**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,DC 20549**

 

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**FORM 10-K**

 

| **ý** | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE  ACT OF 1934**                                                                                                                      |
|------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                      |
|       |       | **For the fiscal year ended December 31,  2005**                                                                                                                                                                     |
|       |       |                                                                                                                                                                                                                      |
| **OR**     |
|       |       |                                                                                                                                                                                                                      |
| **o**      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE EXCHANGE ACT OF 1934**                                                                                                                              |
| ** ** | ** ** | ** **                                                                                                                                                                                                                |
| ** ** | ** ** | **For the transition period  from               to               ** |

 

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**PAULSONCAPITAL CORP.**

(Exactname of registrant as specified in its charter)

 

| **Oregon**                                                       | ** ** | **0-18188**               | ** ** | **93-0589534**                         |
|------------------------------------------------------------------|------------|---------------------------|------------|----------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |       | (Commission  File Number) |       | (IRS  Employer  Identification Number) |
|                                                             |       |                      |       |                                   |
| **811 SW  Naito Parkway, Suite 200, Portland, OR 97204**    | ** ** | **97204**                 |
| (Address  of principal executive offices)                        |       | (Zip  Code)               |

 

**(503)243-6000**

(Registrant’stelephone number, including area code)

 

(Formername, former address and former fiscal year, if changed since last report)

 

Securitiesregistered pursuant to Section 12(b) of the Act: **None**

 

Securitiesregistered pursuant to section 12(g) of the Act: **Common Stock**

 

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Indicate by check markwhether the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.   Yes  o  No  ý

 

Indicate by check markwhether the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act.   Yes  o  No  ý

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.   Yes  ý   No  o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-Kis not contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act.

 
| Large accelerated filer    o |   | Accelerated filer    o |   | Non-accelerated filer    ý |
|--------------------------------------------------|--------|--------------------------------------------|--------|-----------------------------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).  Yes  o  No  ý

 

The aggregate market valueof the voting common stock held by non-affiliates of the registrant as of June 30,2005, the last business day of the registrant’s most recently completed secondfiscal quarter, was $14,420,509 based on the last reported sale price of theCompany’s Common Stock as reported by the NASDAQ Capital Market.

 

The number of shares ofCommon Stock outstanding on March 15, 2006, was 3,093,970.

 

Part III isincorporated by reference to the registrant’s proxy statement for its 2006annual meeting of shareholders to be filed with the Commission within 120 daysof December 31, 2005.

 

 

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**PAULSONCAPITAL CORP.**

 

**FORM 10-KFOR FISCAL YEAR ENDED**

 

**DECEMBER 31,2005**

 

**TABLE OFCONTENTS**

 
| **Item**      | ** ** | ** **                                                                                                          | **Page** |
|---------------|------------|---------------------------------------------------------------------------------------------------------------------|----------|
|          |       | **PART I**                                                                                                     |     |
|          |       | ** **                                                                                                          |     |
| Item 1.       |       | Business                                                                                                            | 3        |
|          |       |                                                                                                                |     |
| Item 1A. |       | Risk Factors                                                                                                        | 9        |
|          |       |                                                                                                                |     |
| Item 1B. |       | Unresolved Staff  Comments                                                                                          | 9        |
|          |       |                                                                                                                |     |
| Item 2.       |       | Properties                                                                                                          | 10       |
|          |       |                                                                                                                |     |
| Item 3.       |       | Legal Proceedings                                                                                                   | 10       |
|          |       |                                                                                                                |     |
| Item 4.       |       | Submission of  Matters to a Vote of Security Holders                                                                | 11       |
|          |       |                                                                                                                |     |
|          |       | **PART II**                                                                                                    |     |
|          |       |                                                                                                                |     |
| Item 5.       |       | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities | 12       |
|          |       |                                                                                                                |     |
| Item 6.       |       | Selected Financial Data                                                                                             | 14       |
|          |       |                                                                                                                |     |
| Item 7.       |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         | 14       |
|          |       |                                                                                                                |     |
| Item 7A. |       | Quantitative and  Qualitative Disclosures of Market Risk                                                            | 23       |
|          |       |                                                                                                                |     |
| Item  8.      |       | Financial  Statements and Supplementary Data                                                                        | 25       |
|          |       |                                                                                                                |     |
| Item  9.      |       | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                               | 25       |
|          |       |                                                                                                                |     |
| Item 9A. |       | Controls  and Procedures                                                                                            | 26       |
|          |       |                                                                                                                |     |
| Item 9B. |       | Other  Information                                                                                                  | 26       |
|          |       |                                                                                                                |     |
|          |       | **PART III**                                                                                                   |     |
|          |       |                                                                                                                |     |
| Item 10. |       | Directors  and Executive Officers of the Registrant                                                                 | 27       |
|          |       |                                                                                                                |     |
| Item 11. |       | Executive  Compensation                                                                                             | 27       |
|          |       |                                                                                                                |     |
| Item 12. |       | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    | 27       |
|          |       |                                                                                                                |     |
| Item 13. |       | Certain  Relationships and Related Transactions                                                                     | 27       |
|          |       |                                                                                                                |     |
| Item 14. |       | Principal  Accountant Fees and Services                                                                             | 28       |
|          |       |                                                                                                                |     |
|          |       | **PART IV**                                                                                                    |     |
|          |       |                                                                                                                |     |
| Item 15. |       | Exhibits  and Financial Statement Schedules                                                                         | 28       |
|          |       |                                                                                                                |     |
| Signatures    |       |                                                                                                                |     |

