**SECURITIES AND EXCHANGE COMMISSION**

 

**WASHINGTON D.C. 20549**

----

 

**Annual ReportPursuant to Section 13 or 15(d) of**

**the Securities Exchange Act of 1934**

 
| **For  the fiscal year ended December 31, 2001** | **Commission  file number: 0-18188** |
|-------------------------------------------------------|--------------------------------------|

**FORM 10-KSB**

 

**PAULSON CAPITAL CORP.**

Name of smallbusiness issuer as specified in its charter

 

| **Oregon**                                                                    |   | **93-0589534**                        |
|-------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization)               |   | (I.R.S. Employer  Identification No.) |
|                                                                          |   |                                  |
| **811  S.W. Naito Parkway, Suite 200 Portland, OR**                           |   | **97204**                             |
| (Address of principal  executive offices)                                     |   | (Zip Code)                            |
|                                                                          |   |                                  |
| Issuer’s telephone  number, including area code: **(503) 243–6000** |

 

Securities registered pursuant to Section 12(b) of theAct:

 

**None**

 

Securities registered pursuant to Section 12(g) of theAct:

 

| **Title of Class**          |
|-----------------------------|
| Common Stock, no par  value |

 

Check whether the issuer (1)filed all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the past 12 months (or for such shorter period thatthe registrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.     Yes   ý    No  o

 

Check if there is no disclosureof delinquent filers in response to Item 405 of Regulation S-B is not containedin this form, and no disclosure will be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part II of this Form 10-KSB or any amendment to this Form10-KSB.  o

 

 

 

State issuer’s revenues for itsmost recent fiscal year:

 

$25,337,000

 

As of March 14, 2002, 3,158,562 shares of theregistrant’s common stock, no par value, were outstanding and the aggregatemarket value of the shares of common stock of the Registrant held bynon-affiliates (based upon the average of the closing bid and asked prices ofRegistrant’s shares in the over-the-counter market as of such date) was$7,705,175.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Registrant’s definitive proxy statementfor the 2002 annual meeting of shareholders to be filed with the Securities andExchange Commission are incorporated by reference into Part III.

 

Transitional Small Business Disclosure Format:

 

Yes o   No  ý

 

2

----

 

**PART I**

 

**FORWARD LOOKING STATEMENTS**

 

**This report, including, without limitation, “Item 6Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” contains or incorporates both historical and “forward-looking”statements within the meaning of Section 27A of the Securities Act of 1933, asamended, and Section 21E of the Securities Exchange Act of 1934, as amended.Words such as “anticipates”, “believes”, “expects”, “intends”, “future” and similar expressions identify forward-lookingstatements.  Any such forward-lookingstatements in this report reflect our current views with respect to futureevents and financial performance and are subject to a variety of factors thatcould cause our actual results to differ materially from historical results orfrom anticipated results expressed or implied by such forward-lookingstatements.  Because of such factors, wecannot assure you that the results anticipated in this report will berealized.  As noted elsewhere in thisreport, various aspects of our business are subject to extreme volatility oftenas a result of factors beyond our ability to anticipate or control.  In particular, factors, such as thecondition of the securities markets, which are in turn based on popularperceptions of the health of the economy, generally, can be expected to affectthe volume of our business as well as the value of the securities maintained inour trading and investment accounts. Other factors that may affect our future financial condition or results ofoperations include the following:**

 

•                      **The performance of companies whosesecurities we have underwritten or otherwise sold to our customers may affectour reputation with other potential syndicate and selling group members andinstitutional and other retail accounts and may also affect the amount of moneyin our customers’ portfolios available for the kinds of investments that weoffer.**

 

•                      **The value of our investment portfolio,including the value of securities without a readily ascertainable market value,that we have estimated for the purpose of reporting on our financial conditionand results of operations, may be significantly and adversely affected bychanges in the value of the companies themselves or of comparable companieswhose stock values we use in estimating the value of our portfolio securities.**

 

•                      **We are subject to a very high degree ofregulation and are responsible for compliance with applicable regulations byall of our personnel.  A significantregulatory infraction by us or any of our registered representatives couldresult in significant penalties, including the loss of our license to conductsecurities business in one or more jurisdictions.**

 

•                      **Alternatives available to our customersto transact securities trades could affect our ability to continue to executeour brokerage customers’ transactions.**

 

•                      **The loss of our Chairman, ChesterPaulson could have a material adverse impact on our business.**

 

3

----

 

**ITEM 1.DESCRIPTION OF BUSINESS**

 

**General**

 

Paulson Capital Corp. (“Paulson Capital” or the“Company”), established in 1970, is a holding company whose only operatingsubsidiary is Paulson Investment Company, Inc. (“PIC”), a full servicebrokerage firm engaged in the purchase and sale of securities from and to thepublic and for its own account and in investment banking activities.  The Company operates in one industrysegment, the financial services industry. At December 31, 2001, PIC employed 22 brokers and had independentcontractor arrangements with 66 brokers registered with the NationalAssociation of Securities Dealers, Inc. (“NASD”).  PIC also employed a support staff of 48 persons in itsheadquarters in Portland, Oregon and in certain of its branch offices.  At December 31, 2001 PIC had 37 branchoffices throughout the United States.

 

Paulson Capital is located at 811 S.W. Naito Parkway,Suite 200, Portland, Oregon 97204.  Itstelephone number is (503) 243-6000.

 

**Principal Products, Services and Markets**

 

Virtually all of Paulson Capital’s business is carriedon through PIC.  PIC is involved in thepurchase and sale of most investment securities but is not involved incommodities or futures.  Four broadcategories of securities activities contribute to revenues of PIC: retailbrokerage, corporate finance/investment banking, trading and market making (orwholesale).  PIC also receives revenuesfrom gains and losses in investment accounts, from underwriter warrantsreceived in connection with its corporate finance activities, and from othersources.

 

The following table indicates the approximate percentageof revenues that were accounted for by each of these categories and frominvestment income (including underwriter warrants) in the last two fiscalyears:

 
|                     |   | **2001** |   | **2000** |   |
|--------------------------|--------|----------|--------|----------|--------|
| **Securities Brokerage** |   | 30       | %      | 94       | %      |
| **Corporate Finance**    |   | 24       |   | 34       |   |
| **Investment Income**    |   | 42       |   | (41      | )      |
| **Trading**              |   | 4        |   | 12       |   |
| **Other**                |   | —   |   | 1        |   |

 

The table listed above reflects revenue categories anddoes not take into account any associated expenses. Because Trading andInvestment Income are determined by changes in the market value of PIC’sassociated accounts, revenue in these categories can be either positive ornegative.

 

**SecuritiesBrokerage**

 

                As a securities broker, PIC actsas agent for its customers in the purchase and sale of common and preferredstocks, options, warrants and debt securities traded on securities exchanges orin the over-the-counter (“OTC”) market. A portion of its revenue is derived from commissions from customers onthese transactions. In the OTC market, transactions with customers insecurities not listed on an exchange may be effected as principal, rather thanagent, primarily in securities for which PIC is a market maker.  Customer transactions in securities areeffected either on a cash or margin basis.

 

 

4

----

 

PICalso enters into dealer agreements with mutual fund management companies andpublicly registered limited partnerships. Commissions on the sale of these securities are derived from thestandard dealers discounts, which range from approximately 1 percent to 8.5percent of the purchase price of the securities, depending on the terms of thedealer agreement and the amount of the purchase.  PIC does not generally sell interests in limited partnershipsthat are not publicly registered.

 

Inthe case of corporate finance transactions, described below, a portion of thediscount applicable to securities placed by PIC’s retail brokerage group iscredited to securities brokerage and the commission payable to the broker isrecorded as securities brokerage expense.

 

Pursuantto an agreement between PIC and Correspondent Services Corporation (“CSC”), aUBS PaineWebber Company, CSC carries all of PIC’s customer securities accountsand performs the following services: (1) preparation and mailing ofmonthly statements to PIC customers; (2) settlement of contracts andtransactions in securities between PIC and other broker-dealers and between PICand its customers; (3) custody and safe-keeping of securities and cash,the handling of margin accounts, dividends, exchanges, rights offerings andtender offers; and (4) the execution of customer orders placed on anexchange.  PIC determines the amount ofcommission to be charged to its customers on agency transactions and the priceof securities purchased or sold in principal transactions.  CSC receives compensation based on the sizeof the transaction, subject to certain minimum and maximum amounts. Theagreement between PIC and CSC may be canceled by either party upon 60 dayswritten notice, which period may be reduced in certain events.  In the event of a liability arising from abad debt from a customer, PIC is required to indemnify CSC against anyloss.  This potential liability isuninsured.

 

Inaddition to providing clearing services for PIC, CSC loans money to PIC in theordinary course of PIC’s business, pursuant to an arrangement under which CSCagrees to finance PIC’s trading accounts. At December 31, 2001, no net loans were outstanding pursuant tothis arrangement.

 

**CorporateFinance**

 

PICraises capital for its corporate finance clients through public offerings ofsecurities of corporations that are engaged in a variety of businesses.  PIC participates in underwritings ofcorporate securities as managing underwriter and as a syndicate member.  Management of an underwriting generates morerevenue than participation as a member of an underwriting syndicate.  Revenues generated by syndicateparticipations have not been material.

 

                PIC acts as the managingunderwriter of public offerings of securities that typically range in size from$5 million to $20 million.  PICunderwrites these offerings on a “firm commitment” basis, which means that itagrees to purchase a specific amount of securities from the issuer at adiscount, after the registration statement for the offering is declaredeffective by the Securities and Exchange Commission (the “SEC”), and resellsthe securities to the public at a specified price. Managing these publicofferings involves the risk of loss if PIC is unable to resell at a profit thesecurities it is committed to purchase. This risk is usually reduced by accepting other stock brokerage firms asa part of an underwriting syndicate in which each member commits to purchase aspecified amount of the offering.  PICand the other underwriters may also sell a portion of their commitment througha “selling group” of other stock brokerage firms that participate in sellingthe offering but are not subject to an underwriter’s commitment.  As an underwriter, PIC is also subject topotential liability under federal and state securities laws if the registrationstatement or prospectus contains a material misstatement or omission.  PIC has limited insurance to cover itspotential liabilities as an underwriter.

 

 

5

----

 

Thecommitment of capital by PIC between the time a firm commitment underwritingagreement becomes effective and the time PIC resells the securities constitutesa charge against its net capital. Accordingly, PIC’s participation in or initiation of underwritings maybe limited by the financial requirements of the SEC and NASD.  See “Net Capital Requirements.”

 

BetweenJune 1, 1978 and December 31, 2001 PIC acted as the managing underwriteror co-managing underwriter for 143 securities offerings, raising approximately$920 million for corporate finance clients. Of these, 88 were initial public offerings.  PIC typically receives 2 to 3 percent of the aggregate amount ofmoney raised in an offering to cover nonaccountable expenses and between 7 and9 percent as compensation to underwriters, selling group members and registeredrepresentatives, although these percentages may be lower for largertransactions. PIC also typically receives warrants to purchase securities,equal to 10 percent of the securities sold in the offering, for a period offive years at a price equal to 120 percent of the public offering price.  A portion of these underwriter warrants aretypically transferred as compensation to persons associated with PIC and, incertain cases, to other major underwriters in the public offering.

 

**Investment Income**

 

Fora variety of reasons, PIC holds securities for investment.  Securities held for investment aremaintained in investment accounts that are segregated from the tradingaccounts.  PIC’s investment portfolioprincipally consists of securities purchased for investment and underwriterwarrants.

 

Fromtime to time, PIC makes investments as a principal in companies that are, orare expected to be, corporate finance clients. The investment may be as convertible debt in anticipation of a publicoffering, in which case, if the offering is successful, the principal andinterest are either converted to equity or repayable from the offeringproceeds.  If the offering is not successful,the debt is typically converted to equity. PIC also makes investments in companies that are not anticipating animmediate public offering.  In suchcases, the investment is typically made in the form of the purchase ofrestricted equity securities.  Typicalinvestments described in this paragraph have ranged from $100,000 to $600,000.

