Assets*** -
 
 Other
        intangible assets are comprised of the following:
  **September
                    30,**
                
                **December
                    31,****Useful
                    Life**
                
                **2006**
                
                **2005**Royalty
                    rights
                
                
                5
                    years
                
                **$**
                90,000
                
                **$**
                90,000Other
                    Intangibles
                
                
                5
                    years
                
                
                666,300
                
                
                41,000Patent
                    and contractual rights
                
                
                Varied
                    (1
                )
                
                5,556,052
                
                
                4,634,071**6,312,352**
                
                
                **4,765,071**Less
                    accumulated amortization
                
                
                
                
                
                1,317,598
                
                
                556,109Net
                    carrying value
                
                
                
                
                **$**
                **4,994,754**
                
                **$**
                **4,208,962**(1)-
                    patent rights are amortized over their expected useful life which
                    is
                    generally the legal life of the patent. As of September 30, 2006
                    the
                    weighted average expected useful life of these assets was 6.7
                    years.
 
 F-6
 ***Goodwill
        -*** In
        accordance with the provisions of SFAS No. 142, "Goodwill and Other Intangible
        Assets" (SFAS 142), the Company performs an annual fair value test of its
        recorded goodwill for its reporting units using a discounted cash flow and
        capitalization of earnings approach. During the first quarter of 2006, the
        Company recorded a preliminary estimate of goodwill of $942,000 associated
        with
        its acquisition of the assets of Plastic Printing Professionals. During the
        second quarter of 2006, the Company revised its estimate of goodwill associated
        with this acquisition to $685,000. As of September 30, 2006, the Company’s
        goodwill of $1,397,000 consists of $81,000 attributable to the legal segment
        and
        $1,316,000 attributable to the document security and production segment.
        The
        Company plans to conduct annual impairment tests in the fourth quarter of
        each
        year, unless impairment indicators exist at an earlier date.
  **4.    
        Acquisition**
  On
        February 7, 2006, the Company acquired substantially all of the assets of
        Plastic Printing Professionals, Inc. ("P3") for $1.25 million in cash, 18,704
        shares of the Company’s Common Stock valued at $250,000 and the assumption of
        certain liabilities. The cash portion of the purchase price was paid using
        the
        Company’s cash on hand. P3 is a security printer specializing in plastic cards
        containing security technologies. P3 has 25 full-time employees and had sales
        of
        approximately $2.7 million in 2005.  Commencing
        on February 7, 2006, the results of P3’s operations are included in the
        consolidated financial statements of the Company. The Company accounted for
        the
        acquisition as a business combination under FASB 141 “Business Combinations”.
        During the quarter ended June 30, 2006, the Company revised its allocations
        from
        its preliminary estimates based upon the receipt of a valuation report that
        resulted in an increase in the amount allocated to acquired intangibles and
        a
        corresponding decrease in the amount allocated to goodwill of $225,000. The
        purchase price has been allocated based on the estimated fair market value
        of
        the assets acquired and liabilities assumed as follows:
 Accounts
                    receivable
                
                $
                166,000Inventory
                    & pre-paid assets
                
                
                83,000Fixed
                    assets
                
                
                258,000Identified
                    intangible assets
                
                
                625,000Goodwill
                
                
                685,000Total
                    Assets
                
                $
                1,817,000Liabilities
                    Assumed
                
                $
                (265,000
                )Total
                    Purchase Price
                
                $
                1,552,000
  Set
        forth
        below is the unaudited pro forma revenue, operating loss, net loss and loss
        per
        share of the Company as if P3 had been acquired by the Company as of January
        1,
        2005:
  **Three
                    Months Ended September 30,**
                
                **Nine
                    Months Ended September 30,****2006**
                
                **2005**
                
                **2006**
                
                **2005**Revenue
                
                $
                1,263,310
                
                $
                994,185
                
                $
                3,685,931
                
                $
                3,237,348Operating
                    Loss
                
                
                (1,208,838
                )
                
                (687,444
                )
                
                (3,448,001
                )
                
                (1,796,714
                )Net
                    Loss
                
                
                (1,204,426
                )
                
                (664,141
                )
                
                (3,409,849
                )
                
                (1,750,035
                )Basic
                    and diluted loss per share
                
                
                (0.09
                )
                
                (0.05
                )
                
                (0.26
                )
                
                (0.15
                )
   F-7
  **5.
        Stock Based Compensation**
 
 In
        December 2004, the Financial Accounting Standards Board issued SFAS 123R,
        Share-Based Payment (“SFAS 123R”). SFAS 123R supersedes SFAS 123, Accounting for
        Stock Based Compensation, and Accounting Principles Board Opinion 25, Accounting
        for Stock Issued to Employees (“APB 25) and its related implementation guidance.
        On January 1, 2006, the Company adopted the provisions of SFAS 123R using
        the
        modified prospective transition method. Under this method, the Company is
        required to record compensation expense for all stock based awards granted
        after
        the date of adoption and for the unvested portion of previously granted awards
        that remain outstanding as of the beginning of the adoption and prior periods
        have not been restated. Under SFAS 123R, compensation expense related to
        stock
        based payments are recorded over the requisite service period based on the
        grant
        date fair value of the awards.
 
 Prior
        to
        the adoption of SFAS 123R, the Company accounted for employee stock options
        using the intrinsic value method in accordance with APB 25. Accordingly,
        no
        compensation expense was recognized for stock options issued to employees
        as
        long as the exercise price was greater than or equal to the market value
        of the
        Common Stock at the date of grant. In accordance with SFAS 123, the Company
        disclosed the summary of pro forma effects to reported net loss as if the
        Company had elected to recognize compensation costs based on the fair value
        of
        the awards at the grant date.
 
 The
        Company has adopted the
        2004
        Employees' Stock Option Plan (the "2004 Plan") to provide for the grant of
        options, restricted stock and other forms of equity to employees, including
        executive officers, and consultants. A total of 1,200,000 shares of Common
        Stock
        are authorized to be issued under the 2004 Plan. Under the terms of the 2004
        Plan, options granted thereunder may be designated as options which qualify
        for
        incentive stock option treatment ("ISOs") under Section 422A of the Internal
        Revenue Code, or options which do not so qualify ("Non-ISOs"). The
        2004
        Plan is administered by the Compensation Committee of the Company’s Board of
        Directors. The Compensation Committee has the discretion to determine the
        eligible employees to whom, and the times and the price at which, options
        will
        be granted; whether such options shall be ISOs or Non-ISOs; the periods during
        which each option will be exercisable; and the number of shares subject to
        each
        option. The Compensation Committee has full authority to interpret the 2004
        Plan
        and to establish and amend rules and regulations relating thereto.
  The
        Company also adopted The Non-Executive Director Stock Option Plan (the "Director
        Plan"), which provides for options for up to 100,000 shares to non-executive
        directors and advisors. Under the terms of the Director Plan, an option to
        purchase (a) 5,000 shares of our common stock shall be granted to each
        non-executive director upon joining the Board of Directors and (b) 5,000
        shares
        of our common stock shall be granted to each non-executive director thereafter
        on January 2 nd of each
        year; provided that any non-executive director who has not served as a director
        for the entire year immediately prior to January 2nd shall receive a pro
        rata
        number of options based on the time the director has served in such capacity
        during the previous year.
  The exercise price for options granted under the Director Plan is 100% of
        the
        fair market value of the Common Stock on the date of grant. Until otherwise
        provided in the Director Plan, the exercise price of options granted under
        the
        Director Plan must be paid at the time of exercise, either in cash, by delivery
        of shares of the common stock of the Company or by a combination of each.
        The
        term of each option commences on the date it is granted and unless terminated
        sooner as provided in the Director Plan, expires five years from the date
        of
        grant. Neither the Board nor the Compensation Committee has discretion to
        determine which non-executive director or advisory board member will receive
        options or the number of shares subject to the option, the term of the option
        or
        the exercisability of the option. However, the Compensation Committee will
        make
        all determinations of the interpretation of the Director Plan. Options granted
        under the Director Plan are not qualified for incentive stock option
        treatment.
  F-8
 The
        compensation cost that has been charged against income for options granted
        under
        the plans was approximately $21,000 and $63,000 for the three-month and
        nine-month periods, respectively, ended September 30, 2006. The impact of
        these
        expenses to basic and diluted earnings per share was less than $0.01 during
        those periods. The adoption of SFAS 123R did not have an impact on cash flows
        from operating or financing activities. For stock options issued as non-ISO’s a
        tax deduction is not allowed until the options are exercised. The amount
        of this
        deduction will be the difference between the fair value of the Company’s Common
        Stock and the exercise price at the date of exercise. Accordingly, there
        is a
        deferred tax asset recorded for the tax effect of the financial statement
        expense recorded. The tax effect of the income tax deduction in excess of
        the
        financial statement expense will be recorded as an increase to additional
        paid-in capital. Due to the uncertainty of the Company’s ability to generate
        sufficient taxable income in the future to utilize the tax benefits of the
        options granted, the Company has recorded a valuation allowance to reduce
        gross
        deferred tax asset to zero. As a result for the periods ended September 30,
        2006, there is no income tax expense impact from recording the fair value
        of
        options granted. No tax deduction is allowed for stock options issued and
        exercised as ISO’s.
  In
        December 2005, the Company approved an
        acceleration of all unvested options at that time. Pursuant to this, the
        Company recorded stock based compensation expense based on the intrinsic
        value
        of in-the-money options and our estimate of the benefit of the modification
        to
        the Company's employees and officers. As of that date, our estimate of
        the benefit was $78,000, which was recorded as stock based compensation expense.
        As of September 30, 2006, there remained an additional $252,000 of potential
        expense that would be recorded if actual forfeiture results differ from
        management's estimates.
 
