**UNITED
      STATES SECURITIES AND EXCHANGE**


**COMMISSION**


**Washington,
      D.C. 20549**




**FORM
      10-Q**




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


**THE
      SECURITIES EXCHANGE ACT OF 1934**




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




**1-32146**Commission
                file number





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





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





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





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





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





Indicate
                by check mark whether the registrant is a large accelerated filer,
                an
                accelerated filer, or a non-accelerated filer. See definition of
                “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the
                Exchange Act. (Check one):
              
              Large
                accelerated filer oAccelerated
                filer oNon-accelerated
                filer x
              
              Indicate
                by check mark whether the registrant is a shell company (as defined
                in
                Rule 12b-2 of the Exchange Act)
              **Yes
                o No
x**
              
              **Applicable
                only to corporate issuers**As
                of August 10, 2006 (the most recent practicable date), there were
                12,926,989 shares of the issuer's Common Stock, $0.02 par value per
                share,
                outstanding.Indicate
                by check mark whether the registrant is a shell company (as defined
                in
                Rule 12b-2 of the Exchange Act)
              **Yes
                  o
                  No x**









**DOCUMENT
                SECURITY SYSTEMS, INC.**
              **FORM
                10-Q**
              **TABLE
                OF CONTENTS****PART
                I**
            
            **FINANCIAL
                INFORMATION**Item
                1
            
            Financial
                StatementsConsolidated
                Balance Sheets
            
            3Consolidated
                Statements of Operations
            
            4Consolidated
                Statements of Cash Flows
            
            5Notes
                to Financial Statements
            
            6Item
                2
            
            Management's
                Discussion and Analysis of Financial Condition and Results of
                Operations
            
            17Item
                3
            
            Quantitative
                and Qualitative Disclosures about Market Risk
            
            28Item
                4
            
            Controls
                and Procedures
            
            28**PART
                II**
            
            **OTHER
                INFORMATION**Item
                1
            
            Legal
                Proceedings
            
            29Item
              1a
            
            Risk
                Factors
            
            29Item
                2
            
            UnregisteredSales
                of Equity Securities and Use of Proceeds
            
            35Item
                3
            
            Defaults
                upon Senior Securities
            
            36Item
                4
            
            Submission
                of Matters to a Vote of Security Holders
            
            36Item
                5
            
            Other
                Information
            
            36Item
                6
            
            Exhibits
            
            36**SIGNATURES**
            
            37





2




**PART
      I**




**FINANCIAL
      INFORMATION**




ITEM
      1 -
      FINANCIAL STATEMENTS


**DOCUMENT
                  SECURITY SYSTEMS, INC.  AND
                  SUBSIDIARIES****Consolidated
                  Balance SheetsAs of****June
                  30,**
              
              **December
                  31,****2006**
              
              **2005****(unaudited)**
              
              **(audited)****ASSETS****Current
                  assets:**Cash
                  and cash equivalents
              
              $
              1,703,240
              
              $
              3,953,482Accounts receivable, net
              
              
              692,724
              
              
              164,726Inventory
              
              
              276,551
              
              
              148,804Prepaid expenses and other current assets
              
              
              275,404
              
              
              225,114Total
                  current assets
              
              
              2,947,919
              
              
              4,492,126**Restricted
                  cash**
              
              
              240,000
              
              
              240,000**Fixed
                  assets, net**
              
              
              659,894
              
              
              451,195**Other
                  assets**
              
              
              159,948
              
              
              229,050**Goodwill**
              
              
              1,396,734
              
              
              711,785**Other
                  intangible assets, net**
              
              
              5,005,828
              
              
              4,208,962$
              10,410,323
              
              $
              10,333,118**LIABILITIES
                  AND STOCKHOLDERS' EQUITY****Current
                  liabilities:**Accounts
                  payable
              
              $
              1,505,606
              
              $
              547,512Accrued
                  expenses & other current liabilities
              
              
              285,957
              
              
              212,559Current
                  portion of long-term debt
              
              
              52,458
              
              
              50,891Current
                  portion of capitalized lease obligations
              
              
              34,817
              
              
              33,374Total
                  current liabilities
              
              
              1,878,838
              
              
              844,336**Long-term
                  debt**
              
              
              140,667
              
              
              167,309**Long-term
                  capital lease obligations**
              
              
              67,155
              
              
              84,931**Stockholders'
                  equity**Common
                  stock, $.02 par value;200,000,000
                  shares authorized,12,897,929 shares
                  issued and outstanding (12,698,872 in 2005)
              
              
              257,959
              
              
              253,977Additional paid-in capital
              
              
              22,662,234
              
              
              21,377,996Accumulated deficit
              
              
              (14,596,530
              )
              
              (12,395,431
              )Total
                  stockholders' equity
              
              
              8,323,663
              
              
              9,236,542$
              10,410,323
              
              $
              10,333,118




See
      accompanying notes




3




**DOCUMENT
                  SECURITY SYSTEMS, INC. AND SUBSIDIARIES****Consolidated
                  Statements of Operations****(unaudited)****Three
                  Months Ended**
              
              **Six
                  Months Ended****June
                  30,**
              
              **June
                  30,**
              
              **June
                  30,**
              
              **June
                  30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Sales,
                  net
              
              $
              1,309,805
              
              $
              491,074
              
              $
              2,172,515
              
              $
              924,274Costs
                  of sales
              
              
              718,643
              
              
              259,612
              
              
              1,264,840
              
              
              485,596**Gross
                  profit**
              
              
              591,162
              
              
              231,462
              
              
              907,675
              
              
              438,678**Operating
                  expenses:**Selling,
                  general and administrative expenses
              
              
              1,445,003
              
              
              590,876
              
              
              2,484,909
              
              
              1,282,657Research
                  and development
              
              
              96,282
              
              
              80,473
              
              
              168,884
              
              
              160,585Amortization
                  of intangibles
              
              
              268,275
              
              
              130,500
              
              
              488,275
              
              
              135,000Operating expenses
              
              
              1,809,560
              
              
              801,849
              
              
              3,142,068
              
              
              1,578,242**Operating
                    loss**
              
              
              (1,218,398
              )
              
              (570,387
              )
              
              (2,234,393
              )
              
              (1,139,564
              )Other
                  income (expense):Interest income
              
              
              17,242
              
              
              24,471
              
              
              44,138
              
              
              37,425Interest expense
              
              
              (5,381
              )
              
              (6,850
              )
              
              (10,844
              )
              
              (14,049
              )**Loss
                  before income taxes**
              
              
              (1,206,537
              )
              
              (552,766
              )
              
              (2,201,099
              )
              
              (1,116,188
              )Income
                  taxes
              
              
              -
              
              
              -
              
              
              -
              
              
              -**Net
                  loss**
              
              $
              (1,206,537
              )
              $
              (552,766
              )
              
              (2,201,099
              )
              
              (1,116,188
              )**Net
                  loss per share, basic and diluted**
              
              $
              (0.09
              )
              $
              (0.05
              )
              
              (0.17
              )
              
              (0.10
              )**Weighted
                  average common shares outstanding, basic and
                  diluted**
              
              
              12,850,491
              
              
              12,100,413
              
              
              12,824,935
              
              
              11,636,333




See
      accompanying notes.




