UNITED
STATES SECURITIES AND EXCHANGE


COMMISSION


Washington,
D.C. 20549




FORM
10-Q




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


THE
SECURITIES EXCHANGE ACT OF 1934




For the quarterly period ended
September 30,
2010




1-32146Commission
      file number








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





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





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





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




Indicate
by check mark whether the registrant:


(1) has
filed all reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports)




And




(2) has
been subject to such filing requirements for the past 90 days.


Yes
x No  ̈





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Date File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding
12 months (or for such shorter period that the registrant was required to submit
and post such files)*


Yes  ̈  No  ̈





*   The
issuer has not yet been phased into the interactive data
requirements





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See definition of “large accelerated filer”, “accelerated
filer” and “smaller reporting company”  in Rule 12b-2 of the Exchange
Act. (Check one):





Large
accelerated filer  ̈           Accelerated
filer  ̈        Non-accelerated
filer     ̈      Smaller
reporting company  x





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act)


Yes
 ̈  No
x




Applicable
only to corporate issuers




As of
November 12, 2010 (the most recent practicable date), there were 18,191,166
shares of the issuer's Common Stock, $0.02 par value per share,
issued.








DOCUMENT
SECURITY SYSTEMS, INC.


FORM
10-Q


TABLE
OF CONTENTS





PART
      I
                
                FINANCIAL
      INFORMATIONItem
      1
                
                Financial
      StatementsConsolidated
      Balance Sheets
                
                3Consolidated
      Statements of Operations
                
                4Consolidated
      Statements of Cash Flows
                
                5Notes
      to Interim Consolidated Financial Statements
                
                6Item
      2
                
                Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
                
                16Item
      4
                
                Controls
      and Procedures
                
                23PART
      II
                
                OTHER
      INFORMATIONItem
      1
                
                Legal
      Proceedings
                
                23Item
      1A
                
                Risk
      Factors
                
                25Item
      2
                
                Unregistered Sales
      of Equity Securities and Use of Proceeds
                
                31Item
      3
                
                Defaults
      upon Senior Securities
                
                31Item
      4
                
                (Removed
      and Reserved)
                
                31Item
      5
                
                Other
      Information
                
                31Item
      6
                
                Exhibits
                
                31SIGNATURES


2




PART
I




FINANCIAL
INFORMATION


ITEM 1 -
FINANCIAL STATEMENTS


DOCUMENT
SECURITY SYSTEMS, INC.  AND SUBSIDIARIES


Consolidated
Balance Sheets


As
of





September 30,
                  2010
                
                
                December 31,
                  2009(Unaudited)ASSETSCurrent
      assets:Cash
      and cash equivalents
                
                $
                408,082
                
                
                $
                448,895Accounts
      receivable, net of allowance of  $66,000 ($66,000-
      2009)
                
                
                1,835,093
                
                
                
                1,143,939Inventory,
      net
                
                
                813,717
                
                
                
                184,174Prepaid
      expenses and other current assets
                
                
                80,675
                
                
                
                91,310Investment
                
                
                228,607
                
                
                
                -Total
      current assets
                
                
                3,366,174
                
                
                
                1,868,318Fixed
      assets, net
                
                
                2,652,350
                
                
                
                1,286,226Other
      assets
                
                
                325,953
                
                
                
                305,507Investment
                
                
                -
                
                
                
                350,000Goodwill
                
                
                1,943,081
                
                
                
                1,315,721Other
      intangible assets, net
                
                
                2,396,599
                
                
                
                1,588,969Total
      assets
                
                $
                10,684,157
                
                
                $
                6,714,741LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilities:Accounts
      payable
                
                $
                1,715,431
                
                
                $
                1,673,901Accrued
      expenses & other current liabilities
                
                
                1,079,293
                
                
                
                934,595Dividends
      payable
                
                
                228,607
                
                
                
                -Revolving
      line of credit
                
                
                285,705
                
                
                
                -Current
      portion of long-term debt
                
                
                300,000
                
                
                
                -Current
      portion of capital lease obligations
                
                
                85,994
                
                
                
                78,167Total
      current liabilities
                
                
                3,695,030
                
                
                
                2,686,663Revolving
      notes from related party
                
                
                583,000
                
                
                
                583,000Long-term
      debt, net of unamortized discount of $298,000 ($420,000
    -2009)
                
                
                2,101,812
                
                
                
                954,616Capital
      lease obligations
                
                
                105,173
                
                
                
                182,424Deferred
      tax liability
                
                
                85,042
                
                
                
                70,830Commitments
      and contingencies (see Note 8)Stockholders'
      equityCommon
      stock, $.02 par value;  200,000,000 shares authorized,
      18,106,166 shares issued and outstanding (16,397,887 in
    2009)
                
                
                362,122
                
                
                
                327,957Additional
      paid-in capital
                
                
                43,273,348
                
                
                
                38,399,033Accumulated
      other comprehensive loss
                
                
                (31,834
                )
                
                
                -Accumulated
      deficit
                
                
                (39,489,536
                )
                
                
                (36,489,782
                )Total
      stockholders' equity
                
                
                4,114,100
                
                
                
                2,237,208Total
      liabilities and stockholders' equity
                
                $
                10,684,157
                
                
                $
                6,714,741




See
accompanying notes


3




DOCUMENT
SECURITY SYSTEMS, INC. AND SUBSIDIARIES


Consolidated
Statements of Operations


(Unaudited)





Three Months Ended September 30,
                        
                        
                        Nine Months Ended September 30,2010
                        
                        
                        2009
                        
                        
                        2010
                        
                        
                        2009RevenueSecurity
      and commercial printing
                        
                        $
                        1,620,204
                        
                        
                        $
                        2,246,700
                        
                        
                        $
                        5,306,980
                        
                        
                        $
                        6,605,209Packaging
                        
                        
                        1,381,526
                        
                        
                        
                        -
                        
                        
                        
                        3,452,106
                        
                        
                        
                        -Technology
      license royalties and digital solutions
                        
                        
                        149,206
                        
                        
                        
                        204,334
                        
                        
                        
                        492,052
                        
                        
                        
                        618,908Legal
      products
                        
                        
                        -
                        
                        
                        
                        101,611
                        
                        
                        
                        -
                        
                        
                        
                        355,107Total
      Revenue
                        
                        
                        3,150,936
                        
                        
                        
                        2,552,645
                        
                        
                        
                        9,251,138
                        
                        
                        
                        7,579,224Costs
      of revenueSecurity
      and commercial printing
                        
                        
                        1,210,009
                        
                        
                        
                        1,516,188
                        
                        
                        
                        3,963,595
                        
                        
                        
                        4,546,512Packaging
                        
                        
                        1,056,274
                        
                        
                        
                        -
                        
                        
                        
                        2,673,455
                        
                        
                        
                        -Technology
      license royalties and digital solutions
                        
                        
                        -
                        
                        
                        
                        3,507
                        
                        
                        
                        5,476
                        
                        
                        
                        10,521Legal
      products
                        
                        
                        -
                        
                        
                        
                        56,073
                        
                        
                        
                        -
                        
                        
                        
                        178,892Total
      costs of revenue
                        
                        
                        2,266,283
                        
                        
                        
                        1,575,768
                        
                        
                        
                        6,642,526
                        
                        
                        
                        4,735,925Gross
      profit
                        
                        
                        884,653
                        
                        
                        
                        976,877
                        
                        
                        
                        2,608,612
                        
                        
                        
                        2,843,299Operating
      expenses:Selling,
      general and administrative
                        
                        
                        1,332,229
                        
                        
                        
                        1,436,533
                        
                        
                        
                        4,441,793
                        
                        
                        
                        4,139,751Research
      and development
                        
                        
                        71,731
                        
                        
                        
                        61,317
                        
                        
                        
                        204,086
                        
                        
                        
                        223,409Amortization
      of intangibles
                        
                        
                        189,467
                        
                        
                        
                        323,936
                        
                        
                        
                        619,667
                        
                        
                        
                        971,068Operating
      expenses
                        
                        
                        1,593,427
                        
                        
                        
                        1,821,786
                        
                        
                        
                        5,265,546
                        
                        
                        
                        5,334,228Operating
      loss
                        
                        
                        (708,774
                        )
                        
                        
                        (844,909
                        )
                        
                        
                        (2,656,934
                        )
                        
                        
                        (2,490,929
                        )Other
      income (expense):Interest
      income
                        
                        
                        -
                        
                        
                        
                        18,140
                        
                        
                        
                        -
                        
                        
                        
                        18,140Loss
      in equity investment
                        
                        
                        (49,714
                        )
                        
                        
                        -
                        
                        
                        
                        (121,393
                        )
                        
                        
                        -Interest
      expense
                        
                        
                        (78,572
                        )
                        
                        
                        (57,998
                        )
                        
                        
                        (228,082
                        )
                        
                        
                        (207,172
                        )Amortizaton
      of note discount
                        
                        
                        (40,732
                        )
                        
                        
                        (63,756
                        )
                        
                        
                        (122,196
                        )
                        
                        
                        (189,211
                        )Gain
      on foreign currency transactions
                        
                        
                        -
                        
                        
                        
                        (1,453
                        )
                        
                        
                        -
                        
                        
                        
                        10,329Other
      income
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        143,063
                        
                        
                        
                        -Loss
      before income taxes
                        
                        
                        (877,792
                        )
                        
                        
                        (949,976
                        )
                        
                        
                        (2,985,542
                        )
                        
                        
                        (2,858,843
                        )Income
      tax expense
                        
                        
                        4,737
                        
                        
                        
                        4,738
                        
                        
                        
                        14,212
                        
                        
                        
                        14,214Net
      loss
                        
                        $
                        (882,529
                        )
                        
                        $
                        (954,714
                        )
                        
                        $
                        (2,999,754
                        )
                        
                        $
                        (2,873,057
                        )Other
      comprehensive loss:Interest
      rate swap loss
                        
                        
                        (6,000
                        )
                        
                        
                        -
                        
                        
                        
                        (31,834
                        )
                        
                        
                        -Comprehensive
      Loss
                        
                        $
                        (888,529
                        )
                        
                        $
                        (954,714
                        )
                        
                        $
                        (3,031,588
                        )
                        
                        $
                        (2,873,057
                        )Net
      loss per share -basic and diluted:
                        
                        $
                        (0.05
                        )
                        
                        $
                        (0.06
                        )
                        
                        $
                        (0.17
                        )
                        
                        $
                        (0.20
                        )Divedend
      per share
                        
                        $
                        0.01
                        
                        
                        $
                        -
                        
                        
                        $
                        0.01
                        
                        
                        $
                        -Weighted
      average common shares outstanding, basic and diluted
                        
                        
                        18,008,012
                        
                        
                        
                        14,711,105
                        
                        
                        
                        17,599,410
                        
                        
                        
                        14,510,056




See
accompanying notes


4




DOCUMENT SECURITY SYSTEMS, INC. AND
SUBSIDIARIES


Consolidated
Statements of Cash Flows


For
the Nine Months Ended September 30,





(Unaudited)





2010
                    
                    
                    2009Cash
      flows from operating activities:Net
      loss
                    
                    $
                    (2,999,754
                    )
                    
                    $
                    (2,873,057
                    )Adjustments
      to reconcile net loss to net cash used by operating
      activities:Depreciation
      and amortization
                    
                    
                    949,683
                    
                    
                    
                    1,221,103Stock
      based compensation expense (reversal)
                    
                    
                    336,111
                    
                    
                    
                    (78,725
                    )Amortization
      of note discount
                    
                    
                    122,196
                    
                    
                    
                    189,211Loss
      in equity investment
                    
                    
                    121,393
                    
                    
                    
                    -Provision
      for inventory reserve
                    
                    
                    10,000
                    
                    
                    
                    -(Increase)
      decrease in assets:Accounts
      receivable
                    
                    
                    593,122
                    
                    
                    
                    (88,690
                    )Inventory
                    
                    
                    (135,381
                    )
                    
                    
                    28,890Prepaid
      expenses and other assets
                    
                    
                    (59,881
                    )
                    
                    
                    (33,261
                    )Increase
      (decrease) in liabilities:Accounts
      payable
                    
                    
                    (406,598
                    )
                    
                    
                    367,454Accrued
      expenses and other current liabilities
                    
                    
                    207,614
                    
                    
                    
                    (216,574
                    )Net
      cash used by operating activities
                    
                    
                    (1,261,495
                    )
                    
                    
                    (1,483,649
                    )Cash
      flows from investing activities:Decrease
      in restricted cash
                    
                    
                    -
                    
                    
                    
                    131,004Purchase
      of fixed assets
                    
                    
                    (138,640
                    )
                    
                    
                    (18,255
                    )Purchase
      of other intangible assets
                    
                    
                    (118,999
                    )
                    
                    
                    (183,630
                    )Acquisition
      of business
                    
                    
                    (2,272,405
                    )
                    
                    
                    -Net
      used by investing activities
                    
                    
                    (2,530,044
                    )
                    
                    
                    (70,881
                    )Cash
      flows from financing activities:Borrowing
      on revolving note- related parties
                    
                    
                    100,000
                    
                    
                    
                    1,030,000Repayment
      on revolving note- related parties
                    
                    
                    (100,000
                    )
                    
                    
                    (280,000
                    )Borrowings
      on revolving line of credit
                    
                    
                    285,705
                    
                    
                    
                    -Borrowings
      on long-term debt
                    
                    
                    1,500,000
                    
                    
                    
                    -Payments
      of long-term debt
                    
                    
                    (175,000
                    )
                    
                    
                    -Payments
      of capital lease obligations
                    
                    
                    (69,424
                    )
                    
                    
                    (101,717
                    )Issuance
      of common stock, net
                    
                    
                    2,209,445
                    
                    
                    
                    1,241,503Net
      cash provided by financing activities
                    
                    
                    3,750,726
                    
                    
                    
                    1,889,786Net
      increase (decrease) in cash and cash equivalents
                    
                    
                    (40,813
                    )
                    
                    
                    335,256Cash
      and cash equivalents beginning of period
                    
                    
                    448,895
                    
                    
                    
                    87,820Cash
      and cash equivalents end of period
                    
                    $
                    408,082
                    
                    
                    $
                    423,076




See
accompanying notes.