 The
        fair
        value of each option award is estimated on the date of grant utilizing the
        Black
        Scholes Option Pricing Model that uses the assumptions noted in the following
        table.
  **Nine Months Ended September 30,****2006**
              
              **2005**Volatility
              
              
              42.6
              %
              
              55
              %Expected
                  option term
              
              
              3
                  years
              
              
              4
                  yearsRisk-free
                  interest rate
              
              
              4.4
              %
              
              4.1
              %Expected
                  dividend yield
              
              
              0
              %
              
              0
              %
 
 F-9
 A
        summary
        of the status of the options granted under the 2004 Plan and the Director
        Plan,
        respectively, is presented below:
 
 **2004
                    Employee Plan**
                
                **Non-Executive
                    Director Plan****Number
                    of Options**
                
                **Weighted
                    Average Exercise Price**
                
                **Weighted
                    Average Life Remaining**
                
                **Number
                    of Options**
                
                **Weighted
                    Average Exercise Price**
                
                **Weighted
                    Average Life Remaining**(years)
                
                
                
                
                
                (years)Outstanding
                    at December 31, 2005
                
                
                277,000
                
                
                8.05
                
                
                
                
                
                36,250
                
                
                5.47Granted
                
                
                —
                
                
                
                
                
                
                
                
                20,000
                
                
                12.65Exercised
                
                
                —
                
                
                
                
                
                
                
                
                —
                
                
                -Canceled
                
                
                50,000
                
                
                10.19
                
                
                
                
                
                —
                
                
                -Outstanding
                    at September 30, 2006:
                
                
                227,000
                
                
                7.58
                
                
                
                
                
                56,250
                
                
                8.02Exercisable
                    at September 30, 2006:
                
                
                217,000
                
                
                7.67
                
                
                
                
                
                36,250
                
                
                5.47Aggregate
                    Intrinsic Value of outstanding options at September 30, 2006
                
                $
                519,830
                
                
                
                
                
                3.8
                
                $
                159,500
                
                
                
                
                
                3.3Aggregate
                    Intrinsic Value of exercisable options at September 30, 2006
                
                $
                477,400
                
                
                
                
                
                3.9
                
                $
                159,500
                
                
                
                
                
                2.8
 
 The
        weighted-average grant date fair value of options granted during the six-month
        period ended September 30, 2006 was $4.24 ($2.99 during the nine-month period
        ended September 30, 2005). There were no options exercised during the nine-month
        periods ended September 30, 2006 or 2005, respectively.
 
 The
        following table summarizes the status of the Company’s non-vested options under
        the its stock option plans:
  Number
                  of
                  Non-vested
                
                Weighted-
                    AverageShares
                
                Grant
                    DateSubject
                    to Options
                
                Fair
                    ValueNon-vested
                    as of December 31, 2005
                
                
                10,000
                
                $
                3.68Non-vested
                    granted- nine month period ended September 30, 2006
                
                
                20,000
                
                $
                4.24Vested
                    - nine month period ended September 30, 2006
                
                
                —
                
                $
                —Forfeited
                    - nine month period ended September 30, 2006
                
                
                —
                
                $
                —Non-vested
                    as of September 30, 2006
                
                
                30,000
                
                $
                4.05
  As
        of
        September 30, 2006, there was approximately $25,000 of total unrecognized
        compensation cost related to non-vested options granted under the Non-Executive
        Director plan. That cost will be recognized over a weighted average period
        of
        one year. The total fair value of shares that vested during the nine-month
        period ended September 30, 2006 was $0 ($450,000 during the nine-month period
        ended September 30, 2005).
  F-10
 ***Pro-Forma
        Stock Compensation Expense:***
  For
        the
        quarterly and nine-month periods ended September 30, 2005, the Company
        applied the intrinsic value method of accounting for stock options as prescribed
        by APB 25. Since all options granted during the quarterly and nine-month
        periods
        ended September 30, 2005 had an exercise price equal to the closing market
        price of the underlying common stock on the grant date, no compensation expense
        was recognized. If compensation expense had been recognized based on the
        estimated fair value of each option granted in accordance with the provisions
        of
        SFAS 123 as amended by Statement of Financial Accounting Standard 148, our
        net
        loss and net loss per share would have been reduced to the following pro-forma
        amounts (in thousands, except per share amounts):
 **September
                    30, 2005****Three
                    months**
                
                **Nine
                    months****ended**
                
                **ended**$
                    Amount
                
                $
                    Per share
                
                $
                    Amount
                
                $
                    Per shareNet
                    loss, as reported
                
                $
                (678,406
                )
                $
                (0.06
                )
                $
                (1,794,594
                )
                $
                (0.15
                )Fair
                    value method compensation expense, net of tax
                
                
                (224,473
                )
                
                (0.02
                )
                
                (449,693
                )
                
                (0.04
                )Net
                    loss, pro-forma
                
                $
                (902,879
                )
                $
                (0.08
                )
                $
                (2,244,287
                )
                $
                (0.19
                )
  ***Restricted
        Stock*** - Restricted common stock is issued for services to be rendered and may not
        be
        sold, transferred or pledged for such period as determined by our Compensation
        Committee. Restricted stock compensation cost is measured as the stock’s fair
        value based on the market price at the date of grant. The restricted shares
        issued reduce the amount available under our stock option plans. We recognize
        compensation cost only on restricted shares that will ultimately vest. We
        estimate the number of shares that will ultimately vest at each grant date
        based
        on our historical experience and adjust compensation cost and the carrying
        amount of unearned compensation based on changes in those estimates over
        time.
        Restricted stock compensation cost is recognized ratably over the requisite
        service period which approximates the vesting period. An employee may not
        sell
        or otherwise transfer unvested shares and, in the event that employment is
        terminated prior to the end of the vesting period, any unvested shares are
        surrendered to us. We have no obligation to repurchase restricted stock.
 
 On
        June
        26, 2006, the Company granted 65,000 in restricted stock to recently hired
        employees, including 50,000 to its new President. The restricted shares vest
        over 3 years beginning on the grant date. The company will recognize
        compensation costs associated with these restricted shares of approximately
        $700,000 over the vesting periods of which $58,000 was recognized during
        the
        third quarter of 2006.
 
 The
        following is a summary with respect to restricted stock outstanding at
        September 30, 2006:
 
 **Weighted-
                  average****grant-date********Shares******
              
              **fair
                  value per share******Restricted
                  shares outstanding, December 31, 2005
              
              
              —
              
              $
              —Restricted
                  shares granted
              
              
              65,000
              
              
              10.77Restricted
                  shares vested
              
              
              —
              
              
              —Restricted
                  shares forfeited
              
              
              —
              
              
              —Restricted
                  shares outstanding, September 30, 2006
              
              
              65,000
              
              $
              10.77
 
 
 F-11
  **6.    
        Stockholders Equity**
  ***Stock
        Issued for Acquisition -*** In
        February 2006, the Company issued 18,704 of its Common Stock plus additional
        costs related to the acquisition of substantially all of the assets of Plastic
        Printing Professionals (See Note 4). The value of the shares of Common Stock
        was
        determined based upon the average closing price of the shares of the Company’s
        Common Stock on the American Stock Exchange on for 10 trading days immediately
        prior to February 7, 2006 of $13.36 per share.
 
 ***Stock
        Warrants*** - During
        the first nine months of 2006, the Company received approximately $900,000
        in
        proceeds from the exercise of warrants.
 
 On
        June
        16, 2006, the Company issued to International Barcode Corporation (d/b/a
        Barcode
        Technology)(“BTI”), a warrant to purchase 500,000 shares of the Company's common
        stock, $0.02 par value per share, at a price of $10.00 per share vesting
        over
        approximately one year and with an expiration date of June 16, 2007. The
        fair
        value of the warrants amounted to $890,000 utilizing Black Scholes pricing
        model. This value is being recognized as the warrants vests. During the three
        months and nine months ended September 30, 2006, the Company has recognized
        approximately $223,000 and $445,000, respectively, of expense related to
        these
        warrants. The warrants were issued in conjunction with an agreement that
        provides BTI with the exclusive right to market, sell and manufacture DSS
        technologies, products and processes for all security-related applications
        for
        government and commercial use in China.
 
 
 The
        following is a summary with respect to warrants outstanding at
        September 30, 2006:
 
 **2006****Weighted****Average****Exercise****Warrants**
                
                **Price**Warrants
                    outstanding at January 1, 2006
                
                
                296,783
                
                $
                4.12Granted
                
                
                500,000
                
                $
                10.00Exercised
                
                
                204,597
                
                $
                4.49Lapsed
                
                
                —
                
                $
                —Warrants
                    outstanding at September 30, 2006
                
                
                592,186
                
                $
                8.9610.6
 
 F-12
 The
        following table summarizes the warrants outstanding
        and exercisable as of September 30, 2006:
 **Warrants
                    Outstanding**
                
                **Warrants
                    Exercisable****Range
                    of Exercise Prices**
                
                **Number
                    of Shares**
                
                **Weighted
                    Average Remaining Contractual Life (in years)**
                
                **Weighted
                    Average Exercise Price**
                
                **Number
                    of Shares**
                
                **Weighted
                    Average Remaining Contractual Life (in years)**
                
                **Weighted
                    Average Exercise Price**$2.00-$4.99
                
                
                59,375
                
                
                1.5
                
                $
                2.38
                
                
                59,375
                
                
                1.5
                
                $
                2.38$5.00-$7.75
                
                
                32,811
                
                
                2.2
                
                $
                5.00
                
                
                32,811
                
                
                2.2
                
                $
                5.00$7.76-$10.00
                
                
                500,000
                
                
                0.7
                
                $
                10.00
                
                
                250,000
                
                
                0.7
                
                $
                10.00592,186
                
                
                
                
                
                
                