4


**DOCUMENT
                  SECURITY SYSTEMS, INC. AND SUBSIDIARIES****Consolidated
                  Statements of Cash Flows****For
                  the Six Months Ended June 30,****2006**
              
              **2005****(unaudited)**
              
              **(unaudited)****Cash
                  flows from operating activities:**Net loss
              
              $
              (2,201,099
              )
              $
              (1,116,188
              )Adjustments to reconcile net loss to net cash used by operating
                  activities:Depreciation and amortization expense
              
              
              607,410
              
              
              225,351Stock
                  based compensation
              
              
              280,450
              
              
              20,320(Increase) decrease in assets:Accounts receivable
              
              
              (362,012
              )
              
              150,751Inventory
              
              
              (57,600
              )
              
              (72,118
              )Prepaid expenses and other assets
              
              
              (8,385
              )
              
              (103,435
              )Increase in liabilities:Accounts payable and accrued expenses
              
              
              224,030
              
              
              4,199Net
                  cash used by operating activities
              
              
              (1,517,206
              )
              
              (891,120
              )**Cash
                  flows from investing activities:**Purchase
                  of fixed assets
              
              
              (69,887
              )
              
              (67,182
              )Acquisition
              
              
              (1,301,670
              )
              
              -Purchase
                  of other intangible assets
              
              
              (77,841
              )
              
              (122,306
              )Net
                  cash used by investing activities
              
              
              (1,449,398
              )
              
              (189,488
              )**Cash
                  flows from financing activities:**Repayment
                  of long-term debt
              
              
              (25,075
              )
              
              (23,598
              )Repayment
                  of capital lease obligations
              
              
              (16,333
              )
              
              (15,005
              )Issuance
                  of common stock, net
              
              
              757,770
              
              
              2,243,854Net
                  cash provided by financing activities
              
              
              716,362
              
              
              2,205,251**Net
                  increase (decrease) in cash and cash equivalents**
              
              
              (2,250,242
              )
              
              1,124,643**Cash
                  and cash equivalents beginning of period**
              
              
              3,953,482
              
              
              2,657,865**Cash
                  and cash equivalents end of period**
              
              $
              1,703,240
              
              $
              3,782,508




See
      accompanying notes.


5




**DOCUMENT
      SECURITY SYSTEMS, INC.**


**NOTES
      TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS**


**June
      30, 2006**


**(Unaudited)**




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




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





*Interim
      Financial Statements*




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




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




*Reclassifications*




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




*Use
      of Estimates*




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




6




*Share-Based
      Payments*




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




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




**2.
      Inventory**




Inventory
      consisted of the following:


**June
                    30,**
              
              **December
                  31,****2006**
              
              **2005****(unaudited)**
              
              **(audited)**Finished
                  Goods
              
              $
              202,237
              
              $
              148,804Materials
              
              
              74,314
              
              
              -$
              276,551
              
              $
              148,804




7




**3.    
      Goodwill and Other Intangible Assets**





***Other
      Intangible Assets*** -





Other
      intangible assets are comprised of the following:


**June
                  30,**
              
              **December
                  31,****Useful
                  Life**
              
              **2006**
              
              **2005**Royalty
                  rights
              
              
              5
                  years
              
              **$**
              90,000
              
              **$**
              90,000Other
                  Intangibles
              
              
              5
                  years
              
              
              666,300
              
              
              41,000Patent
                  and contractual rights
              
              
              Varied
                  (1
              )
              
              5,293,912
              
              
              4,634,071**6,050,212**
              
              
              **4,765,071**Less
                  accumulated amortization
              
              
              
              
              
              1,044,384
              
              
              556,109Net
                  carrying value
              
              
              
              
              **$**
              **5,005,828**
              
              **$**
              **4,208,962**(1)-
                  patent rights are amortized over their expected useful life which
                  is
                  generally the legal life of the patent. As of June 30, 2006 the
                  weighted
                  average expected useful life of these assets was 6.7
                  years.


***Goodwill
      -*** In
      accordance with the provisions of SFAS No. 142, "Goodwill and Other Intangible
      Assets" (SFAS 142), the Company performs an annual fair value test of its
      recorded goodwill for its reporting units using a discounted cash flow and
      capitalization of earnings approach. During the first quarter of 2006, the
      Company recorded a preliminary estimate of goodwill of $942,000 associated
      with
      its acquisition of the assets of Plastic Printing Professionals. During the
      second quarter of 2006, the Company revised its estimate of goodwill associated
      with this acquisition to $685,000. As of June 30, 2006, the Company’s goodwill
      of $1,397,000 consists of $81,000 attributable to the legal segment and
      $1,316,000 attributable to the document security segment. The Company plans
      to
      conduct annual impairment tests in the fourth quarter of each year, unless
      impairment indicators exist at an earlier date.




**4.    
      Acquisition**




On
      February 7, 2006, the Company acquired substantially all of the assets of
      Plastic Printing Professionals, Inc. ("P3") for $1.25 million in cash, 18,704
      shares of the Company’s Common Stock valued at $250,000 and the assumption of
      certain liabilities. The cash portion of the purchase price was paid using
      the
      Company’s cash on hand. P3 is a security printer specializing in plastic cards
      containing security technologies. P3 has 25 full-time employees and had sales
      of
      approximately $2.7 million in 2005.  Commencing
      on February 7, 2006, the results of P3’s operations are included in the
      consolidated financial statements of the Company. The Company accounted for
      the
      acquisition as a business combination under FASB 141 “Business Combinations”.
      During the quarter ended June 30, 2006, the Company revised its allocations
      from
      its preliminary estimates based upon the receipt of a valuation report that
      resulted in an increase in the amount allocated to acquired intangibles and
      a
      corresponding decrease in the amount allocated to goodwill of $225,000. The
      purchase price has been allocated based on the estimated fair market value
      of
      the assets acquired and liabilities assumed as follows:


Accounts
                  receivable
              
              $
              166,000Inventory
                  & pre-paid assets
              
              
              83,000Fixed
                  assets
              
              
              258,000Identified
                  intangible assets
              
              
              625,000Goodwil
              
              
              685,000Total
                  Assets
              
              $
              1,817,000Liabilities
                  Assumed
              
              $
              (265,000
              )Total
                  Purchase Price
              
              $
              1,552,000




8




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


**Three
                  Months Ended June 30,**
              
              **Six
                  Months Ended June 30,****2006**
              
              **2005**
              
              **2006**
              
              **2005****Revenue**
              
              $
              1,309,805
              
              $
              1,191,922
              
              $
              2,422,621
              
              $
              2,243,163**Operating
                  Loss**
              
              
              (1,218,398
              )
              