5




DOCUMENT
SECURITY SYSTEMS, INC.


NOTES
TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS


September
30, 2010


(Unaudited)




1.    
Basis of Presentation and Significant Accounting Policies




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





Interim
results are not necessarily indicative of results expected for a full year. For
further information regarding Document Security Systems, Inc (the “Company”)
accounting policies, refer to the audited consolidated financial statements and
footnotes thereto included in the Company's Form 10-K for the fiscal year ended
December 31, 2009.





The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ materially from those estimates
and assumptions. In preparing these financial statements, the Company has
evaluated events and transactions for potential recognition or
disclosure.




Reclassifications
-Certain prior period amounts in the accompanying consolidated financial
statements and notes thereto have been reclassified to current period
presentation.  These classifications had no effect on the results of
operations for the period presented.  These reclassifications include
the combination of deferred revenue and customer deposits into accrued
expenses.




Fair Value of
Financial Instruments-Fair value estimates discussed herein are based upon certain market
assumptions and pertinent information available to management as of September
30, 2010. The carrying amounts reported in the balance sheet as of September 30,
2010 of cash and cash equivalents, accounts receivable, accounts payable and
accrued expenses approximate fair value because of the immediate or short-term
maturity of these financial instruments. The fair value of revolving credit
lines, notes payable and long-term debt approximates their carrying value as the
stated or discounted rates of the debt reflect recent market
conditions.




Derivative
instruments are recorded as assets and liabilities at estimated fair value based
on available market information. The Company's derivative instrument is an
interest rate swap that changes a variable rate into a fixed rate on the term
loan and qualifies as a cash flow hedge and is included in accrued expenses on
the accompanying Consolidated Balance Sheet as of September 30,
2010.   Gains and losses on these instruments are recorded in
other comprehensive income (loss) until the underlying transaction is recorded
in earnings. When the hedged item is realized, gains or losses are reclassified
from accumulated other comprehensive income (loss) (AOCI) to the Consolidated
Statement of Operations on the same line item as the underlying
transaction.   The cumulative net loss attributable to this cash
flow hedge recorded in AOCl at September 30, 2010, was approximately
$32,000.





Conventional
Convertible Debt-When the convertible feature of the conventional convertible debt
provides for a rate of conversion that is below market value, this feature is
characterized as a beneficial conversion feature (“BCF"). Prior to the
determination of the BCF, the proceeds from the debt instrument were first
allocated between the convertible debt and any detachable free standing
instruments that are included, such as common stock warrants. The Company
recorded a BCF as a debt discount pursuant to ASC Topic 470-20, (formerly EITF
Issue No. 98-5 “Accounting for Convertible Securities with Beneficial Conversion
Features or Contingency Adjustable Conversion Ratio," and EITF Issue No. 00-27,
“Application of EITF Issue No. 98-5 to Certain Convertible Instrument(s)"). In
those circumstances, the convertible debt will be recorded net of the discount
related to the BCF. The Company amortizes the discount to interest expense over
the life of the debt using the effective interest method.


6





Investment- On October 8, 2009,
the Company entered into an Asset Purchase Agreement with Internet Media
Services, Inc. (“IMS”) whereby the Company sold the assets and liabilities of
Legalstore.com, a division of the Company, in exchange for 7,500,000 shares of
common stock of IMS. The Company recorded its investment IM as an equity method
investment at the fair market value of the business sold.  Management
determined that the transaction qualified as a derecoginition of a subsidiary
under ASC 810-10-40. Therefore, the Company accounted for the deconsolidation of
a subsidiary (“the business”) by recording the consideration received at fair
market value and recognizing a gain in net loss during the year ending December
31, 2009 measured as the difference between: the fair value of the consideration
received (7,500,000 shares of common stock of IMS or a 37% interest) and the
carrying value of the assets and liabilities sold. Given that the consideration
received was not readily measurable because of the lack of activity in IMS prior
to the transaction, the Company determined that the value of the “business
transferred” was more readily measurable. The Company determined the fair market
value of the business transferred based on a discounted cash flow model. Under
the equity method investment the Company is required to account for the
difference between the cost of an investment and the amount of the underlying
equity in net assets of an investee as if the investee were a consolidated
subsidiary. If the investor is unable to relate the difference to specific
accounts of the investee (e.g., property and
equipment), the difference should be considered to be the same as goodwill.
Investors shall not amortize goodwill associated with equity method investments
after the date ASC 350 (formally Statement No. 142, Goodwill and Other Intangible
Assets), is initially applied by the entity in its entirety. The Company
determined that given the lack of activity in IMS prior to the transaction, the
difference between the cost of the investment (fair market value) and the
underlying equity interest is attributable to goodwill which difference amounted
to approximately $243,000 at December 31, 2009.





Up until
September 23, 2010, the Company recognized a loss on its investment in IMS of
approximately $121,000 using the equity method of accounting for the
investment.   On September 23, 2010, the Company’s Board of
Directors declared a dividend whereas the Company would distribute to its
stockholders of record on October 8, 2010 on a pro-rata basis its shares of
stock in Internet Media Services.  As a result, the Company has
recorded a dividend payable of approximately $229,000 which was the book value
of the investment as of September 23, 2010.





Earnings Per
Common Share-The
Company presents basic and diluted earnings per share.  Basic earnings
per share reflects the actual weighted average of shares issued and outstanding
during the period. Diluted earnings per share are computed including the number
of additional shares that would have been outstanding if dilutive potential
shares had been issued. In a loss year, the calculation for basic and diluted
earnings per share is considered to be the same, as the impact of potential
common shares is anti-dilutive.





For the
nine months ended September 30, 2010 and 2009, there were up to 2,580,699 and
1,815,270 respectively, of shares potentially issuable under convertible debt
agreements, options, warrants and restricted stock agreements that could dilute
basic earnings per share in the future were excluded from the calculation of
diluted earnings per share because their inclusion would have been anti-dilutive
to the Company’s losses in the respective periods.





Concentration
of Credit Risk - The
Company acquired Premier Packaging Corporation in February
2010. During the year
ended December 31, 2009, 72% of Premier Packaging’s sales were to two customers
and which comprised 81% of Premier Packaging’s accounts receivable balance as of
December 31, 2009.  During the nine month period ended September 30,
2010, these two customers accounted for 32% of the Company’s consolidated
revenue.   As of  September 30, 2010 one of the
customers, which accounted for 25% of the Company’s consolidated sales for the
first nine months of 2010, has a contract with the Company that is currently set
to expire in July 2011, and comprised 26% of the Company’s consolidated accounts
receivable as of September 30, 2010





Continuing
Operations-The Company
has incurred significant net losses in previous years. The Company’s ability to
fund its capital requirements out of its available cash and cash generated from
its operations depends on a number of factors. Some of these factors include the
Company’s ability to (i) increase commercial and security printing and plastic
card sales; (ii) increase sales of the Company’s digital products; and (iii)
integrate its new acquisition of Premier Packaging with its existing
product lines. As of September 30, 2010, the Company has approximately $408,000
in cash but a negative working capital of $329,000.   As of
September 30, 201, the Company has $417,000 available to it under one
credit facility, along with up to $714,000 available under a credit line at its
Premier Packaging subsidiary, which the Company may need to use in order to
ensure it has sufficient working capital to operate its
business.  Furthermore, the Company may need additional funds for its
business.  To address its working capital needs in the past, the
Company has been able to obtain equity based financing, including most recently,
on July 21, 2010 and July 22, 2010, the Company raised a aggregate of
$1,080,000, net of fees, from the sale of common
stock.    The Company expects to be able to continue to
obtain equity based financing to meet its obligations if the Company cannot
generate sufficient cash from its operations, although there is no guarantee
that the Company will be able to do so.


7




Recent Accounting
Pronouncements





In
January 2010, the FASB issued ASU 2010-6, “Improving Disclosures About Fair
Value Measurements”(“ASU 2010-6”), which requires reporting entities to
make new disclosures about recurring or nonrecurring fair-value measurements
including significant transfers into and out of Level 1 and Level 2 fair-value
measurements and information on purchases, sales, issuances, and settlements on
a gross basis in the reconciliation of Level 3 fair- value measurements. ASU
2010-6 is effective for interim and annual reporting periods beginning after
December 15, 2009, except for Level 3 reconciliation disclosures which are
effective for interim and annual periods beginning after December 15, 2010.
The Company adopted the requirements within ASU 2010-6 as of January 1,
2010. The adoption did not have an impact on our financial
statements.





In July
2010, the FASB issued ASU 2010-20, “Disclosures about the Credit Quality
of Financing Receivables and the Allowance for Credit Losses.”  The
new disclosure guidance will significantly expand the existing requirements and
will lead to greater transparency into a company’s exposure to credit losses
from lending arrangements.  The extensive new disclosures of information as
of the end of a reporting period will become effective for both interim and
annual reporting periods ending on or after December 15, 2010.  Specific
disclosures regarding activity that occurred before the issuance of the ASU,
such as the allowance roll-forward and modification disclosures, will be
required for periods beginning on or after December 15, 2010.  The Company
is currently assessing the impact that ASU 2010-20 will have on its consolidated
financial statements.





2.    Inventory




Inventory
approximately consisted of the following:




September 30,
                  
                  
                  December 31,2010
                  
                  
                  2009Finished
      Goods
                  
                  $
                  381,274
                  
                  
                  $
                  38,093Work
      in process
                  
                  
                  145,135
                  
                  
                  
                  58,493Raw
      Materials
                  
                  
                  297,308
                  
                  
                  
                  87,588823,717
                  
                  
                  
                  184,174Less
      inventory reserve
                  
                  
                  (10,000)
                  
                  
                  
                  -$
                  813,717
                  
                  
                  $
                  184,174




3.     Other
Intangible
Assets




Other
intangible assets are comprised of the following:


8





September30,2010(unaudited)
                    
                    
                    December31,2009UsefulLife
                    
                    GrossCarrying
                      Amount
                    
                    
                    Accumulated
                      Amortizaton
                    
                    
                    NetCarrying
                      Amount
                    
                    
                    Gross
                      Carrying
                      Amount
                    
                    
                    Accumulated
                      Amortizaton
                    
                    
                    NetCarrying
                      AmountAcquired
      intangibles
                    
                    5
      years
                    
                    $
                    2,038,300
                    
                    
                    $
                    736,588
                    
                    
                    $
                    1,301,712
                    
                    
                    $
                    756,300
                    
                    
                    $
                    622,285
                    
                    
                    $
                    134,015Patent
      acquisition and defense costs
                    
                    Varied
      (1)
                    
                    
                    4,729,889
                    
                    
                    
                    4,257,789
                    
                    
                    
                    472,100
                    
                    
                    
                    4,729,889
                    
                    
                    
                    3,879,341
                    
                    
                    
                    850,548Patent
      application costs
                    
                    Varied
      (2)
                    
                    
                    831,961
                    
                    
                    
                    209,174
                    
                    
                    
                    622,787
                    
                    
                    
                    776,159
                    
                    
                    
                    171,753
                    
                    
                    
                    604,406$
                    7,600,150
                    
                    
                    $
                    5,203,551
                    
                    
                    $
                    2,396,599
                    
                    
                    $
                    6,262,348
                    
                    
                    $
                    4,673,379
                    
                    
                    $
                    1,588,969





(1)-
patent rights are amortized over their expected useful life which is generally
the legal life of the patent.  As of September 30, 2010 the weighted
average remaining useful life of these assets in service was 1.24
years.





(2)-
patent rights are amortized over their expected useful life which is generally
the legal life of the patent.  As of September 30, 2010 the weighted
average remaining useful life of these assets in service was 14.4
years.





