UNITED
STATES SECURITIES AND EXCHANGE COMMISSION


Washington,
D.C. 20549




FORM
10-Q




QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF


THE
SECURITIES EXCHANGE ACT OF 1934




For the quarterly period ended
March 31,
2009




1-32146Commission
      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)
      has filed all reports required to be filed by Section 13 or 15(d) of the
      Securities Exchange Act of 1934 during the preceding 12 months (or for
      such shorter period that the registrant was required to file such
      reports)And(2)
      has been subject to such filing requirements for the past 90
      days.
              Yes x No o





Indicate
      by check mark whether the registrant has submitted electronically and
      posted on its corporate Web site, if any, every Interactive Date File
      required to be submitted and posted pursuant to Rule 405 of Regulation S-T
      during the preceeding 12 months (or for such shorter period that the
      registrant was required to submit and post such files)*
              Yes o  No
      o
              
              *   The
      issuer has not yet been phased into the interactive data
      requirements




Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer, or a smaller reporting
      company.  See definition of “large accelerated filer”,
      “accelerated filer” and “smaller reporting company”  in Rule
      12b-2 of the Exchange Act. (Check one):
              
              Large
      accelerated filer o       Accelerated
      filer o       Non-accelerated
      filer o       Smaller
      reporting company x
              
              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
              
              Applicable
      only to corporate issuersAs
      of May 8, 2009 (the most recent practicable date), there were 14,535,056
      shares of the issuer's Common Stock, $0.02 par value per share,
      issued.









DOCUMENT SECURITY SYSTEMS, INC.
              FORM
      10-Q
              TABLE
      OF CONTENTSPART I
            
            FINANCIAL
      INFORMATIONItem 1
            
            Financial
      StatementsConsolidated Balance
      Sheets
            
            3Consolidated Statements of
      Operations
            
            4Consolidated Statements of Cash
      Flows
            
            5Notes to Interim Consolidated
      Financial Statements
            
            6Item 2
            
            Management's Discussion and
      Analysis of Financial Condition and Results of
      Operations
            
            14Item 4T
            
            Controls and
      Procedures
            
            20PART II
            
            OTHER
      INFORMATIONItem 1
            
            Legal
      Proceedings
            
            21Item
      1A
            
            Risk
      Factors
            
            22Item 2
            
            UnregisteredSales of Equity Securities and Use
      of Proceeds
            
            23Item 3
            
            Defaults upon Senior
      Securities
            
            24Item 4
            
            Submission of Matters to a Vote of
      Security Holders
            
            24Item 5
            
            Other
      Information
            
            24Item 6
            
            Exhibits
            
            24SIGNATURES




2




PART I






FINANCIAL
INFORMATION


ITEM 1 - FINANCIAL
STATEMENTS






DOCUMENT
SECURITY SYSTEMS, INC.  AND SUBSIDIARIES
 Consolidated
Balance Sheets
 
 As
of
 
 March
      31
              
              December
      31,2009
              2008(unaudited)
              (audited)ASSETSCurrent
      assets:Cash
      and cash equivalents
              
              $
              169,286
              
              
              $
              87,820Restricted
      cash
              
              
              131,004
              
              
              
              131,004Accounts
      receivable, net of allowanceof  $50,000
      ($50,000- 2008)
              
              
              1,535,625
              
              
              
              1,284,208Inventory
              
              
              341,320
              
              
              
              359,034Loans
      to employees
              
              
              57,781
              
              
              
              67,781Prepaid
      expenses and other current assets
              
              
              56,106
              
              
              
              75,066Total
      current assets
              
              
              2,291,122
              
              
              
              2,004,913Fixed
      assets, net
              
              
              1,449,357
              
              
              
              1,517,357Other
      assets
              
              
              277,834
              
              
              
              264,529Goodwill
              
              
              1,396,734
              
              
              
              1,396,734Other
      intangible assets, net
              
              
              2,571,054
              
              
              
              2,873,789Total
      assets
              
              $
              7,986,101
              
              
              $
              8,057,322LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilities:Accounts
      payable
              
              $
              1,511,468
              
              
              $
              1,411,942Accrued
      expenses & other current liabilities
              
              
              1,379,608
              
              
              
              1,312,745Deferred
      revenue & customer deposits
              
              
              35,646
              
              
              
              30,193Revolving
      notes from related parties
              
              
              3,083,000
              
              
              
              -Short-term
      debt, net of discount of $186,000 ($247,000 -2008)
              
              
              714,210
              
              
              
              652,511Current
      portion of capital lease obligations
              
              
              72,500
              
              
              
              78,367Total
      current liabilities
              
              
              6,796,432
              
              
              
              3,485,758Revolving
      notes from related parties
              
              
              -
              
              
              
              2,283,000Capital
      lease obligations
              
              
              195,023
              
              
              
              210,365Deferred
      tax liability
              
              
              56,616
              
              
              
              51,878Commitments
      and contingencies (see Note 7)Stockholders'
      equityCommon
      stock, $.02 par value;200,000,000
      shares authorized,14,385,062
      shares issued and outstanding (14,369,764 in 2008)
                (325,000
      subscribed in 2009 and 2008)
              
              
              287,701
              
              
              
              287,395Additional paid-in capital
              
              
              35,393,630
              
              
              
              35,538,695Common
      stock subscriptions receivable
              
              
              (1,300,000)
              
              
              
              (1,300,000)Accumulated deficit
              
              
              (33,443,301)
              
              
              
              (32,499,769)Total
      stockholders' equity
              
              
              938,030
              
              
              
              2,026,321Total
      liabilities and stockholders' equity
              
              $
              7,986,101
              
              
              $
              8,057,322
 See
accompanying notes
  3




DOCUMENT SECURITY SYSTEMS, INC. AND
SUBSIDIARIES
 
 Consolidated Statements of
Operations
 For the Three Months Ended March
31,
 (unaudited)
  2009
              
              
              
              2008RevenueSecurity and commercial
      printing
              
              $
              2,416,691
              
              
              $
              932,221Technology license royalties and
      digital solutions
              
              
              223,240
              
              
              
              336,761Legal
    products
              
              
              138,625
              
              
              
              173,133Total
    Revenue
              
              
              2,778,556
              
              
              
              1,442,115Costs of
      revenueSecurity and commercial
      printing
              
              
              1,575,043
              
              
              
              595,633Technology license royalties and
      digital solutions
              
              
              3,507
              
              
              
              3,507Legal
    products
              
              
              63,062
              
              
              
              97,096Total costs of
      revenue
              
              
              1,641,612
              
              
              
              696,236Gross
profit
              
              
              1,136,944
              
              
              
              745,879Operating
      expenses:Selling, general and
      administrative
              
              
              1,522,412
              
              
              
              2,076,116Research and
      development
              
              
              87,416
              
              
              
              114,779Impairment of patent defense
      costs
              
              
              -
              
              
              
              291,581Amortization of
      intangibles
              
              
              323,457
              
              
              
              526,741Operating
      expenses
              
              
              1,933,285
              
              
              
              3,009,217Operating
    loss
              
              
              (796,341)
              
              
              
              (2,263,338)Other income
      (expense):Interest
    income
              
              
              -
              
              
              
              80Loss on foreign currency
      transactions
              
              
              -
              
              
              
              (11,629)Interest
      expense
              
              
              (80,754)
              
              
              
              (20,849)Amortizaton of note
      discount
              
              
              (61,699)
              
              
              
              -Loss before income
      taxes
              
              
              (938,794)
              
              
              
              (2,295,736)Income tax
      expense
              
              
              4,738
              
              
              
              4,738Net loss
              
              $
              (943,532)
              
              
              $
              (2,300,474)Net loss per share -basic and
      diluted:
              
              $
              (0.07)
              
              
              $
              (0.17)Weighted average common shares
      outstanding, basic and diluted
              
              
              14,378,609
              
              
              
              13,654,364


See
accompanying notes




4




DOCUMENT
SECURITY SYSTEMS, INC. AND SUBSIDIARIES
 Consolidated
Statements of Cash Flows
 For
the Three Months Ended March 31,
 
 (unaudited)
  2009
              
              
              2008Cash
      flows from operating activities:Net
      loss
              
              $
              (943,532
              )
              
              $
              (2,300,474
              )Adjustments
      to reconcile net loss to net cash used by operating
      activities:Depreciation
      and amortization
              
              
              409,515
              
              
              
              605,698Stock
      based compensation
              
              
              (144,759
              )
              
              
              406,848Impairment
      of patent defense costs
              
              
              -
              
              
              
              291,581Amortization
      of note discount
              
              
              61,699
              
              
              
              -(Increase)
      decrease in assets:Accounts
      receivable
              
              
              (251,417
              )
              
              
              (78,731
              )Inventory
              
              
              17,714
              
              
              
              5,679Prepaid
      expenses and other assets
              
              
              15,655
              
              
              
              (51,613
              )Increase
      (decrease) in liabilities:Accounts
      payable
              
              
              99,526
              
              
              
              (9,708
              )Accrued
      expenses and other liabilities
              
              
              77,055
              
              
              
              166,393Net
      cash used by operating activities
              
              
              (658,544
              )
              
              
              (964,327
              )Cash
      flows from investing activities:Purchase
      of fixed assets
              
              
              (18,059
              )
              
              
              (46,362
              )Purchase
      of other intangible assets
              
              
              (20,722
              )
              
              
              (536,842
              )Net
      cash used by investing activities
              
              
              (38,781
              )
              
              
              (583,204
              )Cash
      flows from financing activities:Borrowing
      on revolving note- related parties
              
              
              800,000
              
              
              
              990,000Repayments
      of capital lease obligations
              
              
              (21,209
              )
              
              
              (31,232
              )Net
      cash provided by financing activities
              
              
              778,791
              
              
              
              958,768Net
      increase (decrease) in cash and cash equivalents
              
              
              81,466
              
              
              
              (588,763
              )Cash
      and cash equivalents beginning of period
              
              
              87,820
              
              
              
              742,468Cash
      and cash equivalents end of period
              
              $
              169,286
              
              
              $
              153,705


See
accompanying notes.