 

**Tradingand Market Making**

 

Inaddition to executing trades as an agent, PIC regularly acts as a principal inexecuting trades in equity securities, corporate debt securities and municipalbonds.  At December 31, 2001, PICmade a market in 33 securities of 23 issuers. Of these, 19 were corporations for which PIC has acted as managing orco-managing underwriter of public financings. In addition, at December 31, 2001, PIC held securities of 21companies in its investment account.  In2001, the value of securities held in the trading accounts and investmentaccount ranged between $14,431,705 and $26,735,096.  The level of positions carried in PIC’s trading and investmentaccounts fluctuates significantly.  Thesize of the securities positions at any date may not be representative of PIC’sexposure on any other date, because the securities positions vary substantiallydepending upon economic and market conditions, the allocation of capital amongtypes of inventories, underwriting commitments, customer demands and tradingvolume.  The aggregate value ofinventories that PIC may carry is limited by certain requirements under theSEC’s net capital rules.  See “NetCapital Requirements.”

 

6

----

 

 

PIC’smarket making activities are conducted both with other dealers in the“wholesale market” and with PIC’s customers. Transactions with customers are effected as principal at a net priceequal to the current interdealer price plus or minus the approximate equivalentof a brokerage commission.  In suchtransactions, the commission is recorded as securities brokerage revenue whileany profit or loss attributable to a change in value of the security in PIC’strading account is recorded as trading profit or loss. PIC’s transactions asprincipal expose PIC to risk because securities positions are subject tofluctuations in market value and liquidity. Profits or losses on trading and investment positions depend upon theskills of the employees in PIC’s trading department and employees responsiblefor taking investment positions.  Thetrading department is headquartered in PIC’s Portland, Oregon office.

 

**BranchOffices**

 

PICbranch offices are generally run by independent contractors who assumeliability for all the operating expenses of the branch.  PIC typically receives between 15 and 20percent of the gross commission earned by the branch, with the balance retainedby the branch to pay its expenses and staff. Persons in these branches are registered with PIC, and PIC assumes thesame compliance and regulatory obligations as would be the case if PIC werefully responsible for the branch’s expenses. As of December 31, 2001, PIC had 37 branch offices in California,Connecticut, District of Columbia, Florida, Georgia, Idaho, Nevada, New Jersey,New York, Oregon, Utah, Vermont and Washington.  All of these branches except one in Salem, Oregon are operatingas independent contractor offices.  PICcontinues to be responsible for all expenses of the Salem office.

 

**Research**

 

PICemploys three persons who devote a majority of their time to gathering andanalyzing information intended to provide PIC with an adequate basis forperforming its investment banking activities and to provide customers with aregular flow of information on the companies for which PIC has in the pastprovided investment banking services.

 

7

----

 

**Regulation**

 

PICis registered with the SEC as a broker-dealer under the Securities Exchange Actof 1934 and is a member of the NASD. It is also registered as a broker-dealerunder the laws of all 50 states and Washington, D.C.

 

The securitiesbusiness is subject to extensive regulation under federal and state laws.  The principal purpose of regulation anddiscipline of broker-dealers is the protection of customers and the securitiesmarkets rather than protection of creditors and stockholders ofbroker-dealers.  The SEC is the federalagency charged with administration of the federal securities laws.  Much of the regulation of broker-dealers,however, has been delegated to self-regulatory organizations, principally theNASD.  These self-regulatoryorganizations adopt rules (subject to approval by the SEC) that govern theindustry and conduct periodic examinations of member broker-dealers.  Securities firms are also subject toregulation and examination by state securities commissions in the states inwhich they are registered.

 

The regulations towhich broker-dealers are subject cover all aspects of the securities business,including sales methods, trading practices among broker-dealers, capitalstructure of securities firms, record keeping and the conduct of directors,officers and employees.  Additionallegislation, changes in rules promulgated by the SEC and by self-regulatorybodies or changes in the interpretation or enforcement of existing laws andrules often affect directly the method of operation and profitability ofbroker-dealers.  The SEC, NASD and stateregulatory authorities may conduct administrative proceedings that can resultin censure, fine, suspension or expulsion of a broker-dealer, its officers oremployees.

 

**NetCapital Requirements**

 

PICis required to maintain minimum “net capital” under the SEC’s net capital ruleof not less than 6.67 percent of its aggregate indebtedness.  In general, net capital consists of thebroker-dealer’s net worth, adjusted by numerous factors specified in theapplicable regulations.  In particular,the value of securities that can be included in net capital is subject toreduction in market value or principal amount. The amount of the requiredreduction or “haircut” depends on the nature of the security.  As of December 31, 2001, PIC had netcapital of $17,621,377, which exceeded its minimum requirement of $111,223 by$17,510,154.  The ratio of aggregateindebtedness of $1,668,348 to net capital of $17,621,377 on December 31,2001 was approximately 0.09 to 1.  In apublic offering in which PIC acts as an underwriter, PIC must have sufficientnet capital to cover the amount of securities underwritten, applying applicableformulae mandated by the SEC, during the period between effectiveness and theclosing of the transaction, usually 3-4 days. This results in a significant temporary increase in PIC’s required netcapital.  In some cases, the amount ofsecurities underwritten by PIC has been limited by its net capital.  Any significant reduction in PIC’s netcapital, even if PIC were still in compliance with the SEC’s net capital rulefor its retail and trading activities, could have a material adverse impact onPIC’s ability to continue its investment banking activities.

 

8

----

 

**Competition**

 

Allaspects of PIC’s business are highly competitive.  In its general brokerage activities, PIC competes directly withnumerous other broker-dealers, many of which are large well known firms withsubstantially greater financial and personnel resources than PIC.  Many of PIC’s competitors employ extensiveadvertising and actively solicit potential clients in order to increasebusiness.  In addition, brokerage firmscompete by furnishing investment research publications to existing clients, thequality and breadth of which are considered important in the development of newbusiness and the retention of existing clients.  PIC also competes with a number of smaller regional brokeragefirms.

 

Somecommercial banks and thrift institutions offer securities brokerageservices.  Many commercial banks offer avariety of investment banking services. Competition among financial services firms also exists for investmentrepresentatives and other personnel.

 

Thesecurities industry has become considerably more concentrated and morecompetitive since the Company was founded, as numerous securities firms haveeither ceased operations or have been acquired by or merged into otherfirms.  This trend has been particularlypronounced among firms similar in size and business mix to PIC.  In addition, companies not engaged primarilyin the securities business, but with substantial financial resources, haveacquired leading securities firms. These developments have increased competition from firms with greatercapital resources than those of the Company. Various legislative and regulatory developments have tended to increasecompetition within the industry or reduced profits for the industry.  In particular, various recent developmentshave tended to increase competition from commercial banks.

 

Thesecurities industry has experienced substantial commission discounting bybroker-dealers competing for brokerage business.  In addition, an increasing number of specialized firms now offer“discount” services to individual customers. These firms generally effect transactions for their customers on an“execution only” basis without offering other services such as portfoliovaluation, investment recommendations and research.  A growing number of discount brokerage firms offer their servicesover the Internet, further decreasing offered commission rates and increasingease of use for customers.  Thecontinuation of such discounting and an increase in the number of new andexisting firms offering discounts could adversely affect the Company.  In addition, rapid growth in the mutual fundindustry is presenting potential customers of PIC with an increasing number ofalternatives to traditional stock brokerage accounts.

 

Inits investment banking activities, PIC competes with other brokerage firms,venture capital firms, banks and all other sources of capital for small,growing companies.  Since PIC generallymanages offerings smaller than $20 million, it does not typically compete withthe investment banking departments of large, well-known national brokeragefirms.  Nevertheless, PIC occasionallymanages larger offerings.  In addition,large national and regional investment banking firms occasionally manageofferings of a size that is competitive with PIC, typically for fees andcompensation less than that charged by PIC. When the market for initial public offerings is active, many smallregional firms that do not typically engage in investment banking activitiesalso begin to compete with PIC.

 

9

----

 

**Employees**

 

AtDecember 31, 2001, PIC had 70 employees, of whom 48 were executives andsupport staff and 22 were involved in brokerage activities and compensatedprimarily on a commission basis.  PICalso had independent contractor arrangements with 66 independent contractors,all of whom are compensated solely on a commission basis.  Paulson Capital had no employees separatefrom PIC.

 

**ITEM 2.          DESCRIPTIONOF PROPERTY**

 

PIC leases approximately 17,100 square feet of space forits office in Portland, Oregon under a lease expiring May 31, 2009.  The base monthly rental rate on this leaseis currently $22,848.  The rental rateincreases every 2-3 years, from $25,704 beginning in June 2002 to $29,988through the expiration of the lease in June 2009.   PIC’s Salem office leases space under a lease expiring onOctober 31, 2002 at a monthly rent of $2,922, with rent subject to increasesbased upon inflation.  The Companybelieves the existing leased space is suitable and adequate for its businessfor the foreseeable future.  PIC’s otherbranch offices lease space but, under the terms of the relationship between PICand these offices, PIC is not responsible for these lease costs.

 

**ITEM 3.          LEGALPROCEEDINGS**

 

1.  In January2001, V.J.E. Enterprises, Inc. and Vincent and Diana Nartker, former PICcustomers, filed a complaint with PIC regarding the handling of their accountby PIC and one of its registered representatives.  They have asserted that their account was mismanaged and that PICfailed to supervise its registered representative.  They have requested that PIC pay them $275,100.  PIC is investigating this claim, but believesit has meritorious defenses and intends to defend this matter vigorously if anarbitration is filed.

 

2.  In May 2001, PIC received notice that EugeneV. Doty, a former PIC customer, had made a complaint about the handling of hisaccount at PIC.  Mr. Doty alleges thathis account was traded excessively but has not identified what amount, if any,he seeks from PIC or its former broker. PIC is investigating this claim, but believes it has meritoriousdefenses and intends to defend this matter vigorously if an arbitration isfiled.

 

                3.  OnNovember 7, 2001, the Company and PIC were named as defendants in a lawsuitfiled by Spirit Partners, L.P. and Tech-Trade Capital LLC.  The lawsuit was filed in the Supreme Courtof the State of New York for the County of New York.  The lawsuit alleges that PIC committed fraud and was unjustlyenriched in connection with the redemption of warrants issued in the initialpublic offering of audiohighway.com, for which PIC served as underwriter.  According to plaintiffs, the warrantagreement and prospectus contain different provisions governing the redemptionof the warrants.  This allegedlyoccurred because the redemption provisions were changed during the registrationprocess and the warrant agreement was not amended to reflect the change inprovisions.  audiohighway.com’sredemption was proper under the terms of the prospectus, which contains theupdated redemption provisions and allowed the issuer to redeem when the closingbid price of the common stock was at least $13.50 for 10 calendardays.  Plaintiffs allege that theredemption was improper under the terms of the warrant agreement, which theyallege contains the original redemption provisions and allows the issuer toredeem when the closing bid price of the common stock exceeded $13.50for 20 consecutive trading says. Plaintiffs also allege that counsel foraudiohighway.com and PIC fraudulently concealed the alleged discrepancy betweenthe prospectus and warrant agreement by amending the warrant agreement to beconsistent with the prospectus. Plaintiffs claim unspecified monetary damages and seek $3 million inpunitive damages.  The lawsuit is in avery early stage and PCC and PIC have not yet responded to the claims or conducteddiscovery.  However, PCC and PIC believethey have meritorious defenses to these claims and intend to defend the casevigorously.

 

 

10

----

 

4.  In January 2002, PIC was served in anarbitration brought by one of its former customers, Patricia Weber, against PICand its registered representative Melvin Vuckevich.  The arbitration claim alleges unsuitable securitiesrecommendations, misrepresentation, breach of fiduciary duty andnegligence.  The claimant is seekingdamages of $255,000, interest, an additional return on her portfolio, punitivedamages and attorney fees.  PIC has nothad an opportunity to fully investigate this claim, but believes it hasmeritorious defenses and intends to defend this matter vigorously.