4.    
Debt





Revolving Note -
Related Party-On January 4, 2008, the Company entered into a Credit
Facility Agreement with Fagenson and Co., Inc., as agent, a related party to
Robert B. Fagenson, the Chairman of the Company's Board of Directors. Under the
Fagenson Credit Agreement, the Company could borrow up to a maximum of
$3,000,000 from time to time up to and until January 4, 2010.  Any
amount borrowed by the Company pursuant to the Fagenson Credit Agreement has
annual interest rate of 2% above LIBOR and is secured by the Common Stock of
Plastic Printing Professionals, Inc., (“P3”) the Company's wholly owned
subsidiary.  Interest is payable quarterly in arrears and the
principal is payable in full at the end of the term under the Fagenson Credit
Agreement.  On December 11, 2009, the Company entered into a Letter
Agreement with the lender for the conversion of $2,000,000 of debt owed under
the Credit Facility into 1,250,000 shares of Document Security Systems Common
Stock.   In addition, the parties amended the Credit Facility to
allow for a maximum borrowing of up to $1,000,000 and extended the due date to
January 4, 2012.   As of September 30, 2010, the Company had
outstanding $583,000 ($583,000 – December 31, 2009) under the Fagenson Credit
Agreement.    Under the terms of the agreement the Company
is required to comply with various covenants.  As of September 30,
2010, the Company was in default of the Fagenson Credit Agreement due to a
failure to pay interest when due.  Fagenson and Co. has waived the
defaults through January 1, 2012.





Interest
expense for revolving notes from related parties for the nine months ended
September 30, 2010 was approximately $14,000 ($84,000 – 2009) of which
approximately $167,000 is included in accrued expenses as of September 30, 2010
($152,000 –December 31, 2009).





Notes
Payable  -On December 9, 2009, the Company used the proceeds
from a $350,000 Convertible Note and a $575,000 Promissory Note, respectively,
to pay in full a $900,000 Term Note.   The $350,000 Convertible
Note matures November 24, 2012, accrues interest at 10%, payable quarterly, and
is convertible into up to 218,750 shares of Document Security Systems Common
Stock.  The $575,000 Promissory Note matures November 24, 2012 and
accrues interest at 10%, payable quarterly.   Both Notes are
secured with equal rights by the assets of the Company’s wholly owned
subsidiary, DPI Secuprint.   In conjunction with the convertible
note, the Company determined a beneficial conversion feature existed amounting
to approximately $94,000 which was recorded as discount on debt and is being
amortized over the term of the Note.  Under the terms of the
agreements the Company is required to comply with various covenants, which the
Company was in compliance with as of September 30, 2010.





On
December 30, 2009, the Company used the proceeds from a $450,000 Convertible
Note to pay in full $450,000 due under a Credit Facility.   The
$450,000 Convertible Note matures June 23, 2012, accrues interest at 8%, payable
quarterly, is convertible into up to 260,116 shares of Document Security Systems
Common Stock, and is secured by the accounts receivable of the Company,
excluding the accounts receivable of the Company’s wholly owned subsidiaries,
Plastic Printing Professionals and DPI Secuprint.   In
conjunction with the Note, the Company issued to the holders of the Note
warrants to purchase up to 65,000 shares of the Company’s common stock within
five years at $2.00 per share.  The estimated fair market value of
these warrants was determined using the Black Scholes option pricing model at
approximately $72,000, which was recorded as discount on debt and is being
amortized over the term of the Note.  Furthermore, in conjunction with
this convertible note, the Company determined a beneficial conversion feature
existed amounting to approximately $257,000, which was recorded as discount on
debt and is being amortized over the term of the Note.   In
addition, the Company recorded expense of approximately $110,000 for the fair
value of 40,000 warrants to purchase the shares of the Company’s common stock at
$2.00 issuable under the terms of the Convertible Note as a result of the
Company’s failure to timely file a registration statement for the shares
issuable upon conversion of the note and underlying the warrants,
respectively,   Under the terms of the agreements the Company is
required to comply with various covenants, which the Company was in compliance
as of September 30, 2010.


9





On
February 12, 2010, the Company acquired all of the outstanding common stock of
Premier Packaging Corporation (“Premier”) from Robert B. and Joan T. Bzdick
for $2,000,000 in cash and 735,437 shares of the Company's common
stock.   In connection with the transaction, the Company incurred
secured bank debt in the principal amount of $1,500,000 which was used to
partially satisfy the purchase price of the Premier common stock. In
conjunction with the transaction, the Company entered into a Credit Facility
Agreement with RBS Citizens, N.A. (“Citizens Bank”) pursuant to which Citizens
Bank provided Premier Packaging Corporation with a term loan of $1,500,000,
and a revolving credit line of up to $1,000,000.  The Credit Facility
Agreement contains customary representations and warranties, affirmative and
negative covenants, including financial covenants (minimum coverage ratio,
debt to EBITDA ratio, and current ratio requirements) and events of default and
is secured by all of the assets of Premier Packaging Corporation.  The
credit facilities are also secured by cross guarantees by Document Security
Systems, Inc., and its other wholly owned subsidiaries, Plastic Printing
Professionals, Inc. and Secuprint, Inc (“DPI Secuprint”).  The
$1,500,000 term loan matures March 1, 2013 and is payable in 35 monthly payments
of $25,000 plus interest commencing March 1, 2010 and a payment of $625,000 on
the 36 month.  Interest accrues at LIBOR plus
3.75%.   The proceeds of the term loan were used as partial
payment of the purchase of all of the outstanding common stock of Premier
Packaging Corporation.    The revolving line of credit up to
$1,000,000 is accessible by the Premier Packaging division subject to
certain terms matures on February 12, 2011 and is payable in monthly
installments of interest only beginning on March 1, 2010. Interest accrues at 1
Month LIBOR plus 3.75%.   The Company subsequently entered into an
interest rate swap agreement to lock into a 5.6% effective interest over the
life of the term loan.  As of September 30, 2010, the remaining
principal balance due on the Note was $1,325,000 and there was approximately
$286,000 outstanding on the revolving credit line.




5.    
Stockholders’ Equity




Restricted Stock
–As of September 30, 2010, there are 40,000 unvested restricted shares
granted to an employee that vests proratably through December
2013.  The unvested shares are valued at $84,000.  In
addition, there are 45,000 restricted shares that will vest only upon the
occurrence of certain events prior to May 3, 2012, which include, among other
things a change of control of the Company or other merger or acquisition of the
Company, the achievement of certain financial goals, including among other
things a successful result of the Company’s patent infringement lawsuit against
the European Central Bank.   These 45,000 shares, if vested,
would result in the recording of stock based compensation expense of
approximately $563,000, the grant date fair value, over the period beginning
when any of the contingent vesting events is deemed to be probable over the
expected requisite service period.  As of September 30, 2010, vesting
is not considered probable and no compensation expense has been recognized
related to the performance grants.





On
February 12, 2010, the Company acquired all of the outstanding common stock of
Premier Packaging Corporation from Robert B. and Joan T. Bzdick for
$2,000,000 in cash and 735,437 shares of the Company's common stock which was
valued at $2,547,675.





On
February 17, 2010, the Company completed the sale of 20 investment units in a
private placement pursuant to subscription agreements with six accredited
investors.  Each investment unit was comprised of 5,000 shares of the
Company’s common stock and five year warrants to purchase 1,000 shares of common
stock at an exercise price of $3.50 per share. In the transaction, the Company
sold 20 investment units for $15,000 per unit for gross cash proceeds of
$300,000, consisting of 100,000 shares of common stock and warrants to purchase
an aggregate of 20,000 shares of common stock.  In connection with
these sales EKN Financial Services Inc., a registered broker-dealer, acted as
non-exclusive placement agent.  EKN Financial Services, Inc. received
a cash fee in the aggregate of $30,000 as commission for these sales. On
February 17, 2010, the Company also sold 20 investment units for gross cash
proceeds of $270,000, consisting of 100,000 shares of common stock and warrants
to purchase an aggregate of 20,000 shares of common stock.   No
placement agent fees were paid on these sales. On February 23, 2010, the Company
issued 304,000 shares of common stock pursuant to the exercise of warrants in
which the Company received proceeds of $608,000.





On July
21, 2010 and July 22, 2010, Document Security Systems entered into subscription
agreements with each of twenty two (22) accredited
investors.   Under these subscription agreements the Company
issued an aggregate of 413,787 shares of common stock and five-year warrants to
purchase 82,753 shares of common stock, in consideration of an aggregate of
$1,200,000.  The warrants are exercisable at $3.75 per share.The Company paid Aegis
Capital Corp., for its services as placement agent, a 7% commission, and a 3%
non-accountable expense allowance, in the aggregate amount of
$120,000.  In addition, we issued the placement agent five year
warrants to purchase 41,379 shares of common stock, exercisable at $3.75 per
share.


10




Stock
Options – During the nine months ended September 30, 2010, the Company
issued options to purchase 40,000 of its common shares at an exercise price of
$2.45 per share to non-employee directors pursuant to the 2004 Non-Employee
Officer Director Stock Option Plan that vest at the end of one year of service
on the Company’s Board of Directors.  The fair value of these options
amounted to approximately $38,000 determined by utilizing the Black Scholes
option pricing model.  In addition, the Company issued options to
purchase 170,000 of its common shares at an exercise prices between $3.23 and
$4.00 per share under the Company’s 2004 Employees’ Stock Option Plan to certain
employees.  The fair value of these options amounted to approximately
$235,000 determined by utilizing the Black Scholes option pricing
model.  The Company records stock-based payment expense related to
these options based on the grant date fair value in accordance with ASC
718.




Stock-Based
Compensation -Stock-based
compensation includes expense charges for all stock-based awards to employees,
directors and consultants. Such awards include option grants, warrant grants,
and restricted stock awards.   During the nine months ended
September 30, 2010, the Company had stock compensation expense of approximately
$336,000 and impacted net loss by  ($0.02 per share) (negative stock
compensation expense of $79,000- 2009; $0.01 per share).





As of
September 30, 2010, there was approximately $454,000 of total unrecognized
compensation costs (excluding the $563,000 that vest upon the occurrence of
certain events) related to non-vested options and restricted stock granted under
the Company’s stock option plans which the Company expects to vest proratably
through December 2013.





Dividend Declared
-On September 23, 2010, the Company’s Board of Directors declared a
dividend whereas the Company would distribute to its stockholders of record on
October 8, 2010 on a pro-rata basis its 7,500,000 shares of  stock in
Internet Media Services.  As a result, the Company has recorded a
dividend payable of approximately $229,000 which was the book value of the
investment as of September 23, 2010.




6.    
Business Combination




On
February 12, 2010, the Company acquired all of the outstanding common stock of
Premier Packaging Corporation (“Premier”) from Robert B. and Joan T. Bzdick
for $2,000,000 in cash and 735,437 shares of the Company's common stock with a
value of $2,566,675 at February 12, 2010.  The cash payment was subject to
a working capital adjustment which was not required as the working capital was
within the target range.   In addition, the purchase price is
subject to increase if the capital gains tax rate that was in effect as of
February 12, 2010 is retroactively increased by legislation or otherwise whereas
the seller’s tax on its gain increases.   Any increase in taxes
will be payable by the Company in either cash or stock.  The Company
believes this contingent payment is remote.  In addition, the seller
has registration rights for its shares to which the Company is subject to
registration penalties of up to $5,000 per month after 120 days.





The
acquisition has been accounted for as a business combination, whereby the
Company measured the identifiable assets acquired and liabilities assumed based
on the acquisition date fair value.  The Company incurred
approximately $30,000 of acquisition related legal and professional fees that
were expensed in the period in which they were incurred.   The
Company is required to recognize and measure any related goodwill acquired in
the business combination or a gain from a bargain purchase.  Based on
management’s preliminary assumptions, the fair value of the assets acquired and
liabilities assumed was less than the purchase price resulting in the recording
of goodwill.   Goodwill totaling approximately $627,000
represents the excess of the purchase price over the fair value of tangible and
identifiable intangible assets acquired and is due primarily to expected
increased market penetration from future products in the secure packaging market
and synergies expected from combining packaging capabilities of Premier with the
printing capabilities of the Company’s Secuprint division.   The
goodwill recorded with the transaction is not deductible for income
taxes.   Since the acquisition through September 30, 2010,
Premier has $1,382,000 in sales and a net loss of $27,000





The
Company engaged a valuation expert, The Financial Valuation Group, to assist
management in determining the fair value of the assets acquired.  The
allocation of the purchase price and the estimated useful lives associated with
the acquired assets and liabilities is as follows:


11





Fair
      value of the consideration transferred
                      
                      $
                      4,566,675
                      
                      Estimated
      Useful
                        LivesFair
      value of assets acquired and liabilities assumed:Cash
                      
                      $
                      5,290Accounts
      receivable
                      
                      
                      1,284,227Inventories
                      
                      
                      504,162Machinery
      and equipment
                      
                      
                      1,557,500
                      
                      3
      to 7 yearsOther
      intangible assets
                      
                      
                      1,372,000
                      
                      5
      to 10 yearsGoodwill
                      
                      
                      627,360Total
      Assets
                      
                      $
                      5,350,539Liabilities
      assumed:Accounts
      payable
                      
                      $
                      448,128Revolving
      credit lines
                      
                      
                      277,645Accrued
      Liabilities
                      
                      
                      58,091Total
      Liabilities
                      
                      $
                      783,864Total
      prelimary purchase price
                      
                      $
                      4,566,675





Set forth
below is the unaudited proforma revenue, operating loss, net loss and loss per
share of the Company as if Premier Packaging Corporation had been acquired by
the Company as of January 1, 2009.