 

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**FORWARD-LOOKING STATEMENTS**

 

**This report, including, without limitation, “Item7. Management’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 of1933, as amended, 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-looking statements. 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, we cannot assure you that the resultsanticipated in this report will be realized. As noted elsewhere in this report,various aspects of our business are subject to extreme volatility often as aresult of factors beyond our ability to anticipate or control. In particular,factors, such as the condition of the securities markets, which are in turnbased on popular perceptions of the health of the economy generally, can beexpected to affect the volume of our business as well as the value of thesecurities maintained in our trading and investment accounts. Other factorsthat may affect our future financial condition or results of operationsinclude the following:**

 

•                  **The performance of companies whose securities we have underwritten orotherwise sold to our customers may affect our reputation with otherpotential syndicate and selling group members and institutional and otherretail accounts and may also affect the amount of money in our customers’portfolios available for the kinds of investments that we offer.**

 

•                  **The value of our investment portfolio, including the value ofsecurities without a readily ascertainable market value, that we have estimatedfor the purpose of reporting on our financial condition and results ofoperations, may be significantly and adversely affected by changes in thevalue of the companies themselves or of comparable companies whose stock valueswe use in estimating the value of our portfolio securities.**

 

•                  **We are subject to a very high degree of regulation and are responsiblefor compliance with applicable regulations by all of our personnel. Asignificant regulatory infraction by us or any of our registeredrepresentatives could result in significant penalties, including the loss ofour license to conduct securities business in one or more jurisdictions.**

 

•                  **Alternatives available to our customers to transact securities tradescould affect our ability to continue to execute our brokerage customers’transactions.**

 

•                  **The loss of our Chairman, Chester Paulson, could have a materialadverse impact on our business.**

 

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**PART I**

 

**ITEM 1.****                             BUSINESS**

 

**General**

 

Paulson Capital Corp. (“Paulson Capital” orthe “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. TheCompany operates in one industry segment, the financial services industry. At March 15,2006, PIC employed 34 brokers and had independent contractor arrangements with57 brokers registered with the National Association of Securities Dealers, Inc.(“NASD”). PIC also employed executive and support staff of 57 persons in itsheadquarters in Portland, Oregon and in certain of its employee branch offices.At March 15, 2006, PIC had 31 branch offices throughout the United States.

 

Paulson Capital is located at 811 S.W. NaitoParkway, Suite 200, Portland, Oregon 97204. Its telephone number is (503)  243-6000.

 

**Principal Products, Services and Markets**

 

Virtually all of Paulson Capital’s businessis carried on through PIC. PIC is involved in the purchase and sale of mostinvestment securities but is not involved in commodities or futures. Four broadcategories of securities activities contribute to revenues of PIC: retailbrokerage, corporate finance/investment banking, trading and market making (orwholesale), and investments. PIC receives revenues from gains and losses in itsinvestment accounts, from underwriter warrants received in connection with itscorporate finance activities, and from other sources.

 

The following table shows the portion of ourrevenues that was attributable to each category for the last three fiscalyears:

 
| ** **                | ** ** | **2005**   | ** ** | **% of Total** | ** ** | **2004**   | ** ** | **% of Total** | ** ** | **2003**  | ** ** | **% of Total** | ** ** |
|---------------------------|------------|------------|------------|----------------|------------|------------|------------|----------------|------------|-----------|------------|----------------|------------|
| **Securities  Brokerage** |       | $          | 16,517,709 |           | 41.5       |       | $          | 18,304,103     |       | 55.6      |       | $              | 16,597,119 |   | 59.2 |   |
| **Corporate  Finance**    |       | 3,259,092  |       | 8.2            |       | 11,213,195 |       | 34.1           |       | 6,801,330 |       | 24.2           |       |
| **Investment  Income**    |       | 15,839,768 |       | 39.9           |       | 2,017,840  |       | 6.1            |       | 3,359,973 |       | 12.0           |       |
| **Trading  Income**       |       | 2,926,440  |       | 7.4            |       | 1,350,816  |       | 4.1            |       | 1,245,018 |       | 4.4            |       |
| **Other**                 |       | 1,193,339  |       | 3.0            |       | 29,321     |       | 0.1            |       | 55,719    |       | 0.2            |       |
| **Total**                 |       | $          | 39,736,348 |           | 100.0      |       | $          | 32,915,275     |       | 100.0     |       | $              | 28,059,159 |   | 100.0 |   |

 

The table listed above reflects revenue categories and does not takeinto account any associated expenses. Because trading and investment income aredetermined by changes in the market value of PIC’s investment accounts, revenuein these categories can be either positive or negative. In fiscal years 2003through 2005, none of PIC’s revenues were from foreign sources. Please refer toour financial statements for an income statement and summary of our totalassets.