              (554,289
              )
              
              (2,239,163
              )
              
              (1,109,270
              )**Net
                  Loss**
              
              
              (1,206,537
              )
              
              (536,668
              )
              
              (2,205,423
              )
              
              (1,085,894
              )**Basic
                  and diluted loss per share**
              
              
              (0.09
              )
              
              (0.05
              )
              
              (0.17
              )
              
              (0.09
              )




**5.
      Stock Based Compensation**





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





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





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




9




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




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




The
      compensation cost that has been charged against income for options granted
      under
      the plans was approximately $21,000 and $42,000 for the three-month and
      six-month periods, respectively, ended June 30, 2006. The impact of these
      expenses to basic and diluted earnings per share was less than $0.01 during
      those periods. The adoption of SFAS 123R did not have an impact on cash flows
      from operating or financing activities. For stock options issued as non-ISO’s a
      tax deduction is not allowed until the options are exercised. The amount of
      this
      deduction will be the difference between the fair value of the Company’s Common
      Stock and the exercise price at the date of exercise. Accordingly, there is
      a
      deferred tax asset recorded for the tax effect of the financial statement
      expense recorded. The tax effect of the income tax deduction in excess of the
      financial statement expense will be recorded as an increase to additional
      paid-in capital. Due to the uncertainty of the Company’s ability to generate
      sufficient taxable income in the future to utilize the tax benefits of the
      options granted, the Company has recorded a valuation allowance to reduce gross
      deferred tax asset to zero. As a result for the periods ended June 30, 2006,
      there is no income tax expense impact from recording the fair value of options
      granted. No tax deduction is allowed for stock options issued as
      ISO’s.





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




**Six Months Ended June 30,****2006**
            
            **2005**Volatility
            
            
            42.6
            %
            
            80
            %Expected
                option term
            
            
            3
                years
            
            
            5
                yearsRisk-free
                interest rate
            
            
            4.4
            %
            
            4.0
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %





10




A
      summary
      of the status of the options granted under the 2004 Plan and the Director Plan,
      respectively, is presented below:


**2004
                  Employee Plan**
              
              **Non-Executive
                  Director Plan****Number
                  of Options**
              
              **Weighted
                  Average Exercise Price**
              
              **Weighted
                  Average Life Remaining**
              
              **Number
                  of Options**
              
              **Weighted
                  Average Exercise Price**
              
              **Weighted
                  Average Life Remaining**(years)
              
              
              
              
              
              (years)Outstanding
                  at December 31, 2005
              
              
              277,000
              
              
              8.05
              
              
              
              
              
              36,250
              
              
              5.47Granted
              
              
              -
              
              
              
              
              
              
              
              
              20,000
              
              
              12.65Exercised
              
              
              -
              
              
              
              
              
              
              
              
              -
              
              
              -Canceled
              
              
              50,000
              
              
              10.19
              
              
              
              
              
              -
              
              
              -Outstanding
                  at June 30, 2006:
              
              
              227,000
              
              
              7.58
              
              
              
              
              
              56,250
              
              
              8.02Exercisable
                  at June 30, 2006:
              
              
              217,000
              
              
              7.67
              
              
              
              
              
              36,250
              
              
              5.47Aggregate
                  Intrinsic Value of outstanding options at June 30, 2006
              
              $
              696,890
              
              
              
              
              
              4.1
              
              $
              187,775
              
              
              
              
              
              3.6Aggregate
                  Intrinsic Value of exercisable options at June 30, 2006
              
              $
              646,660
              
              
              
              
              
              4.1
              
              $
              187,775
              
              
              
              
              
              3.1





The
      weighted-average grant date fair value of options granted during the six-month
      period ended June 30, 2006 was $4.24 ($4.71 during the six-month period ended
      June 30, 2005). There were no options exercised during the six-month periods
      ended June 30, 2006 or 2005, respectively.





The
      following table summarizes the status of the Company’s non-vested options under
      the its stock option plans:


**Number
                  of Non-vested Shares Subject to Options**
              
              **Weighted-
                  Average Grant Date Fair Value**Non-vested
                  as of December 31, 2005
              
              
              10,000
              
              $
              3.68Non-vested
                  granted- six month period ended June 30, 2006
              
              
              20,000
              
              $
              4.24Vested
                  - six month period ended June 30, 2006
              
              
              -
              
              $
              -Forfeited
                  - six month period ended June 30, 2006
              
              
              -
              
              $
              -Non-vested
                  as of June 30,2006
              
              
              30,000
              
              $
              4.05


As
      of
      June 30, 2006, there was approximately $58,000 of total unrecognized
      compensation cost related to non-vested options. That cost will be recognized
      over a weighted average period of one year. The total fair value of shares
      that
      vested during the six-month period ended June 30, 2006 was $0 ($163,000 during
      the six-month period ended June 30, 2005).





11





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




For
      the
      quarterly and six-month periods ended June 30, 2005, the Company applied
      the intrinsic value method of accounting for stock options as prescribed by
      APB
      25. Since all options granted during the quarterly and six month periods ended
      June 30, 2005 had an exercise price equal to the closing market price of
      the underlying common stock on the grant date, no compensation expense was
      recognized. If compensation expense had been recognized based on the estimated
      fair value of each option granted in accordance with the provisions of SFAS
      123
      as amended by Statement of Financial Accounting Standard 148, our net loss
      and
      net loss per share would have been reduced to the following pro-forma amounts
      (in thousands, except per share amounts):


**June
                  30, 2005****Three
                  months ended**
              
              **Six
                  months ended**$
                  Amount
              
              $
                  Per share
              
              $
                  Amount
              
              $
                  Per shareNet
                  loss, as reported
              
              $
              (552,766
              )
              $
              (0.05
              )
              $
              (1,116,188
              )
              $
              (0.10
              )Fair
                  value method compensation expense, net of tax
              
              
              (36,073
              )
              
              (0.00
              )
              
              (225,221
              )
              
              (0.02
              )Net
                  loss, pro-forma
              
              $
              (588,839
              )
              $
              (0.05
              )
              $
              (1,341,409
              )
              $
              (0.12
              )





***Restricted
      Stock*** - Restricted common stock is issued for services to be rendered and may not be
      sold, transferred or pledged for such period as determined by our Compensation
      Committee. Restricted stock compensation cost is measured as the stock’s fair
      value based on the market price at the date of grant. The restricted shares
      issued reduce the amount available under our stock option plans. We recognize
      compensation cost only on restricted shares that will ultimately vest. We
      estimate the number of shares that will ultimately vest at each grant date
      based
      on our historical experience and adjust compensation cost and the carrying
      amount of unearned compensation based on changes in those estimates over time.
      Restricted stock compensation cost is recognized ratably over the requisite
      service period which approximates the vesting period. An employee may not sell
      or otherwise transfer unvested shares and, in the event that employment is
      terminated prior to the end of the vesting period, any unvested shares are
      surrendered to us. We have no obligation to repurchase restricted stock.