Three Months Ended September 30,
                                            
                                            
                                            Nine Months Ended September 30,(unaudited)
                                            
                                            2010
                                            
                                            
                                            2009
                                            
                                            
                                            2010
                                            
                                            
                                            2009Revenue
                                            
                                            
                                            3,150,936
                                            
                                            
                                            
                                            4,214,950
                                            
                                            
                                            
                                            10,135,506
                                            
                                            
                                            
                                            12,179,226Operating
      Loss
                                            
                                            
                                            (708,774
                                            )
                                            
                                            
                                            (749,606
                                            )
                                            
                                            
                                            (2,722,790
                                            )
                                            
                                            
                                            (2,278,642
                                            )Net
      Loss
                                            
                                            
                                            (882,529
                                            )
                                            
                                            
                                            (859,411
                                            )
                                            
                                            
                                            (3,067,421
                                            )
                                            
                                            
                                            (2,660,770
                                            )Basic
      and diluted loss per share
                                            
                                            
                                            (0.05
                                            )
                                            
                                            
                                            (0.06
                                            )
                                            
                                            
                                            (0.17
                                            )
                                            
                                            
                                            (0.18
                                            )





7.     Other
Income





In March,
2010, the Company received notification that it was due approximately $143,000
for New York State Qualified Emerging Technology Company (“QETC”) refundable tax
credits for the tax year ended 2008 which the Company received in April,
2010.




8.    
Commitments and Contingencies




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





In
2006, the Company received notices that the ECB had filed separate claims in
each of the United Kingdom, The Netherlands, Belgium, Italy, France, Spain,
Germany, Austria and Luxembourg courts seeking the invalidation of the
Patent.  Proceedings were commenced before the national courts seeking
revocation and declarations of invalidity of the Patent.  On March 26,
2007, the High Court of Justice, Chancery Division, Patents Court in London,
England  ruled that the Patent was deemed invalid in the United
Kingdom, and on March 19, 2008 this decision was upheld on appeal.  
As a result of these decisions, the Company was notified of the final assessment
of the reimbursable ECB costs for both court cases was ₤356,490.  At
September 30, 2010, the Company had paid all except approximately $16,000 of the
final assessment.  The remaining  $16,000 was in accrued
expenses as of September 30, 2010 which the Company paid in full as of October
31, 2010.


12





On March
27, 2007 the Bundespatentgericht of the Federal Republic of Germany ruled that
the German part of the Patent was valid, having considered the English Court’s
decision.  On July 6, 2010, the Company was notified that the German
Court has ruled that the Patent, that was awarded to the Company by the European
Patent Office and upheld as valid in a previous hearing in the German Court of
First Instance, has now been deemed invalid in Germany due to added
matter.   On January 9, 2008 the French Court held that the
Patent was invalid in France for the same reasons given by the English
Court.  The Company filed an appeal against the French decision on May 7,
2008. On March 20, 2010, the Company was informed that the decision was
upheld in the French appeal.  On March 12, 2008 the Dutch
Court  ruled that the Patent is valid in the
Netherlands.  The ECB filed an appeal against the Dutch decision on
March 27, 2008.  The Dutch appeal was heard in June 2010, with a decision
expected in late 2010 or early 2011.  On November 3, 2009, the Belgium
Court held that the Patent was invalid in Belgium for the same reasons given by
the English and French courts as were similarly informed by the Austrian court
on November 17, 2009.   Cost reimbursement, if any, associated with
the Belgium, Austrian, and French validity cases as well as the appeals in
Germany and France are covered under the Trebuchet agreement described
below.  On March 24, 2010 the Spanish Court ruled that the Patent was
valid.  In Italy the validity case is expected to be heard again by a newly
appointed judge in late 2010 and a hearing in Luxembourg
thereafter.





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





The
Patent has thus been confirmed to be valid and enforceable in two
jurisdictions (the Netherlands and Spain) that use the Euro as its national
currency allowing the Company or Trebuchet Capital Partners, on the Company’s
behalf, to proceed with infringement cases in these countries if we choose to do
so.   On February 18, 2010, Trebuchet, on behalf of the Company, filed
an infringement suit in the Netherlands.  The suit is being lodged against
the ECB and two security printing entities with manufacturing operations in the
Netherlands, Joh. Enschede Banknotes B.V.; and Koninklijke Joh. Enschede
B.V.    The ECB and the security printers have been notified and
the court hearing date is tentatively scheduled for January 21,
2011.





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





Contingent
Litigation Payment – In May 2005, the Company made an agreement with its
legal counsel in charge of the Company’s litigation with the European Central
Bank which capped the fees for all matters associated with that litigation at
$500,000 plus expenses, and a $150,000 contingent payment upon a successful
ruling or settlement on the Company’s behalf in that litigation.  The
Company will record the $150,000 in the period in which the Company has
determined that a successful ruling or settlement is probable.


13


In
addition, pursuant to an agreement made in December 2004, the Company is
required to share the economic benefit derived from settlements, licenses or
subsequent business arrangements that the Company obtains from any infringer of
patents formerly owned by the Wicker Family.  For infringement matters
involving certain U.S. patents, the Company will be required to disburse 30% of
the net settlement proceeds.  For infringement matters involving
certain foreign patents, the Company will be required to disburse 14% of the net
settlement proceeds.  These payments do not apply to licenses or
royalties to patents that the Company has developed or obtained from persons
other than the Wicker Family.  As of September 30, 2010, there has
been no settlement amounts related to these agreements.





Contingent
Purchase Price -In December, 2008, the Company acquired substantially all
of the assets of DPI of Rochester, LLC (“DPI”) in which the Company guaranteed
up to $50,000 to certain parties depending on whether certain conditions
occurred within five years of the acquisition.   As of September 30,
2010, the Company considers the likelihood that the payment will be required as
remote.





Employment
agreements - In May 2008, the Company entered into a Separation Agreement
with its former President that, among other things, accelerated the vesting of
33,333 shares of restricted common stock of the Company that were previously
awarded to the former President pursuant to the Company’s 2004 Employee Stock
Option Plan so that such shares vested in equal monthly installments during the
immediately following ten months.  The Separation Agreement further
provided that if the former President did not realize at least $212,000 in gross
proceeds from the sale of such 33,333 shares of restricted stock upon their
vesting, then the Company would pay the former President the amount that such
proceeds is less than $212,000 in cash or additional shares of common stock of
the Company.  As of September 30, 2010, there is no remaining amount
due under the agreement.





Operating
leaseswith a related
party - In conjunction with it acquisition of Premier Packaging in
February 2010, the Company entered into a ten-year lease for a production
facility in Victor, NY with Robert Bzdick, the former owner of Premier
Packaging, and the Company’s Chief Operating Officer and President
of  Premier Packaging.   The minimum future lease
payments subsequent to September 30, 2010 under this lease are as
follows:





2010
                    
                    $
                    40,0002011
                    
                    $
                    160,0002012
                    
                    $
                    160,0002013
                    
                    $
                    160,0002014
                    
                    $
                    160,0002015
                    
                    $
                    160,000Thereafter
                    
                    $
                    735,000




9.      Supplemental
Cash Flow Information




During the nine months ended September
30, 2010, the Company issued 735,437 shares valued at $2,566,675 as a partial
payment of an acquisition.  In addition, the Company satisfied
approximately $74,000 of accrued expenses by issuing common stock of the Company
and had a non-cash other comprehensive loss item for an interest rate swap loss
of approximately $32,000.  Cash paid for interest during the nine
months ended September 30, 2010, was approximately $185,000 ($153,000 -
2009).  On
September 23, 2010, the Company declared a "non-cash" dividend of 7,500,000
shares of the Company's investment in Internet Media Services to be distributed
to stockholders of the Company on record on October 8, 2010. During the nine months ended September 30, 2009, the Company
entered into capital leases of approximately $96,000 for production equipment at
its commercial print facility and
satisfied approximately $33,000 of accrued expenses by issuing common
stock.




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 DPI Secuprint, are engaged
in various aspects of developing and applying printing technologies and
procedures to produce, or allow others to produce, documents with a wide range
of features, including the Company’s patented technologies and trade secrets,
along with traditional commercial printing on paper and
plastic.    For the purposes of providing segment
information, these three operating segments have been aggregated into one
reportable segment in accordance with ASC 280.  The fourth business is
engaged in the production of packaging products and is classified as a separate
segment.    A summary of the three segments
follows:




Security
      and
              CommercialPrinting
            License, manufacture and sale of
      patented document security technologies, including digital security print
      solutions, and general commercial printing, primarily on paper and
      plastic.  Comprises the operations of Document Security Systems,
      Plastic Printing Professionals, and DPI Secuprint.





Packaging
            The Company acquired Premier
      Packaging in February 12, 2010 which produces packaging products such as
      boxes, mailers, and point of sale displays for various
      end-users.





Legal
      Supplies
            Sale of specialty legal supplies,
      primarily to lawyers and law firms located throughout the United States as
      Legalstore.com. During the fourth quarter of 2009, the Company sold
      its legal products
business.


14





Approximate
information concerning the Company’s operations by reportable segment for the
three and nine months ended September 30, 2010 and 2009 is as follows.  The
Company relies on intersegment cooperation and management does not represent
that these segments, if operated independently, would report the results
contained herein:




3 months ended September 30, 2010:
                            
                            Legal
                              Supplies
                            
                            
                            Security and
                              Commercial
                              Printing
                            
                            
                            Packaging
                            
                            
                            Corporate
                            
                            
                            TotalRevenues
      from external customers
                            
                            $
                            -
                            
                            
                            $
                            1,769,000
                            
                            
                            $
                            1,382,000
                            
                            
                            $
                            -
                            
                            
                            $
                            3,151,000Depreciation
      and amortization
                            
                            
                            -
                            
                            
                            
                            221,000
                            
                            
                            
                            86,000
                            
                            
                            
                            1,000
                            
                            
                            
                            308,000Segment
      profit (loss)
                            
                            
                            -
                            
                            
                            
                            (657,000
                            )
                            
                            
                            (27,000
                            )
                            
                            
                            (199,000
                            )
                            
                            
                            (883,000
                            )Indentifiable
      assets
                            
                            
                            -
                            
                            
                            
                            5,099,000
                            
                            
                            
                            5,177,000
                            
                            
                            
                            408,000
                            
                            
                            
                            10,684,0003
      months ended September 30, 2009:Revenues
      from external customers
                            
                            $
                            102,000
                            
                            
                            $
                            2,451,000
                            
                            
                            $
                            -
                            
                            
                            $
                            -
                            
                            
                            $
                            2,553,000Depreciation
      and amortization
                            
                            
                            5,000
                            
                            
                            
                            395,000
                            
                            
                            
                            -
                            
                            
                            
                            1,000
                            
                            
                            
                            401,000Segment
      profit (loss)
                            
                            
                            10,000
                            
                            
                            
                            (505,000
                            )
                            
                            
                            -
                            
                            
                            
                            (460,000
                            )
                            
                            
                            (955,000
                            )Indentifiable
      assets
                            
                            
                            255,000
                            
                            
                            
                            6,649,000
                            
                            
                            
                            -
                            
                            
                            
                            431,000
                            
                            
                            
                            7,335,000





9 months ended September 30, 2010:
                          
                          Legal
                            Supplies
                          
                          
                          Security and
                            Commercial
                            Printing
                          
                          
                          Packaging
                          
                          
                          Corporate
                          
                          
                          TotalRevenues
      from external customers
                          
                          $
                          -
                          
                          
                          $
                          5,799,000
                          
                          
                          $
                          3,452,000
                          
                          
                          $
                          -
                          
                          
                          $
                          9,251,000Depreciation
      and amortization
                          
                          
                          -
                          
                          
                          
                          736,000
                          
                          
                          
                          212,000
                          
                          
                          
                          2,000
                          
                          
                          
                          950,000Segment
      profit (loss)
                          
                          
                          -
                          
                          
                          
                          (1,941,000
                          )
                          
                          
                          (102,000
                          )
                          
                          
                          (957,000
                          )
                          
                          
                          (3,000,000
                          )Indentifiable
      assets
                          
                          
                          -
                          
                          
                          
                          5,099,000
                          
                          
                          
                          5,177,000
                          
                          
                          
                          408,000
                          
                          
                          
                          10,684,0009
      months ended September 30, 2009:Revenues
      from external customers
                          
                          $
                          355,000
                          
                          
                          $
                          7,224,000
                          
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          7,579,000Depreciation
      and amortization
                          
                          
                          15,000
                          
                          
                          
                          1,203,000
                          
                          
                          
                          -
                          
                          
                          
                          3,000
                          
                          
                          
                          1,221,000Segment
      profit (loss)
                          
                          
                          37,000
                          
                          
                          
                          (1,610,000
                          )
                          
                          
                          -
                          
                          
                          
                          (1,300,000
                          )
                          
                          
                          (2,873,000
                          )Indentifiable
      assets
                          
                          
                          255,000
                          
                          
                          
                          6,649,000
                          
                          
                          
                          -
                          
                          
                          
                          431,000
                          
                          
                          
                          7,335,000




11.    
Subsequent Events




OnOctober 8, 2010, the
Company wholly owned subsidiary, Premier Packaging Corporation amended
its  Credit Facility Agreement with RBS Citizens, N.A. (“Citizens
Bank”) to add a Standby Term Loan Note pursuant to which Citizens Bank will
provide Premier Packaging with up to $450,000 towards the funding of eligible
equipment purchases.   The Company has 12 months to draw a line
of credit, after which the balance of funds advanced from the line is converted
into a 5 year term loan.  Interest accrues at  LIBOR plus
3.00%.   The Credit Facility Agreement was amended to include the
Standby Term Note and contains customary representations and warranties,
affirmative and negative covenants, and events of default and is secured by all
of the assets of Premier Packaging Corporation.  The Credit Facility
is secured by cross guarantees by Document Security Systems, Inc., and its other
wholly owned subsidiaries, Plastic Printing Professionals, Inc. and Secuprint,
Inc.   On October 12, 2010, the Company drew approximately
$53,000 from the Standby line for the purchase of certain
equipment.