 

**Securities Brokerage**

 

As a securities broker, PIC acts as agent forits customers in the purchase and sale of common and preferred stocks, options,warrants and debt securities traded on securities exchanges or in theover-the-counter (“OTC”) market. A portion of its revenue is derived fromcommissions from customers on these transactions. In the OTC market,transactions with customers in securities not listed on an exchange may beeffected as principal, rather than agent, primarily in securities for which PICis a market maker. Customer transactions in securities are effected either on acash or margin basis.

 

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PIC also enters into dealer agreements withmutual fund management companies and publicly registered limited partnerships. Commissionson the sale of these securities are derived from the standard dealer discounts,which range from approximately 1 percent to 8.5 percent of the purchase priceof the securities, depending on the terms of the dealer agreement and theamount of the purchase. PIC does not generally sell interests in limitedpartnerships that are not publicly registered.

 

In the case of corporate financetransactions, described below, a portion of the discount applicable tosecurities placed by PIC’s retail brokerage group is credited to securitiesbrokerage and the commission payable to the broker is recorded as securitiesbrokerage expense.

 

Pursuant to an agreement between PIC and NationalFinancial Services LLC, a Fidelity Investment Company (“NFS”), NFS carries allof PIC’s customer securities accounts and performs the following services: (1) preparationand mailing of monthly statements to PIC customers; (2) settlement ofcontracts and transactions in securities between PIC and other broker-dealersand between PIC and its customers; (3) custody and safe-keeping ofsecurities and cash, the handling of margin accounts, dividends, exchanges,rights offerings and tender offers; and (4) the execution of customerorders placed on an exchange. PIC determines the amount of commission to becharged to its customers on agency transactions and the price of securitiespurchased or sold in principal transactions. NFS receives compensation based onthe size of the transaction, subject to certain minimum and maximum amounts. Inthe event of a liability arising from a bad debt from a customer, PIC isrequired to indemnify NFS against any loss. This potential liability isuninsured.

 

In addition to providing clearing servicesfor PIC, NFS loans money to PIC in the ordinary course of PIC’s business,pursuant to an arrangement under which NFS agrees to finance PIC’s tradingaccounts. At December 31, 2005 and 2004, no net loans were outstandingpursuant to this arrangement.

 

**Corporate Finance**

 

PIC raises capital for its corporate financeclients through public offerings and, to a lesser extent, private offerings ofsecurities of corporations that are engaged in a variety of businesses. PICparticipates in underwritings of corporate securities as managing underwriterand as a syndicate member. Management of an underwriting generates more revenuethan participation as a member of an underwriting syndicate. Revenues generatedby syndicate participations have not been material.

 

PIC acts as the managing underwriter ofpublic offerings of securities that typically range in size from $5 million to$45 million. PIC underwrites these offerings on a “firm commitment” basis,which means that it agrees to purchase a specific amount of securities from theissuer at a discount and resells the securities to the public at a specifiedprice after the registration statement for the offering is declared effectiveby the Securities and Exchange Commission (the “SEC”). 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 byincluding other stock brokerage firms as a part of an underwritingsyndicate in which each member commits to purchase a specified amount of theoffering. PIC and the other underwriters may also sell a portion of theircommitment through a “selling group” of other stock brokerage firms thatparticipate in selling the offering but are not subject to an underwriter’scommitment. As an underwriter, PIC is also subject to potential liability underfederal and state securities laws if the registration statement or prospectuscontains a material misstatement or omission. PIC has no insurance to cover itspotential liabilities as an underwriter.

 

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The commitment of capital by PIC between thetime a firm commitment underwriting agreement becomes effective and the timePIC resells the securities constitutes a charge against its net capital. Accordingly,PIC’s participation in or initiation of underwritings may be limited bythe financial requirements of the SEC and NASD. See “Net Capital Requirements.”

 

Between June 1, 1978 and December 31,2005, PIC acted as the managing underwriter or co-managing underwriter for 154securities offerings, raising approximately $1.1 billion for corporate financeclients. Of these, 96 were initial public offerings. PIC typically receives 2to 3 percent of the aggregate amount of money raised in an offering to covernonaccountable expenses and between 7 and 9 percent as compensation tounderwriters, selling group members and registered representatives, althoughthese percentages may be lower for larger transactions. PIC also typicallyreceives warrants to purchase securities, equal to 10 percent of the securitiessold in the offering, exercisable for a period of five years from the effectivedate of the public offering at a price equal to 120 percent of the publicoffering price. A portion of these underwriter warrants is typicallytransferred as compensation to persons associated with PIC and, in certaincases, to other major underwriters in the public offering. In 2005, theCompany completed two corporate finance transactions with gross proceedstotaling $13.4 million. In addition, during 2005 the Company completed severalsmall private placements and participated in a few small transactions in whichanother investment banking firm was the lead underwriter.