 

5.  On March 26, 2002, PIC was informed thatLouis Barinaga and Stuart MacKenzie, two former PIC customers, had filedseparate, though related, lawsuits against PIC. Barinaga and MacKenzie eachassert claims against E.Com International, Inc. relating to investments incertain convertible notes of E.Com International, Inc. made between 1999 and2001; the combined principal amount invested in these notes by these plaintiffswas approximately $882,000. The plaintiffs are seeking return of their principal,interest and attorney fees. Barinaga and MacKenzie assert that PIC had someconnection with the sale of the convertible notes through the actions of MarvinCox, a PIC registered representative. Accordingly, Barinaga and MacKenzieassert that PIC is liable as a material participant under state securities law.PIC has not yet had an opportunity to fully investigate these claims, butbelieves it has meritorious defenses and intends to defend these claimsvigorously.

 

PIC hasinformation that certain former customers may file claims against it; however,no claims have been asserted at this time. PIC has no information regarding what amounts, if any, may be soughtfrom PIC but believes the amounts may be material.  PIC has not had an opportunity to fully investigate these claims,but believes it has meritorious defenses and intends to defend these mattersvigorously if any claims are filed.

 

An adverse outcomein certain of the matters described above could have a material adverse effecton PIC or the Company.  PIC has beennamed in certain other legal proceedings and has received notice that certaincustomers may commence legal proceedings against PIC.  The Company believes, based upon information received to dateand, where the Company believes it appropriate, discussions with legal counsel,that resolution of this additional pending or threatened litigation will haveno material adverse effect on the consolidated financial condition, results ofoperations, or business of the Company.

 

**ITEM 4.          SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS.**

 

None

 

11

----

 

**PART II**

 

**ITEM 5.          MARKETFOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.**

 

The Company’s common stock trades in theover-the-counter market.  The Company’sstock is quoted on the Nasdaq SmallCap Market under the symbol “PLCC,” but itis not actively traded.  The followingare high and low sales prices for the common stock for the periods shown.

 
|            |   | **2001  Prices** |   | **2000  Prices** |   |
|-----------------|--------|------------------|--------|------------------|--------|
|            |   | **High**         |   | **Low**          |   | **High** |   | **Low** |   |
| **1st Quarter** |   | $                | 6.75   |             | $      | 4.4375 |   | $ | 7.844 |   | $ | 5.156 |   |
| **2nd Quarter** |   | 5.30             |   | 4.36             |   | 8.125 |   | 6.500 |   |
| **3rd Quarter** |   | 6.05             |   | 5.25             |   | 8.750 |   | 5.688 |   |
| **4th Quarter** |   | 6.75             |   | 5.55             |   | 9.625 |   | 5.062 |   |
|                 |        |                  |        |                  |        |  |  |  |  |  |  |  |  |

 

The high and low prices for the first quarter of 2002,through March 14, 2002, were $7.22 and $6.60 respectively.

 

Asof March 14, 2002, there were 3,158,562 shares of the Company’s commonstock outstanding and held of record by 111 holders.  The number of record holders includes as single holders variousinstitutions (such as brokerage firms) that hold shares in “street name” formultiple shareholders.  Based on thenumber of requests for the Company’s proxy materials for its 2002 annualmeeting, the Company believes there are approximately 379 beneficial holders ofits common stock.  The Companyrepurchased 211,304 shares of common stock during 2001.  Additional shares of common stock may berepurchased from time to time in the future.

 

TheCompany has never paid a dividend on its common stock.  Net capital requirements may limit theability of PIC to pay dividends to the Company, which would affect theCompany’s ability to pay dividends to its shareholders.  The Company anticipates that, for theforeseeable future, earnings will be retained for use in its business and doesnot anticipate the payment of dividends.

 

12

----

 

**ITEM 6.          MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF**

**OPERATIONS**

 

**SELECTEDFINANCIAL DATA**

 

**IncomeStatement Information**

 
|                                         |   | **Years Ended  December 31,**                |   |
|----------------------------------------------|--------|----------------------------------------------|--------|
|                                         |   | **2001**                                     |   | **2000** |   |
|                                         |   | **(in thousands, except per share amounts)** |   |
| Revenues                                     |   | $                                            | 25,337 |   | $ | 15,876 |   |
| Commissions and  Salaries                    |   | 9,563                                        |   | 15,651 |   |
| Other Expenses                               |   | 4,178                                        |   | 4,351 |   |
| Total Expenses                               |   | 13,741                                       |   | 20,002 |   |
| Pretax Income  (loss)                        |   | 11,596                                       |   | (4,126 | ) |
| Net Income  (loss)                           |   | 7,037                                        |   | (3,048 | ) |
| Diluted Earnings  (loss) per share           |   | $                                            | 2.17   |   | $ | (0.88 | ) |
| Average number  of common shares outstanding |   | 3,240                                        |   | 3,474 |   |

 

**BalanceSheet Information**

 
|                       |   | **December  31,**                            |   |
|----------------------------|--------|----------------------------------------------|--------|
|                       |   | **2001**                                     |   | **2000** |   |
|                       |   | **(in thousands, except per share amounts)** |   |
| Total Assets               |   | $                                            | 38,591 |   | $ | 33,212 |   |
| Working Capital            |   | 32,635                                       |   | 26,441 |   |
| Short-Term Debt            |   | 0                                            |   | 0 |   |
| Long-Term Debt             |   | 0                                            |   | 0 |   |
| Shareholders’  Equity |   | 33,131                                       |   | 27,185 |   |
|                            |        |                                              |        |  |  |  |  |

 

**Overview**

 

Substantially all of our business consists of the securities brokerageand investment banking activities of our wholly owned subsidiary, PaulsonInvestment Company, Inc., or PIC.  PIChas operations in four principal categories, all of them in the financialservices industry.  These categoriesare:

 

•     securities brokerage activities for which PIC earnscommission revenues;

•     corporate finance revenues consisting principally ofunderwriting discounts and underwriter warrants;

•     securities trading from which PIC records profit orloss, depending on trading results; and

•     investment income resulting from earnings on, andincreases or decreases in the value of, PIC’s investment portfolio.

 

13

----

 

 

Because we operate in the financial services industry, our revenues andearnings are substantially affected by conditions in financial marketsgenerally.  In our securities brokerageand corporate finance business, the amount of our revenues depends on levels ofmarket activity requiring the services we provide.  Our investment banking activity, which consists primarily ofacting as managing or participating underwriter of initial and follow-on publicofferings for smaller companies, is similarly affected by the strength of themarket for new equity offerings, which has historically experienced substantialcyclical fluctuation.  Although weattempt to match operating costs with activity levels, many of our expenses areeither fixed or difficult to change on short notice.  Accordingly, fluctuations in brokerage and investment bankingrevenues tend to result in sharper fluctuations, on a percentage basis, in netincome or loss.

 

Our investment income or loss and, to a lesser extent, our tradingincome or loss is affected by changes in market valuation of securitiesgenerally and, in particular, by changes in valuation of the equity securitiesof microcap companies in which our investments and trading activities tend tobe concentrated.  Equity markets ingeneral, and microcap equity markets in particular, have always experiencedsignificant volatility and this volatility has, in recent years beenextreme.  The results of this volatilityon the value of our investment portfolio and securities held in connection withour trading and investment activities include large quarterly fluctuations inincome or loss from these operations and substantial increases or decreases inour net worth as our securities holdings are marked to market.

 

A substantial portion of our investment banking business consists ofacting as managing underwriter of initial and follow-on public offerings formicrocap companies.   As a part of ourcompensation for this activity, we typically receive warrants exercisable topurchase securities identical to those that we offer and sell to the public.  The warrants are not exercisable for thefirst year after the offering in which they are earned and are thereafterexercisable for four years, after which they expire.  The exercise price is typically 120% of the price at which weinitially sold the securities to the public. Accordingly, unless there is at least a 20% increase in the price ofthese securities at some time more than one and less than five years after theoffering, the warrants will remain “under water” and will ultimately expireunexercised.

 

We are required to estimate the value of all derivativesecurities that we hold at the date of any financial statements and to includethat value, and changes in such value, in those financial statements.  Accordingly, the aggregate estimated valueof our warrants as of the date of any balance sheet is recorded as an asset onthat balance sheet.   When a new warrantis received as a result of our investment banking activity, its estimated valueis included in corporate finance revenue on the date on which it isearned.  Subsequently, any change inestimated value is recorded as investment income or loss.  If, and when, a warrant is exercised thebook value is adjusted to reflect the value of the securities purchased, net ofthe exercise price, and the adjustment amount is recorded as income or loss forthe relevant period. If the warrant expires unexercised, the book value isadjusted to zero and the decrease is recorded as a loss in the relevant period.

 

                We are estimating the value ofour underwriter warrants using the Black-Scholes Option Pricing Model. Themodel requires us to use historical price data combined with variousassumptions and judgments to develop the inputs for the model. In particular,we have calculated a volatility factor for each company’s warrants that isbased on its own stock price movements as well as an index: as our warrants getcloser to their expiration date their individual volatility factors are almostentirely based on the historical price volatility of each company’s commonstock.  We cannot assure you that wewill ultimately be able to exercise any of our warrants in a way that willrealize the value that we attribute to them in our financial statements basedon this model.

 

 

14

----

 

As a result of the factors described above, our revenues and earningsare subject to substantial fluctuation from period to period based oncircumstances many of which are beyond our control.  An increase in financial market activity generally, and/or anincrease in equity valuations generally, will normally result in increases inrevenue, earnings and net worth as our activity levels and the value of ourinvestment portfolio increase. Conversely, a general market retrenchment will typically lead todecreased revenue, earnings and net worth as a result both of decreasedactivity and the need to adjust high investment portfolio values to lowerlevels.  Accordingly results for anyhistorical period are not necessarily indicative of similar results for anyfuture period.

 

**Results ofOperations**

 

PIC’s revenues and operating results are influenced byfluctuations in the equity underwriting markets as well as general economic andmarket conditions, particularly conditions in the over-the-counter market,where PIC’s investment account, trading inventory positions and underwriterwarrants are heavily concentrated. Significant fluctuations can occur in PIC’s revenues and operatingresults from one period to another. PIC’s results of operations depend upon many factors, such as the numberof companies that are seeking public financing, the quality and financialcondition of those companies, market conditions in general, the performance ofprevious PIC underwritings and interest in certain industries by investors.  As a result, revenues and income derivedfrom these activities may vary significantly from year to year.  In the tables below, “Trading Income” is thenet gain or loss from trading positions before commissions paid to therepresentatives in the trading department. “Investment Income” includes realized gains from the exercise ofunderwriter warrants, gains and losses from the sales of investment securities,and unrealized gains and losses from underwriter warrants and other investmentsecurities.