5




DOCUMENT SECURITY SYSTEMS, INC.


NOTES
TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS


March
31, 2009


(Unaudited)




1.    
Basis of Presentation and Significant Accounting Policies




The accompanying unaudited condensed
consolidated financial statements have been prepared in accordance withU.S.generally accepted accounting
principles for interim financial information and with the instructions to Form
10-Q and Rule 8-03 of Regulation S-X for smaller reporting companies.
Accordingly, these statements do not include all of the information and
footnotes required byU.S.generally accepted accounting
principles for complete financial statements. In the opinion of management, the
accompanying balance sheets and related interim statements of operations and
cash flows include all adjustments, consisting only of normal recurring items,
necessary for their fair presentation in accordance withU.S.generally accepted accounting
principles. All significant intercompany transactions have been
eliminated.





Interim results are not necessarily
indicative of results expected for a full year. For further information
regarding Document Security Systems, Inc (the “Company”) accounting policies,
refer to the audited consolidated financial statements and footnotes thereto
included in the Company's Form 10-K for the fiscal year ended December 31,
2008.





The preparation of financial statements
in conformity with accounting principles generally accepted in theUnited Statesrequires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ materially from those estimates
and assumptions.




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 combination of technology license royalties and digital solutions revenue
items into a single revenue item and cost of sale item.




Restricted Cash
-In July
2007, the Company established a restricted cash balance of 87,500 British
pounds, (approximately $131,000 as of March 31, 2009), as collateral for a
deed of guarantee that was required by the English Court of Appeals in order for
the Company to pursue an appeal in that court. On March 19, 2008, the Company
was notified that its appeal was denied and that the Company owed the European
Central Bank, the successful party in the appeal, the 87,500 British
pounds.  On May 14, 2008, the Company made a payment of 87,500 British
pounds to the European Central Bank as an interim payment of the appeal costs
pending final assessment by the Court which is expected in the latter half of
2009.   The Company will use the restricted funds to pay
additional fees due upon final assessment of the costs by the Court, if
any.   (See Note 8 Commitments and Contingencies)




Continuing
Operations -The Company has incurred
significant net losses in previous years.  The Company’s ability to
fund its capital requirements out of its available cash and cash generated from
its operations depends on a number of factors. Some of these factors include the
Company’s ability to (i) increase commercial and security printing and plastic
card sales and (ii) increase sales of the Company’s digital
products.  While the Company has approximately $517,000 of funds
available to it under various credit facilities as of March 31, 2009, the
Company is planning to raise up to $1.4 million of equity capital in a private
placement transaction and may still need to raise additional funds in the future
in order to fund its working capital needs.   There can be no assurance
that such additional financing, will be available on terms acceptable to the
Company or at all.  Failure to raise the funds necessary to finance future
cash requirements would adversely affect the Company’s ability to pursue its
strategy and could negatively affect operations in future periods.  The
accompanying financial statements do not reflect any adjustments that may be
necessary in the event the Company is unsuccessful in its fundraising
efforts.




6







Recent
Accounting Pronouncements





In
December 2007, the Financial Accounting Standards Board (“FASB”) issued
SFAS 141(r), Business
Combinations, which addresses the accounting and disclosure for
identifiable assets acquired, liabilities assumed, and noncontrolling interests
in a business combination. In April 2009, the FASB issued FASB Staff
Position No. FAS 141(r)-1, Accounting for Assets Acquired and
Liabilities Assumed in a Business Combination That Arise from
Contingencies (FSP FAS 141(r)-1), which amended certain provisions of
SFAS 141(r) related to the recognition, measurement, and disclosure of assets
acquired and liabilities assumed in a business combination that arise from
contingencies. SFAS 141(r) and FSP FAS 141(r)-1 became effective in the first
quarter of 2009, and did not have a material impact on our financial condition
or results of operations.





In
June 2008, the EITF reached a consensus in Issue No. 07-5,
“Determining Whether an Instrument (or Embedded Feature) Is Indexed to an
Entity’s Own Stock” (“EITF 07-5”). This Issue addresses the determination of
whether an instrument (or an embedded feature) is indexed to an entity’s own
stock, which is the first part of the scope exception in paragraph 11(a) of SFAS
133. EITF 07-5 is effective for fiscal years beginning after December 15,
2008, and interim periods within those fiscal years. Early application is not
permitted. The adoption of EITF 07-05 as of January 1, 2009 did not have a
material impact on our results of operations or financial
position.





In April 2009, the FASB issued FSP
No. 157-4,Determining Fair
Value When the Volume and Level of Activity for the Asset or Liability Have
Significantly Decreased and Identifying Transactions That Are Not Orderly(FSP 157-4), which provides
additional guidance for estimating fair value when the volume and level of
activity for the asset or liability have significantly decreased. FSP 157-4 also
provides additional guidance on circumstances that may indicate that a
transaction is not orderly. This guidance is effective for interim reporting
periods ending after June 15, 2009 and will apply to the Company’s
disclosures beginning with its second fiscal quarter of 2009. The Company does
not believe the adoption of this staff position will materially impact its
consolidated financial statements and disclosures.





In April 2009, the FASB issued FSP
No. 107-1 and APB 28-1,Interim Disclosures
About Fair Value of Financial Instruments(FSP 107-1 and APB 28-1), which require
disclosures about fair value of financial instruments for interim reporting
periods. This guidance is effective for interim reporting periods ending after
June 15, 2009 and will apply to the Company’s disclosures beginning with
its second fiscal quarter of 2009. The Company has not determined the effect
that the adoption of this staff position will have on its consolidated financial
statements and disclosures.




2.    Inventory




Inventory
approximately consisted of the following:




March 31,
              
              
              December
31,2009
              
              
              2008(unaudited)
              
              
              (audited)Finished
    Goods
              
              $
              147,000
              
              
              $
              138,000Work in
    process
              
              
              56,000
              
              
              
              121,000Raw
    Materials
              
              
              138,000
              
              
              
              100,000$
              341,000
              
              
              $
              359,000
  7




3.     Other
Intangible Assets




Other intangible assets are comprised of
the following:




March 31, 2009
      (unaudited)
              
              
              December 31, 2008
      (audited)Useful Life
              
              Gross Carrying
      Amount
              
              
              Accumulated
      Amortizaton
              
              
              Net Carrying
      Amount
              
              
              Gross Carrying
      Amount
              
              
              Accumulated
      Amortizaton
              
              
              Net Carrying
      AmountRoyalty
    rights
              5 years
              
              $
              90,000
              
              
              $
              90,000
              
              
              $
              -
              
              
              $
              90,000
              
              
              $
              90,000
              
              
              $
              -Other
      intangibles
              5 years
              
              
              666,300
              
              
              
              437,140
              
              
              
              229,160
              
              
              
              666,300
              
              
              
              405,424
              
              
              
              260,876Patent acquisition and defense
      costs
              Varied (1)
              
              
              4,729,889
              
              
              
              3,016,466
              
              
              
              1,713,423
              
              
              
              4,729,889
              
              
              
              2,732,422
              
              
              
              1,997,467Patent application
      costs
              Varied (2)
              
              
              739,597
              
              
              
              111,126
              
              
              
              628,471
              
              
              
              718,875
              
              
              
              103,429
              
              
              
              615,446$
              6,225,786
              
              
              $
              3,654,732
              
              
              $
              2,571,054
              
              
              $
              6,205,064
              
              
              $
              3,331,275
              
              
              $
              2,873,789
 
 (1)- patent rights
are  amortized over their expected useful life which is generally the
legal life of the patent.  As of March 31, 20a09 the weighted average remaining useful
life of these assets in service was 1.8 years.
  (2)- patent rights
are  amortized over their expected useful life which is generally the
legal life of the patent.  As of March 31, 2009 the weighted average
remaining useful life of these assets in service was 14.7
years.


4.    
Short Term and Long Term Debt




Long Term Revolving
Note- Related Parties- On
January 4, 2008, the Company entered into a Credit Facility Agreement with
Fagenson & Co., Inc., as agent, a related party to Robert B. Fagenson, the
Chairman of the Company's Board of Directors. Under the Fagenson Credit
Agreement, the Company can borrow up to a maximum of $3,000,000 from time to
time up to and until January 4, 2010.  The advances are generally
limited to $400,000 unless otherwise mutually agreed upon by both parties per
fiscal quarter, with the exception of $600,000 that can be advanced at any time
for patent litigation related bills.  Any amount borrowed by the
Company pursuant to the Fagenson Credit Agreement will have an annual interest
rate of 2% above LIBOR and will be secured by the Common Stock of Plastic
Printing Professionals, Inc., (“P3”) the Company's wholly owned
subsidiary.  Interest is payable quarterly in arrears and the
principal is payable in full at the end of the term under the Fagenson Credit
Agreement.  In addition, on January 4, 2008, the Company also entered
into a Credit Facility Agreement with Patrick White, the Company's Chief
Executive Officer and a member of the Board of Directors.  Under the
White Credit Agreement, the Company can borrow up to $600,000 from time to time
up to and until January 4, 2010.  Any amount borrowed by the Company
pursuant to the White Credit Agreement will have an annual interest rate of 2%
above LIBOR and is secured by the accounts receivable of the Company, excluding
the accounts receivable of P3.  Interest is payable quarterly in
arrears and the principal is payable in full at the end of the term under the
White Credit Agreement.  Mr. White can accept common stock as
repayment of the loan upon a default.   Under the terms of the
agreement the Company is required to comply with various
covenants.  As of March 31, 2009, the Company was in default of both
agreements due to a failure to pay interest when due.  Both Fagenson
& Co., Inc. and Patrick White have waived the defaults through January 1,
2010.