 

**Investment Income**

 

For a variety of reasons, PIC holdssecurities for investment. Securities held for investment are maintained ininvestment accounts that are segregated from the trading accounts. PIC’sinvestment portfolio principally consists of securities purchased for investmentand underwriter warrants.

 

From time to time, PIC makes investments as aprincipal in companies that are, or are expected to be, corporate financeclients. The investment may be as convertible debt in anticipation of apublic offering, in which case, if the offering is successful, the principaland interest are either converted to equity or repayable from the offeringproceeds. If the offering is not successful, the debt is typically converted toequity. PIC also makes investments in companies that are not anticipating animmediate public offering. In such cases, the investment is typically made inthe form of the purchase of restricted equity securities. Typicalinvestments described in this paragraph have ranged from $100,000 to$1,000,000.

 

**Trading and Market Making**

 

In addition to executing trades as an agent,PIC regularly acts as a principal in executing trades in equity securities,corporate debt securities and municipal bonds. At December 31, 2005, PICmade a market in 45 securities of 41 issuers. Of these, 21 were corporationsfor which PIC has acted as managing or co-managing underwriter of publicfinancings. In addition, at December 31, 2005, PIC held securities of 21companies in its investment account. In 2005, the value of securities held inthe trading accounts and investment account ranged between $22.3 million and$40.6 million. At December 31, 2004, PIC made a market in 50 securities of44 issuers. Of these, 21 were corporations for which PIC has acted as managingor co-managing underwriter of public financings. In addition, at December 31,2004, PIC held securities of 22 companies in its investment account. In 2004,the value of securities held in the trading accounts and investment accountranged between $16.9 million and $23.8 million. The level of positions carriedin PIC’s trading and investment accounts fluctuates significantly. The size ofthe 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 of inventories that PIC may carry is limitedby certain requirements under the SEC’s net capital rules. See “Net CapitalRequirements.”

 

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PIC’s market making activities are conductedboth with other dealers in the “wholesale market” and with PIC’s customers. Transactionswith customers are effected as principal at a net price equal to the currentinterdealer price plus or minus the approximate equivalent of a brokeragecommission. In such transactions, the commission is recorded as securitiesbrokerage revenue while any profit or loss attributable to a change in value ofthe security in PIC’s trading account is recorded as trading profit or loss.PIC’s transactions as principal expose PIC to risk because securities positionsare subject to fluctuations in market value and liquidity. Profits or losses ontrading and investment positions depend upon the skills of the employees in PIC’strading department and employees responsible for taking investment positions. Thetrading department is headquartered in PIC’s Portland, Oregon office.

 

**Branch Offices**

 

PIC branch offices are generally run byindependent contractors who assume liability for all the operating expenses ofthe branch. PIC typically receives between 10 and 20 percent of the grosscommission earned by the branch, with the balance retained by the branch to payits expenses and staff. Persons in these branches are registered with PIC, andPIC assumes the same compliance and regulatory obligations as would be the caseif PIC were fully responsible for the branch’s expenses. As of March 15,2006, PIC had 31 branch offices in California, Connecticut, Georgia, Montana,New Jersey, New York, North Carolina, Oregon, Utah, Vermont, and Washington. Allof these branches, except our offices in Salem, Oregon and Manhattan, New York,operate as independent contractor offices. PIC continues to be responsible forall expenses of the Salem and Manhattan offices.

 

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**Regulation**

 

PIC is registered with the SEC as abroker-dealer under the Securities Exchange Act of 1934 and is a member of theNASD. It is also registered as a broker-dealer under the laws of all 50 statesand Washington, D.C.

 

The securities business is subject toextensive regulation under federal and state laws. The principal purpose ofregulation and discipline of broker-dealers is the protection of customers andthe securities markets rather than protection of creditors and stockholders ofbroker-dealers. The SEC is the federal agency charged with administration ofthe federal securities laws. Much of the regulation of broker-dealers, however,has been delegated to self-regulatory organizations, principally the NASD. Theseself-regulatory organizations adopt rules (subject to approval by the SEC)that govern the industry and conduct periodic examinations of memberbroker-dealers. Securities firms are also subject to regulation and examinationby state securities commissions in the states in which they are registered.

 

The regulations to which broker-dealers aresubject cover all aspects of the securities business, including sales methods,trading practices among broker-dealers, capital structure of securities firms,record keeping and the conduct of directors, officers and employees. Additionallegislation, changes in rules promulgated by the SEC and byself-regulatory bodies or changes in the interpretation or enforcement ofexisting laws and rules often directly affect the method of operation andprofitability of broker-dealers. The SEC, NASD and state regulatory authoritiesmay conduct administrative proceedings that can result in censure, fine,suspension or expulsion of a broker-dealer, its officers or employees.