 

15

----

 

**Summary of Changes in MajorCategoriesof Revenues and Expense**

 
|                          |   | **2001 vs. 2000** |       |
|-------------------------------|--------|-------------------|------------|
| Revenues:                     |   |              |       |   |   |
| Sales  Commissions            |   | $                 | (7,351,064 | ) | (49.3 | )% |
| Corporate  Finance            |   | 716,201           |       | 13.5 | % |
| Investment  Income            |   | 17,182,452        |       | N/A | % |
| Trading Income                |   | (1,038,461        | )          | (50.7 | )% |
| Other                         |   | (47,622           | )          | (49.6 | )% |
|                          |   |              |       |   |   |
| Total                         |   | $                 | 9,461,506  |   | 59.6 | % |
|                          |   |              |       |   |   |
| Expenses:                     |   |              |       |   |   |
| Commissions and  Salaries     |   | $                 | (6,088,388 | ) | (38.9 | )% |
| Underwriting  Expenses        |   | 115,360           |       | 22.1 | % |
| Rent, Telephone  & Quotes |   | 14,228            |       | 1.5 | % |
| Other                         |   | (301,631          | )          | (10.5 | )% |
|                          |   |              |       |   |   |
| Total                         |   | $                 | (6,260,431 | ) | (31.3 | )% |
|                          |   |              |       |   |   |
| Pretax Income                 |   | $                 | 15,721,937 |   | N/A |   |

 

**2001 Comparedto 2000**

 

Total revenues for 2001 increased by 59.6 percent from2000, to $25,337,346 from $15,875,840. As shown in the table above, sales commissions fell $7,351,064, or 49.3percent, to $7,561,535 in 2001 from $14,912,599 in 2000.  This decrease resulted primarily fromreduced retail sales activity in 2001 relative to 2000.  The Nasdaq Composite Index was down 21percent in 2001, to 1951.07 at December 31, 2001 from 2470.50 at year-end2000.  PIC’s focus is on very smallcapitalization issues, especially those tied to PIC’s corporate financeclients.  Corporate finance revenuesincreased 13.5 percent, or $716,201, in 2001 compared to 2000.  Four transactions were completed in 2001,raising approximately $47 million for the issuers; four transactions were alsocompleted in 2000, raising a total of $63 million for corporate financeclients.  In general, corporate financerevenues are a function of total annual offering proceeds, compensation peroffering, and the fair value of underwriter warrants received. Investmentincome includes realized gains from the exercise of underwriter warrants, gainsand losses from the sales of investment securities and unrealized gains andlosses from underwriter warrants and other investment securities. Investmentincome increased $17,182,452, from a loss of $6,481,555 in 2000 to a profit of$10,700,897 in 2001, due to an increase in unrealized appreciation of underwriterwarrants held by the Company, based upon the Company’s estimate of their fairvalue, and gains on positions held. Trading income decreased $1,038,461, or50.7%, percent, to $1,008,957 in 2001 from $2,047,418 in 2000.  This decrease was primarily due to reducedtrading activity in securities generally as well as in the securities of PIC’scorporate finance clients, as a result of the poor economic conditions in 2001,and, in particular the terrorist attacks in September 2001.

 

                Total expensesdecreased by $6,260,431 in 2001 from 2000, a decrease of 31.3 percent to$13,741,310 from $20,001,741. Commissions and salaries fell $6,088,388, or 38.9 percent, to $9,562,856in 2001 from $15,651,244 in 2000.  Thisdecrease was primarily due to decreased commission revenues resulting in alower level of commissions paid. Underwriting expenses increased by $115,360,or 22.1 percent, from 2000.  While thesame number of transactions was completed in 2001 as in 2000, the 2001transactions incurred higher legal and other expenses. Rent, telephone andquote expenses increased to $975,242 in 2001 from $961,014 in 2000, an increaseof 1.5 percent.  Other expensesdecreased 10.5 percent, to $1,459,840 in 2001 from $1,782,754 in 2000,primarily due to reduced write-downs of notes receivable and no expenses foremployee stock option grants in 2001.

 

 

16

----

 

The Company had pretax income of $11,596,036 in 2001compared to a pretax loss of $4,125,901 in 2000, due primarily to a significantincrease in investment income. Independent of investment income, the Company would have had a pretaxprofit of $895,139 in 2001 compared to a pretax profit of $2,355,654 in 2000.Investment income in 2001 was significantly higher than investment income in2000, primarily due to greater profits on positions held and unrealizedappreciation of underwriter warrants held by the Company, based upon theCompany’s estimate of their fair value. This source of income cannot beexpected to regularly recur.  Significant fluctuations can occur in PIC’s revenues and operatingresults from one period to another.  TheCompany also incurred an income tax expense of $4,558,974 in 2001, compared toa tax benefit of $1,077,687 in 2000.

 

**Liquidity andCapital Resources**

 

Conducting business as a dealer in securities requiresthat a substantial inventory of securities be maintained and that a largeamount of liquid assets be readily available. PIC is also required to maintain net capital as described in “Item 1 -Description of Business — Net Capital Requirements” above.  PIC’s working capital at December 31,2001 was $30,201,261.  Of PIC’s totalassets (net of intercompany accounts) at December 31, 2001 of $35,862,734approximately 72 percent consisted of securities in PIC’s investment account,trading inventory and underwriter warrant securities, at fair value, andapproximately 24 percent consisted of cash, certificates of deposit andreceivables from its correspondent broker.

 

PIC’s securities inventory is stated at fair value.  The liquidity of the market for many ofPIC’s securities holdings, however, varies with trends in the stockmarket.  Since many of the securitiesheld by PIC are thinly traded, and PIC is in many cases a primary market makerin the issues held, any significant sales of PIC’s positions could adverselyaffect the liquidity and prices of the issues held.  In general, falling prices in OTC securities (which make up mostof PIC’s trading positions) lead to decreased liquidity in the market for theseissues, while rising prices in OTC issues tends to increase the liquidity ofthe market for these securities.  Theoverall decline in prices for the very small capitalization OTC securitiestraded by PIC in 2001, 2000 and 1998 were combined with a general reduction inthe liquidity of the markets for these securities.  This situation was the reverse of 1999, 1997, 1996 and 1995, whenincreases in prices of OTC securities increased the liquidity of the marketsfor these securities.  PIC’s investmentaccount and trading inventory accounts are stated at fair value, which is at orbelow quoted market price.  They includeshares of restricted stock recorded by PIC, with an original cost of$4,603,101, currently valued at $1,356,859, which the Company believes, basedupon available evidence, approximates market value.

 

                PIC borrows moneyfrom CSC in the ordinary course of its business, pursuant to an arrangementunder which CSC agrees to finance PIC’s trading accounts in an amountdetermined by the size of those accounts and the type of securities held, withinterest charged at prevailing margin rates. As of December 31, 2001, nonet loans were owed by PIC to CSC pursuant to this arrangement.  PIC and the Company are generally able tomeet their compensation and other obligations out of current liquid assets.

 

 

17

----

 

The recorded value of our underwriter’s warrants istypically not readily realizable, either because the warrants are not currentlyexercisable or because their exercise price is more than the price that wecould realize if we exercised the warrant and sold the underlyingsecurities.  There is no public marketfor our underwriter warrants and the warrants themselves are transferable onlyunder very limited circumstances. Accordingly, their value cannot be realized by selling the warrantsthemselves.   Underwriter’s warrantsexercisable to purchase securities having a value in excess of the exerciseprice are liquid, subject to restrictions on liquidity applicable to OTCsecurities generally and discussed in the foregoing paragraph.  The securities issuable on exercise of ourunderwriter’s warrants are registered under the Securities Act of 1933, asamended, and, in some cases, may also be resold under an exemption fromregistration.  Accordingly, there is nolegal impediment to liquidity with respect to these securities, except duringthe first year following a company’s public offering.

 

In 2001, $5,365,320 of net cash was used in operating activities.  The major adjustments to reconcile thisresult to the Company’s net income included an unrealized gain in investmentsecurities of $12,179,138, receipt of new underwriter warrants valued at$4,016,714, a change in income taxes receivable/payable of $5,742,100, and anincrease in trading securities of $253,971, partially offset by a realized lossin investment securities of $1,478,241, a change in deferred income taxes of$6,546,200, a change in receivable from/payable to clearing organization of$1,034,964 and an increase in accounts payable and accrued liabilities of$473,584.  In 2001, $6,394,882 of netcash was provided by investing activities, primarily sales of investmentsecurities exceeding purchases of investment securities. Net cash used infinancing activities in 2001 totaled $1,090,933, resulting from payments torepurchase common stock of $1,121,996 exceeding $31,063 in proceeds from theissuance of common stock.

 

As a securities broker-dealer, the Company’s whollyowned subsidiary, PIC, is required by SEC regulations to meet certain liquidityand capital standards.  In the unlikelyevent that PIC was unable to meet these regulatory standards, it would beunable to pay dividends to the Company. Since PIC is the Company’s only operating business, such a failure couldhave a material adverse affect on the Company.

 

At December 31, 2001, the Company had no materialcommitments for capital expenditures.

 

In general, the primary sources of PIC’s, and thereforethe Company’s, liquidity, including PIC’s trading positions, borrowings onthose positions and profits realized upon the exercise of underwriter warrants,all depend in large part on the trend in the general markets for OTCsecurities.  Rising OTC price levels willtend to increase the value and liquidity of PIC’s trading positions, the amountthat can be borrowed from CSC based upon those positions, and the value ofPIC’s underwriter warrants.  The Companybelieves its liquidity is sufficient to meet its needs for the foreseeablefuture.

 

18

----

 

**Inflation**

 

Because PIC’s assets are primarily liquid, they are notsignificantly affected by inflation. The rate of inflation affects PIC’s expenses, such as employeecompensation, office leasing and communications costs.  These costs may not readily be recoverablein the price of services offered by the Company.  To the extent inflation results in rising interest rates and hasother adverse effects in the securities markets and the value of securitiesheld in inventory or PIC’s investment account, it may adversely affect theCompany’s financial position and results of operations.

 

19

----

 

**ITEM 7.****                                                    ****FINANCIAL STATEMENTS AND SUPPLEMENTARYDATA.**

 
|                                                                                                      | **(a) Financial Statements** |
|-----------------------------------------------------------------------------------------------------------|------------------------------|
|                                                                                                      |                         |
| Report  of Independent Certified Public Accountants                                                       |
|                                                                                                      |                         |
| Consolidated Balance Sheet  as of December 31, 2001                                                  |
|                                                                                                      |                         |
| Consolidated  Statements of Operations for the years ended December 31, 2001 and 2000                |
|                                                                                                      |                         |
| Consolidated  Statement of Shareholders’ Equity for the years ended December 31, 2001  and 2000 |
|                                                                                                      |                         |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2001 and 2000                |
|                                                                                                      |                         |
| Notes to  Consolidated Financial Statements                                                               |
|                                                                                                      |                         |
| Supplementary  Schedule of Warrants Owned                                                                 |
|                                                                                                      |                         |
| Schedule II - Valuation and  Qualifying Accounts                                                          |

 

20

----

 

**PART III**

 

All information required by Items 9, 10, 11 and 12 ofPart III of this Report will be included in the Company’s definitive proxystatement for its 2002 annual meeting of shareholders filed or to be filed notlater than 120 days after the end of the fiscal year covered by this Report andis incorporated herein by reference, other than the information with respect toexecutive officers of the Company included below.

 

**DIRECTORS ANDEXECUTIVE OFFICERS OF THE COMPANY**

 

Directors of the Company are elected for a term of oneyear and until their successors are elected and qualify.  Executive officers are appointed by theboard of directors and do not have fixed terms of office.  The board of directors and executiveofficers as of December 31, 2001 are set forth below.  The year each person became a directorfollows his or her name.

 
| **Name**                     |   | **Age** |   | **Position(s) with  Company**     |   | **Principal Occupation(s) During Past  Five Years**                                                                                                                                                                                                      |
|------------------------------|--------|---------|--------|-----------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Chester L.F. Paulson (1970)  |   | 65      |   | President and Director            |   | Director of Corporate Finance  of PIC                                                                                                                                                                                                                    |
|                         |   |    |   |                              |   |                                                                                                                                                                                                                                                     |
| Jacqueline M. Paulson (1976) |   | 62      |   | Secretary-Treasurer and  Director |   | Secretary-Treasurer of PIC                                                                                                                                                                                                                               |
|                         |   |    |   |                              |   |                                                                                                                                                                                                                                                     |
| Glen Davis(1999)             |   | 46      |   | Director                          |   | President of PIC since  February 1998 (Senior Vice President of PIC until February 1998)                                                                                                                                                                 |
|                         |   |    |   |                              |   |                                                                                                                                                                                                                                                     |
| Steve Kleemann(2001)         |   | 61      |   | Director                          |   | Private Investor                                                                                                                                                                                                                                         |
|                         |   |    |   |                              |   |                                                                                                                                                                                                                                                     |
| Shannon P. Pratt(1998)       |   | 68      |   | Director                          |   | Managing Director, Founder –  Willamette Management Associates, a business valuation firm                                                                                                                                                           |
|                         |   |    |   |                              |   |                                                                                                                                                                                                                                                     |
| Paul Shoen(1998)             |   | 45      |   | Director                          |   | Chairman of the Board of Directors and Chief  Executive Officer of Pantechnicon Aviation, an operator and lessor of  aircraft; private investor; Director – AMERCO, the parent company of U-Haul  Trucking Rental, from January 1997 to August 1998 |
|                         |   |    |   |                              |   |                                                                                                                                                                                                                                                     |
| John Westergaard(1998)       |   | 70      |   | Director                          |   | Publisher/Editor of  Westergaard.com, Inc., an Internet publisher of financial “webzines”                                                                                                                                                      |

 

ChesterL.F. Paulson and Jacqueline M. Paulson are husband and wife.