On
      June
      26, 2006, the Company granted 65,000 in restricted stock to recently hired
      employees, including 50,000 to its new President. The restricted stock vests
      over 3 years beginning on the grant date. The company will recognize
      compensation costs associated with these restricted shares of approximately
      $700,000 over the vesting periods.





12





The
      following is a summary with respect to restricted stock outstanding at
      June 30, 2006:





******Shares******
            
            **Weighted-
                average**
              **grant-date**
              **fair
                value per share******Restricted
                shares outstanding, December 31, 2005
            
            
            -
            
            $
            -Restricted
                shares granted
            
            
            65,000
            
            
            10.77Restricted
                shares vested
            
            
            -
            
            
            -Restricted
                shares forfeited
            
            
            -
            
            
            -Restricted
                shares outstanding, June 30, 2006
            
            
            65,000
            
            $
            10.77




**6.    
      Stockholders Equity**




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




***Stock
      Warrants*** - During
      the first half of 2006, the Company received approximately $758,000 in proceeds
      from the exercise of warrants.





On
      June
      16, 2006, the Company issued to International Barcode Corporation (d/b/a Barcode
      Technology)(“BTI”), a warrant to purchase 500,000 shares of the Company's common
      stock, $0.02 par value per share, at a price of $10.00 per share vesting over
      approximately one year and with an expiration date of June 16, 2007. The fair
      value of the warrants amounted to $890,000 utilizing Black Scholes pricing
      model. This value is being recognized as the warrants vests. During the period
      ended June 30, 2006, the Company recognized approximately $223,000 of expense
      related to these warrants. The warrants were issued in conjunction with an
      agreement that provides BTI with the exclusive right to market, sell and
      manufacture DSS technologies, products and processes for all security-related
      applications for government and commercial use in China.




The
      following is a summary with respect to warrants outstanding at June 30,
      2006:


**2006****Weighted****Average****Exercise****Warrants**
              
              **Price**Warrants
                  outstanding at January 1
              
              
              296,783
              
              $
              4.12Granted
              
              
              500,000
              
              $
              10.00Exercised
              
              
              175,537
              
              $
              4.43Lapsed
              
              
              -
              
              $
              -Warrants
                  outstanding at June 30
              
              
              621,246
              
              $
              8.77
  13





The
      following table summarizes the warrants outstanding and exercisable as of June
      30, 2006:


**Warrants
                  Outstanding**
              
              **Warrants
                  Exercisable****Range
                  of Exercise Prices**
              
              **Number
                  of Shares**
              
              **Weighted
                  Average Remaining Contractual Life (in years)**
              
              **Weighted
                  Average Exercise Price**
              
              **Number
                  of Shares**
              
              **Weighted
                  Average Remaining Contractual Life (in years)**
              
              **Weighted
                  Average Exercise Price**$2.00-$4.99
              
              
              79,060
              
              
              1.9
              
              $
              2.98
              
              
              79,060
              
              
              1.9
              
              $
              2.98$5.00-$7.75
              
              
              42,186
              
              
              2.5
              
              $
              5.00
              
              
              42,186
              
              
              2.5
              
              $
              5.00$7.76-$10.00
              
              
              500,000
              
              
              10.
              
              $
              10.00
              
              
              125,000
              
              
              1.00
              
              $
              10.00621,246
              
              
              
              
              
              
              
              
              246,246





**7.    
      Loss per Share**




Basic earnings per share is computed by dividing net income by the
      weighted-average number of common shares, outstanding for the period. Diluted
      earnings per share is computed by including the number of additional shares
      that
      would have been outstanding if dilutive potential shares had been issued. In
      periods of losses, diluted loss per share is computed on the same basis as
      basic
      loss per share as the inclusion of any other potential shares outstanding would
      be anti-dilutive.  As of June 30, 2006, there were 904,496 (548,000 as of
      June 30, 2005) stock options and warrants outstanding with exercise prices
      below
      the average share price for the period that would have been included in the
      calculation of diluted earnings per share had the Company generated net
      income.




**8.    
      Commitments and Contingencies**




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




In
      May
      2005, the Company made an agreement with its legal counsel in charge of the
      Company’s litigation with the European Central Bank (“ECB”) which capped the
      fees for all matters associated with that litigation at $500,000 plus expenses,
      and a $150,000 contingent payment upon a successful ruling or settlement on
      the
      Company’s behalf in that litigation. The Company will record the $150,000 in the
      period in which the Company has determined that a successful ruling or
      settlement is probable. As discussed below, in March 2006, the Company was
      countersued by the ECB in several European national courts. While it is the
      Company’s belief that the costs of defending these countersuits is covered under
      the litigation cap, if not, the costs of defending these suits may be
      significant. As such, the Company has been billed approximately $485,000 for
      costs associated with the countersuits that it has recorded as accounts payable
      and patent assets until such time a formal agreement is established with its
      legal counsel regarding the countersuit fees.




14


On
      June
      29, 2006, the Company received notice of favorable summary judgment from the
      State of New York Supreme Court in the case of “ *Frank
      LaLoggia v. Document Security Systems, Inc* ”.
      The
      Court ruled in favor of the Company and dismissed all claims against the
      Company. The Company will continue to pursue its counterclaim against Mr.
      LaLoggia which was not dismissed by the Court.





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




**9.
      Supplemental Cash Flow Information**




During
      the six months ended June 30, 2006, the Company issued 18,704 shares of Common
      Stock valued at $250,000 in conjunction with the acquisition of the assets
      of P3
      (See Note 4).




**10.    
      Segment Information**




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




15


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




Approximate information concerning the operations by reportable segment for
      the
      three and six months ended June 30, 2006 and 2005 is as follows. The Company
      relies on intersegment cooperation and management does not represent that these
      segments, if operated independently, would report the results contained herein:


**Document****Security
                  &****3
                  months ended June 30, 2006:**
              
              **Legal
                  Supplies**
              
              **Production**
              
              **Corporate**
              
              **Total**Revenues
                  from external customers
              
              $
              144,000
              
              $
              1,166,000
              
              $
              -
              
              $
              1,310,000Depreciation
                  and amortization
              
              
              1,000
              
              
              302,000
              
              
              28,000
              
              
              331,000Segment
                  profit or (loss)
              
              
              (18,000
              )
              
              (645,000
              )
              
              (544,000
              )
              
              (1,207,000
              )**3
                  months ended June 30, 2005:**Revenues
                  from external customers
              
              $
              121,000
              
              $
              370,000
              
              $
              -
              
              
              491,000Depreciation
                  and amortization
              
              
              1,000
              
              
              153,000
              
              
              25,000
              
              
              179,000Segment
                  profit or (loss)
              
              
              33,000
              
              
              (226,000
              )
              
              (360,000
              )
              
              (553,000
              )**Document****Security
                  &****6
                    months ended June 30, 2006:**
              