                
                342,186
 **7.    
        Loss per Share**
  Basic earnings per share is computed by dividing net income by the
        weighted-average number of common shares, outstanding for the period. Diluted
        earnings per share is computed by including the number of additional shares
        that
        would have been outstanding if dilutive potential shares had been issued.
        In
        periods of losses, diluted loss per share is computed on the same basis as
        basic
        loss per share as the inclusion of any other potential shares outstanding
        would
        be anti-dilutive.  As of September 30, 2006, there were 875,436 (580,969 as
        of September 30, 2005) stock options and warrants outstanding with exercise
        prices below the average share price for the period that would have been
        included in the calculation of diluted earnings per share had the Company
        generated net income.
  **8.    
        Commitments and Contingencies**
  On
        August
        1, 2005, we commenced a suit against the European Central Bank alleging patent
        infringement by the European Central Bank and have claimed unspecified damages.
        We brought the suit in European Court of First Instance in Luxembourg. We
        alleged that all Euro banknotes in circulation infringe our European Patent
        455750B1 (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. On March
        24,
        2006, we received notice that the ECB has filed a separate claim in the United
        Kingdom and Luxembourg patent courts (Luxembourg being the seat of the European
        Court of First Instance) seeking the invalidation of the Patent.
 Claims to invalidity in each of the Netherlands, Belgium, Italy, France,
        Spain, Germany and Austria were subsequently served on the Company. The
        main basis of the ECB’s claim is the existence of prior art. A second basis is
        that the scope of the Patent was extended in prosecution, which in Europe
        is a
        ground of invalidity. On
        October 27, 2006 both parties exchanged Expert Reports in the United Kingdom
        proceedings which is expected to go to trial in January 2007.
  In
        May
        2005, the Company made an agreement with its legal counsel in charge of the
        Company’s litigation with the European Central Bank (“ECB”) which capped the
        fees for all matters associated with that litigation at $500,000 plus expenses,
        and a $150,000 contingent payment upon a successful ruling or settlement
        on the
        Company’s behalf in that litigation. The Company will record the $150,000 in the
        period in which the Company has determined that a successful ruling or
        settlement is probable. As described above, in March 2006, the Company was
        countersued by the ECB in several European national courts seeking revocation
        of
        the Company’s patents. Through September 30, 2006, the Company has been billed
        approximately $500,000 for legal costs associated with these aforementioned
        countersuits. It was the Company’s belief that the costs of defending these
        countersuits would be fully covered under the litigation cap it had previously
        negotiated with its legal counsel, However, given the potentially significant
        costs associated with these countersuits, the Company determined that additional
        reimbursements to its legal counsel was warranted. As such, on November 14,
        2006
        the Company entered into an agreement with its legal counsel in which the
        Company will issue approximately 47,000 shares of its common stock for payment
        of the approximately $500,000 of bills currently residing in accounts payable
        relating to the ECB countersuits. In addition, the Company will have the
        right
        to pay all future legal fees incurred by its lead legal counsel related to
        the
        countersuits with shares of its common stock. In addition to these payments,
        the
        Company will be responsible for certain third party fees and expenses associated
        with the countersuits. Depending of the duration of these cases and any appeals,
        these third party costs may be significant and could be material to the
        Company’s financial condition.
  F-13
  In
        addition, if the ECB is successful in its claims of invalidity against the
        Company’s patent, it may materially affect the Company’s financial condition,
        including the potential requirement to pay all of the ECB’s legal fees
        associated with the suit, and the Company’s ability to market certain of its
        technology.
  On
        June
        29, 2006, the Company received notice of favorable summary judgment from
        the
        State of New York Supreme Court in the case of “ *Frank
        LaLoggia v. Document Security Systems, Inc* ”.
        The
        Court ruled in favor of the Company and dismissed all claims against the
        Company. The Company will continue to pursue its counterclaim against Mr.
        LaLoggia which was not dismissed by the Court.
  In
        addition to the foregoing, we are subject to other legal proceedings that
        have
        arisen in the ordinary course of business and have not been finally adjudicated.
        Although there can be no assurance in this regard, in the opinion of management,
        none of the legal proceedings to which we are a party, whether discussed
        herein
        or otherwise, will have a material adverse effect on our results of operations,
        cash flows or our financial condition.
  **9.
        Supplemental Cash Flow Information**
  During
        the nine months ended September 30, 2006, the Company issued 18,704 shares
        of
        Common Stock valued at $250,000 in conjunction with the acquisition of the
        assets of P3 (See Note 4).
  **10.    
        Subsequent Event**
  On
        November 14, 2006, the Company entered into an agreement with its legal counsel
        regarding the European Central Bank countersuit in which the Company will
        issue
        approximately 47,000 shares of its common stock for payment of approximately
        $500,000 of legal bills currently residing in accounts payable. In addition,
        per
        the agreement, the Company has the right to pay all future legal fees
        incurred by its lead legal counsel related to countersuits initiated by the
        European Central Bank with shares of its common stock. Under the agreement,
        the
        Company will be responsible for third party fees associated with the countersuit
        litigation. ( *See
        Note 8* )
  F-14
 **11.    
        Segment Information**
  The Company's businesses are organized, managed and internally reported as
        four
        operating segments. Three of these operating segments, Document Security
        Systems, Plastic Printing Professionals and Patrick Printing, respectively,
        are
        engaged in various aspects of developing and applying printing technologies
        and
        procedures to produce, or allow others to produce, documents with a wide
        range
        of features, including the Company’s patented technologies and trade secrets.
        Consistent with the Company’s strategic initiative to increase its focus on
        servicing the end-user of secure documents, the Company has reorganized Patrick
        Printing, which was formerly considered a separate reportable segment, to
        concentrate its internal printing capabilities for these end-users. While
        Patrick Printing continues to offset its costs and utilize its capacity with
        retail copying and printing work, the Company determined that it was appropriate
        to aggregate this segment with its other document production and security
        companies because of the similarities in the nature of their products and
        production and sales processes and types of customers. Thus, for the purposes
        of
        providing segment information, these three operating segments have been
        aggregated into one reportable segment in accordance with Financial Accounting
        Standards Board (“FASB”) Statement No. 131- *“Disclosures
        about Segments of an Enterprise and Related Information”* .
        Prior
        period amounts have been reclassified to reflect the change in reporting
        segments and all inter-company transactions are eliminated. A summary of
        the two
        segments is as follows:
  **Document
                  Security and Production**
              License,
                  manufacture and sale of document security technologies and secure
                  printed
                  products at its Document Security Systems, Plastic Printing Professionals
                  and Patrick Printing divisions. Also, includes revenues from copying
                  services and residual royalties from motion picture
                  operations.**Legal
                  Supplies**
              Sale
                  of specialty legal supplies to lawyers and law firms located throughout
                  the United States as
                  Legalstore.com.
 
  Approximate information concerning the operations by reportable segment for
        the
        three and nine months ended September 30, 2006 and 2005 is as follows. The
        Company relies on intersegment cooperation and management does not represent
        that these segments, if operated independently, would report the results
        contained herein:
  **Document****Legal**
                
                **Security
                    &****3
                    months ended September 30, 2006:**
                
                **Supplies**
                
                **Production**
                
                **Corporate**
                
                **Total**Revenues
                    from external customers
                
                $
                168,000
                
                $
                1,095,000
                
                $
                -
                
                
                1,263,000Depreciation
                    and amortization
                
                
                3,000
                
                
                301,000
                
                
                16,000
                
                
                320,000Segment
                    profit or (loss)
                
                
                13,000
                
                
                (789,000
                )
                
                (428,000
                )
                
                (1,204,000
                )
 **3
                    months ended September 30, 2005:**Revenues
                    from external customers
                
                $
                122,000
                
                $
                251,000
                
                $
                -
                
                
                373,000Depreciation
                    and amortization
                
                
                1,000
                
                
                157,000
                
                
                22,000
                
                
                180,000Segment
                    profit or (loss)
                
                
                12,000
                
                
                (394,000
                )
                
                (296,000
                )
                
                (678,000
                )
 **Document****Legal**
                
                
                **Security
&****9
                    months ended September 30,
                    2006:**
                
                
                **Supplies**
                
                
                **Production**
                
                
                **Corporate**
                
                
                **Total**Revenues
                    from external customers
                
                $
                484,000
                
                $
                2,952,000
                
                $
                -
                
                
                3,436,000Depreciation
                    and amortization
                
                
                9,000
                
                
                847,000
                
                
                72,000
                
                
                928,000Segment
                    profit or (loss)
                
                
                (18,000
                )
                
                (1,933,000
                )
                
                (1,455,000
                )
                
                (3,406,000
                )**9
                    months ended September 30, 2005:**Revenues
                    from external customers
                
                $
                381,000
                
                $
                916,000
                
                $
                -
                
                
                1,297,000Depreciation
                    and amortization
                
                
                4,000
                
                
                335,000
                
                
                66,000
                
                
                405,000Segment
                    profit or (loss)
                
                
                50,000
                
                
                (789,000
                )
                
                (1,056,000
                )
                
                (1,795,000
                )
  F-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-KSB for the year ended
        December 31, 2005 and those described herein that could cause actual results
        to
        differ materially from the results anticipated in the forward-looking
        statements.
  **Overview**
  We
        are a supplier of advanced optical anti-scanning, anti-counterfeiting, and
        verification technologies and products for all forms of printed media. We
        provide document security technology to security printers, corporations and
        governments worldwide. Our technology can be used in securing sensitive and
        critical documents such as currency, automobile titles, spare parts forms
        for
        the aerospace industry, psychological examinations, gift certificates, permits,
        checks, licenses, receipts, prescription and medical forms, engineering
        schematics, ID cards, labels, original music, coupons, homeland security
        manuals, consumer product and pharmaceutical packaging, tickets, and school
        transcripts. In addition, we sell legal supplies on the Internet at a non-core
        division.
 
 Generally,
        we generate revenue from our document security and production business in
        three
        ways. We produce document security products for the end-user market including
        pre-packaged security paper. We license our patented technology to security
        printers so that they can provide their customers with anti-counterfeiting
        capabilities, and finally, we design, produce and consult for customized
        anti-counterfeiting solutions for corporate and government customers, including
        custom documents printed on paper, plastic or various other materials or
        delivered via electronic means.
 
 **Security
        Paper** : Our
        primary product for the end-user market is AuthentiGuard Security Paper.
        AuthentiGuard Security Paper is a paper which reveals hidden warning words,
        logos or images when a clear plastic viewer is placed over the paper or when
        the
        paper is faxed, copied, scanned or re-imaged in any form. The hidden words
        appear on the duplicate copy or the computer digital file and essentially
        prevent important documents from ever being counterfeited. We market and
        sell
        our Security Paper primarily through two major paper distributors: Boise
        White
        Paper and PaperlinX Limited. Since 2005, Boise markets our Security Paper
        under
        its Boise Beware brand name in North America, primarily through its commercial
        paper sales group, and in OfficeMax and CopyMax stores. In late 2005, we
        entered
        into an agreement with PaperlinX to market and sell our Security Paper under
        the
        name SecurelinX in Europe, Australia and New Zealand. The initial orders
        under
        this agreement were shipped during the second quarter of 2006. In
        addition, our licensee, PyroTech, has the marketing rights to manufacture
        and
        sell our Security Paper in the continent of Africa.   We retain
        the rights to sell the same Security Paper direct to end users anywhere in
        the
        world. Pricing for the Security Paper is determined on mark-up from cost.
 
 1
 Currently,
        our Security Paper is manufactured and stored for us by a third-party printer
        which has sufficient capacity to meet the foreseeable demand for this product. We
        are
        seeking to increase profit margins by developing manufacturing capabilities
        through strategic mergers and acquisitions that will allow us to service
        larger
        and a wider range of potential customers while eliminating a layer of costs
        by
        reducing our reliance on third-party printers.
 
 **Technology
        Licensing:** We
        license our anti-counterfeiting technology and trade secrets through licensing
        arrangements with security printers. We seek licensees that have a broad
        customer base that can benefit from our technologies. Licensees generally
        pay on
        a usage basis royalties to us based on the revenue of each job in which our
        technologies are used.
 
 In
        addition, we believe that some of our technologies are being used on an
        un-authorized basis. By aggressively defending our intellectual property
        rights,
        we believe that we will be able to secure a potentially significant amount
        of
        additional and ongoing revenue by securing licensing agreements with those
        persons, companies or governments that we believe are infringing our patents.
        We
        also anticipate that we may be required to pursue litigation in some cases
        and
        that we will need to spend a significant amount of money and time on these
        matters.
 