 

21

----

 

**(a) Exhibits**

 
| **Number** |   | **Description**                                                                                                                                                                                                                       |
|------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1        |   | Articles of  Incorporation (incorporated by reference to Exhibit 3.1 to the Company’s  Registration Statement on Form 10 filed with the Commission on  December 18, 1989 (the “Form 10”))                         |
|       |   |                                                                                                                                                                                                                                  |
| 3.2        |   | Bylaws (incorporated by  reference to Exhibit 3.2 to the Form 10)                                                                                                                                                                     |
|       |   |                                                                                                                                                                                                                                  |
| 10.1       |   | Office lease dated June  28, 1988 (incorporated by reference to Exhibit 10.2 to the Form 10)                                                                                                                                          |
|       |   |                                                                                                                                                                                                                                  |
| 10.3       |   | Contract with  Correspondent Services Corporation, dated July 24, 1992 (Incorporated by  reference to Exhibit 10.3 to the Form 10-Q for the quarter ended September  30, 1992 filed with the Commission on November 13, 1992)         |
|       |   |                                                                                                                                                                                                                                  |
| 10.4       |   | Office Lease renewal  for the period from 6/1/97 to 5/31/02, dated as of May 6, 1997 (Incorporated  by reference to Exhibit 10.4 to the Form 10-QSB for the quarter ended June  30, 1997 filed with the Commission on August 13, 1997 |
|       |   |                                                                                                                                                                                                                                  |
| 10.5       |   | Amendment 1 to Office  Lease dated as of May 6, 1997                                                                                                                                                                                  |
|       |   |                                                                                                                                                                                                                                  |
| 10.6       |   | 1999 Stock Option Plan  (incorporated by reference to Exhibit 10.5 to the Form 10-KSB for the year  ended December 31, 1999)                                                                                                          |
|       |   |                                                                                                                                                                                                                                  |
| 21.1       |   | Subsidiaries – The  Company’s only subsidiary is Paulson Investment Company, Inc., an Oregon  corporation.                                                                                                                  |

 

(b)There were no reports on Form 8-K filed during the last quarter of the periodcovered by this report.

 

22

----

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15 of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 
|                      | PAULSON  CAPITAL CORP. |
|---------------------------|------------------------|
|                      |                   |   |
| Date:   3/21/02 | By:                    | /s/ Chester L.F. Paulson |   |
|                      |                   | Chester L.F. Paulson |
|                      |                   | President |

 

23

----

 

Pursuant to the requirements of the Securities ExchangeAct of 1934, this report has been signed below by the following persons onbehalf of the Registrant in the capacities and on the dates indicated.

 
| **Signature**                                      |   | **Title**                             |   | **Date** |
|----------------------------------------------------|--------|---------------------------------------|--------|----------|
| **(1) Principal Executive and  Financial Officer** |   |                                  |   |     |
|                                               |   |                                  |   |     |
| /s/ Chester L.F. Paulson                           |   |                                  |   |     |
| Chester L.F. Paulson                               |   | Chairman  of the Board and  President |   | 3/19/02  |
|                                               |   |                                  |   |     |
| **(2) Principal Accounting Officer**               |   |                                  |   |     |
|                                               |   |                                  |   |     |
| /s/ Carol Rice                                     |   |                                  |   |     |
| Carol Rice                                         |   | Principal  Accounting Officer         |   | 3/19/02  |
|                                               |   |                                  |   |     |
| **(3)  Directors**                                 |   |                                  |   |     |
|                                               |   |                                  |   |     |
| /s/ Jacqueline M. Paulson                          |   |                                  |   |     |
| Jacqueline M. Paulson                              |   | Secretary, Treasurer  and  Director   |   | 3/19/02  |
|                                               |   |                                  |   |     |
| /s/ Glen Davis                                     |   |                                  |   |     |
| Glen Davis                                         |   | Director                              |   | 3/19/02  |
|                                               |   |                                  |   |     |
| /s/ Steve Kleemann                                 |   |                                  |   |     |
| Steve Kleemann                                     |   | Director                              |   | 3/19/02  |
|                                               |   |                                  |   |     |
| /s/ Shannon Pratt                                  |   |                                  |   |     |
| Shannon Pratt                                      |   | Director                              |   | 3/19/02  |
|                                               |   |                                  |   |     |
| /s/ Paul Shoen                                     |   |                                  |   |     |
| Paul Shoen                                         |   | Director                              |   | 3/19/02  |
|                                               |   |                                  |   |     |
| /s/ John Westergaard                               |   |                                  |   |     |
| John Westergaard                                   |   | Director                              |   | 3/19/02  |

 

24

----

 
| **Exhibit  Number** |   | **Description**                                                                                                                                                                                                                        |   | **Page Number** |
|---------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------|
| 3.1                 |   | Articles of Incorporation (incorporated by reference  to Exhibit 3.1 to the Company’s Registration Statement on Form 10 filed with  the Commission on December 18, 1989 (the “Form 10”))                           |   |            |
|                |   |                                                                                                                                                                                                                                   |   |            |
| 3.2                 |   | Bylaws (incorporated by reference to Exhibit 3.2 to  the Form 10)                                                                                                                                                                      |   |            |
|                |   |                                                                                                                                                                                                                                   |   |            |
| 10.1                |   | Office lease dated June 28, 1988 (incorporated by  reference to Exhibit 10.2 to the Form 10)                                                                                                                                           |   |            |
|                |   |                                                                                                                                                                                                                                   |   |            |
| 10.3                |   | Contract with Correspondent Services Corporation,  dated July 24, 1992 (Incorporated by reference to Exhibit 10.3 to the Form  10-Q for the quarter ended September 30, 1992 filed with the Commission on  November 13, 1992)          |   |            |
|                |   |                                                                                                                                                                                                                                   |   |            |
| 10.4                |   | Office Lease renewal for the period from 6/1/97 to  5/31/02, dated as of May 6, 1997 (Incorporated by reference to Exhibit 10.4  to the Form 10-QSB for the quarter ended June 30, 1997 filed with the  Commission on August 13, 1997) |   |            |
|                |   |                                                                                                                                                                                                                                   |   |            |
| 10.5                |   | Amendment 1 to the Office Lease dated as of May 6,  1997                                                                                                                                                                               |   |            |
|                |   |                                                                                                                                                                                                                                   |   |            |
| 10.6                |   | 1999 Stock Option Plan (incorporated by reference to  Exhibit 10.5 to the Form 10-KSB for the year ended December 31, 1999)                                                                                                            |   |            |
|                |   |                                                                                                                                                                                                                                   |   |            |
| 21.1                |   | Subsidiaries – The Company’s only subsidiary is  Paulson Investment Company, Inc., an Oregon corporation.                                                                                                                    |   |            |

 

25

----

 

Financial Statements and Report of

Independent Certified Public Accountants

 

**Paulson Capital Corp. and Subsidiary**

 

December 31, 2001 and 2000

 

----

 

Reportof Independent Certified Public Accountants

 

Board of Directors and Shareholders

Paulson Capital Corp.

 

We have audited the accompanying consolidatedbalance sheet of Paulson Capital Corp. (an Oregon corporation) and Subsidiaryas of December 31, 2001, and the related consolidated statements of operations,shareholders’ equity and cash flows for each of the two years in the periodthen ended.  These financial statementsare the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our audits in accordance withauditing standards generally accepted in the United States of America.  Those standards require that we plan and performthe audit to obtain reasonable assurance about whether the financial statementsare free of material misstatement.  Anaudit includes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referredto above present fairly, in all material respects, the consolidated financialposition of Paulson Capital Corp. and Subsidiary as of December 31, 2001 and2000, and the consolidated results of their operations and their consolidatedcash flows for each of the two years in the period then ended, in conformitywith accounting principles generally accepted in the United States of America.

 

Our audits were made for the purpose of forming anopinion on the basic consolidated financial statements taken as a whole.  The accompanying Supplementary Schedule ofWarrants Owned as of December 31, 2001 is presented for purposes of additionalanalysis and is not a required part of the basic consolidated financialstatements.  Such information has beensubjected to the auditing procedures applied in the audits of the basicconsolidated financial statements and, in our opinion, is fairly stated, in allmaterial respects, in relation to the basic consolidated financial statementstaken as a whole.

 

We have also audited Schedule II for each of thetwo years in the period ended December 31, 2001.  In our opinion, this schedule presents fairly, in all materialrespects, the information required to be set forth therein.

 
| Portland, Oregon | /s/ GRANT THORNTON LLP |   |
|------------------|------------------------|--------|
| February 1, 2002 |                   |

 

F-1

----

 

Paulson Capital Corp. andSubsidiary

 

CONSOLIDATED BALANCE SHEET

 

December 31, 2001

 
| ASSETS                                                                                               |   |       |       |
|------------------------------------------------------------------------------------------------------|--------|------------|------------|
| CURRENT ASSETS                                                                                       |   |       |       |
| Cash and cash equivalents                                                                            |   | $          | 42,938     |   |
| Receivable from clearing organization                                                                |   | 8,433,039  |       |
| Notes and other receivables                                                                          |   | 407,716    |       |
| Income taxes receivable                                                                              |   | 1,846,100  |       |
| Trading securities, at market value                                                                  |   | 1,559,960  |       |
| Investment securities, at market value                                                               |   | 18,632,580 |       |
| Underwriter warrants, at estimated fair value                                                        |   | 6,165,000  |       |
| Prepaid and deferred expenses                                                                        |   | 989,750    |       |
|                                                                                                 |   |       |       |
| Total current assets                                                                                 |   | 38,077,083 |       |
|                                                                                                 |   |       |       |
| FURNITURE AND EQUIPMENT, net                                                                         |   | 344,349    |       |
|                                                                                                 |   |       |       |
| INVESTMENT IN REAL ESTATE                                                                            |   | 169,900    |       |
|                                                                                                 |   |       |       |
| Total Assets                                                                                         |   | $          | 38,591,332 |   |
|                                                                                                 |   |       |       |
| LIABILITIES AND SHAREHOLDERS’  EQUITY                                                           |   |       |       |
|                                                                                                 |   |       |       |
| CURRENT LIABILITIES                                                                                  |   |       |       |
| Accounts payable and accrued liabilities                                                             |   | $          | 369,977    |   |
| Payable to clearing organization                                                                     |   | 1,418,779  |       |
| Compensation, employee benefits and payroll taxes                                                    |   | 1,335,471  |       |
| Securities sold, not yet purchased, at market value                                                  |   | 12,846     |       |
| Deferred income taxes                                                                                |   | 2,305,200  |       |
|                                                                                                 |   |       |       |
| Total  current liabilities                                                                           |   | 5,442,273  |       |
|                                                                                                 |   |       |       |
| DEFERRED INCOME TAXES                                                                                |   | 18,100     |       |
|                                                                                                 |   |       |       |
| Total  liabilities                                                                                   |   | 5,460,373  |       |
|                                                                                                 |   |       |       |
| SHAREHOLDERS’ EQUITY                                                                            |   |       |       |
| Preferred stock, no par value; authorized, 500,000 shares; issued and  outstanding, no shares        |   | —     |       |
| Common stock, no par value; authorized, 10,000,000 shares; issued and  outstanding, 3,163,062 shares |   | 1,062,428  |       |
| Retained earnings                                                                                    |   | 32,068,531 |       |
|                                                                                                 |   |       |       |
| Total shareholders' equity                                                                           |   | 33,130,959 |       |
|                                                                                                 |   |       |       |
| Total liabilities and shareholders' equity                                                           |   | $          | 38,591,332 |   |

 

The accompanying notes are an integral part of these statements.