 

**Net Capital Requirements**

 

PIC is required to maintain minimum “netcapital” under the SEC’s net capital rule of not less than 6.67 percent ofits “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 beincluded in net capital is subject to reduction in market value or principalamount. The amount of the required reduction or “haircut” depends on the natureof the security. As of December 31, 2005, PIC had net capital of $22.7million which exceeded its minimum requirement of $388,271 by $22.3 million.The ratio of aggregate indebtedness of $5.8 million to net capital of $22.7million on December 31, 2005, was approximately 0.26 to 1. As of December 31,2004, PIC had net capital of $14.1 million which exceeded its minimumrequirement of $213,214 by $13.9 million. The ratio of aggregate indebtednessof $3.2 million to net capital of $14.1 million on December 31, 2004, wasapproximately 0.23 to 1. In a public offering in which PIC acts as anunderwriter, PIC must have sufficient net capital to cover the amount ofsecurities underwritten, applying applicable formula mandated by the SEC,during the period between effectiveness and the closing of the transaction,usually 3 business days. This results in a significant temporary increase inPIC’s required net capital. In some cases, the amount of securitiesunderwritten by PIC could be limited by its net capital. Any significantreduction in PIC’s net capital, even if PIC were still in compliance with theSEC’s net capital rule for its retail and trading activities, could have amaterial adverse impact on PIC’s ability to continue its investment bankingactivities.

 

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**Competition**

 

All aspects of PIC’s business are highly competitive.In its general brokerage activities, PIC competes directly with numerous otherbroker-dealers, many of which are large well-known firms with substantiallygreater financial and personnel resources than PIC. Many of PIC’s competitorsemploy extensive advertising and actively solicit potential clients in order toincrease business. In addition, brokerage firms compete by furnishinginvestment research publications to existing clients, the quality and breadthof which are considered important in the development of new business and theretention of existing clients. PIC also competes with a number of smallerregional brokerage firms.

 

Some commercial banks and thrift institutionsoffer securities brokerage services. Many commercial banks offer a variety ofinvestment banking services. Competition among financial services firms alsoexists for investment representatives and other personnel.

 

The securities industry has becomeconsiderably more concentrated and more competitive since the Company was founded,as numerous securities firms have either ceased operations or have beenacquired by or merged into other firms. This trend has been particularlypronounced among firms similar in size and business mix to PIC. In addition,companies not engaged primarily in the securities business, but withsubstantial financial resources, have acquired leading securities firms. Thesedevelopments have increased competition from firms with greater capitalresources than those of the Company. In particular, various recent legislativeand regulatory developments have tended to increase competition within theindustry or reduce profits for the industry.

 

The securities industry has experiencedsubstantial commission discounting by broker-dealers competing for brokeragebusiness. In addition, an increasing number of specialized firms offer “discount”services to individual customers. These firms generally effect transactions fortheir customers on an “execution only” basis without offering other servicessuch as portfolio valuation, investment recommendations and research. A growingnumber of discount brokerage firms offer their services over the Internet,further decreasing offered commission rates and increasing ease of use forcustomers. The continuation of such discounting and an increase in the numberof new and existing firms offering discounts could adversely affect the Company.In addition, rapid growth in the mutual fund industry is presenting potentialcustomers of PIC with an increasing number of alternatives to traditional stockbrokerage accounts.

 

In its investment banking activities, PICcompetes with other brokerage firms, venture capital firms, banks and all othersources of capital for small, growing companies. Since PIC generally managesofferings smaller than $45 million, it does not typically compete with theinvestment banking departments of large, well-known national brokerage firms. Nevertheless,PIC occasionally manages larger offerings. In addition, large national andregional investment banking firms occasionally manage offerings of a size thatis competitive with PIC, typically for fees and compensation less than thatcharged by PIC. When the market for initial public offerings is active, manysmall regional firms that do not typically engage in investment bankingactivities also begin to compete with PIC.

 

**Employees**

 

At March 15, 2006, PIC had 91 employees(of which 89 are full-time), of whom 57 were executives and support staff and34 were involved in brokerage activities and compensated primarily on a commissionbasis. PIC also had independent contractor arrangements with 57 independentcontractors, all of whom are compensated solely on a commission basis. PaulsonCapital had no employees separate from PIC.

 

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**ITEM 1A.****                    RISK FACTORS**

 

In the course of operating a financialservices business, the Company is exposed to a variety of risks. These risksinclude:

 

**Aspects of our business are volatile andaffected by factors beyond our control.**

 

Our business depends heavily on theconditions of the financial and securities markets, which in turn are affectedby domestic and foreign economic conditions generally. These conditions, whichcan be impacted by a variety of factors such as business trends, actual andproposed legislation, political considerations, inflation, interest rates, andthe popular perceptions of the health of the economy, are outside of ourcontrol, and therefore inject significant amounts of uncertainty and volatilityinto our business and financial results. Volatility is compounded by our focuson small-cap companies. In sum, factors outside of our control significantlyinfluence on our business and financial results from year to year, and adownturn in the financial markets, securities markets or economic conditionsgenerally likely would materially and adversely affect our business.