As of
March 31, 2009, the Company had outstanding $450,000 under the White Credit
Agreement, and $2,633,000 under the Fagenson Credit
Agreement.  Interest expense for the first three months of 2009
amounted to approximately $27,000 for these agreements. As of March 31, 2009,
approximately $82,000 of interest expense is included in accrued
expenses.





Short-Term Note- On December
18, 2008, the Company’s wholly owned subsidiary, Secuprint, Inc. (dba DPI
Secuprint, Inc.) entered a Secured Promissory Note with Baum Capital
Investments Inc. (“Baum”) in the principal amount of up to $900,000 to pay for
most of the cash portion of the purchase price of the Company’s acquisition of
substantially all of the assets of DPI of Rochester, LLC.  The Secured
Promissory Note has a one-year term, is secured by all of the assets of DPI
Secuprint and has an annual interest rate of 15%, with a reduction to 12%,
depending on whether certain conditions are met after three
months.   The note is subject to pre-payment provisions if, among
other provisions, DPI Secuprint’s cash receipts do not exceed its cash
expenditures for any two consecutive months during the term.  As of
March 31, 2009, the Company believes that it is in compliance with all of the
covenants of the Note.   Interest expense for the first three
months of 2009 amounted to approximately $34,000 for this agreements, of which
approximately $11,000 is included in accrued expenses as of March 31,
2009.





In
conjunction with the Baum Note, the Company issued warrants to purchase up to a
total of 250,000 shares of the Company’s common stock at an average price of
$2.00 per share.  The warrants are exercisable on February 16, 2009
and expire on December 17, 2013.  The fair value of the warrants of
approximately $256,000 was determined using the Black Scholes option pricing
model, and was recorded as discount on debt and will be amortized over the term
of the Note.   Amortization of note discount expense of
approximately $62,000 was recorded in the first three months of
2009.




8




5.    
Shareholders’ Equity




Restricted
Stock –As of March 31, 2009, there are 104,993 unvested restricted
shares granted to employees and consultants that vest through December
2013.  In addition, there are 45,000 restricted shares that will vest
only upon the occurrence of certain events prior to May 3, 2012, which include,
among other things a change of control of the Company or other merger or
acquisition of the Company, the achievement of certain financial goals,
including among other things a successful result of the Company’s patent
infringement lawsuit against the European Central Bank.   These
45,000 shares, if vested, would result in the recording of stock based
compensation expense of approximately $563,000, the grant date fair value, over
the period beginning when any of the contingent vesting events is deemed to be
probable over the expected requisite service period.  As of March 31,
2009, vesting is not considered probable and no compensation expense has been
recognized related to the performance grants.    During
March, 2009, the Company retired 162,500 of unvested restricted stock as the
result of the resignation during that month of the Company’s Senior Vice
President and General Counsel.




Stock
Subscription Agreement -In June 2008, the Company entered into two Stock
Purchase Agreements in which it sold 500,000 shares of its common stock to
Walton Invesco Inc. for an aggregate purchase price of $2.0
million.  Pursuant to the terms of such Stock Purchase Agreements,
Walton Invesco Inc. may demand registration of such 500,000 shares with the
Securities and Exchange Commission on Form S-3 with such registration statement
to take effect no later than (i) 120 days after payment in full for such shares
under the applicable agreement or, (ii) with respect to 350,000 shares, 270 days
after a Payment Failure Termination Event (as defined in the applicable Stock
Purchase Agreement).   As of March 31, 2009, the share
subscription was not current and the Company is reviewing its options under the
Agreement, which may include termination of the agreement.




Stock
Options – During the three months ended March 31, 2009, the Company
issued options to purchase 40,000 of its common shares at an exercise price of
$1.86 per share to non-employee directors pursuant to the 2004 Non-Employee
Officer Director Stock Option Plan that vest at the end of one year of service
on the Company’s Board of Directors.  The fair value of these options
amounted to approximately $28,000 determined by utilizing the Black Scholes
option pricing model.  Also, during the three months ended March 31,
2009, the Company issued options to purchase 120,000 of its common shares at an
exercise price of $4.00 per share under the Company’s 2004 Employees’ Stock
Option Plan to certain employees, including 50,000 options to its acting chief
financial officer and 50,000 options to its vice president of operation who is
also a board member.  The fair value of these options amounted to
approximately $47,000 determined by utilizing the Black Scholes option pricing
model. The Company records stock-based payment expense related to these options
based on the grant date fair value in accordance with FASB 123R.




Stock-Based
Compensation -Stock-based
compensation includes expense charges for all stock-based awards to employees,
directors and consultants. Such awards include option grants, warrant grants,
and restricted stock awards.   During the three months ended
March 31, 2009, the Company recognized approximately $201,000 ($407,000- 2008)
in stock-based compensation, which was offset by the reversal of
approximately $346,000 of previously recorded stock-based compensation expense
for stock options and restricted shares issued to one of the Company’s senior
management team members which terminated unvested as a result of that employee’
resignation in March 2009.




As of
March 31, 2009, there was approximately $780,000 of total unrecognized
compensation costs (excluding approximately $563,000 that vest upon the
occurrence of certain events) related to non-vested options and restricted stock
granted under the Company’s stock option plans which the Company expects to vest
over a period of not to exceed five years.





6.
            Impairment
      of Patent Defense Costs




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




9




7.    
Earnings Per Share





Basic
earnings per share is computed by dividing net income by the weighted-average
number of common shares outstanding for the period.  Diluted earnings
per share is computed by including the number of additional shares that would
have been outstanding if dilutive potential shares had been issued. In periods
of losses, diluted loss per share is computed on the same basis as basic loss
per share as the inclusion of any other potential shares outstanding would be
anti-dilutive.   If
the Company had generated earnings during the nine month period ended March 31,
2009, 304,226 (547,211- 2008) common equivalent shares would have been added to
the weighted average shares outstanding to compute the diluted weighted average
shares outstanding.




8.    
Commitments and Contingencies




Legal
Matters-On
August 1, 2005, we commenced a suit against the European Central Bank (“ECB”)
alleging patent infringement by the ECB and claimed unspecified damages. We
brought the suit in the European Court of First Instance in
Luxembourg.  We alleged that all Euro banknotes in circulation
infringe the Company European Patent 0 455 750B1 (the “Patent”), which covers a
method of incorporating an anti-counterfeiting feature into banknotes or similar
security documents to protect against forgeries by digital scanning and copying
devices.  The Court of First Instance ruled on September 5, 2007 that
it does not have jurisdiction to rule on the patent infringement claim, and also
ruled that we will be required to pay attorneys and court fees of the
ECB.  The ECB formally requested the Company to pay attorneys and
court fees in the amount of Euro 93,752 ($128,000 as of March 31, 2009), which,
unless the amount is settled will be subject to an assessment procedure that
will not likely be concluded until approximately the middle of 2009, which the
Company will accrue as soon as the assessed amount, if any, is reasonably
estimatable.




On March
24, 2006, we received notice that the ECB has filed a separate claim in the
United Kingdom and Luxembourg courts seeking the invalidation of the
Patent.  Proceedings were commenced before the national courts seeking
revocation and declarations of invalidity of the Patent in each of the
Netherlands, Belgium, Italy, France, Spain, Germany and Austria.  On
March 26, 2007, the High Court of Justice, Chancery Division, Patents Court in
London, England (the “English Court”) ruled that the Patent was deemed invalid
in the United Kingdom, and on March 19, 2008 this decision was upheld on
appeal.  The English Court rejected the ECB’s allegations of
invalidity based on lack of novelty, lack of inventive step and insufficiency,
but held that the patent was invalid for added subject matter. The English
Court’s decision does not affect the validity of the Patent in other European
countries.  On March 30, 2007, the English Court awarded the ECB 30%
of their costs (including legal fees) of the initial trial, of which the Company
paid 90,000 British pounds ($182,000 based on the applicable exchange rate on
that date) on April 19, 2007.    In July 2007, the Company posted
a bond of 87,500 British pounds ($131,000 at March 31, 2009), as collateral for
the appeal costs which is recorded as restricted cash at March 31, 2009 and
December 31, 2008.  On June 19, 2008, the Company paid an additional
87,500 British pounds ($177,000 based on the applicable exchange rate on that
date) towards the ECB’s costs of the English appeal.  In January 2009,
the Company received a formal request for fee reimbursement from the ECB for a
total of 290,000 pounds ($417,000 at March 31, 2009), in addition
to amounts already paid by the Company.  The Company hired an
independent firm to assist the Company in reducing or eliminating the ECB’s fee
request, however, the Company has recorded a $327,000 contingency
in relation to this matter. The Company expects that the UK fee issue will be
resolved in second half of 2009.





On March
27, 2007 the Bundespatentgericht of the Federal Republic of Germany ruled that
the German part of the Patent was valid, having considered the English Court’s
decision.  As a result of this ruling, the Company expects to be
awarded reimbursements for its costs associated with the German validity case,
which is Euro 44,692 ($61,000 at March 31, 2009), which the Company will
record when the amount, if any, is received.  The ECB has filed an
appeal against that decision, which is not expected to be decided before
2010.  On January 9, 2008 the French Court held that the Patent was
invalid in France for the same reasons given by the English
Court.  The Company is required to pay de minimus attorneys’ fees of
the ECB as a result of the French decision.  The Company filed an
appeal against the French decision on May 7, 2008.  On March 12, 2008
the Dutch Court, having considered the English, German and French decisions,
ruled that the Patent is valid in the Netherlands.  The ECB filed an
appeal against the Dutch decision on March 27, 2008. A trial was also held in
Madrid, Spain on June 3 and 5, 2008 and oral and written closing submissions
were made on July 19, 2008. A judgment is expected in the second half of
2009.