 **Custom
        Document Security Solutions and Production** :
        Our
        technology portfolio allows us to create custom secure documents that are
        unique
        to the industry. We target end-users such as governments, agencies and
        corporations which require anti-counterfeiting and authentication features
        in a
        wide range of documents and vital records such as driver’s licenses, birth
        certificates, receipts, manuals and identification materials and corporations
        creating entertainment tickets, coupons, parts tracking forms, as well as
        product packaging including pharmaceutical and a wide range of consumer goods.
 
 In
        February of 2006, we acquired San Francisco-based Plastic Printing
        Professionals, Inc. ("P3"), a privately held, security printer specializing
        in
        plastic cards containing security technologies. P3's primary focus is
        manufacturing composite, laminated and surface printed cards which can include
        magnetic stripes, bar codes, holograms, signature panels, invisible ink,
        micro
        fine printing, guilloche patterns, DNA and a patent pending watermark
        technology. P3's products are marketed through an extensive dealer network
        that
        covers North America, Europe and South America. Its product and client list
        includes the Grammy Awards, the Country Music Association awards, Super Bowl
        media cards, ID cards for major airports and Latin American driver’s licenses.
 
 During
        2006, we expanded our marketing efforts to the end-user of custom secure
        documents. Whereas in the past, we typically sought to license our technology
        to
        the printer of the end-user, we have determined that significant advantages
        exist in the market if we are able to own the end-user relationship from
        the
        design phase through the production phase. Therefore, we have shifted our
        focus
        to utilize more of our internal printing capabilities towards the custom
        security document market.
 
 In
        March
        2006, we entered into a license with a major international bank to provide
        a
        technology for the Internet delivery of secure, verifiable documents that
        can be
        transmitted and printed over the Internet using a customized web-hosting
        site
        for the securitization process. This is the first application of a covert
        method
        we developed for producing secure documents, such as financial instruments,
        at
        multiple locations. The three-year agreement includes implementation and
        initial
        set-up fees for the bank's website, as well as annual licensing and maintenance
        fees and was put into service in August of 2006.
 
 2
 Currently,
        we primarily outsource the production of our custom security print orders
        to
        strategic printing vendors. The
        acquisition of P3 marked the initial execution of our strategy to expand
        our
        manufacturing capabilities through acquisitions or strategic alliances in
        order
        to service our custom security printing business.
 
 **Legal
        Supplies** :
        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, including the legal, medical and educational fields
        .
        While not a component of our core business strategy, we seek to maximize
        the
        revenue and profitability of this operation..
  ***Results
        of Operations for the Three and Nine Months Ended***  ***September
        30, 2006***
  The following discussion and analysis provides information that our management
        believes is relevant to an assessment and understanding of our results of
        operations and financial condition. The discussion should be read in conjunction
        with the financial statements and footnotes in this quarterly report and
        in our
        annual report on Form 10-KSB for the year ended December 31, 2005.
  The
        following discussion also includes a non-GAAP financial measure which has
        been
        reconciled to the most comparable GAAP financial measure of net loss. Our
        management believes that this performance measure is a relevant indicator
        of the
        Company’s financial performance.
  **Summary**
  **Three
                    Months Ended September 30,2006**
                
                **Nine
                    Months Ended September 30,2006**$
                
                %
                    change vs. 3 months ended September 30, 2005
                
                $
                
                %
                    change vs. 9 months ended September 30, 2005Revenue,
                    net
                
                
                1,264,000
                
                
                239
                %
                
                3,436,000
                
                
                165
                %Costs
                    of revenue
                
                
                668,000
                
                
                257
                %
                
                1,933,000
                
                
                188
                %Gross
                    profit
                
                
                596,000
                
                
                220
                %
                
                1,503,000
                
                
                140
                %Total Operating Expenses
                
                
                1,804,000
                
                
                103
                %
                
                4,946,000
                
                
                101
                %Operating
                    loss
                
                
                (1,208,000
                )
                
                72
                %
                
                (3,443,000
                )
                
                87
                %Other
                    income (expense):Interest income
                
                
                7,000
                
                
                -77
                %
                
                51,000
                
                
                -24
                %Interest expense
                
                
                (3,000
                )
                
                -50
                %
                
                (14,000
                )
                
                -33
                %Loss
                    before income taxes
                
                
                (1,204,000
                )
                
                78
                %
                
                (3,406,000
                )
                
                90
                %Income
                    taxes
                
                
                0
                
                
                -
                
                
                0
                
                
                -Net
                    loss
                
                
                (1,204,000
                )
                
                78
                %
                
                (3,406,000
                )
                
                90
                %
  3
 **Revenue**
   For
        the
        three and nine month periods ended September 30, 2006, total revenue increased
        239% and 165% from the same periods ended September 30, 2005, respectively.
        The
        increases in total revenue resulted primarily from increases in royalty revenue
        from the licensing of the Company’s patented technology, and from increases in
        sales of security products and documents from the Company’s acquisition during
        the first quarter of 2006 of Plastic Printing Professionals, a manufacturer
        of
        secure plastic cards and documents.
   In
        addition, not reflected in the results above are deferred revenues of
        approximately $596,000 which represent payments the Company has received
        for
        technology licenses and certain of its on-demand products for which revenue
        recognition is deferred over the terms of the license or service. During
        the
        third quarter of 2006, the Company received $500,000 from one major technology
        licensee as described below.
   During
        the three and nine month periods ended September 30, 2006, the Company continued
        its efforts to increase the market for its technologies and products by
        developing sales and marketing channels by a combination of expanding its
        internal sales and marketing resources and widening its list of partners
        and
        distributors. The following chart summarizes significant new contracts and
        business development agreements entered into by the Company during 2006 that
        are
        expected to drive revenue growth for the remainder of 2006 and
        2007:
  ·
              Renewed
                  and extended the historical licensing agreement with R.R. Donnelley
&
                  Sons Company, the largest printer in North America. A three-year
                  contract,
                  the renewed agreement includes royalties on the usage of DSS's
                  SecureScan(tm) technology and began producing significant revenue
                  for the
                  Company during the third quarter of
                  2006.
 
 ·
              Signed
                  a letter of agreement with The Ergonomic Group (EGI) for the exclusive,
                  limited right to use and market DSS's extensive portfolio of security
                  technologies in the high technology, aerospace, financial and healthcare
                  industries. The agreement guarantees that the Company will receive
                  a
                  minimum of $1,000,000 of which $500,000 was received in the third
                  quarter
                  of 2006 and $500,000 is due in the fourth quarter of 2006. Ergonomics
                  Group is a shareholder of the Company with holdings of less than
                  5% of the
                  outstanding shares of the Company.
 
 ·
              Agreed
                  to provide TransTech Systems, Inc. the exclusive distributions
                  rights of
                  DSS technology when used for large format event identification
                  badges and
                  cards. TransTech is a leading distributor in the ID badge and access
                  control markets and services a network of over 700 security products
                  dealers throughout the United
                  States.
 
 ·
              Signed
                  a licensing contract with Nampak Flexible, a division of Nampak
                  Limited
                  ("Nampak") who is a leading flexible packaging manufacturer in
                  South
                  Africa. The agreement is Company's first licensing agreement with
                  a
                  packaging business and is a royalty-based contract for one-year
                  with
                  automatic annual renewals for an additional four years.
 
 ·
              Signed
                  an exclusive marketing agreement with Assa Abloy HID Global ("HID")
                  to
                  market DSS’s select technologies to enhance the security of HID's
                  contactless smartcards and proximity cards. Assa Abloy HID, is
                  owned by
                  parent ASSA ABLOY (ASZAF.PK) which is headquartered in Stockholm,
                  Sweden.
                  ASSA ABLOY is the world's leading manufacturer and supplier of
                  locking and
                  security access solutions.
 
 4
 ·
              Signed
                  a two-year licensing agreement with Banknote Corporation of America
                  (BCA),
                  a major high security printer in the United States for a variety
                  of secure
                  documents, such as checks, stamps, identification.
 
 ·
              Signed
                  licensing agreement with The Reynolds and Reynolds Company (NYSE:
                  REY), a
                  leading software and services provider for the automotive retailing
                  market
                  in the United States and Canada for the protection of checks and
                  forms.
 
 ·
              Signed
                  an exclusive licensing agreement with Barcode Technology (BTI)
                  to market
                  and produce DSS's technology, both independently and in combination
                  with
                  BTI's technology in China.
 
 ·
              Signed
                  a two-year agreement with ProdoSafe Security Solutions, Turkey's
                  largest
                  supplier of anti-counterfeiting technology. With its recently awarded
                  contracts, ProdoSafe will apply DSS's technology in two metropolitan
                  areas
                  in Turkey.
  **Three
                    Months Ended September 30,2006**
                
                **Nine
                    Months Ended September 30,2006**$
                
                %
                    change vs. 3 months ended September 30, 2005
                
                $
                
                %
                    change vs. 9 months ended September 30, 2005Revenue,
                    netSecurity
                    Products & Printing
                
                $
                849,000
                
                
                282
                %
                $
                2,609,000
                
                
                202
                %Royalties
                
                
                247,000
                
                
                782
                %
                
                343,000
                
                
                560
                %Legal
                    products
                
                
                168,000
                
                
                37
                %
                
                484,000
                
                
                27
                %Total
                    Revenue
                
                
                1,264,000
                
                
                239
                %
                
                3,436,000
                
                
                165
                %
  Security
          Products & Printing
  For
        the
        three and nine month periods ended September 30, 2006, Document Security
        and
        Production sales increased 282% and 200%, respectively compared with the
        same
        periods of 2005. The increases in revenues in the category of $627,000 and
        $1,724,000, respectively for the 2006 periods were primarily due to the
        inclusion of $593,000 and $1,665,000, respectively, of sales from the Company’s
        P3 division (“P3”), which was acquired on February 7, 2006.
  Royalties
  During
        the third quarter of 2006 and for the nine-months ended September 30, 2006,
        the
        substantial increase in the Company’s royalty revenue was primarily a result of
        its recent license agreements with RR Donnelly and The Ergonomics Group.
        In
        addition, the Company received approximately $585,000 in license royalty
        pre-payments during the third quarter for which revenue recognition is deferred
        over the terms of the license or service.
  Legal
        Products
  Revenue from our legal supplies business, Legalstore.com, grew 38% and 27%
        during the third quarter and first nine months of 2006, respectively, compared
        with those periods of 2005. While we view our legal supplies business segment
        as
        a non-core part of our company, we have experienced steady growth in its
        operations as it continues to expand its product catalog and customer reach
        through various keyword advertising campaigns and trade shows..
  5
  **Cost
        of Sales and Gross Profit**
 **Three
                    Months Ended September 30,2006**
                