15




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




FORWARD-LOOKING
STATEMENTS




Certain
statements contained herein constitute “forward-looking statements” within the
meaning of the Private Securities Litigation Reform Act of 1995 (the “1995
Reform Act”).   Document Security Systems, Inc. desires to avail
itself of certain “safe harbor” provisions of the 1995 Reform Act and is
therefore including this special note to enable us to do so.  Except
for the historical information contained herein, this report contains
forward-looking statements (identified by the words "estimate," "project,"
"anticipate," "plan," "expect," "intend," "believe," "hope," "strategy" and
similar expressions), which are based on our current expectations and speak only
as of the date made. These forward-looking statements are subject to various
risks, uncertainties and factors that could cause actual results to differ
materially from the results anticipated in the forward-looking statements,
including, without limitation, those contained in our Form 10-K for the year
ended December 31, 2009, and those described herein that could cause actual
results to differ materially from the results anticipated in the forward-looking
statements, and the following:




·
            Our
      limited operating history with our business
  model,


·
            Our
      low cash balance and negative working capital and limited financing
      currently available to us, we may in the near future have a number of
      obligations that we will be unable to meet without generating additional
      income or raising additional
capital,


·
            The
      risk of insolvency or bankruptcy if we cannot generate additional income
      or raise additional capital in the near
future,


·
            Further
      cost reductions or curtailment in future operations due to our low cash
      balance and negative cash flow,


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


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


·
            The
      loss in current litigation in which we may lose certain of our technology
      rights, which may affect our business
plan,


·
            The
      inability to adequately protect our intellectual
  property,


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


·
            The
      failure of our products and services to achieve market
      acceptance,


·
            Changes
      in document security technology and standards could render our
      applications and services obsolete,


·
            The
      inability to compete in our market, especially against established
      industry competitors with greater market presence and financial
      resources.




Overview




Document
Security Systems, Inc. (referred to in this report as “Document Security,”
“DSS,” “we,” “us,” “our” or  “Company”) develops, markets,
manufactures and sells paper and plastic products designed to protect valuable
information from unauthorized scanning, copying, and digital
imaging.  We have developed security technologies that are applied
during the normal printing process and by all printing methods including
traditional offset, gravure, flexo, digital or via the internet on paper,
plastic, or packaging.  In addition, our technologies can be applied
to product packaging.  Our technologies and products are used by
federal, state and local governments, law enforcement agencies and are also
applied to a broad variety of industries as well, including financial
institutions, high technology and consumer goods, entertainment and gaming,
healthcare/pharmaceutical, defense and genuine parts
industries.   Our customers use our technologies where there is a
need for enhanced security for protecting and verification of critical financial
instruments and vital records, or where there are concerns of counterfeiting,
fraud, identity theft, brand protection and liability.





Our core
business is counterfeit prevention, brand protection and validation of authentic
print media, including government-issued documents, currency, private corporate
record and, securities.  We believe we are a world leader in the
research and development of optical deterrent technologies and have
commercialized these technologies with a broad suite of products that offer our
customers a wide array of document security solutions to satisfy their specific
anti-counterfeiting requirements.  Our technology can be used in
securing sensitive and critical documents such as currency, automobile titles,
spare parts forms for the aerospace industry, gift certificates, permits,
checks, licenses, receipts, prescription and medical forms, engineering
schematics, ID cards, labels, original music, coupons, homeland security
manuals, consumer product and pharmaceutical packaging, tickets, and school
transcripts.  In addition, we have developed a digital product to
implement our technologies in Internet-based environments utilizing standard
desktop printers.  We believe that our digital technology greatly
expands the reach and potential market for our technologies and
solutions.  In February 2010, we acquired Premier Packaging, a
privately held commercial packaging company located in Victor, NY with
approximately $7.3 million in sales in 2009.   As a result of
this acquisition, we have entered the packaging market with the intent to
introduce our security technologies to a new audience geared toward the
protection of brand counterfeiting.  We believe that the use of our
technologies on product packaging presents a significant
opportunity.  In addition, this acquisition will allow us to
strengthen our competitive position in the traditional commercial printing and
packaging markets as we will be able to offer a very price effective combination
of services.


16





Technologies





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





Products
and Services





Security andCommercialPrinting:  Our
technology portfolio allows us to create unique custom secure paper, plastic,
packaging and Internet-based and software enterprise solutions.  We
market and sell under the name Document Security Systems to end-users that
require anti-counterfeiting and authentication features in a wide range of
printed materials such as documents, vital records, prescription paper, driver’s
licenses, birth certificates, receipts, manuals, identification materials,
entertainment tickets, coupons, parts tracking forms.





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





We
produce secure and non-secure printing at our 20,000 square foot printing
facility  in Rochester, NY.  Our printing division has a
high speed 6 color press along with two digital presses along with a full range
of die cutting, packing, and folding capabilities.





We
produce our secure and non-secure plastic printed documents such as ID cards,
event badges, and driver licenses at our 25,000 square foot facility in
Brisbane, California under the name Plastic Printing
Professionals.  Our plastic division has the capabilities for high
speed data encoding and production of high-volume precision RFID
cards.





Packaging: We produce our
secure and non-secure packaging products such as boxes, mailers, point of sale
displays, utilizing a CAD/CAM design system that allows for early stage
prototyping at our manufacturing facility in Victor, New York.  Our
packaging division offers automated die cutting, high speed folding, gluing,
window and paper patching, automated in-line inserting, pick and place and
tip-on systems.





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





The
Company has developed an internet delivered technology called AuthentiGuard® –
On DemandTM where information is hidden and then verified utilizing an
inexpensive viewing glass.  This technology is currently being
utilized by a Central American country for travel visas.





The
Company has also developed digital versions of its AuthentiGuard® –
PrismTM  and AuthentiGuard® – Pantograph 4000TM  technologies
which are produced on HP Indigo Presses, Canon Color Copiers, Ricoh Color
Copiers and Konica Desktop Printers.  The Company sells the digital
products directly through its internal sales force and it has also entered a
contract to sell its digital solutions through a third party who specializes in
hardware software engineering solutions.


17





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





·
            Pay
      us one price per year;


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


·
            Joint
      venture or profit sharing
arrangement


·
            Pay
      Per Finished Piece




Legal Products:  We
also owned and operated Legalstore.com, an Internet company which sells legal
supplies and documents, including security paper and products for the users of
legal documents and supplies in the legal, medical and educational
fields.  On October 8, 2009 we sold the assets and liabilities
associated with our Legalstore.com business in exchange for 7,500,000 shares of
common stock of Internet Media Services, Inc., representing approximately 37% of
the outstanding shares of the newly formed company.  Commencing on
October 18, 2010, the Company distributed its 7,500,000 shares of Internet Media
Services to the Company’s shareholders of record on October 8, 2010 on a
pro-rata basis.     The shares of Internet Media
Services were recorded as an equity method investment by the Company and had a
book value of approximately $229,000 on the date the dividend was
declared.




Results of
Operations for the Three and Nine Months Ended September 30,
2010 Compared to the Three and Nine Months ended September 30,
2009




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.   During the third quarter of
2009, the Company’s Board of Directors finalized an agreement to sell its legal
products business.   In accordance with ASC 205-20-45, the
Company reported the results of Legalstore.com as continued operations because
the operations and cash flow of the component were not eliminated and given the
Company’s continued involvement after the sale.




The
discussion should be read in conjunction with the financial statements and
footnotes in this quarterly report and in our annual report on Form 10-K for the
year ended December 31, 2009.




Revenue




Three Months
                    Ended September
                    30, 2010
                  
                  
                  Three Months
                    Ended September
                    30, 2009
                  
                  
                  % change
                  
                  
                  Nine Months
                    Ended September
                    30, 2010
                  
                  
                  Nine Months
                    Ended September
                    30, 2009
                  
                  
                  % changeRevenueSecurity
      and commercial printing
                  
                  $
                  1,620,000
                  
                  
                  $
                  2,247,000
                  
                  
                  
                  -28
                  %
                  
                  $
                  5,307,000
                  
                  
                  $
                  6,605,000
                  
                  
                  
                  -20
                  %Packaging
                  
                  
                  1,382,000
                  
                  
                  
                  -
                  
                  
                  
                  
                  
                  
                  
                  3,452,000
                  
                  
                  
                  -Technology
      license royalties and digital solutions
                  
                  
                  149,000
                  
                  
                  
                  204,000
                  
                  
                  
                  -28
                  %
                  
                  
                  492,000
                  
                  
                  
                  619,000
                  
                  
                  
                  -21
                  %Legal
      products
                  
                  
                  -
                  
                  
                  
                  102,000
                  
                  
                  
                  -100
                  %
                  
                  
                  -
                  
                  
                  
                  355,000
                  
                  
                  
                  -100
                  %Total
      Revenue
                  
                  $
                  3,151,000
                  
                  
                  $
                  2,553,000
                  
                  
                  
                  23
                  %
                  
                  $
                  9,251,000
                  
                  
                  $
                  7,579,000
                  
                  
                  
                  22
                  %




For the
three months ended September 30, 2010, revenue was $3.2 million compared to $2.6
million for the three months ended September 30, 2009, an increase of
23%.   In February 2010, the Company acquired Premier Packaging
Corp, which had sales of $1,382,000.  The addition of Premier
Packaging sales offset a 28% decline in security and commercial print revenue
and a decrease of 28% of technology license royalties and digital solutions, and
the absence of legal products revenue in 2010 as the division was sold in the
fourth quarter of 2009.   The primary factor in the reduction of
commercial and security printing sales was a 32% reduction in sales of
commercial printing due to the continued weakness in sales in the Company’s
regional market and the absence of larger orders from the Company’s largest
commercial printing customer, which the Company had received in the during
2009.




18




For the
nine months ended September 30, 2010, revenue was $9.3 million compared to $7.6
million for the nine months ended September 30, 2009, an increase of
22%.  The addition of Premier Packaging sales offset a 20% decline in
security and commercial print revenue and a decrease of 21% of technology
license royalties and digital solutions, and the absence of legal products
revenue in 2010 as the division was sold in the fourth quarter of
2009.