The
Patent has thus been confirmed to be valid and enforceable in two jurisdictions
(Germany and the Netherlands) that use the Euro as its national currency
allowing us to proceed with infringement cases in these countries if we choose
to do so.  Additional trials on the validity of the Patent are
expected in other European jurisdictions in 2009.




10





On August
20, 2008, the Company entered into an agreement with Trebuchet Capital Partners,
LLC (“Trebuchet”) under which Trebuchet has agreed to pay substantially all
of the litigation costs associated with pending validity proceedings initiated
by the European Central Bank (“ECB”) in eight European countries relating to the
Company’s European Patent 0 455 750B1 that the Company  has claimed
the ECB infringed in printing of the Euro currency (the “Patent”). Trebuchet
also agreed to pay substantially all of the litigation costs associated with
future validity challenges filed by the ECB or other parties, provided that
Trebuchet elects to assume the defense of any such challenges, in its sole
discretion, and patent infringement suits filed against the ECB and certain
other alleged infringers of the Patent, all of which suits may be brought at the
sole discretion of Trebuchet and may be in the name of the Company, Trebuchet or
both. The Company provided Trebuchet with the sole and exclusive right to manage
infringement litigation relating to the Patent in Europe, including the right to
initiate litigation in the name of the Company, Trebuchet or both and to choose
whom and where to sue, subject to certain limitations set forth in the agreement
under the terms of the Agreement, and in consideration for the Trebuchet's
funding obligations, the Company assigned and transferred a 49% interest of the
Company's rights, title and interest in the Patent to Trebuchet which allows
Trebuchet to have a separate and distinct interest in and share of the Patent,
along with the right to sue and recover in litigation, settlement or otherwise
to collect royalties or other payments under or on account of the Patent. In
addition, the Company and Trebuchet have agreed to equally share all proceeds
generated from litigation relating to the Patent, including judgments and
licenses or other arrangements entered into in settlement of any such
litigation. Trebuchet is also entitled to recoup any litigation expenses
specifically awarded to the Company in such actions.





On
January 31, 2003, the Company commenced an action, unrelated to the above ECB
litigation, entitled New Sky Communications, Inc., As Successor-In-Interest To
Thomas M. Wicker, Thomas M.Wicker Enterprises, Inc. and Document Security
Consultants V. Adler Technologies, Inc. N/K/A Adlertech International, Inc. and
Andrew McTaggert (United States District Court, Western District Of New York
Case No.03-Cv-6044t(F)) regarding certain intellectual property in which the
Company has an interest. The Company commenced this action alleging various
causes of action against Adler Technologies, Inc. and Andrew McTaggert for
breach of contract, breach of the duty of good faith and fair dealing, various
business torts, including unfair competition and declaratory relief. Adler
distributes and supplies anti-counterfeit document products and Mr. McTaggert is
a principal of Adler. Adler had entered into several purported agreements with
Thomas M. Wicker Enterprises and Document Security Consultants, both of which
the Company acquired in 2002. These alleged agreements, generally, would have
authorized Adler to manufacture in Canada the Company’s “Checkmate®” patented
system for verifying the authenticity of currency and documents. Other purported
agreements were signed between these parties and Thomas Wicker regarding other
technology claimed to have been owned by Wicker and assigned to the
Company.  Among other things, the Company contends that certain of the
purported agreements are not binding and/or enforceable.  To the
extent any of them are binding and enforceable, the Company claims that Adler
has breached these purported agreements, failed to make an appropriate
accounting and payments under them, and may have exceeded the scope of its
license. Adler has denied the material allegations of the complaint and has
counterclaimed against the Company, claiming Adler owns or co-owns or has a
license to use certain of the Company’s technologies.  In May 2005,
the Company filed a first amended and supplemental complaint adding Blanks/USA
and Raymond Maxon as additional defendants.  In February 2007, the
Company filed a second amended and supplemental complaint adding Judith Wu
(McTaggert’s wife) and Arcis Digital Security, Inc. (a company in which Ms. Wu
is involved) as additional defendants.  Maxon has asserted a
counterclaim against the Company contending that the Company’s purported
acquisition of a certain patent from Thomas Wicker in 2002 gave rise to an
alleged right on the part of Maxon to receive a portion of Thomas Wicker’s
proceeds from such acquisition.  The Company has denied the material
allegations of all of the counterclaims.  If Adler or Maxon is
successful, it may materially affect the Company, the Company’s financial
condition, and the Company’s ability to market and sell certain of the Company
technology and related products.  This case is in discovery phase, and
it is too soon to determine how the various issues raised by the lawsuit will be
determined.





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.





Contingent
Litigation Payment – In May 2005, the Company made an agreement with its
legal counsel in charge of the Company’s litigation with the European Central
Bank 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.




In
addition, pursuant to an agreement made in December 2004, the Company is
required to share the economic benefit derived from settlements, licenses or
subsequent business arrangements that the Company obtains from any infringer of
patents formerly owned by the Wicker Family.  For infringement matters
involving certain U.S. patents, the Company will be required to disburse 30% of
the settlement proceeds.  For infringement matters involving certain
foreign patents, the Company will be required to disburse 14% of the settlement
proceeds.  These payments do not apply to licenses or royalties to
patents that the Company has developed or obtained from persons other than the
Wicker Family.  As of March 31, 2009, there have been no settlement
amounts related to these agreements.




11





Contingent
Purchase Price-In December, 2008, the Company acquired
substantially all of the assets of DPI of Rochester, LLC (“DPI”) in which the
Company guaranteed up to $50,000 to certain parties depending on whether certain
conditions occurred within five years of the acquisition.   As of
March 31, 2009, the Company considers the likelihood that the payment will be
required as remote.





Employment
agreements - In May 2008, the Company entered into a Separation Agreement
with its former President that, among other things, accelerated the vesting of
33,333 shares of restricted common stock of the Company that were previously
awarded to the former President pursuant to the Company’s 2004 Employee Stock
Option Plan so that such shares vested in equal monthly installments during the
immediately following ten months.  The Separation Agreement further
provided that if the former President did not realize at least $212,000 in gross
proceeds from the sale of such 33,333 shares of restricted stock upon their
vesting, then the Company would pay the former President the amount that such
proceeds is less than $212,000 in cash or additional shares of common stock of
the Company.  As of March 31, 2009, all 33,333 shares had vested
generating gross proceeds of approximately $99,000.  The Company has
not finalized the terms of the settlement of the remaining amount due of
$113,000, which is recorded in accrued expenses as of March 31,
2009.





Operating Leases
-In March 2009, the Company, through its wholly-owned subsidiary DPI
Secuprint, entered into two operating lease agreements for production equipment
with Baum Capital Investments.  The leases contain end of lease
residual values that aggregate a total of $800,000.   Pursuant to
these lease agreements, the Company is subject to certain conditions that place
restrictions on the ability of DPI Secuprint to transfer cash or other assets to
its parent, Document Security Systems, or other subsidiaries, during the lives
of the leases.  Total lease commitments associated with these leases
are as follows:





2009
              
              
              242,9092010
              
              
              422,1312011
              
              
              440,3482012
              
              
              394,4192013
              
              
              274,175Thereafter
              
              
              545,921Total
              
              $
              2,319,903




9.    
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 DPI Secuprint, are engaged
in various aspects of developing and applying printing technologies and
procedures to produce, or allow others to produce, documents with a wide range
of features, including the Company’s patented technologies and trade
secrets.  For the purposes of providing segment information, these
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”.  A summary of the two reportable
segments  follows:




Security
      and
              Commercial
              Printing
            License,
      manufacture and sale of patented document security technologies, including
      digital security print solutions, and general commercial printing,
      primarily on paper and plastic.  Comprises the operations of
      Document Security Systems, Plastic Printing Professionals, and DPI
      Secuprint, which the Company acquired on December 18,
      2008.Legal
      Supplies
            Sale
      of specialty legal supplies, primarily to lawyers and law firms located
      throughout the United States as
Legalstore.com.




12




Approximate
information concerning the Company’s operations by reportable segment for the
three months ended March 31, 2009 and 2008 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:




3 months ended March
      31,  2009:
              
              Legal
    Supplies
              
              
              Security and Commercial
      Printing
              
              
              Corporate
              
              
              TotalRevenues from external
      customers
              
              $
              139,000
              
              
              $
              2,640,000
              
              
              $
              -
              
              
              $
              2,779,000Depreciation and
      amortization
              
              
              5,000
              
              
              
              404,000
              
              
              
              1,000
              
              
              
              410,000Net income
      (loss)
              
              
              17,000
              
              
              
              (336,000
              )
              
              
              (625,000
              )
              
              
              (944,000
              )3 months ended March
      31,  2008:Revenues from external
      customers
              
              $
              173,000
              
              
              $
              1,269,000
              
              
              $
              -
              
              
              $
              1,442,000Depreciation and
      amortization
              
              
              4,000
              
              
              
              601,000
              
              
              
              1,000
              
              
              
              606,000Net income
      (loss)
              
              
              8,000
              
              
              
              (1,709,000
              )
              
              
              (599,000
              )
              
              
              (2,300,000
              )




13




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




FORWARD-LOOKING
STATEMENTS




Certain
statements contained herein constitute “forward-looking statements” within the
meaning of the Private Securities Litigation Reform Act of 1995 (the “1995
Reform Act”).   Document Security Systems, Inc. desires to avail
itself of certain “safe harbor” provisions of the 1995 Reform Act and is
therefore including this special note to enable us to do so.  Except
for the historical information contained herein, this report contains
forward-looking statements (identified by the words "estimate," "project,"
"anticipate," "plan," "expect," "intend," "believe," "hope," "strategy" and
similar expressions), which are based on our current expectations and speak only
as of the date made. These forward-looking statements are subject to various
risks, uncertainties and factors, including, without limitation, those contained
in our Form 10-K for the year ended December 31, 2008 and those described herein
that could cause actual results to differ materially from the results
anticipated in the forward-looking statements.