              
              **Legal
                  Supplies**
              
              
              **Production**
              
              
              **Corporate**
              
              
              **Total**Revenues
                  from external customers
              
              $
              315,000
              
              $
              1,858,000
              
              $
              -
              
              $
              2,173,000Depreciation
                  and amortization
              
              
              2,000
              
              
              549,000
              
              
              56,000
              
              
              607,000Segment
                  profit or (loss)
              
              
              (30,000
              )
              
              (1,144,000
              )
              
              (1,027,000
              )
              
              (2,201,000
              )**6
                  months ended June 30, 2005:**Revenues
                  from external customers
              
              $
              246,000
              
              $
              678,000
              
              $
              -
              
              $
              924,000Depreciation
                  and amortization
              
              
              1,000
              
              
              182,000
              
              
              42,000
              
              
              225,000Segment
                  profit or (loss)
              
              
              38,000
              
              
              (393,000
              )
              
              (761,000
              )
              
              (1,116,000
              )






16




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




***FORWARD-LOOKING
      STATEMENTS***




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




**Overview**




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





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





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





17


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





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





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





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





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





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





In
      March
      2006, we entered into a license with a major international bank to provide
      a
      technology for the Internet delivery of secure, verifiable documents that can
      be
      transmitted and printed over the Internet using a customized web-hosting site
      for the securitization process. This is the first application of a covert method
      we developed for producing secure documents, such as financial instruments,
      at
      multiple locations. The three-year agreement includes implementation and initial
      set-up fees for the bank's website, as well as annual licensing and
      infrastructure maintenance fees.





18


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





**Other** :
      Revenue
      we receive from the sale of legal supplies, our copying operations and from
      our
      former motion picture operations. While we seek to maximize the revenue from
      these sources, we consider these sources as unrelated to our core business
      operation.




***Results
      of Operations for the Three and Six Months Ended***  ***June
      30, 2006***




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




The
      following discussion also includes a non-GAAP financial measure which has been
      reconciled to the most comparable GAAP financial measure of net loss. Our
      management believes that this performance measure is a relevant indicator of
      the
      Company’s financial performance.




**Summary**




19




**Three
                  Months Ended June 30, 2006**
              
              **Six
                  Months Ended June 30, 2006**$
              
              %
                  change vs. 3 months ended June 30, 2005
              
              $
              
              %
                  change vs. 6 months ended June 30, 2005Sales,
                  net
              
              
              1,310,000
              
              
              167
              %
              
              2,173,000
              
              
              135
              %Costs
                  of sales
              
              
              719,000
              
              
              177
              %
              
              1,265,000
              
              
              160
              %Gross
                  profit
              
              
              591,000
              
              
              156
              %
              
              908,000
              
              
              107
              %Total Operating Expenses
              
              
              1,810,000
              
              
              126
              %
              
              3,142,000
              
              
              99
              %Operating
                  loss
              
              
              (1,219,000
              )
              
              114
              %
              
              (2,234,000
              )
              
              96
              %Other
                  income (expense):Interest income
              
              
              17,000
              
              
              -29
              %
              
              44,000
              
              
              19
              %Interest expense
              
              
              (5,000
              )
              
              -29
              %
              
              (11,000
              )
              
              -21
              %Loss
                  before income taxes
              
              
              (1,207,000
              )
              
              118
              %
              
              (2,201,000
              )
              
              97
              %Income
                  taxes
              
              
              0
              
              
              -
              
              
              0
              
              
              -Net
                  loss
              
              
              (1,207,000
              )
              
              118
              %
              
              (2,201,000
              )
              
              97
              %Net
                  loss per share, basic and diluted
              
              
              (0.09
              )
              
              106
              %
              
              (0.17
              )
              
              79
              %Weighted
                  average common shares outstanding, basic and diluted
              
              
              12,850,491
              
              
              6
              %
              
              12,824,935
              
              
              10
              %




**Non-GAAP
      Financial Performance Measure**




The
      following adjusted Earnings before interest, taxes, depreciation, amortization
      and non-cash stock compensation expense (“Adjusted EBITDA”) is presented because
      the Company’s management believes it to be a relevant measure of the performance
      of the Company. The Adjusted EBITDA is used by the Company’s management to
      measure its core operating performance without certain non-cash expenditures.
      The reconciliation of Adjusted EBITDA to net loss, the most comparable GAAP
      measure is presented below.




20




**Three
                  Months Ended June 30, 2006**
              
              **Six
                  Months Ended June 30, 2006****$**
              ****
              **% change vs. 3 months ended June 30, 2005**
              ****
              **$**
              ****
              **%
                  change vs. 6 months ended June 30, 2005**Net
                  Loss
              
              
              (1,207,000
              )
              
              118
              %
              
              (2,201,000
              )
              
              97
              %Add
                  back:Depreciation
              
              
              63,000
              
              
              24
              %
              
              120,000
              
              
              28
              %Amortization
                  of Intangibles
              
              
              268,000
              
              
              105
              %
              
              488,000
              
              
              261
              %Stock
                  Based Compensation
              
              
              253,000
              
              
              2430
              %
              
              280,000
              
              
              1300
              %Interest
                  Income
              
              
              (17,000
              )
              
              -29
              %
              
              (44,000
              )
              
              19
              %Interest
                  Expense
              
              
              5,000
              
              
              -29
              %
              
              11,000
              
              
              -21
              %Income
                  Taxes
              
              
              -
              
              
              
              
              
              -Adjusted
                  EBITDA
              
              
              (635,000
              )
              
              68
              %
              
              (1,346,000
              )
              
              51
              %




**Sales**




**Three
                  Months Ended June 30,2006**
              
              **Six
                  Months Ended June 30, 2006**Sales,
                  net
              
              **$**
              ****
              ******% change vs. 3 months ended June 30,  2005**
              ****
              **$**
              ****
              ******%
                  change vs. 6 months ended June 30, 2005**Document
                  Security & Production
              
              
              1,165,000
              
              
              215
              %
              
              1,858,000
              
              
              174
              %Legal
                  supplies
              
              
              145,000
              
              
              20
              %
              
              315,000
              
              
              28
              %Total
                  Revenue
              
              
              1,310,000
              
              
              167
              %
              
              2,173,000
              
              
              135
              %




Document
      Security & Production




During
      the second quarter of 2006, Document Security sales increased 215% compared
      with
      the second quarter of 2005. The increase of $795,000 in revenue in the category
      during the second quarter was primarily due to the inclusion of $656,000 of
      sales from the Company’s P3 division, which was acquired on February 7, 2006.
      Absent the acquisition of P3 during the first quarter of 2006, Document Security
      sales increased by $139,000, or 38%, from $370,000 in the second quarter of
      2005. During the 2006 quarter, the Company shipped the initial order under
      its
      agreement with PaperLinx Ltd for SecureLinx security paper, which was announced
      in the fourth quarter of 2005.