 

F-2

----

 

CONSOLIDATED STATEMENTSOF OPERATIONS

 

Year ended December 31,

 
|                                        |   | **2001**   |      | **2000**   |   |
|---------------------------------------------|--------|------------|-----------|------------|--------|
| Revenues                                    |   |       |      |       |   |
| Commissions                                 |   | $          | 7,561,535 |       | $      | 14,912,599 |   |
| Corporate finance                           |   | 6,017,517  |      | 5,301,316  |   |
| Investment income (loss)                    |   | 10,700,897 |      | (6,481,555 | )      |
| Trading income                              |   | 1,008,957  |      | 2,047,418  |   |
| Interest and dividends                      |   | 44,428     |      | 91,650     |   |
| Other                                       |   | 4,012      |      | 4,412      |   |
|                                        |   |       |      |       |   |
|                                        |   | 25,337,346 |      | 15,875,840 |   |
|                                        |   |       |      |       |   |
| Expenses                                    |   |       |      |       |   |
| Commissions and salaries                    |   | 9,562,856  |      | 15,651,244 |   |
| Underwriting expenses                       |   | 638,190    |      | 522,830    |   |
| Rent, telephone and quotation services      |   | 975,242    |      | 961,014    |   |
| Interest expense                            |   | 60,825     |      | 85         |   |
| Professional fees                           |   | 512,894    |      | 302,952    |   |
| Bad debt expense                            |   | 111,037    |      | 436,984    |   |
| Travel and entertainment                    |   | 351,926    |      | 284,542    |   |
| Settlements                                 |   | 68,500     |      | 59,336     |   |
| Other                                       |   | 1,459,840  |      | 1,782,754  |   |
|                                        |   |       |      |       |   |
|                                        |   | 13,741,310 |      | 20,001,741 |   |
|                                        |   |       |      |       |   |
| Earnings (loss) before income taxes         |   | 11,596,036 |      | (4,125,901 | )      |
|                                        |   |       |      |       |   |
| Income tax expense (benefit)                |   | 4,558,974  |      | (1,077,687 | )      |
|                                        |   |       |      |       |   |
| NET EARNINGS (LOSS)                         |   | $          | 7,037,062 |       | $      | (3,048,214 | ) |
|                                        |   |       |      |       |   |
| Basic earnings (loss) per share             |   | $          | 2.18      |       | $      | (.88 | ) |
|                                        |   |       |      |       |   |
| Diluted earnings (loss) per share           |   | $          | 2.17      |       | $      | (.88 | ) |
|                                        |   |       |      |       |   |   |   |
| Weighted average common shares outstanding: |   |       |      |       |   |   |   |
| Basic                                       |   |       | 3,234,157 |       |   | 3,474,142 |   |
| Diluted                                     |   |       | 3,239,604 |       |   | 3,474,142 |   |

 

The accompanying notes are an integral part of these statements.

 

F-3

----

 

CONSOLIDATED STATEMENT OFSHAREHOLDERS’ EQUITY

 

Two year period endedDecember 31, 2001

 
|                         |   | **Common Stock** |   | **Retained  Earnings** |      |
|------------------------------|--------|------------------|--------|------------------------|-----------|
|                         |   | **Shares**       |   | **Amount**             |      |   |
| Balance at December 31, 1999 |   | 3,541,235        |   | $                      | 732,343   |   | $ | 30,388,263 |   |
|                         |   |             |   |                   |      |   |   |
| Stock option grants          |   | —           |   | 317,750                |      | — |   |
|                         |   |             |   |                   |      |   |   |
| Stock options exercised      |   | 16,000           |   | 71,000                 |      | — |   |
|                         |   |             |   |                   |      |   |   |
| Redemption of common stock   |   | (189,869         | )      | (41,082                | )         | (1,235,230 | ) |
|                         |   |             |   |                   |      |   |   |
| Net loss for the year        |   | —           |   | —                 |      | (3,048,214 | ) |
|                         |   |             |   |                   |      |   |   |
| Balance at December 31, 2000 |   | 3,367,366        |   | 1,080,011              |      | 26,104,819 |   |
|                         |   |             |   |                   |      |   |   |
| Stock options exercised      |   | 7,000            |   | 31,063                 |      | — |   |
|                         |   |             |   |                   |      |   |   |
| Redemption of common stock   |   | (211,304         | )      | (48,646                | )         | (1,073,350 | ) |
|                         |   |             |   |                   |      |   |   |
| Net earnings for the year    |   | —           |   | —                 |      | 7,037,062 |   |
|                         |   |             |   |                   |      |   |   |
| Balance at December 31, 2001 |   | 3,163,062        |   | $                      | 1,062,428 |   | $ | 32,068,531 |   |

 

The accompanying notes are an integral part of these statement.

 

F-4

----

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

Year ended December 31,

 
|                                                                                      |   | **2001**    |      | **2000**     |   |
|-------------------------------------------------------------------------------------------|--------|-------------|-----------|--------------|--------|
| Increase (Decrease) in Cash and Cash Equivalents                                          |   |        |      |         |   |
|                                                                                      |   |        |      |         |   |
| Cash flows from operating activities                                                      |   |        |      |         |   |
| Net earnings (loss)                                                                       |   | $           | 7,037,062 |         | $      | (3,048,214 | ) |
| Adjustments to reconcile net earnings (loss) to net cash used in  operating activities    |   |        |      |         |   |
| Receipt of underwriter warrants                                                           |   | (4,016,714  | )         | (2,797,000   | )      |
| Unrealized (appreciation) depreciation on investment securities and  underwriter warrants |   | (12,179,138 | )         | 35,797,450   |   |
| Realized (gain) loss on investment securities                                             |   | 1,478,241   |      | (29,316,895  | )      |
| Deferred income taxes                                                                     |   | 6,546,200   |      | (12,614,400  | )      |
| Compensation expense on stock option grants                                               |   | —      |      | 317,750      |   |
| Depreciation and amortization                                                             |   | 197,465     |      | 182,785      |   |
| Write-down of notes receivable, net of recoveries                                         |   | 111,037     |      | 436,984      |   |
| Interest accrued on notes receivable                                                      |   | (7,486      | )         | (3,551       | )      |
| Changes in assets and liabilities                                                         |   |        |      |         |   |
| Receivables                                                                               |   | 97,951      |      | 87,010       |   |
| Receivable from/payable to clearing organization                                          |   | 1,034,964   |      | (2,596,264   | )      |
| Trading securities                                                                        |   | (253,971    | )         | 932,809      |   |
| Income taxes receivable/payable                                                           |   | (5,742,100  | )         | 2,779,200    |   |
| Prepaid and deferred expenses                                                             |   | (123,764    | )         | (196,387     | )      |
| Accounts payable and accrued liabilities                                                  |   | 473,584     |      | (2,895,900   | )      |
| Securities sold, not yet purchased                                                        |   | (18,650     | )         | (34,298      | )      |
|                                                                                      |   |        |      |         |   |
| Net cash used in operating activities                                                     |   | (5,365,320  | )         | (12,968,921  | )      |
|                                                                                      |   |        |      |         |   |
| Cash flows from investing activities                                                      |   |        |      |         |   |
| Purchases of investment securities                                                        |   | (34,235,237 | )         | (117,771,535 | )      |
| Proceeds from sale of investment securities                                               |   | 40,662,257  |      | 132,268,612  |   |
| Issuance of note receivable                                                               |   | —      |      | (100,000     | )      |
| Additions to furniture and equipment                                                      |   | (32,138     | )         | (166,745     | )      |
|                                                                                      |   |        |      |         |   |
| Net cash provided by investing activities                                                 |   | 6,394,882   |      | 14,230,332   |   |
|                                                                                           |        |             |           |              |        |  |  |

 

F-5

----

 
| Cash flows from financing activities                   |   |       |      |       |   |
|--------------------------------------------------------|--------|------------|-----------|------------|--------|
| Proceeds from issuance of stock                        |   | $          | 31,063    |       | $      | 71,000 |   |
| Payments to retire common stock                        |   | (1,121,996 | )         | (1,276,312 | )      |
|                                                   |   |       |      |       |   |
| Net cash used in financing activities                  |   | (1,090,933 | )         | (1,205,312 | )      |
|                                                   |   |       |      |       |   |
| Net increase (decrease) in cash and cash equivalents   |   | (61,371    | )         | 56,099     |   |
|                                                   |   |       |      |       |   |
| Cash and cash equivalents at beginning of year         |   | 104,309    |      | 48,210     |   |
|                                                   |   |       |      |       |   |
| Cash and cash equivalents at end of year               |   | $          | 42,938    |       | $      | 104,309 |   |
|                                                   |   |       |      |       |   |
| Cash paid during the year for                          |   |       |      |       |   |
|                                                   |   |       |      |       |   |
| Interest                                               |   | $          | 60,825    |       | $      | 85 |   |
|                                                   |   |       |      |       |   |
| Income taxes                                           |   | $          | 3,746,609 |       | $      | 8,785,000 |   |
|                                                   |   |       |      |       |   |
| Non-cash items                                         |   |       |      |       |   |
|                                                   |   |       |      |       |   |
| Conversion of note receivable to investment securities |   | $          | 741,854   |       | — |   |

----

The accompanying notes are an integral part of these statements.

 

F-6

----

 

NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

 

NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANTACCOUNTING POLICIES

 

PaulsonCapital Corp. (the Company) is a holding company whose wholly-owned subsidiary,Paulson Investment Company, Inc. (Subsidiary) is a registered broker-dealer insecurities under the Securities and Exchange Act of 1934, as amended.  The Subsidiary renders broker-dealerservices in securities on both an agency and principal basis to its customerswho are fully introduced to Correspondent Services Corporation (CSC), asubsidiary of Paine Webber Group, Inc. The Subsidiary also acts as lead or participating underwriter forover-the-counter and American Stock Exchange securities offerings.  The Subsidiary conducts business throughoutthe United States.  The Subsidiary isexempt from the reserve requirements under SEC Rule 15c3-3(k)(2)(ii), since itdoes not handle or carry customer securities and cash.

 

A summary of the significant accounting policies consistentlyapplied in the preparation of the accompanying financial statements follows.

 

1.   Principles of Consolidation

 

Theaccompanying consolidated financial statements include the accounts of PaulsonCapital Corp. and its wholly-owned subsidiary, Paulson Investment Company,Inc.  All significant intercompanybalances and transactions have been eliminated in the consolidation.

 

2.   Security Transactions

 

Securitiestransactions and related revenue are recorded on a trade date basis.  Manager’s fees, underwriter’s fees, andother underwriting revenues are recognized at the time the underwriting iscompleted.  Tax shelter revenue isrecognized at the time individual tax shelter units are sold.  Revenue from the receipt of underwriter warrantsreceived in corporate finance transactions is recognized based on the estimatedfair value of the securities received as estimated using the Black-Scholesoption-pricing model.  Marketablesecurities are valued at market value and securities not readily marketable arevalued at fair value as determined by management.  The fair value of not readily marketable securities is estimatedby management using available information including the following: quoted marketprices of similar securities (i.e., unrestricted shares of the same company);price of recent known trades of the same or similar securities; the cost of thesecurity if recently purchased adjusted for changes in the financial conditionof the issuer; all other information available from review of availabledocuments related to the issuer or discussions with management of theissuer.  Changes in the value of thesesecurities are reflected currently in the results of operations.  Underwriter warrants are valued at estimatedfair value using the Black-Scholes option-pricing model, taking into accountthe exercise price, remaining life of the warrant, the current price of theunderlying stock and its expected volatility, expected dividends on the stockand the risk-free interest rate for the remaining term of the warrant.  Changes in the estimated fair value of theseunderwriter warrants are reflected currently in the results of operations.