Overview




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





Our core business is counterfeit
prevention, brand protection and validation of authentic print media, including
government-issued documents, currency, private corporate record and,
securities.  We believe we are a world leader in the research and
development of optical deterrent technologies and have commercialized these
technologies with a broad suite of products that offer our customers a wide
array of document security solutions to satisfy their specific
anti-counterfeiting requirements.  Our technology can be used in
securing sensitive and critical documents such as currency, automobile titles,
spare parts forms for the aerospace industry, gift certificates, permits,
checks, licenses, receipts, prescription and medical forms, engineering
schematics, ID cards, labels, original music, coupons, homeland security
manuals, consumer product and pharmaceutical packaging, tickets, and school
transcripts.  In addition, we have developed a digital product to
implement our technologies in Internet-based environments utilizing standard
desktop printers.  We believe that our digital technology greatly
expands the reach and potential market for our technologies and solutions.In December 2008, we
acquired substantially all of the assets of DPI ofRochester, LLC, a privately held commercial
printer located inRochester,NYwith approximately $7.6 million in
sales in 2007.   We formed a new subsidiary called DPI Secuprint
to house this new company.  As a result of this acquisition, we have
significantly improved our ability to meet our current and expected future
demand of our security paper products as well as improving our competitiveness
in the market for custom security printing, especially in the areas of vital
records, coupons, transcripts, and prescription paper.   In
addition, as a result of the acquisition, we believe we can offer our customers
a wider range of commercial printing offerings.




Technologies





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




14




Products
and Services





Generic Security
Paper:Our
primary product for the retail end-user market is AuthentiGuard® Security
Paper.  AuthentiGuard® Security Paper is blank paper that contains our
Pantograph 4000TM technology.  The paper reveals hidden warning words,
logos or images using The Authenticator- our proprietary viewing lens – or when
the paper is faxed, copied or scanned.  The hidden words appear on the
duplicate or the computer digital file and essentially prevent documents,
including forms, coupons and tickets, from being counterfeited.  We
market and sell our AuthentiGuard® Security Paper primarily through one major
paper distributors:Boise.  Since 2005,Boisehas marketed our AuthentiGuard®
Security Paper under its Boise Beware brand name inNorth America, primarily through its commercial paper
sales group. We retain the rights to sell the AuthentiGuard® Security Paper
directly to end-users anywhere in the world.





Security andCommercialPrinting:  Our technology portfolio
allows us to create unique custom secure paper, plastic, packaging and
Internet-based and software enterprise solutions.  We market and sell
to end-users that require anti-counterfeiting and authentication features in a
wide range of printed materials such as documents, vital records, prescription
paper, driver’s licenses, birth certificates, receipts, manuals, identification
materials, entertainment tickets, coupons, parts tracking forms, as well as
product packaging including pharmaceutical and a wide range of consumer
goods.  In addition, we provide a full range of digital and large
offset commercial printing capabilities to our customers.





Since our inception, we have primarily
outsourced the production of the majority of our custom security print orders to
strategic printing vendors.  In December 2008, we acquired a
commercial printer with long-run offset and short run digital printing
capabilities that will allow us to produce the majority of our security print
orders in-house.As a result of this acquisition, we have
significantly improved our ability to meet our current and expected future
demand of our security paper products as well as improving our competitiveness
in the market for custom security printing, especially in the areas of vital
records, coupons, transcripts, and prescription
paper.We
produce our plastic printed documents such as ID cards, event badges, and driver
licenses at our are manufacturing facility inBrisbane,Californiaunder the name Plastic Printing
Professionals. In late 2007, we moved our P3 manufacturing facility to a 25,000
square foot facility in order to increase our plastic manufacturing capacity,
and during 2008, we upgraded their production capabilities by adding equipment
that will improve its productivity, along with equipment for high speed data
encoding and equipment for production of high-volume precision RFID
cards.





Digital Security
Solutions:Using software that we have developed,
we can electronically render several of our technologies digitally to extend the
use of optical security to the end-user of sensitive
information.  With our  AuthentiGuardTM DX  we
market a networked appliance that allows the author of any Microsoft Office
document (Outlook, Word, Excel, or PowerPoint) to secure nearly any of its
alphanumeric content when it is printed or digitally stored. AuthentiGuard® DX
prints selected content using DMC’S patented technology so that it cannot be
read by the naked eye.Readingthe hidden content, or authenticating
the document is performed with a proprietary viewing device or
software.





Technology
Licensing:We
license our anti-counterfeiting technology and trade secrets to security
printers through licensing arrangements.  We seek licensees that have
a broad customer base that can benefit from our technologies or have unique and
strategic capabilities that expand the capabilities that we can offer our
potential customers.Licenses can be for a single technology
or for a package of technologies.  We offer licensees a variety of
pricing models, including:





·
            Pay us one price per
      year;


·
            Pay us a percentage of gross sales
      price of the product containing the technology during the term;
      or


·
            Joint venture or profit sharing
      arrangement.





Legal
Products:  We
also own and operate Legalstore.com, an Internet company which sells legal
supplies and documents, including security paper and products for the users of
legal documents and supplies in the legal, medical andeducational fields.




Results of
Operations for the Three Months Ended March 31, 2009
Compared to the Three Months ended March 31, 2008




The following discussion and analysis provides information that our management
believes is relevant to an assessment and understanding of our results of
operations and financial condition. The discussion should be read in conjunction
with the financial statements and footnotes in this quarterly report and in our
annual report on Form 10-K for the year ended December 31, 2008.




15




Revenue




Three Months Ended March 31,
      2009
              
              
              Three Months Ended March 31,
      2008
              
              
              % change vs.
      2008RevenueSecurity and commercial
      printing
              
              $
              2,417,000
              
              
              $
              932,000
              
              
              
              159
              %Technology license royalties
      and digital solutions
              
              
              223,000
              
              
              
              337,000
              
              
              
              -34
              %Legal
      products
              
              
              139,000
              
              
              
              173,000
              
              
              
              -20
              %Total
    Revenue
              
              
              2,779,000
              
              
              
              1,442,000
              
              
              
              93
              %






For the
three months ended March 31, 2009, revenue increased 93% from the same period in
2008.  The increase in revenue was the result of the Company’s
acquisition of its commercial printing business in December 2008, which
generated $1.7 million in revenue during first quarter of
2009.    Otherwise, sales in the first quarter of 2009 in
the Company’s other divisions were a total of $1,079,000, a decrease of 25% as
compared to the first quarter of 2008.  All of the Company’s divisions
were adversely affected by significant delays or reductions in orders by core
customers that reflected the rapid decline in the U.S. and global economies
during the latter half of 2008 and the first quarter of
2009.    The Company expects that demand in each of its
divisions, including its newly acquired commercial printing division will return
to historical levels during the latter half of 2009 as the U.S. and global
economies stabilize.




Cost
of Sales and Gross Profit




Three Months Ended March 31,
      2009
              
              
              Three Months Ended March 31,
      2008
              
              
              % change vs.
      2008Costs of
      revenueSecurity and commercial
      printing
              
              $
              1,575,000
              
              
              $
              596,000
              
              
              
              164
              %Technology license royalties and
      digital solutions
              
              
              4,000
              
              
              
              4,000
              
              
              
              0
              %Legal
    products
              
              
              63,000
              
              
              
              97,000
              
              
              
              -35
              %Total cost of
      revenue
              
              
              1,642,000
              
              
              
              697,000
              
              
              
              136
              %Gross
profitSecurity and commercial
      printing
              
              
              842,000
              
              
              
              336,000
              
              
              
              151
              %Technology license royalties and
      digital solutions
              
              
              219,000
              
              
              
              333,000
              
              
              
              -34
              %Legal
    products
              
              
              76,000
              
              
              
              77,000
              
              
              
              -1
              %Total gross
      profit
              
              
              1,137,000
              
              
              
              746,000
              
              
              
              52
              %






Three Months Ended March 31,
      2009
              
              
              Three Months Ended March 31,
      2008
              
              
              % change vs.
      2008Gross profit
      percentage:
              
              
              41
              %
              
              
              52
              %
              
              
              -21
              %




Gross
profit increased 52% to $1,137,000 in the first quarter of 2009 as compared to
the first quarter of 2008 as the result of the Company’s acquisition of its
commercial printing business in December 2008, which generated $504,000 of gross
profit during the 2009 quarter.   Gross profits in the Company’s
other divisions was $633,000, a decline of approximately 15% for these divisions
from the first quarter of 2008.   Gross profit percentage
decreased 21% to 41% primarily as the result of the change in product mix caused
by the Company’s acquisition of its commercial printing business in December
2008.    In addition, the Company increased equipment costs
at its plastic printing facility in late 2008, which increased its fixed
production costs, that have lowered margins in that division, which were
slightly offset by reductions in labor costs as a result of the efficiencies
created by the new equipment.  The Company expects to further leverage
its new equipment to increase its gross margins in its plastics division during
2009.