 

**Our ability to attract and retain customers may beaffected by our reputation.**

 

The performance of companies whose securitieswe have underwritten or otherwise sold to our customers may affect ourreputation with other potential syndicate and selling group members andinstitutional and other retail accounts and may also affect the amount ofmoney in our customers’ portfolios available for the kinds of investments thatwe offer.

 

**We are subject to extensive regulation thatcould result in investigations, fines or other penalties.**

 

We are subject to a very high degree ofregulation and are responsible for compliance with applicable regulations byall of our personnel. A significant regulatory infraction by us or any of ourregistered representatives could result in significant penalties, including theloss of our license to conduct securities business in one or morejurisdictions.

 

**We face intense competition in our industry.**

 

There are several competitors in all aspectsof our business. For example, alternatives available to our customers totransact securities trades could affect our ability to continue to execute ourbrokerage customers’ transactions. If we are unable to compete effectively inany aspect of our business, our results of operations could suffer.

 

**Our future success depends on retainingexisting management and hiring and assimilating new key employees, and ourinability to attract or retain key personnel would materially harm our businessand results of operations.**

 

Our success depends on the continuing effortsand abilities of Chester Paulson, our Chairman. Our success also will depend,in part, on our ability to attract and retain highly skilled employees,including management. The loss of services of any of our key personnel, theinability to attract, retain or assimilate key personnel in the future, ordelays in hiring required personnel could materially harm our business.

 

**As a public company, we are subject to complex legal and accountingrequirements that require us to incur substantial expense and expose us to riskof non-compliance.**

 

As a public company, we aresubject to numerous legal and accounting requirements. The cost of compliancewith many of these requirements is substantial, not only in absolute terms but,more importantly, in relation to the overall scope of the operations of ourcompany. Failure to comply with these requirements can have numerous adverseconsequences including, but not limited to, our inability to file requiredperiodic reports on a timely basis, loss of market confidence, delisting of oursecurities and/or governmental or private actions against us. We cannot assureyou that we will be able to comply with all of these requirements in the futureor that the cost of such compliance will not prove to be a substantialcompetitive disadvantage vis-à-vis our competitors.

 

**ITEM 1B.****                   ****UNRESOLVED STAFF COMMENTS**

 

Notapplicable.

 

9

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**ITEM 2.****                             PROPERTIES**

 

PIC leases approximately 17,100 square feetof space for its office in Portland, Oregon under a lease expiring May 2009.The base monthly rental rate on this lease is currently $27,846. The rentalrate increases every 2-3 years, from $25,704 beginning in June 2002 to$29,988 through the expiration of the lease in May 2009. PIC’s Salemoffice leases space under a lease that expires on October 2008 at amonthly rent of $3,129, with rent subject to increases based upon inflation. PICleases approximately 2,500 square feet of space for its office in Manhattanunder a lease expiring September 2010. The base monthly rental rate onthis lease is currently $12,311. The rental rate increases every year, from$12,311 beginning in July 2005 to $13,593 through the expiration of thelease in September 2010. The Company’s operating leases are accounted foron a straight-line basis. The Company believes the existing leased space inPortland, Salem, and Manhattan is adequate for its business for the foreseeablefuture. The other branch offices lease space but, under the terms of therelationship between PIC and these offices, PIC is not responsible for theselease costs. The Company has no additional leases other than through PIC.

 

**ITEM 3.****                             LEGALPROCEEDINGS**

 

In October 2002, PIC was named as a defendantin a lawsuit filed by Special Situations Fund III, LP and Special SituationsCayman Fund, LP. The lawsuit was filed in U.S. District Court for the Districtof New Jersey. It asserts various federal securities law claims and common lawfraud and negligence against numerous defendants, including PIC, arising out oftwo follow-on offerings of Suprema Specialties, Inc. PIC participated inone of the two offerings, the August 25, 2000 follow-on offering ofSuprema Specialties, Inc., as a member of the underwriting syndicate,underwriting 75,000 shares in total. The stock was sold in the August 25,2000 offering at a price of $8.00 per share. Plaintiffs seek damages for thepurchase of 399,151 shares of Suprema Specialties, Inc. stock between August 25,2000 and November 14, 2001. The federal district court dismissed theclaims against PIC. In February 2006, the United States Third CircuitCourt of Appeals affirmed the dismissal in part and reversed the dismissalin part. With respect to PIC, the Third Circuit affirmed the dismissal of the Rule 10b-5claim and reversed the dismissal of the Section 11 claim. Therefore, PICnow faces claims for Section 11 violations, common law fraud andnegligence. The Third Circuit has not yet issued its mandate, returning thecase to the district court, although it should do so shortly. PIC believes ithas meritorious defenses and intends to defend this matter vigorously.