                **Nine
                    Months Ended September 30,2006**%
                    change vs. 3 months ended September 30, 2005
                
                
                
                %
                    change vs. 9 months ended September 30, 2005Costs
                    of revenueSecurity
                      Products & Printing
                
                $
                582,000
                
                
                349
                %
                $
                1,667,000
                
                
                251
                %Legal
                    products
                
                
                86,000
                
                
                50
                %
                
                266,000
                
                
                35
                %Total
                    cost of sales
                
                
                668,000
                
                
                257
                %
                
                1,933,000
                
                
                188
                %Gross
                    profitSecurity
                      Products & Printing
                
                
                267,000
                
                
                189
                %
                
                942,000
                
                
                142
                %Royalties
                
                
                247,000
                
                
                782
                %
                
                343,000
                
                
                560
                %Legal
                    products
                
                
                82,000
                
                
                25
                %
                
                218,000
                
                
                18
                %Total
                    gross profit
                
                
                596,000
                
                
                220
                %
                
                1,503,000
                
                
                140
                %
  **Three
                      Months Ended September 30,2006**
                  
                  **Nine
                      Months Ended September 30,2006**%
                      change vs. 3 months ended September 30, 2005
                  
                  
                  
                  %
                      change vs. 9 months ended September 30, 2005Gross
                      profit percentage:
                  
                  
                  47
                  %
                  
                  -5
                  %
                  
                  44
                  %
                  
                  -9
                  %
  Gross
        Profit
  During
        the third quarter of 2006, gross profit increased 220% to $596,000 which
        was
        primarily the result of increases in both document security & production
        profits and royalties profits. The increase in the document security and
        production category during the 2006 quarter included $246,000 in gross profit
        derived from the Company’s P3 division which was acquired in 2006.
  During
        the first nine months of 2006, the gross profit increased by 140% as compared
        with the first nine months of 2005. The increase of $878,000 in gross profit
        included $631,000 from P3.
  The
        gross
        profit percentage decrease during the first nine months of 2006 reflects
        the
        impact of P3’s gross profit margin of approximately 37% which was consistent
        with its historical gross profit margin, but is less than the document security
        category’s historical profit margin. However, the gross profit of 47% realized
        by the Company during the third quarter of 2006 reflects a 12% increase over
        the
        year to date through June 30, 2006 gross profit margin of 42% which reflects
        the
        positive effect of the increase in license royalty revenue earned during
        the
        third quarter.
  6
 **Operating
        expenses**
  **Three
                    Months Ended September 30,2006**
                
                **Nine
                    Months Ended September 30,2006**$
                
                %
                    change vs. 3 months ended September 30, 2005
                
                $
                
                %
                    change vs. 9 months ended September 30, 2005Selling,
                    general and administrativeCompensation
                
                $
                541,000
                
                
                105
                %
                $
                1,434,000
                
                
                105
                %Stock
                    based payments
                
                
                311,000
                
                
                3010
                %
                
                592,000
                
                
                1873
                %Professional
                    Fees
                
                
                212,000
                
                
                36
                %
                
                945,000
                
                
                77
                %Sales
                    and marketing
                
                
                128,000
                
                
                2
                %
                
                399,000
                
                
                19
                %Depreciation
                    and amortization
                
                
                18,000
                
                
                -18
                %
                
                74,000
                
                
                16
                %Other
                
                
                224,000
                
                
                131
                %
                
                475,000
                
                
                60
                %Research
                    and development
                
                
                94,000
                
                
                19
                %
                
                263,000
                
                
                10
                %Amortization
                    of intangibles
                
                
                276,000
                
                
                104
                %
                
                764,000
                
                
                183
                %Total Operating Expenses
                
                
                1,804,000
                
                
                103
                %
                
                4,946,000
                
                
                101
                %
  **Selling,
        General and Administrative**
  The
        Company’s selling, general and administrative costs increases generally reflect
        increases to the size of our organization as the result of the Company’s
        acquisition of P3 and increases in executive management, sales and operations
        personnel integral to the company’s sales growth strategy.
  SG&A
        Compensation costs
        increases for non-production personnel that the Company has experienced in
        2006
        to date are primarily due to the addition of executive management, sales,
        and
        operations personnel, as well as the addition of executive and administrative
        personnel at P3. Of the $277,000 and $752,000 increase in compensation expense
        during the third quarter and first nine months of 2006, respectively, $147,000
        and $344,000 stem from P3 which was acquired in February of 2006. The Company
        believes that it has obtained appropriate levels of staffing for its near
        term
        forecasted business levels and that future staffing additions will be
        concentrated on sales, marketing and operations to coincide with expected
        revenue growth.
  Stock
        based payments during
        the first nine months of 2006 include approximately $445,000 of expense
        recognized for the issuance of warrants to International Barcode Corporation
        (d/b/a Barcode Technology) (“BTI”) in consideration for a cross-marketing
        relationship that enables the Company to expedite its entry into the Chinese
        market for secure documents, and $63,000 associated with annual option grants
        to
        the non-executive members of our Board of Directors. The Company will continue
        to incur approximately $223,000 in expense per quarter for the next two quarters
        associated with the grant of the BTI warrants based on the estimated value
        of
        the warrants on the grant date using the Black-Scholes option valuation model.
        These warrants have an exercise price of $10.00 and do not include a non-cash
        exercise provision. Therefore, the exercise of these warrants, if ever, would
        result in the receipt of $5,000,000 by the Company.
  Professional
        fees include
        legal, accounting, shareholder services, investor relations, and consulting
        costs. Consulting fees ($74,000 and $215,000 for three and nine month periods
        ended September 30, 2006, respectively), are primarily directed towards efforts
        to help the Company develop market opportunities with government and large
        multinational corporations, and intellectual property management, legal fees
        ($53,000 and $266,000 for three and nine month periods ended September 30,
        2006,
        respectively) and accounting fees ($23,000 and $138,000 for three and nine
        month
        periods ended September 30, 2006, respectively) are generally associated
        with
        the Company’s corporate governance and reporting compliance requirements. In
        addition, legal fees include costs associated with certain legal matters
        regarding Adlertech and F. Laloggia, respectively- (See *Part
        II -Legal Proceeding* s).
        These
        legal costs do not include costs associated with the application and defense
        of
        our patents which the company capitalizes and amortizes over the expected
        life
        of the patent. (See *Part
        I -Financial Information -Note 8* )
  7
  Sales
        and marketing expenses
        increases in 2006 have been the result of investments in resources to expand
        its
        sales and marketing efforts in order to increase customer awareness and
        understanding of the Company technologies and solutions. The Company expects
        to
        continue to increase its sales and marketing efforts in correlation with
        expected revenue growth.
  Other
        expenses are
        primarily rent and utilities, office supplies, IT support, and insurance
        costs.
        Increases in 2006 reflect costs associated with a larger organization including
        higher rent and utility costs associated with the addition of P3.
  **Research
        and Development**
  We
        continue to invest in research and development to improve our existing
        technologies and develop new technologies that will enhance our position
        in the
        document security market. Research and development costs consist primarily
        of
        compensation costs for our four persons who spend all or at least half of
        their
        time on developing new technologies or developing new uses for our existing
        technology. In addition, we incur costs for the use of third party printers’
facilities to test our technologies on equipment that we do not have access
        to
        internally. We expect that our research and development costs will continue
        at
        current levels for the foreseeable future.
  **Amortization
        of intangibles**
  Commencing
        in the second quarter of 2005, we began to amortize the costs associated
        with
        the patents that we acquired in 2005 and the legal costs associated with
        the
        development and defense of our patents, including the costs associated with
        our
        suit against the European Central Bank for patent infringement. In addition,
        we
        amortize our acquired intangibles from business combinations. A significant
        portion of these assets were acquired by the issuance of equity in the company.
        Our amortizable asset base at September 30, 2006 was approximately $6.5 million
        and will generate approximately $900,000 in annual amortization
        expense during the next 6 years. The Company reviews these assets for
        impairment annually. If an impairment, such as unfavorable ruling in the
        Company’s patent 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.
  In
        addition, the Company has $1,397,000 in goodwill derived from acquisitions.
        Goodwill is not amortized, but could become a component of expense if an
        impairment is determined.
  8
 **Net
        loss and loss per share**
  **Three
                    Months Ended September 30,2006**
                
                **Nine
                    Months Ended September 30,2006**$
                
                %
                    change vs. 3 months ended September 30, 2005
                
                $
                
                %
                    change vs. 9 months ended September 30, 2005Net
                    loss
                
                
                (1,204,000
                )
                
                78
                %
                
                (3,406,000
                )
                
                90
                %Net
                    loss per share, basic and diluted
                
                
                (0.09
                )
                
                69
                %
                
                (0.26
                )
                
                75
                %Weighted
                    average common shares outstanding, basic and diluted
                
                
                12,920,315
                
                
                5
                %
                
                12,868,887
                
                
                9
                %
  During
        the third quarter and first nine months of 2006, the Company continued to
        experience net losses. While we have experienced growth in our sales and
        gross
        profits, these increases have not offset our increases in our operating
        expenses, especially significant increases in amortization expense, stock
        based
        compensation, compensation and professional fees.
  Our
        basic
        and diluted loss per share has increased due to the increased dollar value
        of
        our loss partially offset by an increase in the weighted average common shares
        outstanding in 2006 compared to 2005. Our shares have increased as we have
        issued our common shares for warrants exercised, for an acquisition and for
        the
        purchase of patent assets.
  **Non-GAAP
        Financial Performance Measure**
  The
        following adjusted Earnings before interest, taxes, depreciation, amortization
        and non-cash stock compensation expense (“Adjusted EBITDA”) is presented because
        the Company’s management believes it to be a relevant measure of the performance
        of the Company. The Adjusted EBITDA is used by the Company’s management to
        measure its core operating performance without certain non-cash expenditures.
        The reconciliation of Adjusted EBITDA to net loss, the most comparable GAAP
        measure is presented below.
  Adjusted
        EBITDA
  **Three
                    Months Ended September 30,2006**
                
                **Nine
                    Months Ended September 30,2006**$
                
                %
                    change vs. 3 months ended September 30, 2005
                
                $
                
                %
                    change vs. 9 months ended September 30, 2005Net
                    Loss
                
                $
                (1,204,000
                )
                
                78
                %
                $
                (3,405,000
                )
                