 

3.   Fair Value of Financial Instruments

 

Thecarrying amounts reflected in the balance sheet for cash, cash equivalents,notes and other receivables and payables approximate their respective fairvalues due to the short maturities of these instruments.

 

4.   Furniture and Equipment

 

Depreciationof furniture and equipment is computed generally by the straight-line methodover their estimated useful lives (5 years). Leasehold improvements are amortized over the lesser of their estimateduseful life or the lives of their respective leases.

 

 

F-7

----

 

5.   Cash Flows

 

Forpurposes of reporting cash flows, cash and cash equivalents include cash onhand, cash due from banks and brokerage accounts, certificates of deposit andhighly liquid debt instruments purchased with a maturity of three months orless.

 

6.   Use of Estimates

 

Inpreparing the Company’s financial statements, management is required to makeestimates and assumptions that affect the reported amounts of assets andliabilities, the disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period. Actual results could differ from those estimates.

 

7.   Earnings Per Share

 

Basicearnings (loss) per share is computed based on the weighted average number ofcommon shares outstanding during the year. Diluted earnings (loss) per share is computed using the weighted averagenumber of common and dilutive common equivalent shares outstanding during theyear.  Common equivalent shares fromstock options are excluded from the computation when their effect isantidilutive.  (Note I).

 

8.   Income taxes

 

TheCompany provides for income taxes under the liability method.  Deferred tax assets and liabilities aredetermined based on differences between financial reporting and tax bases ofassets and liabilities as measured by the enacted tax rates which are expectedto be in effect when these differences reverse.  Income tax expense is the tax payable for the period and thechange during the period in net deferred tax assets and liabilities.

 

9.   RecentlyIssued Accounting Pronouncements 

 

On July 20, 2001 theFinancial Accounting Standards Board issued Statement of Financial AccountingStandards (SFAS) No. 141, “Business Combinations,” and SFAS No. 142, “Goodwilland Other Intangible Assets.”  Thesestatements make significant changes to the accounting for businesscombinations, goodwill, and intangible assets. The adoption of SFAS 141 and 142 had no impact on the Company’sfinancial statements.

 

In June 2001, theFinancial Accounting Standards Board issued SFAS No. 143, “Accounting for AssetRetirement Obligations.”  This statementaddresses the financial accounting and reporting for the retirement of tangiblelong-lived assets and the associated asset retirementcosts.  In August 2001, the FinancialAccounting Standards Board issued SFAS No. 144, “Accounting for the Impairmentor Disposal of Long-Lived Assets.”  Thisstatement addresses the financial accounting and reporting for the impairmentor disposal of long-lived assets.  TheCompany believes the adoption of SFAS 143 and 144 will have no significantimpact on its financial statements.

 

F-8

----

 

10.   StockOptions

 

The Company accounts forits stock option plan under SFAS No. 123 “Accounting for Stock-BasedCompensation.”  As allowed under this statement, the Company continues toaccount for stock options for employees under APB No. 25, “Accounting for StockIssued to Employees,” and has adopted the disclosure only requirements of SFASNo. 123.

 

NOTE B - RECEIVABLE FROM AND PAYABLE TO CLEARINGORGANIZATION

 

TheSubsidiary introduces all customer transactions in securities traded on U.S.securities markets to CSC on a fully-disclosed basis.  The agreement between the Subsidiary and its clearing brokerprovides that the Subsidiary is obligated to assume any exposure related tononperformance by customers or counterparties. The Subsidiary monitors clearance and settlement of all customertransactions on a daily basis.

 

The exposure to creditrisk associated with the nonperformance of customers and counterparties infulfilling their contractual obligations pursuant to these securitiestransactions can be directly impacted by volatile trading markets which mayimpair the customer’s or counterparty’s ability to satisfy their obligations tothe Subsidiary.  In the event ofnonperformance, the Subsidiary may be required to purchase or sell financialinstruments at unfavorable market prices resulting in a loss.  Management does not anticipate nonperformance by customers andcounterparties in the above situations.

 

Inaddition to the clearing services provided, CSC also loans money to theSubsidiary to finance trading accounts.

 

NOTE C – NOTES AND OTHER RECEIVABLES

 

Notesand other receivables consist of the following at December 31, 2001:

 

| Employees           |   | $       | 169,506 |   |
|---------------------|--------|---------|---------|--------|
| Independent brokers |   | 174,480 |    |
| Other               |   | 63,730  |    |
|                |   |    |    |
|                |   | $       | 407,716 |   |

 

Employeeand independent broker receivables relate principally to advances, expenses,inventory losses and settlements charged to the registered representatives ofthe Subsidiary in excess of commission earnings.  For the years ended December 31, 2001 and 2000, receivables fromemployees and independent brokers of $131,383 and $175,702, respectively, weredetermined by management to be uncollectible and written off to other operatingexpenses.

 

F-8

----

 

NOTE D - TRADING AND INVESTMENT SECURITIES

 

Tradingsecurities and securities sold not yet purchased represent the market value ofsecurities held long and short by the Company’s subsidiary.

 

Thecategories of trading securities and their related market values at December31, 2001 follow:

 

|                      |   | **Long** |      | **Short** |   |
|---------------------------|--------|----------|-----------|-----------|--------|
| Common stock              |   | $        | 1,386,146 |      | $      | 12,846 |   |
| State and municipal bonds |   | 150,861  |      | —    |   |
| Corporate bonds           |   | 22,953   |      | —    |   |
|                      |   |     |      |      |   |
|                      |   | $        | 1,559,960 |      | $      | 12,846 |   |

 

As asecurities broker-dealer, the Subsidiary is engaged in various securitiestrading and brokerage activities as principal. In the normal course of business, the Subsidiary has sold securitiesthat it does not currently own and will therefore be obligated to purchase suchsecurities at a future date.  Thisobligation is recorded in the financial statements at the market value of therelated securities and will incur a trading loss on the securities if themarket price increases and a trading gain if the market price decreasessubsequent to December 31, 2001.

 

Investment securitiesheld by the Subsidiary which are readily marketable are stated at marketvalue.  Included in investmentsecurities are certain securities which are not readily marketable.  Securities not readily marketable includeinvestment securities (a) for which there is no market on a securities exchangeor no independent publicly quoted market, (b) that cannot be publicly offeredor sold unless registration has been effected under the Securities Act of 1933,or (c) that cannot be offered or sold because of other arrangements,restrictions, or conditions applicable to the securities or to theCompany.  At December 31, 2001 thesesecurities consist of corporate stocks and warrants at estimated fair value ofapproximately $1,725,000.  A summary ofthe investment securities portfolio at December 31, 2001 follows:

 

| Corporate equities |   | $       | 18,299,150 |   |
|--------------------|--------|---------|------------|--------|
| Corporate warrants |   | 333,430 |       |
|               |   |    |       |
|               |   | $       | 18,632,580 |   |

 

Realizedgain (loss) included in the determination of net earnings was $(1,478,241) and$29,316,895 for the years ended December 31, 2001 and 2000, respectively.

 

F-9

----

 

NOTE E — UNDERWRITER WARRANTS

 

Theestimated fair value of warrants is determined by management using theBlack-Scholes option-pricing model, taking into account the exercise price,remaining contractual life of the warrant, the current price of the underlyingstock and its expected volatility, expected dividends on the stock and therisk-free interest rate for the remaining term of the warrant (see NoteA2).  The warrants generally have afive-year expiration date and vest immediately.  The warrants are generally subject to a one-year restrictionperiod in which the Company cannot exercise the warrants.  Significant assumptions used to estimate thefair values of the warrants include the risk-free interest rate, expectedvolatility factors for the underlying securities and an expected dividend yieldfor those securities that were expected to pay dividends.  The expected volatility factors weredetermined using historical volatility of the underlying stock if available andhistorical volatility of a peer group if volatility for the underlying stock isnot available.

 

The following table summarized activity inunderwriter warrants:

 

| Estimated fair value at December 31, 2000                  |   | $         | 2,702,000 |   |
|------------------------------------------------------------|--------|-----------|-----------|--------|
| Warrants  received                                         |   | 4,017,000 |      |
| Warrants expired                                           |   | (242,000  | )         |
| Unrealized  appreciation (depreciation) in estimated value |   | (312,000  | )         |
| Estimated fair  value at December 31, 2001                 |   | $         | 6,165,000 |   |

 

NOTE F - FURNITURE AND EQUIPMENT

 

Furnitureand equipment are stated at cost and consist of the following at December 31,2001:

 

| Office equipment                               |   | $         | 1,334,818 |   |
|------------------------------------------------|--------|-----------|-----------|--------|
| Leasehold improvements                         |   | 72,436    |      |
| Vehicles                                       |   | 65,619    |      |
|                                           |   | 1,472,873 |      |
| Less accumulated depreciation and amortization |   | 1,128,524 |      |
|                                           |   |      |      |
|                                           |   | $         | 344,349   |   |

 

F-10

----

 

NOTE G - INCOME TAXES

 

Incometax expense (benefit) consists of the following:

 

|                           |   | **2001**   |       | **2000**    |   |
|--------------------------------|--------|------------|------------|-------------|--------|
| Current tax expense            |   |       |       |        |   |
| Federal                        |   | $          | (1,626,854 | )           | $      | 8,638,164 |   |
| State and local                |   | (360,372   | )          | 2,898,549   |   |
|                           |   |       |       |        |   |
|                           |   | (1,987,226 | )          | 11,536,713  |   |
|                           |   |       |       |        |   |
| Deferred tax expense (benefit) |   |       |       |        |   |
| Federal                        |   | 5,295,400  |       | (9,384,596  | )      |
| State and local                |   | 1,250,800  |       | (3,229,804  | )      |
|                           |   |       |       |        |   |
|                           |   | 6,546,200  |       | (12,614,400 | )      |
|                           |   |       |       |        |   |
|                           |   | $          | 4,558,974  |        | $      | (1,077,687 | ) |

 

Income tax expense (benefit) for each year varies fromthe amount computed by applying the statutory federal income tax rate toearnings (loss) before taxes as follows:

 

|                                                       |   | **2001** |      | **2000** |   |
|------------------------------------------------------------|--------|----------|-----------|----------|--------|
| Income tax expense (benefit) at statutory federal tax rate |   | $        | 3,942,700 |     | $      | (1,403,000 | ) |
| State and local taxes net of federal benefit               |   | 775,300  |      | (14,000  | )      |
| Large corporation incremental rate                         |   | —   |      | 252,000  |   |
| Permanent and other differences                            |   | (159,026 | )         | 87,313   |   |
|                                                       |   |     |      |     |   |
|                                                       |   | $        | 4,558,974 |     | $      | (1,077,687 | ) |

 

The deferred income tax asset (liability)consists of the following at December 31, 2001:

 

| Unrealized depreciation (appreciation) on  securities |   | $       | (2,622,500 | ) |
|-------------------------------------------------------|--------|---------|------------|---|
| Accrued expenses                                      |   | 27,400  |       |
| State net operating loss carryforwards                |   | 283,700 |       |
| Fixed asset depreciation                              |   | (18,100 | )          |
| Contribution carryover                                |   | 6,200   |       |
|                                                  |   |    |       |
|                                                  |   | $       | (2,323,300 | ) |

 

The state net operating loss carryforwardsbegin to expire in 2004.