For
      the
      first six months of 2006, Document Security sales increased 174% compared with
      the first six months of 2005. The increase of $1,180,000 in revenue in the
      category was primarily due to the inclusion of $1,072,000 of sales from the
      Company’s P3 division, which was acquired on February 7, 2006. Absent the
      acquisition of P3 during the first quarter of 2006, Document Security sales
      increased by $108,000, or 16%, from $678,000 in the first six months of 2005.




During
      the second quarter of 2006, the Company had several sales achievements that
      it
      believes will have a significant impact on its ability to continue to grow
      its
      revenue. As displayed in the Paperlinx project discussed above, the initial
      revenue stream from a contract or license can take between three to nine months
      from the signing date due to the high degree of development and customization
      involved in many of our projects. During the second quarter of 2006, the Company
      had several sales achievements that it believes will have a significant impact
      on its ability to continue to grow its revenue. The following chart summarizes
      certain recent agreements entered into by the Company.




21




·
            Signed
                a two-year licensing agreement with Banknote Corporation of America
                (BCA),
                a major high security printer in the United States for a variety
                of secure
                documents, such as checks, stamps, identification.





·
            Signed
                licensing agreement with The Reynolds and Reynolds Company (NYSE:
                REY), a
                leading software and services provider for the automotive retailing
                market
                in the United States and Canada for the protection of checks and
                forms.





·
            Renewed
                and extended the historical licensing agreement with R.R. Donnelley
&
                Sons Company, the largest printer in North America. A three-year
                contract,
                the renewed agreement includes royalties on the usage of DSS's
                SecureScan(tm) technology.





·
            Signed
                an exclusive licensing agreement with Barcode Technology (BTI) to
                market
                and produce DSS's technology, both independently and in combination
                with
                BTI's technology in China.





·
            Signed
                a two-year agreement with ProdoSafe Security Solutions, Turkey's
                largest
                supplier of anti-counterfeiting technology. With its recently awarded
                contracts, ProdoSafe will apply DSS's technology in two metropolitan
                areas
                in Turkey.




In
      addition, DSS recently held two technology meetings with dealers and
      distributors from the dealer network introduced to the Company by its
      acquisition of P3. During the meetings, DSS introduced its technologies and
      products to these dealers, who have traditionally sold plastic ID cards and
      related hardware, as a significant complement to the dealer’s offering and the
      potential to expand their market opportunity. DSS anticipates that it will
      be
      able to expand its reach to the end user of secure documents based on the
      initial response it received from the dealers.




Legal
      Supplies




Revenue from our legal supplies business, Legalstore.com, grew 20% and 28%
      during the second quarter and first six months of 2006, respectively, compared
      with those periods of 2005. While we view our legal supplies business segment
      as
      a non-core part of our company, we have experienced steady growth in its
      operations as it continues to expand its product catalog and customer reach
      through various keyword advertising campaigns.




**Gross
      Profit**


**Three
                  Months Ended June 30, 2006**
              
              **Six
                  Months Ended June 30, 2006****$**
              ****
              **%
                  change vs. 3 months ended June 30, 2005**
              ****
              **$**
              ****
              **%
                  change vs. 6 months ended June 30, 2005**Gross
                  profitDocument
                  Security & Production
              
              
              518,000
              
              
              234
              %
              
              765,000
              
              
              144
              %Legal
                  supplies
              
              
              73,000
              
              
              -4
              %
              
              143,000
              
              
              15
              %Total
                  gross profit
              
              
              591,000
              
              
              156
              %
              
              908,000
              
              
              107
              %




22




**Three
                  Months Ended June 30, 2006**
              
              **Six
                  Months Ended June 30, 2006****%**
              ****
              **%
                  change vs. 3 months ended June 30, 2005**
              ****
              **%**
              ****
              **%
                  change vs. 6 months ended June 30, 2005**Gross
                  profit percentage:Document
                  Security
              
              
              44
              %
              
              6
              %
              
              41
              %
              
              -11
              %Legal
                  supplies
              
              
              50
              %
              
              -20
              %
              
              45
              %
              
              -10
              %Total
                  gross profit percentage
              
              
              45
              %
              
              -4
              %
              
              42
              %
              
              -12
              %




Document
      Security & Production




During
      the second quarter of 2006, gross profit in the Document Security category
      increased by 234% compared with the second quarter of 2005. The increase of
      $363,000 during the 2006 quarter included $238,000 in gross profit derived
      from
      P3. Absent the inclusion of P3’s results, gross profits increased by $125,000,
      or 81%, from $155,000 in 2005.




During
      the first six months of 2006, the gross profit increased by 144% as compared
      with the first six months of 2005. The increase of $451,000 in gross profit
      included $385,000 from P3 operations, acquired in February of 2006.




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




Legal
      Supplies




Legal
      supplies gross profit margins decreased in the second quarter and first six
      months of 2006 when compared with the same periods of 2005 due to the impact
      of
      a favorable one-time inventory adjustment made in the second quarter of 2005.
      However, the gross profit rate for the first six months of 45% is consistent
      with the historical gross profit rate of 2005 of 48%.




**Operating
      expenses**




23




**Three
                  Months Ended June 30, 2006**
              
              **Six
                  Months Ended June 30, 2006****$**
              ****
              **%
                  change vs. 3 months ended June 30, 2005**
              ****
              **$**
              ****
              **%
                  change vs. 6 months ended June 30, 2005**Selling,
                  general and administrativeCompensation
              
              
              490,000
              
              
              117
              %
              
              898,000
              
              
              106
              %Stock
                  based compensation
              
              
              253,000
              
              
              2430
              %
              
              280,000
              
              
              1300
              %Professional
                  Fees
              
              
              378,000
              
              
              126
              %
              
              737,000
              
              
              95
              %Sales
                  and marketing
              
              
              179,000
              
              
              244
              %
              
              261,000
              
              
              34
              %Depreciation
                  and amortization
              
              
              28,000
              
              
              0
              %
              
              57,000
              
              
              24
              %Other
              
              
              118,000
              
              
              10
              %
              
              252,000
              
              
              22
              %Research
                  and development
              
              
              96,000
              
              
              20
              %
              
              169,000
              
              
              5
              %Amortization
                  of intangibles
              
              
              268,000
              
              
              105
              %
              
              488,000
              
              
              261
              %Total Operating Expenses
              
              
              1,810,000
              
              
              126
              %
              
              3,142,000
              
              
              99
              %




**Selling,
      General and Administrative**




Our
      selling, general and administrative costs increases reflect increases to the
      size of our organization that were initiated during the latter half of 2005
      and
      continued during the first six months of 2006 to a level that we believe is
      necessary to execute our business plan. In particular, we expect that the recent
      increases in our sales and marketing staff will enable the Company to continue
      to substantially increase its revenue, especially as the Company develops it
      direct sales strategy.