                90
                %Add
                    back:Depreciation
                
                
                45,000
                
                
                0
                %
                
                163,000
                
                
                21
                %Amortization
                    of Intangibles
                
                
                276,000
                
                
                104
                %
                
                764,000
                
                
                183
                %Stock
                    based payments
                
                
                311,000
                
                
                3010
                %
                
                592,000
                
                
                1873
                %Interest
                    Income
                
                
                (7,000
                )
                
                -77
                %
                
                (51,000
                )
                
                -24
                %Interest
                    Expense
                
                
                3,000
                
                
                -50
                %
                
                14,000
                
                
                -33
                %Income
                    Taxes
                
                
                —
                
                
                
                
                
                —Adjusted
                    EBITDA
                
                
                (576,000
                )
                
                13
                %
                
                (1,923,000
                )
                
                37
                %
 As
        described above, Adjusted EBITDA is a non-GAAP measurement of financial
        performance that the Company believes is relevant to the understanding of
        the
        Company’s financial results. While net loss increased 78% and 90%, respectively,
        during the third quarter and nine months ended September 30, 2006, Adjusted
        EBITDA deficits increased only 13% and 37%, respectively, for the same periods.
        These results reflect that the increases in sales and gross profits have
        outpaced increases in the Company’s core operating expenses, (core operating
        expenses are compensation, professional fees, sales and marketing, other
        and
        research and development costs) which increased 65% and 68%, respectively,
        during the three and nine months ended September 30, 2006 compared to 2005
        levels.
  9
  **LIQUIDITY
        AND CAPITAL RESOURCES**
  The
        Company’s cash flows and other key indicators of liquidity are summarized as
        follows:
  **Nine
                    Months Ended****September
                    30,**
                
                **September
                    30,****2006**
                
                **2005**
                
                %**(unaudited)**
                
                **(unaudited)**
                
                **Change**Cash
                    flows from:Operating
                    activities
                
                $
                (1,496,000
                )
                $
                (1,217,000
                )
                
                -23
                %Investing
                    activities
                
                
                (1,833,000
                )
                
                (269,000
                )
                
                -581
                %Financing
                    activities
                
                
                896,000
                
                
                2,548,000
                
                
                -65
                %Working
                    capital (a)
                
                
                456,000
                
                
                3,648,000
                
                
                -88
                %Current
                    ratio (a)
                
                
                1.21
                x
                
                5.32
                x
                
                -77
                %
 
 During
        the third quarter of 2006, the Company’s significantly reduced its use of cash
        for operations to a breakeven level. The significant improvement reflects
        the
        favorable impact of a $500,000 licensing revenue prepayment received during
        the
        quarter and also reflects increases in revenue and gross profits that have
        outpaced core operating expenses as described above. The Company expects
        that
        due to recent license agreements and the expected continued revenue growth
        that
        the Company will continue to experience improvement in it operating cash
        flows
        during the remainder of 2006 and into 2007.
  During
        2006, the Company has used significant amount of its cash for the acquisition
        of
        P3, a producer of plastic printed cards in San Francisco, California and
        to
        invest in its patent portfolio, including the payment of legal costs associated
        with patent applications and the defense of our patents, which includes payments
        to cover third party experts fees and other fees associated with the Company’s
        case with the European Central Bank.
  During
        its early stages of development, the Company has benefited by its ability
        to use
        its common stock to pay for investments in patents and contractual rights
        which
        we may not have otherwise been able to obtain had we been required to pay
        in
        cash. The use of equity for investments allowed us to retain cash needed
        for
        operations during the early stages of our business without sacrificing the
        investments needed to secure our competitiveness in the future. As the Company
        grows and emerges from the early stages of its development and achieves
        consistent cash flows from operations, it expects it will be able to finance
        a
        larger portion of its investments with its own cash resources.
  10
  During
        2006 and 2005, the Company has partially offset its uses of cash for operations
        and investments with cash received from our warrant holders who paid
        approximately $900,000 $2,566,000, respectively, from the exercise of warrants.
        During the third quarter of 2006, the Company paid off a term loan of $189,000
        that released $240,000 of cash that was restricted as collateral for the
        loan.
        As of September 30, 2006, the Company has approximately 342,000 warrants
        outstanding and exercisable that, if exercised, would produce approximately
        $2.8
        million in cash proceeds to the Company and which would significantly improve
        the Company’s cash position.
  At
        September 30, 2006, the Company had cash and cash equivalents of approximately
        $1,520,000. The Company’s working capital as was approximately $456,000 which
        was 88% lower than working capital at September 30, 2005. The Company’s working
        capital position is adversely affected by approximately $525,000 in accounts
        payable that is related to legal costs associated with the countersuits by
        the
        European Central Bank in response to our lawsuit with the European Central
        Bank.
        In November, 2006, the Company agreed to issue shares of its common stock
        to pay
        for the $525,000. As a result, the Company’s working capital position after
        taking into account this transaction would have been approximately $1,000,000
        as
        of September 30, 2006. (See *Item
        1- Financial Statements -Note 8* ).
  The
        Company’s liquidity could be affected if the Company is not successful in its
        infringement lawsuit against the European Central Bank, or the countersuit
        for
        validity made by the European Central Bank against the Company. As discussed
        above ( *Item
        1- Financial Statements -Note 8* )
        due to
        the potential require that the Company pay a significant portion of the ECB’s
        legal costs upon a negative ruling. The Company estimates that these costs
        could
        be substantial and the payment of these amounts could adversely affect the
        Company’s financial position and would likely require the Company to raise
        additional funds, which may not be on terms favorable to the
        Company.
  Furthermore,
        in order to support our existing and proposed operations, we may need additional
        financing. We currently have outstanding, exercisable warrants to purchase
        our
        common stock with exercise prices below the current market price as of November
        1, 2006 that can generate approximately $305,000 in cash financing for the
        Company. There is no assurance that all or any of the warrants will be
        exercised.
  **ITEM
        3:   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
        RISK**
  Our
        market risk exposures are related to our cash, cash equivalents and investments.
        We invest our excess cash in certificates of deposits with maturities of
        90 days
        or less. Changes in interest rates affect the investment income we earn and
        therefore impact our cash flows and results of operations.
  We
        mitigate our foreign currency risks principally by contracting primarily
        in U.S.
        dollars. For the nine months ended September 30, 2006, all of our billings,
        were denominated in our functional currency, which is the U.S. dollar.
  **ITEM
        4 - CONTROLS AND PROCEDURES**
  Evaluation
        of Disclosure Controls and Procedures. Our
        management, with the participation of our principal executive officer and
        principal accounting officer, has evaluated the effectiveness of our disclosure
        controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under
        the
        Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of the end
        of the period covered by this Quarterly Report on Form 10-Q. Based on that
        evaluation, our principal executive officer and principal accounting officer
        have concluded that as of that date, our disclosure controls and procedures
        were
        effective to provide reasonable assurance that information required to be
        disclosed in reports filed or submitted under the Exchange Act is recorded,
        processed, summarized and reported with the time periods specified in the
        SEC’s
        rules and forms, and to provide reasonable assurance that information required
        to be disclosed by the Corporation in such reports is accumulated and
        communicated to the Corporation’s management, including its principal executive
        officer and principal accounting officer, as appropriate to allow timely
        decisions regarding required disclosure.
 
 11
 During
        the quarter ended September 30, 2006, the Company implemented an ERP (Enterprise
        Reporting Program) system to streamline its accounting and sales reporting
        capabilities and to incorporate the daily activities of its newly acquired
        P3
        division. The program went live on July 1, 2006 and management expects the
        system will materially affect the Corporation’s internal controls over financial
        reporting, especially in regards to controls related to its newly acquired
        P3
        division. Specifically, the new system will eliminate redundant controls
        due to
        the consolidation of subsidiary ledgers and the cash disbursements and cash
        receipts processes. There were no other changes in the Corporation’s “internal
        control over financial reporting” (as such term is defined in Rule 13a-15(f)
        under the Exchange Act) that occurred during the quarter ended September
        30,
        2006, that has materially affected, or is reasonably likely to materially
        affect, the Corporation’s internal control over financial reporting.
 
  **PART
        II**
 **OTHER
        INFORMATION**
  **ITEM
        1 - LEGAL PROCEEDINGS**
  There
        were no significant developments during the first nine months of 2006 in
        connection with our litigation against Adler Technologies and Andrew McTagger.
        This litigation is described in our Form 10-KSB Annual Report for the year
        ended
        December 31, 2005.
  On
        June
        29, 2006, Document Security Systems, Inc. the Supreme Court of the State
        of New
        York (the “Court”) ruled in favor of DSS’s motion for summary judgment in the
        case of *“Frank
        LaLoggia v. Document Security Systems, Inc”.* In its
        ruling, the Court dismissed all of Mr. LaLoggia’s claims against DSS. DSS will
        continue to pursue its counterclaim against Mr. LaLoggia. This litigation
        is
        described in our Form 10-KSB Annual Report for the year ended December 31,
        2005.
  On
        August
        1, 2005, we commenced a suit against the European Central Bank alleging patent
        infringement by the European Central Bank and have claimed unspecified damages.
        We brought the suit in European Court of First Instance in Luxembourg. We
        alleged that all Euro banknotes in circulation infringe our European Patent
        455750B1, which covers a method of incorporating an anti-counterfeiting feature
        into banknotes or similar security documents to protect against forgeries
        by
        digital scanning and copying devices. We will seek all remedies available
        to us
        under the law. In November 2005, the European Central Bank filed its answer
        to
        our complaint asserting mostly procedural and jurisdictional arguments. The
        ECB
        contended that it could not be sued for patent infringement, but rather each
        individual country that comprises the ECB should be sued on an individual
        nation-by-nation basis. We responded to the European Central Bank’s answer in
        late December 2005. On March 24, 2006, we received notice that the ECB has
        filed
        a separate claim in the United Kingdom and Luxembourg patent courts (Luxembourg
        being the seat of the European Court of First Instance) seeking the
        invalidation of the Patent.  Claims to invalidity in each of the
        Netherlands, Belgium, France, Spain, Germany, and Austria were subsequently
        served. The main basis of the ECB’s claim is the existence of prior art. A
        second basis is that the scope of the Patent was extended in prosecution
        which
        in Europe is a ground of invalidity. If
        the
        ECB is successful, it may materially affect us, our financial condition,
        and our
        ability to market certain technology. On October 27, 2006 both parties exchanged
        Expert Reports in the United Kingdom proceedings which is expected to go
        to
        trial in January 2007.
 