Cost
of Revenue and Gross Profit




Three Months
                    Ended September
                    30, 2010
                  
                  
                  Three Months
                    Ended September
                    30, 2009
                  
                  
                  % change
                  
                  
                  Nine Months
                    Ended September
                    30, 2010
                  
                  
                  Nine Months
                    Ended September
                    30, 2009
                  
                  
                  % changeCosts
      of revenueSecurity
      and commercial printing
                  
                  $
                  1,210,000
                  
                  
                  $
                  1,516,000
                  
                  
                  
                  -20
                  %
                  
                  $
                  3,964,000
                  
                  
                  $
                  4,547,000
                  
                  
                  
                  -13
                  %Packaging
                  
                  
                  1,056,000
                  
                  
                  
                  -
                  
                  
                  
                  
                  
                  
                  
                  2,673,000
                  
                  
                  
                  -Technology
      license royalties and digital solutions
                  
                  
                  -
                  
                  
                  
                  4,000
                  
                  
                  
                  -100
                  %
                  
                  
                  5,000
                  
                  
                  
                  11,000
                  
                  
                  
                  -55
                  %Legal
      products
                  
                  
                  -
                  
                  
                  
                  56,000
                  
                  
                  
                  -100
                  %
                  
                  
                  -
                  
                  
                  
                  179,000
                  
                  
                  
                  -100
                  %Total
      cost of revenue
                  
                  
                  2,266,000
                  
                  
                  
                  1,576,000
                  
                  
                  
                  44
                  %
                  
                  
                  6,642,000
                  
                  
                  
                  4,737,000
                  
                  
                  
                  40
                  %Gross
      profitSecurity
      and commercial printing
                  
                  
                  410,000
                  
                  
                  
                  731,000
                  
                  
                  
                  -44
                  %
                  
                  
                  1,343,000
                  
                  
                  
                  2,058,000
                  
                  
                  
                  -35
                  %Packaging
                  
                  
                  326,000
                  
                  
                  
                  -
                  
                  
                  
                  
                  
                  
                  
                  779,000
                  
                  
                  
                  -Technology
      license royalties and digital solutions
                  
                  
                  149,000
                  
                  
                  
                  200,000
                  
                  
                  
                  -26
                  %
                  
                  
                  487,000
                  
                  
                  
                  608,000
                  
                  
                  
                  -20
                  %Legal
      products
                  
                  
                  -
                  
                  
                  
                  46,000
                  
                  
                  
                  -100
                  %
                  
                  
                  -
                  
                  
                  
                  176,000
                  
                  
                  
                  -100
                  %Total
      gross profit
                  
                  
                  885,000
                  
                  
                  
                  977,000
                  
                  
                  
                  -9
                  %
                  
                  
                  2,609,000
                  
                  
                  
                  2,842,000
                  
                  
                  
                  -8
                  %




Three Months
                    Ended September
                    30, 2010
                  
                  
                  Three Months
                    Ended September
                    30, 2009
                  
                  
                  % change
                  
                  
                  Nine Months
                    Ended September
                    30, 2010
                  
                  
                  Nine Months
                    Ended September
                    30, 2009
                  
                  
                  % changeGross
      profit percentage:
                  
                  
                  28
                  %
                  
                  
                  38
                  %
                  
                  
                  -26
                  %
                  
                  
                  28
                  %
                  
                  
                  37
                  %
                  
                  
                  -24
                  %




Gross
profit decreased 9% to $885,000 in the third quarter of 2010 as compared to the
third quarter of 2009.  The decrease was primarily due to the a
significant decrease in the gross profits generated from the Company’s security
and commercial printing as a result of decreases in sales at the Company’s
commercial printing division, which nearly offset the increase in gross profits
as a result of the Company’s packaging  division which the Company
acquired in February 2010.  In addition, the Company did not have any
gross profits from legal product sales as the division was sold in the fourth
quarter of 2009.  Gross profit for the nine months ended September 30,
2010 decreased 8%, which reflect a significant decrease in security and
commercial print profits that the Company has experienced in 2010 due to the
lack of large commercial print orders in 2010 that the Company had experienced
in 2009.   The Company’s gross profit percentage decrease for
both periods reflects the larger weight that packaging sale, which typically
carry a lower gross profit margin, has on the Company’s overall revenue areas,
along with the weakness in commercial printing sales.   The
Company expects that the impact of the Company’s acquisition of it packaging
division will be to decrease overall gross profit margins for at least the near
future, especially as the number of non-security packaging projects out-number
the security packaging projects, which the Company expect will be at higher
profit margins.


19




Operating
Expenses




Three Months
                    Ended September
                    30, 2010
                  
                  
                  Three Months
                    Ended September
                    30, 2009
                  
                  
                  % change
                  
                  
                  Nine Months
                    Ended September
                    30, 2010
                  
                  
                  Nine Months
                    Ended September
                    30, 2009
                  
                  
                  % changeOperating
      ExpensesSales,
      general and administrative compensation
                  
                  $
                  870,000
                  
                  
                  $
                  855,000
                  
                  
                  
                  2
                  %
                  
                  $
                  2,561,000
                  
                  
                  $
                  2,713,000
                  
                  
                  
                  -6
                  %Professional
      Fees
                  
                  
                  92,000
                  
                  
                  
                  147,000
                  
                  
                  
                  -37
                  %
                  
                  
                  437,000
                  
                  
                  
                  434,000
                  
                  
                  
                  1
                  %Sales
      and marketing
                  
                  
                  46,000
                  
                  
                  
                  34,000
                  
                  
                  
                  35
                  %
                  
                  
                  172,000
                  
                  
                  
                  105,000
                  
                  
                  
                  64
                  %Research
      and development
                  
                  
                  72,000
                  
                  
                  
                  61,000
                  
                  
                  
                  18
                  %
                  
                  
                  205,000
                  
                  
                  
                  223,000
                  
                  
                  
                  -8
                  %Rent
      and utilities
                  
                  
                  170,000
                  
                  
                  
                  129,000
                  
                  
                  
                  32
                  %
                  
                  
                  478,000
                  
                  
                  
                  399,000
                  
                  
                  
                  20
                  %Other
                  
                  
                  (10,000
                  )
                  
                  
                  197,000
                  
                  
                  
                  -105
                  %
                  
                  
                  361,000
                  
                  
                  
                  452,000
                  
                  
                  
                  -20
                  %1,240,000
                  
                  
                  
                  1,423,000
                  
                  
                  
                  -13
                  %
                  
                  
                  4,214,000
                  
                  
                  
                  4,326,000
                  
                  
                  
                  -3
                  %Other
      Operating ExpensesDepreciation
      and software amortization
                  
                  
                  34,000
                  
                  
                  
                  36,000
                  
                  
                  
                  -6
                  %
                  
                  
                  96,000
                  
                  
                  
                  116,000
                  
                  
                  
                  -17
                  %Stock
      based compensation
                  
                  
                  130,000
                  
                  
                  
                  38,000
                  
                  
                  
                  242
                  %
                  
                  
                  336,000
                  
                  
                  
                  (79,000
                  )
                  
                  
                  -525
                  %Amortization
      of intangibles
                  
                  
                  189,000
                  
                  
                  
                  324,000
                  
                  
                  
                  -42
                  %
                  
                  
                  620,000
                  
                  
                  
                  971,000
                  
                  
                  
                  -36
                  %353,000
                  
                  
                  
                  398,000
                  
                  
                  
                  -11
                  %
                  
                  
                  1,052,000
                  
                  
                  
                  1,008,000
                  
                  
                  
                  4
                  %Total
      Operating Expenses
                  
                  $
                  1,593,000
                  
                  
                  $
                  1,821,000
                  
                  
                  
                  -13
                  %
                  
                  $
                  5,266,000
                  
                  
                  $
                  5,334,000
                  
                  
                  
                  -1
                  %




Selling, General and
Administrative




Sales, general and
administrative compensation costs were 2% higher in the three months
ending September, 30, 2010 as compared to the three months ended September 30,
2009, which reflects the impact of the addition of approximately $168,000 of
SG&A compensation expense from the packaging division the Company acquired
in February 2010.  Otherwise, SG&A compensation costs would have
decreased 18% during the three months ended September 30, 2010, as compared to
the three months ended September 30, 2009 as the result of staff reductions made
by the Company throughout 2009 and in early 2010 primarily in its commercial
printing division.




For the
nine months ended September 30, 2010, SG&A compensation costs decreased 6%
despite the addition of the packaging division, which added $387,000 of SG&A
compensation expense.  Otherwise, SG&A compensation expense has
decreased 20% during the first nine months of 2010 as compared to the first nine
months of 2009, which also reflects the staff reductions made by the Company
throughout 2009 and in early 2010 primarily in its commercial printing
division.




Professional feesin
the three months ended September 30, 2010 were $92,000 a decrease of 37% from
the third quarter of 2009, as the Company incurred lower legal
costs.  For the nine months ended 2010, professional fees were
consistent with the first nine months of 2009.




Sales and marketing
costs during the third quarter and first nine months of 2010 increased 35% and
64%, respectively, from the 2009 period as the Company re-initiated certain
marketing efforts and trade show participation in 2010 based on expectations
that the sales downturn the Company had experienced during the global recession
was reversing.




Research and development
costsconsist primarily of compensation costs for research personnel and
direct costs for the use of third-party printers’ facilities to test our
technologies on equipment that we do not have access to
internally.   Research and development costs decreased due to a
reduction in compensation cost.




Rent and utilities
increased as a result of the acquisition of Premier Packaging in February
2010.




Otherexpenses are
primarily equipment maintenance and repairs, office supplies, IT support, bad
debt expense and insurance costs.  For the three months ended
September 30, 2010, these costs decreased 105% as the result of a one time write
off of previously accrued estimated expenses of approximately $139,000 that were
never incurred and a write off of previous payroll related accruals that never
transpired.   Without these items, other
expenses  increased 12% in the three months ended September 30, 2010
compared to  the three months ended September 30, 2009, primarily as
the result of costs associated with the Company’s packaging division, which the
Company acquired in February 2010.   Otherwise, other operating
expenses for the three and nine month periods ended September 30, 2010 were
generally consistent with the 2009 periods.


20




Stock based
compensation includes expense charges for all stock based awards to
employees, directors and consultants.  Such awards include option
grants, warrant grants, and restricted stock awards.   Stock
based compensation in the third quarter of 2010 was $130,000 as compared to
$38,000 in the third quarter of 2009 which reflected the impact of options
granted to employees at Premier Packaging when the Company acquired it in
February 2010, and to certain senior management, along with stock based
compensation expense related to warrants issued to third parties for
consulting.




Stock
based compensation in the first nine months of 2010 was $336,000 as compared to
a negative $79,000 stock based compensation expense for the first nine months of
2009 which reflected the effect of reversals of previously recorded stock based
compensation expense for stock options and restricted shares issued to the
Company’s employees which terminated unvested due to employee terminations that
occurred during the first quarter of 2009.




Amortization of
intangibles expense decreases in the three and nine month periods ended
September 30, 2010, as compared to the 2009 periods were a result of the
reduction in the Company’s net capitalized patent acquisition and defense costs
asset, offset by increases in amortization of other intangible expense of new
other intangibles acquired.




Other
Income and expenses




Three Months
                    Ended September
                    30, 2010
                  
                  
                  Three Months
                    Ended September
                    30, 2009
                  
                  
                  %change
                  
                  
                  Nine Months
                    Ended September
                    30, 2010
                  
                  
                  Nine Months
                    Ended September
                    30, 2009
                  
                  
                  %changeOther
      income (expense):Interest
      Income
                  
                  $
                  -
                  
                  
                  $
                  18,000
                  
                  
                  
                  -100
                  %
                  
                  $
                  -
                  
                  
                  $
                  18,000
                  
                  
                  
                  -100
                  %Interest
      expense
                  
                  
                  (79,000
                  )
                  
                  
                  (58,000
                  )
                  
                  
                  36
                  %
                  
                  
                  (228,000
                  )
                  
                  
                  (207,000
                  )
                  
                  
                  10
                  %Amortizaton
      of note discount
                  
                  
                  (41,000
                  )
                  
                  
                  (64,000
                  )
                  
                  
                  -36
                  %
                  
                  
                  (122,000
                  )
                  
                  
                  (189,000
                  )
                  
                  
                  -35
                  %Loss
      in equity investment
                  
                  
                  (50,000
                  )
                  
                  
                  -
                  
                  
                  
                  
                  
                  
                  
                  (121,000
                  )
                  
                  
                  -Gain
      on foreign currency transactions
                  
                  
                  -
                  
                  
                  
                  (1,000
                  )
                  
                  
                  -100
                  %
                  
                  
                  -
                  
                  
                  
                  10,000
                  
                  
                  
                  -100
                  %Other
      income
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  
                  
                  
                  
                  143,000
                  
                  
                  
                  -Other
      income (expense), net
                  
                  $
                  (170,000
                  )
                  
                  $
                  (105,000
                  )
                  
                  
                  62
                  %
                  
                  $
                  (328,000
                  )
                  
                  $
                  (368,000
                  )
                  
                  
                  -11
                  %




Loss in equity investment:The Company recognizes gains or losses on its investment in Internet
Media Services, the entity that purchased Legalstore.com business from the
Company in October 2009 under the equity method of accounting for
investments.   On September 23, 2010, the Company’s Board of
Directors declared a dividend whereas the Company would distribute to its
stockholders of record on October 8, 2010 on a pro-rata basis its shares of
stock in Internet Media Services.  As a result, the Company has
recorded a dividend payable of $229,000 which was the book value of the
investment as of September 23, 2010.





Other income:In March, 2010,
the Company received notification that it was due approximately $143,000 for New
York State Qualified Emerging Technology Company (“QETC”) refundable tax credits
for the tax year ended 2008 which the Company received in April,
2010.




Net
Loss and Loss Per Share




Three Months
                          Ended September
                          30, 2010
                        
                        
                        Three Months
                          Ended September
                          30, 2009
                        
                        
                        % change
                        
                        
                        Nine Months
                          Ended September
                          30, 2010
                        
                        
                        Nine Months
                          Ended September
                          30, 2009
                        
                        
                        % changeNet
      loss
                        
                        $
                        (883,000
                        )
                        
                        $
                        (955,000
                        )
                        
                        
                        -8
                        %
                        
                        $
                        (3,000,000
                        )
                        
                        $
                        (2,873,000
                        )
                        
                        
                        4
                        %Net
      loss per share, basic and diluted
                        
                        $
                        (0.05
                        )
                        
                        $
                        (0.06
                        )
                        
                        
                        -17
                        %
                        
                        $
                        (0.17
                        )
                        
                        $
                        (0.20
                        )
                        
                        
                        -15
                        %Weighted
      average common shares outstanding, basic and diluted
                        
                        
                        18,008,012
                        
                        
                        
                        14,711,105
                        
                        
                        
                        22
                        %
                        
                        
                        17,599,410
                        
                        
                        
                        14,510,056
                        
                        
                        
                        21
                        %




During
the three months ended September 30, 2010, the Company experienced a net loss of
$883,000, an 8% decrease from the net loss during the three months ended
September 30, 2009.  The decrease in net loss during the quarter was
primarily due to a decrease in gross profit during the quarter, offset by a
significant decrease in other operating expenses due to the write-off of certain
estimated accrued expenses.