16




Operating
Expenses




Three Months
                Ended
                March 31,
    2009
              
              
              Three Months
                Ended
                March 31,
    2008
              
              
              % change vs.
      2008Operating
      ExpensesSales, general and administrative
      compensation
              
              $
              953,000
              
              
              $
              780,000
              
              
              
              22
              %Professional
      Fees
              
              
              247,000
              
              
              
              367,000
              
              
              
              -33
              %Sales and
      marketing
              
              
              60,000
              
              
              
              184,000
              
              
              
              -67
              %Research and
      development
              
              
              87,000
              
              
              
              115,000
              
              
              
              -24
              %Rent and
      utilities
              
              
              177,000
              
              
              
              159,000
              
              
              
              11
              %Other
              
              
              191,000
              
              
              
              136,000
              
              
              
              40
              %1,715,000
              
              
              
              1,741,000
              
              
              
              -1
              %Other Operating
      ExpensesDepreciation and
      amortization
              
              
              40,000
              
              
              
              42,000
              
              
              
              -5
              %Stock based
      payments
              
              
              (145,000
              )
              
              
              407,000
              
              
              
              -136
              %Impairment of patent defense
      costs
              
              
              -
              
              
              
              292,000Amortization of
      intangibles
              
              
              323,000
              
              
              
              527,000
              
              
              
              -39
              %218,000
              
              
              
              1,268,000
              
              
              
              -83
              %Total Operating
      Expenses
              
              
              1,933,000
              
              
              
              3,009,000
              
              
              
              -36
              %




Selling, General and
Administrative




Sales, general and
administrative compensation costs were 22% higher in the first quarter of
2009 due to the inclusion of sales and administrative staff additions as the
result of the Company’s acquisition of its commercial printing business in
December 2008.   Otherwise, SG&A compensation costs would
have decreased 16% during the first quarter of 2009 as compared to the first
quarter of 2008 as the result of staff reductions that the Company initiated in
the middle of 2008.




Professional feesdecreased during the first quarter of 2009 from to the first quarter of
2008 as a result of significant decreases in non-patent related legal fees and
accounting fees as the Company had reduced Sarbanes –Oxley related compliance
costs as the result of the Company’s change in classification to a smaller
reporting company for its 2008 end of year audit.  .




Sales and marketing
expenses decreased in the first quarter of 2009 from to the first quarter of
2008 due to a significant reduction in travel expense associated with a change
in its global business development strategy during the middle of 2008 that
significantly reduced planned travel costs.  In addition, the Company
saw reductions in marketing consulting costs that were eliminated during the
Company’s cost reduction that were initiated in the middle of 2008.




Research and development
costsconsist primarily of compensation costs for research personnel and
direct costs for the use of third-party printers’ facilities to test our
technologies on equipment that we do not have access to
internally.   Research and development costs decreased in first
quarter of 2009 as compared to the first quarter of 2008 as the result of lower
external research costs and reduction in compensation cost as the Company
replaced its former vice president of technology, who left the Company in the
middle of 2008 with a software engineer who focuses on the Company’s digital
product development.




Rent and utilities
increased for the first quarter of 2009 over the comparable period in 2008 as a
result of the Company’s acquisition of its commercial printing business in
December 2008, which operates a 20,000 square foot facility in Rochester,
NY.




17




Other operating
expenses are primarily equipment maintenance and repairs, office supplies, IT
support, bad debt expense and insurance costs.  Increases in the first
quarter of 2009 reflect increases in equipment maintenance costs associated with
Company’s commercial printing operation, bad debt costs, and patent annuity
fees.




Stock-based
compensation includes expense charges for all stock-based awards to
employees, directors and consultants.  Such awards include option
grants, warrant grants, and restricted stock
awards.   Stock-based compensation decreased in the first quarter
of 2009 as a result of the reversal of approximately $346,000 of previously
recorded stock-based compensation expense for stock options and restricted
shares issued to one of the Company’s senior management team members which
terminated unvested as a result of that employee’ resignation in March
2009.   Furthermore, the stock-based compensation decease in the
first quarter of 2009 reflect the reduction in the usage of warrants issued to
third parties for services, and reductions in fair values of options granted in
the latter half of 2008 and the first quarter of 2009.




Impairment of Patent Defense
CostsOn March 19, 2008, the Company received notification
that its appeal of the invalidation of its European Patent 455750B1 in the UK
was not successful.  As result of the adverse court decision, the
Company recognized an impairment loss of $292,000 associated with the U.K appeal
as of March 31, 2008.  The impairment loss includes a judgment for
reimbursement of estimated counterpart legal fees.






Amortization of
intangibles expense decreased 39% in the first quarter of 2009 as
compared to the first quarter of 2008 as a result of the reduction in the
Company’s net capitalized patent acquisition and defense costs asset, which
was  $1.7 million as of March 31, 2009 compared to $4.6 million as of
March 31, 2008.  The reduction in the Company’s patent acquisition and
defense costs was due to the Company’s transfer and assignment of 49% of its
interest in the patent to a third-party in August 2008, which resulted in a
reduction in the asset of approximately $1.7 million.




Other
Income and expenses




During
the first quarter of 2009, the Company had significant increase in interest
expense as a result of the Company’s borrowings it made during 2008 against its
various credit facilities, along with interest associated with several capital
leases the Company entered into in late 2007.   As of March 31,
2009, the Company had $3.1 million outstanding under it revolving notes at an
interest rate of LIBOR plus 2%, which was approximately 3.98% as of March 31,
2009.  In addition, during the 2009 quarter, the Company paid interest
on its $900,000 Secured Promissory Note which had an annual interest rate of
15%.  The interest rate on this note is scheduled to be reduced to 12%
depending on whether certain conditions are satisfied, which the Company
believes was achieved as of March 31, 2009.





During
the first quarter of 2009, the Company also incurred amortization of note
discount expense of approximately $62,000 for warrants that were issued in
conjunction with the secured promissory note which had a fair value of
approximately $256,000 and will be amortized over the term of the
note.




Net
Loss and Loss Per Share




Three Months
                Ended
                March 31,
    2009
              
              
              Three Months
                Ended
                March 31,
    2008
              
              
              % change vs.
      2008Net loss
              
              
              (944,000
              )
              
              
              (2,300,000
              )
              
              
              -59
              %Net loss per share, basic and
      diluted
              
              $
              (0.07
              )
              
              $
              (0.17
              )
              
              
              -61
              %Weighted average common shares
      outstanding, basic and diluted
              
              
              14,378,609
              
              
              
              13,654,364
              
              
              
              5
              %




During the first quarter of 2009, the
Company experienced a net loss of $944,000, a 59% decrease from the net loss of
the first quarter of 2008.  The decrease in net loss during the
quarter was primarily the result of the significant increase in the Company’s
revenues and gross profits caused by the Company’s acquisition of its commercial
printing business in December 2008, coupled with significant reductions in the
Company’s operating expenses as detailed above, including a large reversal of
previously recorded stock based compensation expense.  In addition,
the net loss during 2008 reflects the impact of a $292,000 impairment charge
that was not incurred during the 2009 quarter.




18




LIQUIDITY
AND CAPITAL RESOURCES




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


As Of And For The Period
      Ended:March 31,
    2009
              
              
              March 31,
    2008
              
              
              % change vs.
      2008Cash flows
      from:Operating
      activities
              
              $
              (659,000
              )
              
              $
              (964,000
              )
              
              
              32
              %Investing
      activities
              
              
              (39,000
              )
              
              
              (583,000
              )
              
              
              93
              %Financing
      activities
              
              
              779,000
              
              
              
              959,000
              
              
              
              19
              %Working
    capital
              
              
              (4,505,000
              )
              
              
              (1,792,000
              )
              
              
              151
              %Current
    ratio
              
              
              0.34
              x
              
              
              0.50
              x
              
              
              -32
              %Cash and cash
      equivalents
              
              $
              169,000
              
              
              $
              154,000
              
              
              
              10
              %Funds Available from Open Credit
      Facilities
              
              $
              517,000
              
              
              $
              2,310,000
              
              
              
              -78
              %




As of March 31, 2009, our cash and cash
equivalents were approximately $169,000, up from $88,000 at December 31,
2008.  The Company currently holds minimal amounts of cash at any
given time due to its reliance on its credit facilities to fund day-to-day cash
needs.   During the first quarter of 2009, the Company used
$659,000 of cash for operations and $39,000 for investments in long-lived assets
which were funded by borrowings from the Company’s credit
facilities.   These amounts were significantly lower than 2008
levels which reflects the improvement of the Company’s operating results,
including the positive impact on operating cash flows from theCompany’s
acquisition of its commercial printing business in December 2008.  In
addition, the Company essentially eliminated cash outflows associated with the
Company’s patent litigation efforts as a result of its litigation agreement in
August 2008 with Trebuchet Capital Partners.




Future Capital
NeedsWhile the Company expects these
favorable cash flow trends to continue in 2009, we expect to continue to use
cash for operations during the remainder of 2009.  The Company
estimates that it requires a revenue level of approximately $12.0 million to
$15.0 million to breakeven on operating cash flow basis.  This revenue
level is consistent with the 2008 pro-forma revenue level of the Company on a
consolidated basis with its newly acquired commercial printing business, DPI
Secuprint.  The Company believes that it can achieve this revenue
level by the end of 2009, if general economic conditions
stabilize.   Based on this expectation, the Company has committed
to focus its expenditures during 2009 on areas of research and development, and
sales and marketing that support near-term revenue
opportunities.   As of March 31, 2009, the Company has an
aggregate of $517,000 remaining available under two revolving notes that
terminate on January 4, 2010.We are also planning to
raise additional equity capital of up to $1.4 million in the private placement
of common stock in a transactionexempt from registration
under Section 4(2) and Regulation D, promulgated under the Securities Act of
1933, as amended.  There can be no assurance that the Company will
raise this additional equity capital on the anticipated terms, or at all, or
that the amount raised will be sufficient to meet our capital
needs.  The Company's ability to raise additional equity capital and
its business are subject to risks, including but not limited to, those described
in this report and in our other filings with the Securities and Exchange
Commission. This disclosure shall not constitute an offer to sell or the
solicitation of an offer to buy the securities described herein.  The
common stock offered will not be and has not been registered under the
Securities Act, and may not be offered or sold in the United States absent
registration or an applicable exemption from registration
requirements.