 

In December 2005, PIC received notice ofpossible claims being asserted against it by three individuals who invested inWood River Partners LP (“Wood River”). All of the investors purchased theirinterests in Wood River directly from Wood River. One of the individuals was acustomer of PIC. He and his brother have indicated that they paid $1,050,000for their interests in Wood River. The other individual has indicated that hepaid $2,700,000 for his interest in Wood River. The SEC sued Wood River in October 2005,and a receiver currently runs Wood River. At this point, it is not known howmuch the individuals might recover through the receivership. The individualshave indicated that they believe they may have claims against PIC underthe Oregon law for rescission, interest and attorney’s fees. PIC believes ithas meritorious defenses and, if litigation is filed, PIC intends to defendthis matter vigorously.

 

In January 2006, PIC received notice of acustomer complaint against a former PIC registered representative. The customerhas indicated that her accounts declined in value by approximately $500,000. Thecustomer has asserted that the former registered representative failed toimplement strategies and techniques to provide for safety and preservation ofcapital in her accounts and made misrepresentations regarding the handling ofher accounts. The customer has not indicated that she plans to pursuelitigation against PIC. At this time, the customer has requested that theformer registered representative compensate her for the decline in value of heraccount and return any fees earned by the former registered representative. PIChas not yet had an opportunity to investigate this complaint.

 

An adverse outcome in certain of the mattersdescribed above could have a material adverse effect on PIC or the Company.From time to time, PIC is named in certain other legal proceedings and receivesnotice that certain customers may commence legal proceedings against PIC. TheCompany has no additional legal proceedings other than through PIC. The Companybelieves, based upon information received to date and, where the Companybelieves it appropriate, discussions with legal counsel, that resolution of anyadditional pending or threatened litigation will have no material adverseeffect on the consolidated financial condition, results of operations, orbusiness of the Company.

 

10

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

 

None.

 

11

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**PART II**

 

**ITEM 5.****                              MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUERPURCHASES OF EQUITY SECURITIES**

 

The Company’s common stock trades in theover-the-counter market. The Company’s stock is quoted on the Nasdaq CapitalMarket under the symbol “PLCC,” but it is not actively traded. The followingare closing high and low sales prices for the common stock for the periodsshown.

 
| ** **   | ** ** | **2005 Prices** | ** ** | **2004 Prices** | ** ** |
|--------------|------------|-----------------|------------|-----------------|------------|
| ** **   | ** ** | **High**        | ** ** | **Low**         | ** ** | **High** | ** ** | **Low** | ** ** |
| 1st  Quarter |       | $               | 8.57       |            | $          | 7.65 |   | $ | 15.30 |   | $ | 7.83 |   |
| 2nd  Quarter |       | 13.68           |       | 7.90            |       | 9.07 |   | 6.61 |   |
| 3rd  Quarter |       | 18.34           |       | 10.75           |       | 7.41 |   | 5.22 |   |
| 4th  Quarter |       | 12.29           |       | 10.34           |       | 8.70 |   | 5.83 |   |
|              |            |                 |            |                 |            |  |  |  |  |  |  |  |  |

 

The closing low and high prices for the first quarter of 2006, through March 15,2006, were $11.30 and $15.80, respectively.

 

As of March 15, 2006, there were3,093,970 shares of the Company’s common stock outstanding and held of recordby 66 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 the number of requests for the Company’s proxymaterials for its 2005 annual meeting, the Company believes there areapproximately 325 beneficial holders of its common stock. The Companyrepurchased 106,076 shares of common stock during 2005. Additional shares ofcommon stock may be repurchased from time to time in the future.

 

On March 1, 2006, the Company announcedthat the Board of Directors approved a two-for-one stock split of the commonstock to be effected in the form of a stock dividend. The stock split willbe effected by issuing one additional share of common stock for eachoutstanding share of common stock. The record date of the forward split is March 15,2006 and payable on March 29, 2006. The common stock will trade on a splitbasis beginning at market open on March 30, 2006.

 

On December 22, 2005, the Companyannounced the authorization by the Board of Directors of a $0.30 special cashdividend to shareholders of record on January 17, 2006. The dividendpayment date was February 10, 2006.

 

On January 27, 2005, the Companyannounced the authorization by the Board of Directors of a $0.15 special cashdividend to shareholders of record on February 10, 2005. The dividend waspaid on March 3, 2005.

 

No dividend was declared during fiscal year2004.

 

Net capital requirements may limit theability of PIC to pay future dividends to the Company, which would affect theCompany’s ability to pay dividends to its shareholders.

 

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The following table provides certaininformation about the Company’s equity compensation plans in effect as of theend of fiscal year 2005.

 
| **Plan Category**                                       | ** ** | **Number of Securities to be  Issued Upon Exercise of  Outstanding Options,  Warrants and Rights** | ** ** | **Weighted-Average Exercise  Price of Outstanding  Options,  Warrants and Rights** | ** ** | **Number of Securities  Remaining  Available for Future  Issuance under  Equity Compensation Plans  (excluding securities  reflected in  column(a))** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                              | ** ** | **(a)**                                                                                            | ** ** | **(b)**                                                                            | ** ** | **(c)**                                                                                                                                               | ** ** |
|                                                    |       |                                                                                               |       |                                                                               |       |                                                                                                                                                  |       |
| Equity  Compensation Plans Approved by Shareholders(1)  |       | 96,500                                                                                             |       | $                                                                                  | 7.83       |                                                                                                                                                  | 260,500    |   |
| Equity  Compensation Plans Not Approved by Shareholders |       | —                                                                                             |       | —                                                                             |       | —                                                                                                                                                |       |
| Total                                                   |       | 96,500                                                                                             |       | $                                                                                  | 7.83       |                                                                                                                                                  | 260,500    |   |

 

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(1)                                  Consistsof the Company’s 1999 Stock Option Plan.