 12
 In
        addition to the foregoing, we are subject to other legal proceedings that
        have
        arisen in the ordinary course of business and have not been finally adjudicated.
        Although there can be no assurance in this regard, in the opinion of management,
        none of the legal proceedings to which we are a party, whether discussed
        herein
        or otherwise, will have a material adverse effect on our results of operations,
        cash flows or our financial condition.
  **ITEM
        1a - RISK FACTORS**
  An investment in our securities is subject to numerous risks, including the
        Risk
        Factors described below. Our business, operating results or financial condition
        could be materially adversely affected by any of the following risks. The
        risks
        described below are not the only ones we face. Additional risks we are not
        presently aware of or that we currently believe are immaterial may also
        materially affect our business. The trading price of our Common Stock could
        decline due to any of these risks. In assessing these risks, you should also
        refer to the other information contained or incorporated by reference in
        this
        Form 10-Q, including our financial statements and related notes.
  ***We
        have a limited operating history with our business model, which limits the
        information available to you to evaluate our
        business.***
  Since
        our
        inception in 1984, we have accumulated deficits from historical operations
        of
        approximately $15,800,000 at September 30, 2006. In 2002, we changed our
        business model and chose to strategically focus on becoming a developer and
        marketer of secure technologies for all forms of print media. We have continued
        to incur losses since we began our new business model. Also, we have limited
        operating and financial information relating to this new business to evaluate
        our performance and future prospects. Due to the change in our business model,
        we do not view our historical financials as being a good indication of our
        future. We face the risks and difficulties of a company going into a new
        business including the uncertainties of market acceptance, competition, cost
        increases and delays in achieving business objectives. There can be no assurance
        that we will succeed in addressing any or all of these risks, and the failure
        to
        do so could have a material adverse effect on our business, financial condition
        and operating results.
  ***Current
        litigation may affect our technology rights and plan of
        operation.***
  On
        August
        1, 2005, we filed a patent infringement suit in the European Court of First
        Instance against the European Central Bank (“ECB”) alleging that the Euro
        banknotes infringe our European Patent No 0455750B1 (the “Patent”).   On
        October 20, 2005, the ECB challenged the venue of the lawsuit to which we
        formally responded to the court in December, 2005.  The ECB contended that
        it could not be sued for patent infringement, but rather each individual
        country
        that comprises the ECB should be sued on an individual nation-by-nation basis.
        On March 24, 2006, we received notice that the ECB has filed a separate counter
        claim in the United Kingdom and Luxembourg patent courts (Luxembourg being
        the
        seat of the European Court of First Instance) seeking the invalidation of
        the Patent.  Claims to invalidity in each of the Netherlands, Belgium,
        France, Spain, Germany and Austria were subsequently served. The main
        basis of the ECB’s claim is the existence of prior art. A second basis is that
        the scope of the Patent was extended in prosecution which in Europe is a
        ground
        of invalidity. If the ECB is successful, it may materially affect us, our
        financial condition, and our ability to market certain technology. For more
        information regarding this litigation see Item 1- Legal
        Proceedings.
  13
 On
        January 31, 2003, we commenced an action, unrelated to the above ECB litigation,
        entitled *New
        Sky Communications, Inc., As Successor-In-Interest To Thomas M. Wicker, Thomas
        M.Wicker Enterprises, Inc. And Document Security Consultants V. Adler
        Technologies, Inc. N/K/A Adlertech International, Inc. And Andrew Mctaggert
        (United States District Court, Western District Of New York Case
        No.03-Cv-6044t(F))* regarding
        certain intellectual property in which our company has an interest. We commenced
        this action alleging various causes of action against Adler Technologies,
        Inc.
        and Andrew McTaggert for breach of contract, breach of the duty of good faith
        and fair dealing and various business torts. Adler distributes and supplies
        anti-counterfeit currency devices and McTaggert is a principal of, and the
        primary contact at, Adler. Adler had entered into several agreements with
        Thomas
        M. Wicker Enterprises and Document Security Consultants, both of which we
        acquired in 2002. These agreements, generally, authorized Adler to manufacture
        in Canada our “Checkmate ® ”
        patented system for verifying the authenticity of currency and documents.
        Other
        agreements were entered into between the parties and Thomas Wicker regarding
        other technology owned by Wicker and assigned to us  including
        “Archangel,” an anti-copy technology, and “Blockade,” which creates a wave
        pattern on documents when they are reproduced or scanned. It is our contention
        that Adler has breached these agreements, failed to make an appropriate
        accounting, and may have exceeded the scope of its license. Adler has denied
        the
        material allegations of the complaint and has counterclaimed against our
        company, claiming Adler owns or co-owns or has a license to use certain
        technologies of ours, including several U.S. patents. If Adler is successful,
        it
        may materially affect us, our financial condition, and our ability to market
        certain technology.
  In
        addition to the foregoing, we are subject to other legal proceedings that
        have
        arisen in the ordinary course of business and have not been finally adjudicated.
        Although there can be no assurance in this regard, in the opinion of management,
        none of the legal proceedings to which we are a party, whether discussed
        herein
        or otherwise, will have a material adverse effect on our results of operations,
        cash flows or our financial condition .
  ***If
        we lose our current 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 infringement litigation against the European Central
        Bank by negotiating legal fee caps and using shares of our common stock for
        payments. However, if we receive an adverse ruling in any of our infringement
        or
        related 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 which would likely be significant. The payment of these amounts
        could adversely affect the Company’s financial position and would likely require
        the Company to raise additional funds, which may not be on terms favorable
        to
        the Company.
  14
 ***If
        we are unable to adequately protect our intellectual property, our competitive
        advantage may disappear*** .
  Our
        success will be determined in part by our ability to obtain United States
        and
        foreign patent protection for our technology and to preserve our trade secrets.
        Because of the substantial length of time and expense associated with developing
        new document security technology, we place considerable importance on patent
        and
        trade secret protection. Our ability to compete and the ability of our business
        to grow could suffer if these rights are not adequately protected. There
        can be
        no assurance that our patent applications will result in patents being issued
        or
        that current or additional patents will afford protection against competitors.
        We also rely on trade secrets that are not patented. No guarantee can be
        given
        that others will not independently develop substantially equivalent proprietary
        information or techniques, or otherwise gain access to our proprietary
        technology.
  ***We
        may face intellectual property infringement or other claims against us, our
        customers, or our intellectual property rights that could be costly to defend
        and result in our loss of significant rights.***
  Although
        we have received U.S. Patents and a European Patent with respect to certain
        technologies of ours, there can be no assurance that these patents will afford
        us any meaningful protection. We intend to rely primarily on a combination
        of
        patent protection, trade secrets, technical measures, copyright protection
        and
        nondisclosure agreements with our employees to establish and protect the
        ideas,
        concepts and documentation of software and trade secrets developed by us.
        Such
        methods may not afford complete protection, and there can be no assurance
        that
        third parties will not independently develop such technology or obtain access
        to
        the software we have developed. Although we believe that our use of the
        technology and products we developed and other trade secrets used in our
        operations does not infringe upon the rights of others, our use of the
        technology and trade secrets we developed may infringe upon the patents or
        intellectual property rights of others. In the event of infringement, we
        could,
        under certain circumstances, be required to obtain a license or modify aspects
        of the technology and trade secrets we developed or refrain from using same.
        We
        may not have the necessary financial resources to defend any infringement
        claim
        made against us or be able to successfully terminate any infringement in
        a
        timely manner, upon acceptable terms and conditions or at all. Failure to
        do any
        of the foregoing could have a material adverse effect on us. Moreover, if
        the
        patents, technology or trade secrets we developed or use in our business
        are
        deemed to infringe upon the rights of others, we could, under certain
        circumstances, become liable for damages, which could have a material adverse
        effect on us. As we continue to market our products, we could encounter patent
        barriers that are not known today. A patent search will not disclose
        applications that are currently pending in the United States Patent Office;
        and
        there may be one or more such pending applications that would take precedence
        over our applications.
 
 Furthermore,
        since the date of invention (and not the date of application) governs under
        U.S.
        patent law, future applications could be filed by another party, which would
        preempt our position. While we have taken and continue to take steps to become
        aware of related technical developments, there can be no assurance that we
        will
        not encounter an unfavorable patent situation. Other parties may assert
        intellectual property infringement claims against us or our customers, and
        our
        products may infringe the intellectual property rights of third parties.
        Other
        parties may also 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.
  15
 ***If
        our products and services do not achieve market acceptance, we may not achieve
        our revenue and net income goals in the time prescribed or at
        all.***
  We
        are at
        the early stage of introducing our document security technology and products
        to
        the market. If we are unable to operate our business as contemplated by our
        business model or if the assumptions underlying our business model prove
        to be
        unfounded, we could fail to achieve our revenue and net income goals within
        the
        time we have projected, or at all, which could have a material adverse effect
        on
        our business. As a result, the value of your investment could be significantly
        reduced or completely lost.
  We
        cannot
        assure you that a sufficient number of such companies will demand our products
        or services or other document security products. In addition, we cannot predict
        the rate of market's acceptance of our document security solutions. Failure
        to
        maintain a significant customer base may have a material adverse effect on
        our
        business.
  ***The
        results of our research and development efforts are uncertain and there can
        be
        no assurance of the commercial success of our products*** ***.***
  We
        believe that we will need to continue to incur research and development
        expenditures to remain competitive. The products we currently are developing
        or
        may develop in the future may not be technologically successful. In addition,
        the length of our product development cycle may be greater than we originally
        expect and we may experience delays in future product development. If our
        resulting products are not technologically successful, they may not achieve
        market acceptance or compete effectively with our competitors'
        products.
  ***Changes
        in document security technology and standards could render our applications
        and
        services obsolete.***
  The
        market for document security products, applications, and services is fast
        moving
        and evolving. Identification and authentication technology is constantly
        changing as we and our competitors introduce new products, applications,
        and
        services, and retire old ones as customer requirements quickly develop and
        change. In addition, the standards for document security are continuing to
        evolve. If any segments of our market adopt technologies or standards that
        are
        inconsistent with our applications and technology, sales to those market
        segments could decline.
  ***The
        market in which we operate is highly competitive, and we may not be able
        to
        compete effectively, especially against established industry competitors
        with
        greater market presence and financial resources.***
  Our
        market is highly competitive and characterized by rapid technological change
        and
        product innovations. Our competitors may have advantages over us because
        of
        their longer operating histories, more established products, greater name
        recognition, larger customer bases, and greater financial, technical and
        marketing resources. As a result, they may be able to adapt more quickly
        to new
        or emerging technologies and changes in customer requirements, and devote
        greater resources to the promotion and sale of their products. Competition
        may
        also force us to decrease the price of our products and services. We cannot
        assure you that we will be successful in developing and introducing new
        technology on a timely basis, new products with enhanced features, or that
        these
        products, if introduced, will enable us to establish selling prices and gross
        margins at profitable levels. Although several potential competitors have
        expressed an interest to us in forming marketing alliances, there can be
        no
        assurance that we will undertake such efforts or if undertaken, such efforts
        will prove profitable.
  16
  ***Our
        growth strategy depends, in part, on our acquiring complementary businesses
        and
        assets and expanding our existing operations to include manufacturing
        capabilities, which we may be unable to do.***
  Our
        growth strategy is based, in part, on our ability to acquire businesses and
        assets that are complimentary to our existing operations and expanding our
        operations to include manufacturing capabilities. We may also seek to acquire
        other businesses. The success of this acquisition strategy will depend, in
        part,
        on our ability to accomplish the following:
   ·
              identify
                  suitable businesses or assets to buy;
 ·
              complete
                  the purchase of those businesses on terms acceptable to us;
 ·
              complete
                  the acquisition in the time frame we expect;
                  and
 ·
              improve
                  the results of operations of the businesses that we buy and successfully
                  integrate their operations into our
                  own.
  There
        can
        be no assurance that we will be successful in pursuing any or all of these
        steps. Our failure to implement our acquisition strategy could have an adverse
        effect on other aspects of our business strategy and our business in general.
        We
        may not be able to find appropriate acquisition candidates, acquire those
        candidates that we find or integrate acquired businesses effectively or
        profitably.
  Our
        acquisition program and strategy may lead us to contemplate acquisitions
        of
        companies in bankruptcy, which entail additional risks and uncertainties.
        Such
        risks and uncertainties include, without limitation, that, before assets
        may be
        acquired, customers may leave in search of more stable providers and vendors
        may
        terminate key relationships. Also, assets are generally acquired on an “as is”
basis, with no recourse to the seller if the assets are not as valuable as
        may
        be represented. Finally, while bankrupt companies may be acquired for
        comparatively little money, the cost of continuing the operations may
        significantly exceed expectations.
  We
        have
        in the past used, and may continue to use, our Common Stock as payment for
        all
        or a portion of the purchase price for acquisitions. If we issue significant
        amounts of our Common Stock for such acquisitions, this could result in
        substantial dilution of the equity interests of our stockholders.
 