21




For the
first nine months of  2010, the Company has experienced a net loss of
$3,000,000, a 4% increase from the net loss during the first nine months
of  2009, which also primarily reflected a decrease in gross profits
of 8% which was partially offset by a 1% decrease in operating
expenses.




LIQUIDITY
AND CAPITAL RESOURCES




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




As Of And For The Period Ended:September 30,
                    2010
                  
                  
                  September 30,
                    2009
                  
                  
                  % change vs.
                    2009Cash
      flows from:Operating
      activities
                  
                  $
                  (1,261,000
                  )
                  
                  $
                  (1,484,000
                  )
                  
                  
                  15
                  %Investing
      activities
                  
                  
                  (2,530,000
                  )
                  
                  
                  (71,000
                  )
                  
                  
                  -3463
                  %Financing
      activities
                  
                  
                  3,751,000
                  
                  
                  
                  1,890,000
                  
                  
                  
                  98
                  %Working
      capital
                  
                  
                  (329,000
                  )
                  
                  
                  (4,561,000
                  )
                  
                  
                  93
                  %Current
      ratio
                  
                  
                  0.91
                  x
                  
                  
                  0.32
                  x
                  
                  
                  184
                  %Cash
      and cash equivalents
                  
                  $
                  408,000
                  
                  
                  $
                  423,000
                  
                  
                  
                  -4
                  %Funds
      Available from Open Credit Facilities
                  
                  $
                  1,131,000
                  
                  
                  $
                  567,000
                  
                  
                  
                  99
                  %Debt
      (excluding unamortized debt discount and Capitalized
    Leases)
                  
                  $
                  3,569,000
                  
                  
                  $
                  3,933,000
                  
                  
                  
                  -9
                  %




As of
September 30, 2010, our cash balance was approximately $408,000, down from
$449,000 at December 31, 2009.  During the first nine months of 2010,
the Company used $1,261,000 of cash for operations, a 15% improvement over the
use of cash for the first nine months of 2009, which reflects the positive
effect of cost cuts at every division that allows the Company to use less cash
to support its operations, offset by an increase in working capital of the
Company’s packaging division due to that divisions typical increase in orders
during the third and fourth quarters of the year.    On
February 12, 2010, the Company acquired Premier Packaging Corp for $2,000,000 in
cash, which was funded by proceeds from a $1,500,000 Term Note and the proceeds
from the exercise of warrants by certain warrant holders that the Company
received during the quarter.




Future
Capital NeedsAs of September 30,
2010, the Company has approximately $408,000 in cash and $417,000 available
to it under one credit facility, along with up to $714,000 available under a
credit line at its Premier Packaging subsidiary. While the Company’s working capital
position has significantly improved since December 31, 2009, the Company
continued to incur operating losses during the first nine months of 2010, and
has negative working capital as of September 30, 2010.    If
the Company cannot generate sufficient cash from its operations in the future,
the Company may need to raise additional funds in order to fund its working
capital needs and pursue its growth strategy, which although there can be no
assurances, management feels that sources for these additional funds will
continue to be available through either current or future investors.




Off-Balance
Sheet Arrangements




We do not
have any off-balance sheet arrangements that have, or are reasonably likely to
have, an effect on our financial condition, financial statements, revenues or
expenses.


22




Critical
Accounting Policies and Estimates




As of
September 30, 2010, our critical accounting policies and estimates have not
changed materially from those set forth in our Annual Report on Form 10-K for
the year ended December 31, 2009.




ITEM
4 - CONTROLS AND PROCEDURES




Evaluation
of Disclosure Controls and Procedures





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





Based on this evaluation, and in light
of the material weaknesses in our internal control over financial reporting that
are discussed in our Annual Report on Form 10-K for the fiscal year ended
December 31, 2009 these officers have concluded that our disclosure controls and
procedures were not effective.  The material weaknesses consist of an
insufficient complement of qualified accounting personnel and controls
associated with segregation of duties and ineffective controls associated with
identifying and accounting for complex and non-routine transactions in
accordance with U.S. generally accepted accounting principles.  To
address the material weaknesses we performed additional analyses and other
post-closing procedures to ensure our consolidated financial statements were
prepared in accordance with accounting principles generally accepted in the
United States of America (U.S. GAAP). Notwithstanding these material weaknesses,
management believes that the financial statements included in this Quarterly
Report on Form 10-Q fairly present, in all material respects, our financial
condition, result of operations and cash flows for the periods
presented.





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





Changes
in Internal Control Over Financial Reporting





There has
been no change to our internal control over financial reporting during the
quarter covered by this Quarterly Report on Form 10-Q that has materially
affected, or that is reasonably likely to materially affect, our internal
control over financial reporting.




PART II


OTHER
INFORMATION




ITEM
1 - LEGAL PROCEEDINGS




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





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


23





In 2006,
the Company received notices that the ECB had filed separate claims in each of
the United Kingdom, The Netherlands, Belgium, Italy, France, Spain, Germany,
Austria and Luxembourg courts seeking the invalidation of the
Patent.  Proceedings were commenced before the national courts seeking
revocation and declarations of invalidity of the Patent.  On March 26,
2007, the High Court of Justice, Chancery Division, Patents Court in London,
England  ruled that the Patent was deemed invalid in the United
Kingdom, and on March 19, 2008 this decision was upheld on appeal.  
As a result of these decisions, the Company was notified of the final assessment
of the reimbursable ECB costs for both court cases was ₤356,490.  At
September 30, 2010, the Company had paid all except approximately $16,000 of the
final assessment.  The remaining $16,000 was in accrued expenses as of
September 30, 2010 which the Company paid in full as of October 31,
2010.





On March
27, 2007 the Bundespatentgericht of the Federal Republic of Germany ruled that
the German part of the Patent was valid, having considered the English Court’s
decision.  On July 6, 2010, the Company was notified that the German
Court has ruled that the Patent, that was awarded to the Company by the European
Patent Office and upheld as valid in a previous hearing in the German Court of
First Instance, has now been deemed invalid in Germany due to added
matter.   On January 9, 2008 the French Court held that the
Patent was invalid in France for the same reasons given by the English
Court.  The Company filed an appeal against the French decision on May 7,
2008. On March 20, 2010, the Company was informed that the decision was
upheld in the French appeal.  On March 12, 2008 the Dutch
Court  ruled that the Patent is valid in the
Netherlands.  The ECB filed an appeal against the Dutch decision on
March 27, 2008.  The Dutch appeal was heard in June 2010, with a decision
expected in late 2010 or early 2011.  On November 3, 2009, the Belgium
Court held that the Patent was invalid in Belgium for the same reasons given by
the English and French courts as were similarly informed by the Austrian court
on November 17, 2009.   Cost reimbursement, if any, associated with
the Belgium, Austrian, and French validity cases as well as the appeals in
Germany and France are covered under the Trebuchet agreement described
below.  On March 24, 2010 the Spanish Court ruled that the Patent was
valid.  In Italy the validity case is to be heard again by a newly
appointed judge during 2010 and a hearing in Luxembourg thereafter.





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





The
Patent has thus been confirmed to be valid and enforceable in two
jurisdictions (the Netherlands and Spain) that use the Euro as its national
currency allowing the Company or Trebuchet Capital Partners, on the Company’s
behalf, to proceed with infringement cases in these countries if we choose to do
so.   On February 18, 2010, Trebuchet, on behalf of the Company, filed
an infringement suit in the Netherlands.  The suit is being lodged against
the ECB and two security printing entities with manufacturing operations in the
Netherlands, Joh. Enschede Banknotes B.V.; and Koninklijke Joh. Enschede
B.V.    The ECB and the security printers have been notified and
the court hearing date is tentatively scheduled for January 21,
2011.





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.





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


24




ITEM
1A – RISK FACTORS




We face many significant risks in
our business, some of which are unknown to us and not presently foreseen. These
risks could have a material adverse impact on our business, financial condition
and results of operations in the future. We have disclosed a number of material
risks under Item 1A of our annual report on Form 10-K for the year ended
December 31, 2009, which we filed with the Securities and Exchange
Commission on March 25, 2010. The following discussion is of material
changes to risk factors disclosed in that report.





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





The Company has incurred significant
net losses in previous years. The Company’s ability to fund its capital
requirements out of its available cash and cash generated from its operations
depends on a number of factors. Some of these factors include the Company’s
ability to (i) increase commercial and security printing and plastic card sales;
(ii) increase sales of the Company’s digital products; and (iii) integrate its
new acquisition of Premier Packaging with its existing product
lines.  As of September 30, 2010, the Company has approximately
$408,000 in cash and $517,000 available to it under one credit facility,
along with up to $714,000 available under a credit line at its Premier Packaging
subsidiary.   To address its working capital needs in the past, the
Company has been able to obtain equity based financing, including most recently,
on July 21, 2010 and July 22, 2010, the Company raised a aggregate of
$1,080,000, net of fees, from the sale of common stock.   The
Company expects to be able to continue to obtain equity based financing to meet
its obligations if the Company cannot generate sufficient cash from its
operations, although there is no guarantee that the Company will be able to do
so. If we are
not successful in generating needed funds from operations or in capital raising
transactions, we may need to reduce our costs which measures could include
selling or consolidating certain operations or assets, and delaying, canceling
or scaling back product development and marketing programs. These measures could
materially and adversely affect our ability to operate
profitably.





We
have a significant amount of indebtedness and may be unable to satisfy our
obligations to pay interest and principal thereon when due.




As of
September 30, 2010, we have the following approximate amounts of
outstanding indebtedness:




(i)
            $450,000
      Convertible Note bearing interest at 8% per annum due June 23, 2012,
      convertible into up to 260,116 shares of Document Security Systems Common
      Stock, and is secured by the accounts receivable of the Company, excluding
      the accounts receivable of the Company’s wholly owned subsidiaries,
      Plastic Printing Professionals and DPI Secuprint,
      respectively.





(ii)
            $350,000 Convertible Note bearing
      interest at 10% per annum due November 24, 2012, convertible into up to
      218,750 shares of Document Security Systems Common Stock and is secured by
      the assets of the Company’s wholly owned subsidiary DPI
      Secuprint.





(iii)
            $575,000 Promissory Note bearing
      interest at 10% per annum due November 24, 2012 and is secured by the
      assets of the Company’s wholly owned subsidiary DPI
      Secuprint.





(iv)
            $583,000
      due under a Credit Facility to a related party under which the Company can
      borrow up to $1,000,000 bearing interest at LIBOR plus 2% per annum due
      January 4, 2012.





Furthermore,
in February 2010, the Company entered into new debt agreements in conjunction
with its acquisition of Premier Packaging Corp as follows:





(v)
            $1,325,000
      due under Term Loan which matures March 1, 2013 and is payable in 35
      monthly payments of $25,000 plus interest commencing March 1, 2010 and a
      payment of $625,000 on the 36 month.  Interest accrues at 1
      Month LIBOR plus 3.75% and is secured by all of the assets of the
      Company’s subsidiary, Premier Packaging Corporation, which the Company
      acquired on February 12, 2010.  The Company subsequently entered
      into a interest rate swap agreement to lock into a 5.6% effective interest
      over the life of the term loan.  The Loan has also been
      guaranteed by Document Security Systems, and its subsidiaries Plastic
      Printing Professionals and DPI
Secuprint.


25





(vi)
            Up
      to $1,000,000  in a revolving line of credit available for use
      by Premier Packaging, subject to certain limitations which matures on
      February 12, 2011 and is payable in monthly installments of interest only
      beginning on March 1, 2010. Interest accrues at 1 Month LIBOR plus 3.75%.
      As of September 30, 2010, there was approximately $286,000
      outstanding on the line.





We have not made interest payments on
the Credit Facility to a related party and have had to obtainadefault waiver fromthe holderin the past, including one as of September 30,
2010. Absent a new financing or series of
financings, our current operations may not generate sufficient cash to pay the
interest and principal on these obligations when they become due. Accordingly,
we may default in these obligations in the future and there is no guarantee that we will
be able to obtain default waivers from the holders in the
future.