Compensation costs
      increases in 2006 were primarily due to the addition of sales, service and
      finance personnel, as well as the addition of executive and administrative
      personnel at P3. Of the $264,000 and $463,000 increase in compensation expense
      during the second quarter and first six months of 2006, respectively, $128,000
      and $197,000 of the increases were due to the inclusion of P3. We expect that
      our compensation costs will continue to increase during the remainder of 2006,
      albeit at a slower pace, as we continue to increase our sales, marketing and
      support staff.




Stock
      based compensation costs
      during the first six months of 2006 include approximately $223,000 of expense
      recognized for the issuance of warrants to International Barcode Corporation
      (d/b/a Barcode Technology) in consideration for a cross-marketing relationship
      that enables the Company to expedite its entry into the Chinese market for
      secure documents, and $42,000 associated with annual option grants to the
      non-executive members of our Board of Directors. The Company will continue
      to
      incur approximately $223,000 in expense per quarter for the next three
      quarters associated with the grant of these warrants based on the estimated
      value of the warrants on the grant date using the Black-Scholes option valuation
      model. These warrants have an exercise price of $10.00 and do not include a
      non-cash exercise provision. Therefore, the exercise of these warrants, if
      ever,
      could result in a significant source of funds for the Company.




Professional
      fees include
      legal, accounting, shareholder services, investor relations, and consulting
      costs. Consulting fees are primarily directed towards efforts to help the
      Company develop contacts and market opportunities with government and large
      multinational corporations. During the second quarter of 2006, we incurred
      approximately $100,000 in legal fees for general corporate governance matters
      and work on it two non-European Central Bank lawsuits (regarding Adlertech
      and
      F. Laloggia, respectively- See *Part
      II -Legal Proceeding* s).
      These
      legal costs do not include legal costs associated with the application and
      defense of our patents which the company capitalizes and amortizes over the
      expected life of the patent. During the second quarter and first six months
      of
      2006, the Company incurred $458,000 and $658,000, respectively, in legal costs
      associated with its patent and patent defense which were capitalized as patent
      assets.




24




Sales
      and marketing expenses
      increased in the second quarter of 2006 compared with the second quarter of
      2005
      primarily due to an increase in travel costs associated with an increase in
      the
      Company’s direct sales efforts. In addition, the Company incurred costs to
      expand its product and marketing literature and to host a technology event.
      We
      expect that sales and marketing expenses will continue to fluctuate as we incur
      costs incidental with our sales volume.




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




**Research
      and Development**




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




**Amortization
      of intangibles**




Commencing
      in the second quarter of 2005, we began to amortize the costs associated with
      the patents that we acquired in 2005 and the legal costs associated with the
      development and defense of our patents, including the costs associated with
      our
      suit against the European Central Bank for patent infringement. In addition,
      we
      amortize our acquired intangibles from business combinations. A significant
      portion of these assets were acquired by the issuance of equity in the company.
      Our amortizable asset base at June 30, 2006 was approximately $6.0 million
      and
      will generate approximately $900,000 in annual amortization expense for during
      the next 6 years. The Company reviews these assets for impairment. If an
      impairment, such as unfavorable ruling in the Company’s patent infringement
      lawsuits or the non-commerciability of certain of its patents, then the Company
      would write-off a portion of these assets, which could be a significant expense
      in the period incurred.




In
      addition, the Company has $1,397,000 in goodwill derived from acquisitions.
      Goodwill is not amortized, but could become a component of expense if an
      impairment is determined.




**Net
      loss and loss per share**




25




**Three
                  Months Ended June 30, 2006**
              
              **Six
                  Months Ended June 30, 2006****$**
              ****
              **%
                  change vs. 3 months ended June 30, 2005**
              ****
              **$**
              ****
              **%
                  change vs. 6 months ended June 30, 2005**Net
                  loss
              
              
              (1,207,000
              )
              
              118
              %
              
              (2,201,000
              )
              
              97
              %Net
                  loss per share, basic and diluted
              
              
              (0.09
              )
              
              106
              %
              
              (0.17
              )
              
              79
              %Weighted
                  average common shares outstanding, basic and diluted
              
              
              12,850,491
              
              
              6
              %
              
              12,824,935
              
              
              10
              %




During
      the second quarter and first six months of 2006, the Company continued to
      experience net losses. While we have experienced growth in our sales and gross
      profits, these increases have not offset our increases in our operating
      expenses, especially significant increases in amortization expense, stock based
      compensation, and professional fees.




Our
      basic
      and diluted loss per share has increased due to the increased dollar value
      of
      our loss partially offset by an increase in the weighted average common shares
      outstanding in 2006 compared to 2005. Our shares have increased as we have
      issued our common shares for an acquisition and to purchase patent assets.




Adjusted
      EBITDA


**Three
                    Months Ended June 30, 2006**
              
              **Six
                  Months Ended June 30, 2006****$**
              ****
              **%
                  change vs. 3 months ended June 30, 2005**
              ****
              **$**
              ****
              **%
                  change vs. 6 months ended June 30, 2005**Net
                  Loss
              
              
              (1,207,000
              )
              
              118
              %
              
              (2,201,000
              )
              
              97
              %Add
                  back:Depreciation
              
              
              63,000
              
              
              24
              %
              
              120,000
              
              
              28
              %Amortization
                  of Intangibles
              
              
              268,000
              
              
              105
              %
              
              488,000
              
              
              261
              %Stock
                  based compensation
              
              
              253,000
              
              
              2430
              %
              
              280,000
              
              
              1300
              %Interest
                  Income
              
              
              (17,000
              )
              
              -29
              %
              
              (44,000
              )
              
              19
              %Interest
                  Expense
              
              
              5,000
              
              
              -29
              %
              
              11,000
              
              
              -21
              %Income
                  Taxes
              
              
              -
              
              
              
              
              
              -Adjusted
                  EBITDA
              
              
              (635,000
              )
              
              68
              %
              
              (1,346,000
              )
              
              51
              %






As
      described above, Adjusted EBITDA is a non-GAAP measurement of financial
      performance that the Company believes is relevant to the understanding of the
      Company’s financial results. While net loss increased 118% and 97%,
      respectively, during the second quarter and six months ended June 30, 2006,
      adjusted EBITDA deficits increased only 68% and 51%, respectively, for the
      same
      periods. These results reflect that the increases in sales and gross profits
      have outpaced increases in the Company’s core operating expenses, (core
      operating expenses are compensation, professional fees, sales and marketing, other and research and development)
      which increased 100% and 68%, respectively, during the three and six months
      ended June 30, 2006 compared to 2005 levels,




26




**LIQUIDITY
      AND CAPITAL RESOURCES**




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


**Six
                  Months Ended****June
                  30,**
              
              **June
                  30,****2006**
              
              **2005****(unaudited)**
              
              
              **(unaudited**)****
              
              
              **%Change**Operating
                  activities cash flows
              
              $
              (1,517,000
              )
              $
              (891,000
              )
              
              -70
              %Investing
                  activities cash flows:
              
              
              (1,449,000
              )
              
              (189,488
              )
              
              -665
              %Financing
                  activities cash flows
              
              
              716,000
              
              
              2,205,000
              
              
              -68
              %Working
                  capital (a)
              
              
              1,069,000
              
              
              3,648,000
              
              
              -71
              %Current
                  ratio (a)
              
              
              1.57
              x
              
              5.32
              x
              
              -71
              %




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




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




The
      above
      cash outflows were partially offset by cash received from our warrant holders
      who paid approximately $758,000 for the exercise of 180,353 warrants. The
      proceeds from these investors support our operations. Since entering the
      document security business, we have funded a significant portion of our cash
      needs by issuing our securities.