In December 2008, the Company borrowed
$900,000 of short term debt in conjunction with its acquisition of substantially
all of the assets of DPI, a commercial printer.  The Company expects
that existing working capital at DPI will be sufficient to satisfy the payment
of the $900,000 when due, in December 2009.  Furthermore, the Company
has two credit facilities with related parties that will be due in January
2010.   The total amount due may be up to $3,600,000 if the
Company cannot generate sufficient cash from operations to pay these credit
facilities prior to their due dates.    In the event that
the Company cannot pay these credit facilities when due, the Company believes
that it will be able to extend the terms of these notes, or negotiate with the
lenders other means of satisfying these credit facilities, including the payment
of amounts due in the form of the Company’s
equity.    However, there is no assurance that the Company
will be able to do so.The Company believes that
the funds available to it under its credit facility along with the anticipated
proceeds of the planned private placement will be sufficient to meet its
operating cash flow needs for the next twelve months.




19




ITEM 4T - CONTROLS AND
PROCEDURES




Evaluation
of Disclosure Controls and Procedures





Management is responsible for
establishing and maintaining effective disclosure controls and
procedures.  Our Chief Executive Officer and Chief Financial Officer
participated with our management in evaluating the effectiveness of our
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as
of the end of the period covered by this report to provide reasonable assurance
that information we are required to disclose in reports that we file or submit
under the Exchange Act is recorded, processed, summarized and reported within
the time periods specified in SEC rules and forms and that such information is
accumulated and communicated to management, including the CEO and the CFO, as
appropriate, to allow timely decisions regarding required
disclosure.





Based on this evaluation, and in light
of the material weaknesses in our internal control over financial reporting that
are discussed in our Annual Report on Form 10-K for the fiscal year ended
December 31, 2008 these officers have concluded that our disclosure controls and
procedures were not effective.  The material weaknesses consist of an
insufficient complement of qualified accounting personnel and controls
associated with segregation of duties and ineffective controls associated with
identifying and accounting for complex and non-routine transactions in
accordance with U.S. generally accepted accounting principles.  To
address the material weaknesses we performed additional analyses and other
post-closing procedures to ensure our consolidated financial statements were
prepared in accordance with accounting principles generally accepted in the
United States of America (U.S. GAAP). Notwithstanding these material weaknesses,
management believes that the financial statements included in this Quarterly
Report on Form 10-Q fairly present, in all material respects, our financial
condition, result of operations and cash flows for the periods
presented.





There
can be no assurance, however, that our disclosure controls and procedures will
detect or uncover all failures of persons within the Company and its
consolidated subsidiaries to disclose material information otherwise required to
be set forth in our periodic reports. There are inherent limitations to the
effectiveness of any system of disclosure controls and procedures, including the
possibility of human error and the circumvention or overriding of the controls
and procedures. Accordingly, even effective disclosure controls and procedures
can only provide reasonable, not absolute, assurance of achieving their control
objectives.





Changes
in Internal Control Over Financial Reporting





During
the first quarter of 2009, the Company began to incorporate the accounting staff
from its acquisition of a commercial printer in December 2008 into its financial
reporting process and will seek to use these new resources to improve its areas
of deficiency in the financial reporting process.The Company will evaluate
the effect of its changes in internal controls during its annual assessment of
its internal controls as of December 31, 2009.   Additionally, as
described above under "Controls And Procedures -
Evaluation of Disclosure Controls and Procedures," we also began implementing
additional procedures to address the material weaknesses identified in our
internal controls over financial reporting.





An
evaluation was performed under the supervision of the Company’s management,
including the CEO and CFO, as required under Exchange Act Rule 13a-15(d) and
15d-15(d), of whether any change in the Company’s internal control over
financial reporting occurred during the fiscal quarter ended March 31,
2009.  Based on that evaluation, the Company’s management, including
the CEO and CFO, concluded that, other than the changes discussed above, no
other changes in our internal control over financial reporting occurred during
the first quarter of 2009 that have materially affected, or are reasonably
likely to materially affect, our internal control over financial
reporting.




20




PART
II


OTHER
INFORMATION




ITEM
1 - LEGAL PROCEEDINGS




Information concerning pending legal
proceedings is incorporated herein by reference to Note 8 to the Condensed
Consolidated Financial Statements (Unaudited) in Part I of this Form
10-Q.




On August
1, 2005, we commenced a suit against the European Central Bank (“ECB”) alleging
patent infringement by the ECB and claimed unspecified damages. We brought the
suit in the European Court of First Instance in Luxembourg.  We
alleged that all Euro banknotes in circulation infringe the Company European
Patent 0 455 750B1 (the “Patent”), which covers a method of incorporating an
anti-counterfeiting feature into banknotes or similar security documents to
protect against forgeries by digital scanning and copying
devices.  The Court of First Instance ruled on September 5, 2007 that
it does not have jurisdiction to rule on the patent infringement claim, and also
ruled that we will be required to pay attorneys and court fees of the
ECB.  The ECB formally requested the Company to pay attorneys and
court fees in the amount of Euro 93,752 ($128,000 as of March 31, 2009), which,
unless the amount is settled will be subject to an assessment procedure that
will not likely be concluded until approximately the middle of 2009, which the
Company will accrue as soon as the assessed amount, if any, is reasonably
estimatable.




On
March 24, 2006, we received notice that the ECB has filed a separate claim in
the United Kingdom and Luxembourg courts seeking the invalidation of the
Patent.  Proceedings were commenced before the national courts seeking
revocation and declarations of invalidity of the Patent in each of the
Netherlands, Belgium, Italy, France, Spain, Germany and Austria.  On
March 26, 2007, the High Court of Justice, Chancery Division, Patents Court in
London, England (the “English Court”) ruled that the Patent was deemed invalid
in the United Kingdom, and on March 19, 2008 this decision was upheld on
appeal.  The English Court rejected the ECB’s allegations of
invalidity based on lack of novelty, lack of inventive step and insufficiency,
but held that the patent was invalid for added subject matter. The English
Court’s decision does not affect the validity of the Patent in other European
countries.  On March 30, 2007, the English Court awarded the ECB 30%
of their costs (including legal fees) of the initial trial, of which the Company
paid 90,000 British pounds ($182,000 based on the applicable exchange rate on
that date) on April 19, 2007.    In July 2007, the Company
posted a bond of 87,500 British pounds ($131,000 at March 31, 2009), as
collateral for the appeal costs which is recorded as restricted cash at March
31, 2009 and December 31, 2008.  On June 19, 2008, the Company paid an
additional 87,500 British pounds ($177,000 based on the applicable exchange rate
on that date) towards the ECB’s costs of the English appeal.  In
January 2009, the Company received a formal request for fee reimbursement from
the ECB for a total of 290,000 pounds ($417,000 at March 31, 2009), in
addition to amounts already paid by the Company.  The Company
hired an independent firm to assist the Company in reducing or eliminating the
ECB’s fee request, however, the Company has recorded a $327,000 contingency in
relation to this matter. The Company expects that the UK fee issue will be
resolved in second half of 2009.





On March
27, 2007 the Bundespatentgericht of the Federal Republic of Germany ruled that
the German part of the Patent was valid, having considered the English Court’s
decision.  As a result of this ruling, the Company expects to be
awarded reimbursements for its costs associated with the German validity case,
which is Euro 44,692 ($61,000 at March 31, 2009), which the Company will
record when the amount, if any, is received.  The ECB has filed an
appeal against that decision, which is not expected to be decided before
2010.  On January 9, 2008 the French Court held that the Patent was
invalid in France for the same reasons given by the English
Court.  The Company is required to pay de minimus attorneys’ fees of
the ECB as a result of the French decision.  The Company filed an
appeal against the French decision on May 7, 2008.  On March 12, 2008
the Dutch Court, having considered the English, German and French decisions,
ruled that the Patent is valid in the Netherlands.  The ECB filed an
appeal against the Dutch decision on March 27, 2008. A trial was also held in
Madrid, Spain on June 3 and 5, 2008 and oral and written closing submissions
were made on July 19, 2008. A judgment is expected in the second half of
2009.





The
Patent has thus been confirmed to be valid and enforceable in two jurisdictions
(Germany and the Netherlands) that use the Euro as its national currency
allowing us to proceed with infringement cases in these countries if we choose
to do so.  Additional trials on the validity of the Patent are
expected in other European jurisdictions in 2009.





On August
20, 2008, the Company entered into an agreement with Trebuchet Capital Partners,
LLC (“Trebuchet”) under which Trebuchet has agreed to pay substantially all
of the litigation costs associated with pending validity proceedings initiated
by the European Central Bank (“ECB”) in eight European countries relating to the
Company’s European Patent 0 455 750B1 that the Company  has claimed
the ECB infringed in printing of the Euro currency (the “Patent”). Trebuchet
also agreed to pay substantially all of the litigation costs associated with
future validity challenges filed by the ECB or other parties, provided that
Trebuchet elects to assume the defense of any such challenges, in its sole
discretion, and patent infringement suits filed against the ECB and certain
other alleged infringers of the Patent, all of which suits may be brought at the
sole discretion of Trebuchet and may be in the name of the Company, Trebuchet or
both. The Company provided Trebuchet with the sole and exclusive right to manage
infringement litigation relating to the Patent in Europe, including the right to
initiate litigation in the name of the Company, Trebuchet or both and to choose
whom and where to sue, subject to certain limitations set forth in the agreement
under the terms of the Agreement, and in consideration for the Trebuchet's
funding obligations, the Company assigned and transferred a 49% interest of the
Company's rights, title and interest in the Patent to Trebuchet which allows
Trebuchet to have a separate and distinct interest in and share of the Patent,
along with the right to sue and recover in litigation, settlement or otherwise
to collect royalties or other payments under or on account of the Patent. In
addition, the Company and Trebuchet have agreed to equally share all proceeds
generated from litigation relating to the Patent, including judgments and
licenses or other arrangements entered into in settlement of any such
litigation. Trebuchet is also entitled to recoup any litigation expenses
specifically awarded to the Company in such actions.