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




We are
subject to litigation and threatened litigation, including without limitation
our litigation with the European Central Bank, in which parties allege, among
other things, that certain of our patents are invalid.  If the ECB or
other parties are successful in invalidating any or all of our patents, it may
materially affect us, our financial condition, and our ability to market and
sell certain of our products based on any patent that is
invalidated.   Furthermore, we have granted nearly all control
over our ECB Litigation to a third party, Trebuchet Capital Partners, LLC., who
may or may not have the resources or capabilities to successfully defend our
patent rights or meet its financial obligations.   If Trebuchet
is unable to meet its financial obligations, then we may be obligated to pay for
certain court mandated legal costs to the ECB or other parties, which may
materially affect 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.  We intend to continue to rely primarily on a
combination of patent protection, trade secrets, technical measures, copyright
protection and nondisclosure agreements with our employees and customers to
establish and protect the ideas, concepts and documentation of software and
trade secrets developed by us.  Our ability to compete and the ability
of our business to grow could suffer if these intellectual property rights are
not adequately protected.  There can be no assurance that our patent
applications will result in patents being issued or that current or additional
patents will afford protection against competitors.  We rely on a
combination of patents, copyrights, trademarks and trade secret protection and
contractual rights to establish and protect our intellectual
property.  Failure of our patents, copyrights, trademarks and trade
secret protection, non-disclosure agreements and other measures to provide
protection of our technology and our intellectual property rights could enable
our competitors to more effectively compete with us and have an adverse effect
on our business, financial condition and results of operations.  In
addition, our trade secrets and proprietary know-how may otherwise become known
or be independently discovered by others. No guarantee can be given that others
will not independently develop substantially equivalent proprietary information
or techniques, or otherwise gain access to our proprietary
technology.




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




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




Although we have received patents with
respect to certain technologies of ours, there can be no assurance that these
patents will afford us any meaningful protection.  Although we believe
that our use of the technology and products we developed and other trade secrets
used in our operations do not infringe upon the rights of others, our use of the
technology and trade secrets we developed may infringe upon the patents or
intellectual property rights of others. In the event of infringement, we could,
under certain circumstances, be required to obtain a license or modify aspects
of the technology and trade secrets we developed or refrain from using
same.  We may not have the necessary financial resources to defend an
infringement claim made against us or be able to successfully terminate any
infringement in a timely manner, upon acceptable terms and conditions or at all.
Failure to do any of the foregoing could have a material adverse effect on us
and our financial condition.  Moreover, if the patents, technology or
trade secrets we developed or use in our business are deemed to infringe upon
the rights of others, we could, under certain circumstances, become liable for
damages, which could have a material adverse effect on us and our financial
condition.  As we continue to market our products, we could encounter
patent barriers that are not known today. A patent search will not disclose
applications that are currently pending in the United States Patent Office, and
there may be one or more such pending applications that would take precedence
over any or all of our applications.


26


Furthermore,
third parties may assert that our intellectual property rights are invalid,
which could result in significant expenditures by us to refute such
assertions.  If we become involved in litigation, we could lose our
proprietary rights, be subject to damages and incur substantial unexpected
operating expenses. Intellectual property litigation is expensive and
time-consuming, even if the claims are subsequently proven unfounded, and could
divert management’s attention from our business. If there is a successful claim
of infringement, we may not be able to develop non-infringing technology or
enter into royalty or license agreements on acceptable terms, if at
all.  If we are unsuccessful in defending claims that our intellectual
property rights are invalid, we may not be able to enter into royalty or license
agreements on acceptable terms, if at all.  This could prohibit us
from providing our products and services to customers, which could have a
material adverse effect on us and our financial condition.




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




Over the
past several years, we have spent significant funds and time to create new
products by applying our technologies onto media other than paper, including
plastic and cardboard packaging, and delivered our technologies
digitally.  We have had limited success in selling our products that
are on cardboard packaging and those that are delivered
digitally.  Our business plan for 2010 and beyond includes plans to
incur significant marketing and sales costs for these newer products,
particularly the digitally delivered products.  If we are not able to
sell these new products, our financial results will be adversely
affected.




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




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




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




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




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.


27




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 complementary to our existing operations and expanding our
operations to include manufacturing capabilities. We may also seek to acquire
other businesses. The success of this acquisition strategy will depend, in part,
on our ability to accomplish the following:




·
            identify
      suitable businesses or assets to
buy;


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


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


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




Although
we were able to acquire our Plastic Printing Professionals, Inc. subsidiary in
February 2006 and our DPI Secuprint subsidiary in December 2008, and Premier
Packaging in February 2010, there can be no assurance that we will be successful
in pursuing any or all of these steps on future transactions. Our failure to
implement our acquisition strategy could have an adverse effect on other aspects
of our business strategy and our business in general. We may not be able to find
appropriate acquisition candidates, acquire those candidates that we find or
integrate acquired businesses effectively or profitably.




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




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




We
may not realize the anticipated benefits of our recent
acquisitions.




Our
expectations regarding the earnings, operating cash flow, capital expenditures
and liabilities resulting from our recent acquisition Premier Packaging Corp in
February 2010 are based on information currently available to us and may prove
to be incorrect. We may not realize any anticipated benefits of either of this
acquisition and may not be successful in integrating the acquired assets into
our existing business.  In particular, 72% of Premier Packaging’s
sales for the year ended December 31, 2009 were with two customers and which
comprised 81% of Premier Packaging’s accounts receivable balance as of December
31, 2009.  During the nine month period ended September 30, 2010,
these two customers accounted for 32% of the Company’s consolidated
revenue.   As of  September 30, 2010 one of the
customers, which accounted for 25% of the Company’s consolidated sales for the
first nine months of 2010, has a contract with the Company that is currently set
to expire in July 2011, and comprised 26% of the Company’s consolidated accounts
receivable as of September 30, 2010.




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 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.  There
can be no assurance that these persons will continue to agree to be employed by
us after such dates.


28




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.   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 our working capital needs, to fund more aggressive
expansion of our business, to complete development, testing and marketing of our
products, or to 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 necessary funds will be available for us to finance our development
on acceptable terms, if at all.  Furthermore, 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.




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




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




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


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





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





As of September 30, 2010, there were
approximately 182 million authorized but unissued shares of our common stock.
Our management continues 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 NYSE Amex, New York law, or
other applicable laws.   If our Board of Directors determines to
issue additional shares of our common stock from the large pool of 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 such transaction.





The
exercise of our outstanding options and warrants and vesting of restricted stock
awards may depress our stock price.




As of
September 30, 2010, we had (i) outstanding stock options and warrants to
purchase an aggregate of 2,016,833 shares of our Common Stock at exercise prices
ranging from $1.86 to $12.65 per share; (ii) 85,000 unvested restricted shares
of our common stock that are subject to various vesting terms, and (iii)
convertible notes that convert to up to 478,866 shares of our common
stock.   To the extent that these securities are converted into
common stock, dilution to our stockholders will
occur.   Moreover, the terms upon which we will be able to obtain
additional equity capital may be adversely affected, since the holders of these
securities can be expected to exercise or convert them at a time when we would,
in all likelihood, be able to obtain any needed capital on terms more favorable
to us than the exercise and conversion terms provided by those
securities.


29




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




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




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.




We
have material weaknesses in our internal control over financial reporting
structure, which, until remedied, may cause errors in our financial statements
that could require restatements of our financial statements and investors may
lose confidence in our reported financial information, which could lead to a
decline in our stock price.





Section
404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate the effectiveness
of our internal control over financial reporting as of the end of each year, and
to include a management report assessing the effectiveness of our internal
control over financial reporting in each Annual Report on Form
10-K.





We have
identified two material weaknesses in our internal control over financial
reporting in our annual assessment of internal controls over financial reporting
that management performed for the year ended December 31, 2009, in which
management has concluded that (i) we did not maintain a sufficient complement of
qualified accounting personnel and controls associated with segregation of
duties; and (ii) we lack sufficient resources within the accounting department
to have effective controls associated with identifying and accounting for
complex and non-routine transactions in accordance with U.S. generally accepted
accounting principles, and that the foregoing represented material weaknesses in
our internal control over financial reporting. If our internal control over
financial reporting or disclosure controls and procedures are not effective,
there may be errors in our financial statements and in our disclosure that could
require restatements. Investors may lose confidence in our reported financial
information and in our disclosure, which could lead to a decline in our stock
price.





Our
management, including our Chief Executive Officer and Chief Financial Officer,
does not expect that our internal control over financial reporting will prevent
all errors and all fraud. A control system, no matter how well designed and
operated, can provide only reasonable, not absolute, assurance that the control
system's objectives will be met. Further, the design of a control system must
reflect the fact that there are resource constraints, and the benefits of
controls must be considered relative to their costs. Controls can be
circumvented by the individual acts of some persons, by collusion of two or more
people, or by management override of the controls. Over time, controls may
become inadequate because changes in conditions or deterioration in the degree
of compliance with policies or procedures may occur. Because of the inherent
limitations in a cost-effective control system, misstatements due to error or
fraud may occur and not be detected.





We are
uncertain at this time of the costs to remediate all of the above listed
material weaknesses, however, we anticipate the cost to be in the range of$200,000 to $400,000
(including the cost of hiring additional qualified accounting personnel to
eliminate segregation of duties issues and using the services of accounting
consultants for complex and non-routine transaction if and when they arise). We
cannot guarantee that the actual costs to remediate these deficiencies will not
exceed this amount.


30


As a
result, we cannot assure you that significant deficiencies or material
weaknesses in our internal control over financial reporting will not be
identified in the future. Any failure to maintain or implement required new or
improved controls, or any difficulties we encounter in their implementation,
could result in significant deficiencies or material weaknesses, cause us to
fail to timely meet our periodic reporting obligations, or result in material
misstatements in our financial statements. Any such failure could also
materially adversely affect the results of periodic management evaluations
regarding disclosure controls and procedures and the effectiveness of our
internal control over financial reporting required under Section 404 of the
Sarbanes-Oxley Act of 2002 and the rules promulgated thereunder. In
addition, the existence of a material weakness could result in errors in
our financial statements that could result in a restatement of financial
statements, that may cause investors to lose confidence in our
reported financial information, leading to a decline in our stock
price





We
may not meet the continued listing standards of the NYSE AMEX





In
December 2008, we received a letter from the NYSE Amex stating that, based on
the NYSE Amex’s review of publicly available information, we were considered to
be below the NYSE Amex’s continued listing standards.  After
submitting a plan of compliance to the NYSE Amex and additional evaluation by
the Exchange, we were informed in March 2010 that we had resolved the continued
listing deficiencies.  We cannot assure you that we will not receive
additional deficiency letters in the future, or that we will continue to satisfy
the continued listing standards in order to remain listed on the
Exchange.




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




None




ITEM
3 - DEFAULTS UPON SENIOR SECURITIES




The
Company has a Credit Facility Agreement with Fagenson and Co., Inc., as agent, a
related party to Robert B. Fagenson, the Chairman of the Company's Board of
Directors. Under the Credit Agreement,as amended, the Company can borrow up to a
maximum of $1,000,000 from time to time up to and until January 4,
2012.  As of  September 30, 2010, the Company was in default
of the agreement due to a failure to pay interest when due.  The
holder has waived the default through January 1, 2012.




ITEM 4 - (REMOVED AND RESERVED)




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.





ExhibitsItem
      3.1
              
              Certificate
      of Incorporation of the Registrant, as amended (incorporated by reference
      to Exhibit 3.1 to the Company’s Registration Statement No. 2-98684-NY on
      Form S-18).Item
      3.2
              
              By-Laws
      of the Registrant, as amended (incorporated by reference to Exhibit 3.2 to
      the Company’s Registration Statement No. 2-98684-NY on Form
      S-18).Item
      31.1
              
              Certification
      of Chief Executive Officer as required by Rule 13a-14 or 15d-14 of the
      Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
      Sarbanes Oxley Act of 2002.Item
      31.2
              
              Certification
      of Chief Financial Officer as required by Rule 13a-14 or 15d-14 of the
      Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
      Sarbanes Oxley Act of 2002.Item
      32.1
              
              Certification
      of Chief Executive Officer as required by 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes Oxley Act of
      2002.Item
      32.2
              
              Certification
      of Chief Financial Officer as required by 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes Oxley Act of
      2002.


31




SIGNATURES




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




DOCUMENT
      SECURITY SYSTEMS, INC.November
      15, 2010
                    By:
                    /s/
      Patrick WhitePatrick
      White
                      Chief
      Executive OfficerNovember
      15, 2010
                    By:
                    /s/
      Philip JonesPhilip
      Jones
                      Chief
      Financial
Officer


32




Exhibit
Index





Item
3.1      Certificate of Incorporation of the
Registrant, as amended (incorporated by reference to Exhibit 3.1 to the
Company’s Registration Statement No. 2-98684-NY on Form S-18).





Item
3.2      By-Laws of the Registrant, as amended
(incorporated by reference to Exhibit 3.2 to the Company’s Registration
Statement No. 2-98684-NY on Form S-18).





Item
31.1    Certification of Chief Executive Officer as required
by Rule 13a-14 or 15d-14 of the Securities Exchange Act of 1934, as adopted
pursuant to Section 302 of the Sarbanes Oxley Act of 2002.





Item
31.2    Certification of Chief Financial Officer as required
by Rule 13a-14 or 15d-14 of the Securities Exchange Act of 1934, as adopted
pursuant to Section 302 of the Sarbanes Oxley Act of 2002.





Item
32.1    Certification of Chief Executive Officer as required
by 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes
Oxley Act of 2002.





Item
32.2    Certification of Chief Financial Officer as required
by 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes
Oxley Act of 2002.


33