At June 30, 2006, we had cash and cash equivalents of approximately $1,703,000
      along with restricted cash of $240,000. Our restricted cash is held as
      collateral for our current and long-term debt obligation which was approximately
      $193,000. Our working capital as of June 30, 2006 was approximately $1,069,000
      which was 71% lower than working capital at June 30, 2005. Our working capital
      position is adversely affected by approximately $485,000 in accounts payable
      that is related to legal costs associated with the countersuits by the European
      Central Bank in response to our lawsuit with the European Central Bank. The
      Company is in the process of determining if legal costs related to the
      countersuits should be covered under a previously arranged litigation cap that
      the Company had with its lead counsel for its Euro infringement lawsuit. (See *Item
      1- Financial Statements -Note 8* ).
      However, irregardless of the aforementioned $485,000, our working capital
      position is expected to deteriorate as long as we continue to lose money from
      operations. In order to support our existing and proposed operations, we will
      need additional financing. We currently have outstanding warrants to purchase
      our common stock with exercise prices below the current market price as of
      August 1, 2006 that can generate approximately $446,000 in cash financing for
      the Company, there is no assurance that all or any of the warrants will be
      exercised. If the warrants are not exercised, we will be required to raise
      additional funds by borrowing or selling stock to meet our cash needs, and
      there
      is no guarantee that we will be able to raise such additional funds.




27




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




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




We
      mitigate our foreign currency risks principally by contracting primarily in
      U.S.
      dollars. For the six months ended June 30, 2006, all of our billings, were
      denominated in our functional currency, which is the U.S. dollar.




**ITEM
      4 - CONTROLS AND PROCEDURES**




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





During
      the quarter ended June 30, 2006, the Company initiated the implementation of
      an
      ERP (Enterprise Reporting Program) system to streamline its accounting and
      sales
      reporting capabilities and to incorporate the daily activities of its newly
      acquired P3 division. The program went live on July 1, 2006 and management
      expects the system will materially affect the Corporation’s internal controls
      over financial reporting, especially in regards to controls related to its
      newly
      acquired P3 division. Specifically, the new system will eliminate redundant
      controls due to the consolidation of subsidiary ledgers and the cash
      disbursements and cash receipts processes. There were no other changes in the
      Corporation’s “internal control over financial reporting” (as such term is
      defined in Rule 13a-15(f) under the Exchange Act) that occurred during the
      quarter ended June 30, 2006, that has materially affected, or is reasonably
      likely to materially affect, the Corporation’s internal control over financial
      reporting.




**PART
      II**


**OTHER
      INFORMATION**




28




**ITEM
      1 - LEGAL PROCEEDINGS**




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




On
      June
      29, 2006, Document Security Systems, Inc. the Supreme Court of the State of
      New
      York (the “Court”) ruled in favor of DSS’s motion for summary judgment in the
      case of *“Frank
      LaLoggia v. Document Security Systems, Inc”.* In its
      ruling, the Court dismissed all of Mr. LaLoggia’s claims against DSS. DSS will
      continue to pursue its counterclaim against Mr. LaLoggia. This litigation is
      described in our Form 10-KSB Annual Report for the year ended December 31,
      2005.




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





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




**ITEM
      1a - RISK FACTORS**




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





29




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




Since
      our
      inception in 1984, we have accumulated deficits from historical operations
      of
      approximately $12,395,000 at December 31, 2005, which has increased to
      approximately $14,597,000 at June 30, 2006. In 2002, we changed our business
      model and chose to strategically focus on becoming a developer and marketer
      of
      secure technologies for all forms of print media. We have continued to incur
      losses since we began our new business model. Also, we have limited operating
      and financial information relating to this new business to evaluate our
      performance and future prospects. Due to the change in our business model,
      we do
      not view our historical financials as being a good indication of our future.
      We
      face the risks and difficulties of a company going into a new business including
      the uncertainties of market acceptance, competition, cost increases and delays
      in achieving business objectives. There can be no assurance that we will succeed
      in addressing any or all of these risks, and the failure to do so could have
      a
      material adverse effect on our business, financial condition and operating
      results.




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




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




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




30




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




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




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




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




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





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




31




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




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




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




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




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




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




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




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




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




32




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




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




·
            identify
                suitable businesses or assets to buy;




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




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




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




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




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




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





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




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





33


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




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




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




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




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




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




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




**Risks
      Related to Our Stock**




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




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





34






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


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




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




As
      of
      August 1, 2006, there are 186,103,515 million shares of authorized but
      unissued shares of our common stock. Our management will continue to have broad
      discretion to issue shares of our common stock in a range of transactions,
      including capital-raising transactions, mergers, acquisitions, for anti-takeover
      purposes, and in other transactions, without obtaining stockholder approval,
      unless stockholder approval is required for a particular transaction under
      the
      rules of the American Stock Exchange, New York law, or other applicable laws.
      We
      currently have no specific plans to issue shares of our common stock for any
      purpose. However, if our management determines to issue shares of our common
      stock from the large pool of such authorized but unissued shares for any purpose
      in the future without obtaining stockholder approval, your ownership position
      would be diluted without your further ability to vote on that transaction.





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




As
      of
      June 30, 2006, there were outstanding stock options and warrants to purchase
      an
      aggregate of 904,496 shares of our Common Stock at exercise prices ranging
      from
      $2.00 to $12.65 per share, most of which are immediately exercisable. To the
      extent that these securities are exercised, dilution to our shareholders will
      occur. Moreover, the terms upon which we will be able to obtain additional
      equity capital may be adversely affected, since the holders of these securities
      can be expected to exercise or convert them at a time when we would, in all
      likelihood, be able to obtain any needed capital on terms more favorable to
      us
      than the exercise and conversion terms provided by those
      securities.




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




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




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




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




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




35


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




We did not purchase any shares of our common stock during the six months ended
      June 30, 2006.




**ITEM
      3 - DEFAULTS UPON SENIOR SECURITIES**




None




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




None




**ITEM
      5 - OTHER INFORMATION**




None




**ITEM
      6 - EXHIBITS**




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




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




36




**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.**August
                14, 2006
            
            By:
            /s/
                Patrick WhitePatrick
                White
              President,
                Chief Executive Officer and
              Acting
                Chief Financial OfficerAugust
                14, 2006
            
            By:
            /s/
                Philip JonesPhilip
                Jones
              Controller/Principal
                Accounting Officer





37