21





On
January 31, 2003, the Company commenced an action, unrelated to the above ECB
litigation, entitled New Sky Communications, Inc., As Successor-In-Interest To
Thomas M. Wicker, Thomas M.Wicker Enterprises, Inc. and Document Security
Consultants V. Adler Technologies, Inc. N/K/A Adlertech International, Inc. and
Andrew McTaggert (United States District Court, Western District Of New York
Case No.03-Cv-6044t(F)) regarding certain intellectual property in which the
Company has an interest. The Company commenced this action alleging various
causes of action against Adler Technologies, Inc. and Andrew McTaggert for
breach of contract, breach of the duty of good faith and fair dealing, various
business torts, including unfair competition and declaratory relief. Adler
distributes and supplies anti-counterfeit document products and Mr. McTaggert is
a principal of Adler. Adler had entered into several purported agreements with
Thomas M. Wicker Enterprises and Document Security Consultants, both of which
the Company acquired in 2002. These alleged agreements, generally, would have
authorized Adler to manufacture in Canada the Company’s “Checkmate®” patented
system for verifying the authenticity of currency and documents. Other purported
agreements were signed between these parties and Thomas Wicker regarding other
technology claimed to have been owned by Wicker and assigned to the
Company.  Among other things, the Company contends that certain of the
purported agreements are not binding and/or enforceable.  To the
extent any of them are binding and enforceable, the Company claims that Adler
has breached these purported agreements, failed to make an appropriate
accounting and payments under them, and may have exceeded the scope of its
license. Adler has denied the material allegations of the complaint and has
counterclaimed against the Company, claiming Adler owns or co-owns or has a
license to use certain of the Company’s technologies.  In May 2005,
the Company filed a first amended and supplemental complaint adding Blanks/USA
and Raymond Maxon as additional defendants.  In February 2007, the
Company filed a second amended and supplemental complaint adding Judith Wu
(McTaggert’s wife) and Arcis Digital Security, Inc. (a company in which Ms. Wu
is involved) as additional defendants.  Maxon has asserted a
counterclaim against the Company contending that the Company’s purported
acquisition of a certain patent from Thomas Wicker in 2002 gave rise to an
alleged right on the part of Maxon to receive a portion of Thomas Wicker’s
proceeds from such acquisition.  The Company has denied the material
allegations of all of the counterclaims.  If Adler or Maxon is
successful, it may materially affect the Company, the Company’s financial
condition, and the Company’s ability to market and sell certain of the Company
technology and related products.  This case is in discovery phase, and
it is too soon to determine how the various issues raised by the lawsuit will be
determined.





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




ITEM
1A – RISK FACTORS




We face many significant risks in
our business, some of which are unknown to us and not presently foreseen. These
risks could have a material adverse impact on our business, financial condition
and results of operations in the future. We have disclosed a number of material
risks under Item 1A of our annual report on Form 10-K for the year ended
December 31, 2008, which we filed with the Securities and Exchange
Commission on March 31, 2009. The following discussion is of material
changes to risk factors disclosed in that report.




22





We
have two secured credit facilities that have large principal payments due in
January 2010 and a $900,000 secured loan due in December 2009, and if we are
unable to repay them with cash we may be forced to repay, in whole or in part,
with each credit facility's applicable collateral, which would have a material
adverse effect on our financial position.





On
January 4, 2008, we entered into two credit facilities with an aggregate
borrowing capacity of $3.6 million that is repayable in full on January 4, 2010.
One of these credit facilities has a borrowing limit of $3.0 million and is
secured by our stock in our Plastic Printing Professionals, Inc. subsidiary, and
the other credit facility has a borrowing limit of $600,000 and is secured by
our accounts receivable, excluding the accounts receivable of our subsidiary
Plastic Printing Professionals, Inc. As of March 31, 2009, we were in default of
both agreements due to a failure to pay interest when due.  Both
Fagenson & Co., Inc. and Patrick White have agreed to waive the
defaults through January 1, 2010.





On
December 18, 2008, our wholly owned subsidiary, Secuprint, Inc. (dba DPI
Secuprint, Inc.), entered into a secured loan of $900,000 to pay for most of the
cash portion of the purchase price of our acquisition of the assets of DPI of
Rochester, LLC.  The loan is due in December 2009 and is secured by
all of the assets of DPI Secuprint.





If we
cannot generate sufficient cash from operations or raise cash from other sources
including without limitation, fund-raising through additional sales of equity,
and if we cannot refinance the credit facilities or our secured loan, we may
have to repay, in whole or in part, one or all of the credit facilities or
secured loan with each credit facility's or note’s applicable collateral, which
would have a material adverse effect on our financial position.




Due
to our low cash balance and limited financing currently available to us, we may
in the near future have a number of obligations that we will be unable to meet
without generating additional income or raising additional
capital.  If we cannot generate additional income or raise additional
capital in the near future, we may become insolvent, fail to obtain appropriate
relief from bankruptcy, be made bankrupt and/or our stock may become illiquid or
worthless.





As of
March 31, 2009, our cash balance was approximately $169,000, and our current
liabilities totaled approximately $6,796,000, which
includes  $3,083,000 of short term debt under two credit facilities
that are due on January 2, 2010, and a $900,000 Secured Promissory Note due on
December 19, 2009.  In order to meet our operating needs and these
current obligations, we will need to generate additional income from operations
or obtain additional financing, including without limitation, fund-raising
through additional sales of equity.  We may also need to negotiate
with our lenders to extend or refinance our existing credit
facilities.  Additionally, our ability to utilize cash generated by
our DPI Secuprint subsidiary for corporate obligations is restricted by the
terms of certain of its third party equipment operating leases, which could
negatively affect our ability to raise cash from other sources, or to satisfy
our obligations.





If we do
not receive sufficient financing or sufficient funds from our operations we may
(i) liquidate assets,  (ii) seek or be forced into bankruptcy and/or
obtain appropriate relief from bankruptcy and/or, (iii) continue operations, but
incur material harm to our business,  operations or financial
condition. These measures could have a material adverse effect on our ability to
continue as a going concern.  Additionally, because of our financial
condition, our Board of Directors has a duty to our creditors that may conflict
with the interests of our stockholders.  Our Board of Directors may be
required to make decisions that favor the interests of creditors at the expense
of our stockholders to fulfill its fiduciary duty.  For instance, we
may be required to preserve our assets to maximize the repayment of debts versus
employing the assets to further grow our business and increase shareholder
value.  If we cannot generate enough income from our operations or are
unable to locate additional funds through financing, we may not have sufficient
resources to continue operations.





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





We have
incurred significant net losses in previous years.  Our ability to
fund our capital requirements out of our available cash and cash generated from
our operations depends on a number of factors. Some of these factors include our
ability to (i) increase security and commercial printing and plastic card sales
and (ii) increase sales of our digital products. While we have approximately
$517,000 of funds available to us under our various credit facilities as of
March 31, 2009, we are planning to raise additional funds in the future in order
to fund our working capital needs including equity capital.  If we are
not successful in generating needed funds from operations or in capital raising
transactions, we may need to reduce our costs which measures could include
selling or consolidating certain operations or assets, and delaying, canceling
or scaling back product development and marketing programs. These measures could
materially and adversely affect our ability to operate profitably.







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




None




23




ITEM 3 - DEFAULTS UPON SENIOR SECURITIES




On
January 4, 2008, the Company entered into a Credit Facility Agreement with
Fagenson and Co., Inc., as agent, a related party to Robert B.
Fagenson,  the Chairman of the Company's Board of Directors. Under the
Fagenson Credit Agreement, the Company can borrow up to a maximum of $3,000,000
from time to time up to and until January 4, 2010.  The advances are
generally limited to $400,000 unless otherwise mutually agreed upon by both
parties per fiscal quarter, with the exception of $600,000 that can be advanced
at any time for patent litigation related bills.  Any amount borrowed
by the Company pursuant to the Fagenson Credit Agreement will have an annual
interest rate of 2% above LIBOR and will be secured by the Common Stock of
Plastic Printing Professionals, Inc., (“P3”) the Company's wholly owned
subsidiary.  Interest is payable quarterly in arrears and the
principal is payable in full at the end of the term under the Fagenson Credit
Agreement.  In addition, on January 4, 2008, the Company also entered
into a Credit Facility Agreement with Patrick White, the Company's Chief
Executive Officer and a member of the Board of Directors.  Under the
White Credit Agreement, the Company can borrow up to $600,000 from time to time
up to and until January 4, 2010.  Any amount borrowed by the Company
pursuant to the White Credit Agreement will have an annual interest rate of 2%
above LIBOR and will be secured by the accounts receivable of the Company,
excluding the accounts receivable of P3.  Interest is payable
quarterly in arrears and the principal is payable in full at the end of the Term
under the White Credit Agreement.  Mr. White can accept common stock
as repayment of the loan upon a default.   Under the terms of the
agreement the Company is required to comply with various
covenants.  During the year ended December 31, 2007, Patrick White
advanced the Company $300,000 while the terms of the credit facility were being
finalized.  As of March 31, 2009, the Company has borrowed $3,083,000
under the Fagenson & Co., Inc. and White credit facility agreements and was
in default of both agreements due to a failure to pay interest when
due.  Both Fagenson & Co., Inc. and Patrick White have agreed to
waive the default through January 1, 2010.




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




None




ITEM
5 - OTHER INFORMATION




None




ITEM
6 - EXHIBITS




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





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




24






SIGNATURES






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




DOCUMENT
      SECURITY SYSTEMS, INC.May
      14, 2009
            
            By:
            /s/
      Patrick WhitePatrick
      White
              Chief
      Executive OfficerMay
      14, 2009
            
            By:
            /s/
      Philip JonesPhilip
      Jones
              Acting
      Chief Financial Officer
              (Vice
      President of Finance)




25