 ***If
        we fail to retain our key personnel and attract and retain additional qualified
        personnel, we might not be able to pursue our growth
        strategy.***
  Our
        future success depends upon the continued service of our executive officers
        and
        other key sales and research personnel who possess longstanding industry
        relationships and technical knowledge of our products and operations. The
        loss
        of any of our key employees, in particular, Patrick White, our Chief Executive
        Officer and Chief Financial Officer; Peter Ettinger, our President; Thomas
        Wicker, our Vice-President of Research and Development; and David Wicker,
        our
        Vice-President of Operations, could negatively impact our ability to pursue
        our
        growth strategy and conduct operations. Although we believe that our
        relationship with these individuals is positive, there can be no assurance
        that
        the services of these individuals will continue to be available to us in
        the
        future. We have extended our employment agreements with Patrick White to
        June
        2009. We have also extended our employment agreements with Thomas Wicker
        and
        David Wicker to June 2007. There can be no assurance that these persons will
        continue to agree to be employed by us after such dates. Our employment
        agreement with Peter Ettinger has an expiration date of June, 2009.
 
 17
 We
        intend
        to hire a Chief Financial Officer for our company and believe that our ability
        to obtain a qualified Chief Financial Officer is material to our future success.
        We also must continue to hire other highly qualified individuals. Our failure
        to
        attract, train and retain management and technical personnel could adversely
        affect our company's ability to grow and to develop new products or product
        enhancements now and in the future.
  ***If
        we do not successfully expand our sales force, we may be unable to increase
        our
        revenues.***
  We
        must
        expand the size of our marketing activities and sales force to increase
        revenues. We continue to evaluate various methods of expanding our marketing
        activities, including the use of outside marketing consultants and
        representatives and expanding our in-house marketing capabilities. Going
        forward, we anticipate an increasing percentage of our revenues to come from
        the
        licensing of our newer technologies, where profit margins are significantly
        higher than those provided by Security Paper. If we are unable to hire or
        retain
        qualified sales personnel, if newly hired personnel fail to develop the
        necessary skills to be productive, or if they reach productivity more slowly
        than anticipated, our ability to increase our revenues and grow could be
        compromised. The challenge of attracting, training and retaining qualified
        candidates may make it difficult to meet our sales growth targets. Further,
        we
        may not generate sufficient sales to offset the increased expense resulting
        from
        expanding our sales force or we may be unable to manage a larger sales
        force.
  ***Future
        growth in our business could make it difficult to manage our
        resources.***
  Our
        anticipated business expansion could place a significant strain on our
        management, administrative and financial resources. Significant growth in
        our
        business may require us to implement additional operating, product development
        and financial controls, improve coordination among marketing, product
        development and finance functions, increase capital expenditures and hire
        additional personnel. There can be no assurance that we will be able to
        successfully manage any substantial expansion of our business, including
        attracting and retaining qualified personnel. Any failure to properly manage
        our
        future growth could negatively impact our business and operating
        results.
  ***We
        cannot predict our future capital needs and we may not be able to secure
        additional financing.***
  We
        may
        need to raise additional funds in the future to fund more aggressive expansion
        of our business, complete the development, testing and marketing of our
        products, or make strategic acquisitions or investments. We may require
        additional equity or debt financings, collaborative arrangements with corporate
        partners or funds from other sources for these purposes. No assurance can
        be
        given that these funds will be available for us to finance our development
        on
        acceptable terms, if at all. Such additional financings may involve substantial
        dilution of our stockholders or may require that we relinquish rights to
        certain
        of our technologies or products. In addition, we may experience operational
        difficulties and delays due to working capital restrictions. If adequate
        funds
        are not available from operations or additional sources of financing, we
        may
        have to delay or scale back our growth plans.
  18
  **Risks
        Related to Our Stock**
  ***Provisions
        of our certificate of incorporation and agreements could delay or prevent
        a
        change in control of our company.***
  Certain
        provisions of our certificate of incorporation may discourage, delay, or
        prevent
        a merger or acquisition that a shareholder may consider favorable. These
        provisions include:
  ·
              the
                  authority of the Board of Directors to issue preferred stock;
                  and
 ·
              a
                  prohibition on cumulative voting in the election of directors.
  ***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, 2006, there are 186,132,575 million shares of authorized but
        unissued shares of our common stock. Our management will continue to have
        broad
        discretion to issue shares of our common stock in a range of transactions,
        including capital-raising transactions, mergers, acquisitions, for anti-takeover
        purposes, and in other transactions, without obtaining stockholder approval,
        unless stockholder approval is required for a particular transaction under
        the
        rules of the American Stock Exchange, New York law, or other applicable laws.
        We
        currently have no specific plans to issue shares of our common stock for
        any
        purpose. However, if our management determines to issue shares of our common
        stock from the large pool of such authorized but unissued shares for any
        purpose
        in the future without obtaining stockholder approval, your ownership position
        would be diluted without your further ability to vote on that transaction.
  ***The
        exercise of our outstanding options and warrants may depress our stock price.***
  As
        of
        September 30, 2006, there were outstanding stock options and warrants to
        purchase an aggregate of 875,436 shares of our Common Stock at exercise prices
        ranging from $2.00 to $12.65 per share, most of which are immediately
        exercisable. To the extent that these securities are exercised, dilution
        to our
        shareholders will occur. Moreover, the terms upon which we will be able to
        obtain additional equity capital may be adversely affected, since the holders
        of
        these securities can be expected to exercise or convert them at a time when
        we
        would, in all likelihood, be able to obtain any needed capital on terms more
        favorable to us than the exercise and conversion terms provided by those
        securities.
  Sales
        of
        these shares in the public market, or the perception that future sales of
        these
        shares could occur, could have the effect of lowering the market price of
        our
        common stock below current levels and make it more difficult for us and our
        shareholders to sell our equity securities in the future.
  Sale
        or
        the availability for sale of shares of common stock by stockholders could
        cause
        the market price of our common stock to decline and could impair our ability
        to
        raise capital through an offering of additional equity securities.
  19
 ***We
        do not intend to pay cash dividends.***
  We
        do not
        intend to declare or pay cash dividends on our common stock in the foreseeable
        future. We anticipate that we will retain any earnings and other cash resources
        for investment in our business. The payment of dividends on our common stock
        is
        subject to the discretion of our Board of Directors and will depend on our
        operations, financial position, financial requirements, general business
        conditions, restrictions imposed by financing arrangements, if any, legal
        restrictions on the payment of dividends and other factors that our Board
        of
        Directors deems relevant.
  **ITEM
        2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
        PROCEEDS**
  On
        February 7, 2006, the Company issued 18,704 shares of the Company’s Common Stock
        valued at $250,000 in connection with an acquisition. The shares issued in
        the
        transaction were not registered under the Securities Act of 1933.
  We did not purchase any shares of our common stock during the nine months
        ended
        September 30, 2006.
  **ITEM
        3 - DEFAULTS UPON SENIOR SECURITIES**
  None
  **ITEM
        4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY
        HOLDERS**
  None
  **ITEM
        5 - OTHER INFORMATION**
  None
  **ITEM
        6 - EXHIBITS**
  The
        Exhibits listed below designated by an * are incorporated by reference to
        the
        filings by Document Security Systems, Inc. under the Securities Act of 1933
        or
        the Securities and Exchange Act of 1934, as indicated. All other exhibits
        are
        filed herewith.
  (a)    Exhibits
 Item
                  3.1
                Articles
                    of Organization, as amended (incorporated by reference to exhibit
                    3.1 to
                    the Company's Registration Statements No. 2-98684-NY on Form
                    S-18).*
  Item
                  3.2
                By-laws,
                    as amended (incorporation by reference to exhibit 3.2 to the
                    Company's
                    Registration Statement No. 2-98684-NY on Form
                    S-18).*  Item 31.1
                Certifications of Chief Executive
                  Officer
                  Pursuant to Section 302 of the Sarbanes Oxley
                  Act  Item 31.2
                Certifications of Principal Accounting
                  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 principal Accounting
                  Officer
                  Pursuant to Section 906 of the Sarbanes Oxley
                  Act
 
 20
 **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.**November
                  14, 2006
              By:
              /s/ Patrick
                WhitePatrick
                WhitePresident,
                Chief
                Executive Officer andActing
                  Chief Financial Officer
 November
                  14, 2006
              By:
              /s/ Philip
                JonesPhilip
                JonesController/Principal
                  Accounting Officer
  22