 

F-11

----

 

NOTE H - COMMON STOCK

 

TheSubsidiary has a key employee stock purchase plan.  Under the plan, the Subsidiary will match funds (up to $25,000)committed by key employees for the purchase of shares of the Company’s commonstock.  The committed and matching fundswill be used by the Subsidiary to purchase stock of the Company in the openmarket or by negotiated transactions. One half of the shares will be resold to the participating employee andone half of the shares will be transferred to the employee for no cashconsideration.  The named participants,the number of shares purchased in the open market and the amount of matchingfunds will be at the discretion of the Board of Directors of theSubsidiary.  No participants were namedand no purchases of common stock under this plan were made during 2001 or 2000.

 

The Company’s 1999 StockOption Plan reserves 500,000 shares of the Company’s common stock for issuanceupon exercise of the options.  The Planprovides for the grant of incentive options and nonqualified options.  The options granted during 2000 have anexercise price of $4.4375, vest immediately and expire on August 15, 2004.  The market price at the date of grant was$7.00, which resulted in the Companyrecording compensation expense of $317,750 during the year ended December 31,2000.  The estimated fair value of theoptions at the date of grant, as calculated using the Black-Scholesoption-pricing model, was $4.359 per share. The following table summarizes activity under the Plan for the yearsended December 31, 2001 and 2000:

 

|                         |   | **Shares****Under  Option** |   | **Exercise****Price** |   |
|------------------------------|--------|-----------------------------|--------|-----------------------|--------|
| Balance at December 31, 1999 |   | —                      |   | $                     | — |   |
| Granted                      |   | 124,000                     |   | 4.44                  |   |
| Exercised                    |   | (16,000                     | )      | 4.44                  |   |
| Canceled                     |   | —                      |   | —                |   |
|                         |   |                        |   |                  |   |
| Balance at December 31, 2000 |   | 108,000                     |   | 4.44                  |   |
| Granted                      |   | —                      |   | —                |   |
| Exercised                    |   | (7,000                      | )      | 4.44                  |   |
| Canceled                     |   | —                      |   | —                |   |
|                         |   |                        |   |                  |   |
| Balance at December 31, 2001 |   | 101,000                     |   | 4.44                  |   |
|                              |        |                             |        |                       |        |  |

 

TheCompany has adopted the disclosure only provisions of Financial AccountingStandard No. 123, “Accounting for Stock-Based Compensation” (FAS 123).  It applies APB Opinion No. 25, “Accountingfor Stock Issued to Employees,” in accounting for its Plans.  Had the Company elected to recognizecompensation expense based upon the fair value at the grant date for awardsunder these Plans consistent with the methodology prescribed by FAS 123, theeffect on the Company’s net income and earnings per share would have been todecrease net income and earnings per share by approximately $134,000 and $.04for the year ended December 31, 2000. The fair value of each option grant is estimated on the date of grantusing the Black-Scholes option-pricing model with the followingweighted-average assumptions: no dividends; expected volatility of 55%;risk-free interest rate of 6.2% and expected life of 4 years.

 

F-12

----

 

NOTE I - EARNINGS PER SHARE

 

The following table is areconciliation of the numerators and denominators of the basic and diluted pershare computations for each of the two years in the period ended December 31,2001:

 

|                                        |   | **Income   (Numerator)** |       | **Weighted  Average****Shares  (Denominator)** |      | **Per  Share  Amount** |   |
|---------------------------------------------|--------|--------------------------|------------|------------------------------------------------|-----------|------------------------|--------|
| 2000                                        |   |                     |       |                                           |      |                   |   |
| Basic and diluted earnings (loss) per share |   |                     |       |                                           |      |                   |   |
| Loss allocable to common stockholders       |   | $                        | (3,048,214 | )                                              | 3,474,142 |                   | $      | (.88 | ) |
|                                        |   |                     |       |                                           |      |                   |   |
| 2001                                        |   |                     |       |                                           |      |                   |   |
| Basic earnings per share                    |   |                     |       |                                           |      |                   |   |
| Earnings available to common stockholders   |   | $                        | 7,037,062  |                                           | 3,234,157 |                   | $      | 2.18 |   |
|                                        |   |                     |       |                                           |      |                   |   |
| Effect of dilutive securities               |   |                     |       |                                           |      |                   |   |
| Stock options                               |   | $                        | —     |                                           | 5,447     |                   |   |   |
|                                        |   |                     |       |                                           |      |                   |   |
| Diluted earnings per share                  |   |                     |       |                                           |      |                   |   |
| Earnings available to common stockholders   |   | $                        | 7,037,062  |                                           | 3,239,604 |                   | $      | 2.17 |   |

 

NOTE J - LEASES

 

Futureminimum payments required under non-cancelable operatingleases with initial or remaining terms of one year or more consist of thefollowing:

 

| **Year ending  December 31,** |   |    |      |
|-------------------------------|--------|---------|-----------|
| 2002                          |   | $       | 323,385   |   |
| 2003                          |   | 308,448 |      |
| 2004                          |   | 308,448 |      |
| 2005                          |   | 323,442 |      |
| 2006                          |   | 334,152 |      |
| Thereafter                    |   | 858,942 |      |
|                          |   |    |      |
|                          |   | $       | 2,456,817 |   |

 

The leasesprovide for payment of taxes and other expenses by the Company.  Rental expense for the years ended December31, 2001 and 2000 approximated $280,000 and $272,000, respectively.

 

F-13

----

 

NOTE K - EMPLOYEE BENEFIT PLANS

 

Retirement benefits for employees of the Company, who havecompleted certain service requirements, are provided by a defined contributionprofit-sharing plan.  Plan contributionsare determined by the Board of Directors. Contributions to the plan for the years ended December 31, 2001 and2000 were $400,000 and $300,000, respectively.

 

NOTE L - CONTINGENCIES

 

The Company and itsSubsidiary have been named by individuals in certain legal actions, some ofwhich claim state and federal securities law violations and claim principal andpunitive damages.  As preliminaryhearings and discovery in these cases is not complete, it is not possible toassess the degree of liability, the probability of an unfavorable outcome orthe impact on the Company’s financial statements, if any.  Management denies the charges in these legalactions and is vigorously defending against them.  No provision for liability, if any, that may result from theabove contingencies has been made in the financial statements.

 

NOTE M – NET CAPITAL REQUIREMENT

 

TheSubsidiary is subject to the net capital rule (Rule 15c3–1) ofthe Securities and Exchange Commission. This rule prohibits the Subsidiary from engaging in any securitiestransaction at a time when its “aggregate indebtedness” exceeds fifteen timesits “net capital” as those terms are defined by the rule.  At December 31, 2001, the Subsidiary’s netcapital and required net capital were $17,621,377 and $111,223, respectively,and its ratio of aggregate indebtedness to net capital was .09 to 1.  The Subsidiary’s absolute minimum netcapital requirement is $100,000.

 

F-14

----

 

   Schedule I

 

SUPPLEMENTARY SCHEDULE OFWARRANTS OWNED

 

December 31, 2001

 
| **Description**                                         |   | **Number  of  Warrants** |   | **Exercise  Price Per  Share/Unit** |     | **Expiration  Date** |         |
|---------------------------------------------------------|--------|--------------------------|--------|-------------------------------------|----------|----------------------|--------------|
| AdStar, Inc. (units) ERC* 12-17-00                      |   | 60,500                   |   | $                                   | 7.20     |                 | 2004,  12/16 |   |
| AdStar, Inc. ERC 9-25-01                                |   | 149,000                  |   | $                                   | 1.80     |                 | 2005,  09/25 |   |
| Advantage Marketing Systems Inc. (units) ERC 11-12-98   |   | 65,520                   |   | $                                   | 5.40     |                 | 2002,  11/12 |   |
| audiohighway.com (units) ERC 12-17-99                   |   | 163,900                  |   | $                                   | 7.80     |                 | 2003,  12/17 |   |
| AVI Biopharma, Inc. (units) ERC 6-3-98 (ANTIVIRALS)     |   | 112,700                  |   | $                                   | 10.80    |                 | 2002,  06/03 |   |
| AVI Biopharma, Inc. ERC 7-26-01                         |   | 151,014                  |   | $                                   | 8.70     |                 | 2005,  07/26 |   |
| Beta Oil & Gas, Inc. ERC 7-30-00                    |   | 9,300                    |   | $                                   | 7.50     |                 | 2004,  07/30 |   |
| Beta Oil & Gas, Inc. #2 ERC 6-29-01                 |   | 1,850                    |   | $                                   | 9.25     |                 | 2006,  06/29 |   |
| Charles & Colvard, Ltd. ERC 11-14-98 (C3, Inc.)     |   | 214,592                  |   | $                                   | 18.00    |                 | 2002,  11/14 |   |
| Careside, Inc. (units) ERC 06-15-00                     |   | 92,650                   |   | $                                   | 9.00     |                 | 2004,  06/15 |   |
| Caring Products International, Inc. (units) ERC 12-9-98 |   | 83,075                   |   | $                                   | 6.00     |                 | 2002,  12/09 |   |
| Cell Robotics International, Inc. (units) ERC 2-2-99    |   | 29,800                   |   | $                                   | 9.90     |                 | 2003,  02/01 |   |
| Creative Products Intl. ERC 7-01-01                     |   | 30,000                   |   | $                                   | 1.50     |                 | 2006,  06/30 |   |
| Dag Media, Inc. ERC 05-12-00                            |   | 90,562                   |   | $                                   | 7.80     |                 | 2004,  05/12 |   |
| E.Com International, Inc. ERC 12-5-97                   |   | 75,587                   |   | $                                   | 3.50     |                 | 2002,  12/31 |   |
| GMX Resources, Inc. (units) ERC 2-12-01                 |   | 76,475                   |   | $                                   | 9.60     |                 | 2006,  02/12 |   |
| GMX Resources, Inc. #2 ERC 7-18-02                      |   | 126,650                  |   | $                                   | 6.60     |                 | 2006,  07/18 |   |
| Hometown Auto Retailers, Inc. ERC 7-28-99               |   | 120,690                  |   | $                                   | 10.80    |                 | 2003,  07/28 |   |
| Imageware Systems, Inc. (units) ERC 3-30-01             |   | 106,323                  |   | $                                   | 9.60     |                 | 2005,  03/30 |   |
| microHelix, Inc. ERC 11-16-02                           |   | 127,462                  |   | $                                   | 7.20     |                 | 2006,  11/16 |   |
| Pacific Mercantile Bancorp ERC 6-15-01                  |   | 158,350                  |   | $                                   | 9.60     |                 | 2005,  06/14 |   |
| Premium Cigars International, Ltd. ERC 8-21-98          |   | 2,000                    |   | $                                   | 8.40     |                 | 2002,  08/21 |   |
| Taser International, Inc. ERC 5-07-02                   |   | 49,649                   |   | $                                   | 15.60    |                 | 2006,  05/07 |   |
| 3D shopping.com (units) ERC 07-20-00                    |   | 73,466                   |   | $                                   | 14.40    |                 | 2004,  07/20 |   |
| WSG Systems, Inc. ERC 4-8-99                            |   | 11.026                   |   | $                                   | 6,000.00 |                 | 2003,  03/31 |   |

 

----

* ERC = date exercisable

F-15

----

 

   Schedule  II

 

Valuation and Qualifying Accounts

 

Years ended December 31,2001 and 2000

 
| **Description**                  |   | **Balance  Beginning  of Year** |   | **Additions-Charges  to Cost and  Expenses** |   | **Deductions  Write-offs** |   | **Balance  at End  of Year** |    |
|----------------------------------|--------|---------------------------------|--------|----------------------------------------------|--------|----------------------------|--------|------------------------------|---------|
| Allowance for doubtful accounts: |   |                            |   |                                         |   |                       |   |                         |    |
|                             |   |                            |   |                                         |   |                       |   |                         |    |
| Year ended Dec. 31, 2001         |   | $                               | — |                                         | $      | 111,037                    |   | $                            | 111,037 |   | $ | — |   |
| Year ended Dec. 31, 2000         |   | —                          |   | 436,984                                      |   | 436,984                    |   | —                       |    |
|                                  |        |                                 |        |                                              |        |                            |        |                              |         |  |  |  |  |

 

F-16

----