 

The following table provides certain informationabout the Company’s unregistered sales of equity securities and use of proceedsduring the fourth quarter of fiscal year 2005.

 

**Issuer Purchases of EquitySecurities**

 
| **Period**           | ** ** | **(a)  Paulson Capital  Corp. Total  Number of Shares  Purchased** | ** ** | **(b)  Paulson Capital Corp.  Average Price Paid  per Share** | ** ** | **(c)  Total Number of  Shares  Purchased as Part of  Publicly Announced  Plans  or Programs** | ** ** | **(d)  Maximum Number of  Shares that May Yet  Be Purchased Under  The Plans or  Programs** | ** ** |
|----------------------|------------|--------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| 10/01/05 to 10/31/05 |       | None                                                               |       | $                                                             | N/A        |                                                                                                | None       |                                                                                             | 187,733    |   |
| 11/01/05 to 11/30/05 |       | None                                                               |       | $                                                             | N/A        |                                                                                                | None       |                                                                                             | 187,733    |   |
| 12/01/05 to 12/31/05 |       | 11,146                                                             |       | $                                                             | 11.80      |                                                                                                | 11,146     |                                                                                             | 176,587    |   |
| Total                |       | 11,146                                                             | (1)        | $                                                             | 11.80      |                                                                                                | 11,146     |                                                                                             | 176,587    |   |

 

All of the shares reflected in column (c) were open-markettransactions as part of a corporate plan for stock repurchase. The stockrepurchase plan, approved by the board of directors on September 17, 2001,authorizes the repurchase of up to 300,000 shares; a total of 123,413 shareshas been repurchased through December 31, 2005. There is no expirationdate on the stock repurchase plan.

 

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(1) Of these 11,146 shares, none werepurchased from executive officers and employees of the Company (and theiraffiliates).

 

13

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**ITEM 6.****                             SELECTEDFINANCIAL DATA**

 

**IncomeStatement Information**

 
| ** **                                             | ** ** | **Years Ended December 31,**             | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------|------------|
|                                                   |       | **2005**                                      | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** |   |
|                                                   |       | **(in thousands, except per share  amounts)** |       |
| Revenues                                               |       | $                                             | 39,736     |   | $ | 32,915 |   | $ | 28,059 |   | $ | 1,010 |   | $ | 25,337 |   |
| Commissions  and Salaries                              |       | 18,701                                        |       | 19,263 |   | 16,959 |   | 8,266 |   | 9,563 |   |
| Other  Expenses                                        |       | 7,655                                         |       | 7,756 |   | 4,956 |   | 3,654 |   | 4,178 |   |
| Total  Expenses                                        |       | 26,356                                        |       | 27,019 |   | 21,915 |   | 11,920 |   | 13,741 |   |
| Pretax  Income (loss)                                  |       | 13,380                                        |       | 5,896 |   | 6,144 |   | (10,910 | ) | 11,596 |   |
| Net Income  (loss)                                     |       | 8,492                                         |       | 3,489 |   | 4,040 |   | (7,011 | ) | 7,037 |   |
| Diluted  Earnings (loss) per share                     |       | $                                             | 2.70       |   | $ | 1.09 |   | $ | 1.29 |   | $ | (2.23 | ) | $ | 2.17 |   |
| Dividends  Declared per share                          |       | 0.45                                          |       |   |   | 0.10 |   | — |   |   |   |
| Average  Number of Common Shares Outstanding (Diluted) |       | 3,148                                         |       | 3,187 |   | 3,132 |   | 3,141 |   | 3,240 |   |

 

**BalanceSheet Information**

 
| ** **                 | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                 | ** ** | **(in thousands)**    | ** ** |
| Total Assets               |       | 54,995                |       | 44,325 |   | 36,070 |   | 29,112 |   | 38,591 |   |
| Long-Term  Debt            |       | —                |       | — |   | — |   | — |   | — |   |
| Shareholders’  Equity |       | 39,765                |       | 33,570 |   | 29,595 |   | 25,843 |   | 33,131 |   |

 

**ITEM 7.****          MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Overview**

 

Substantially all of our business consists ofthe securities brokerage and investment banking activities of our wholly ownedsubsidiary, Paulson Investment Company, Inc., or PIC. PIC has operationsin four principal categories, all of them in the financial services industry. Thesecategories are:

 

•                  securitiesbrokerage activities for which PIC earns commission revenues;

•                  corporatefinance revenues consisting principally of underwriting discounts andunderwriter warrants;

•                  securitiestrading from which PIC records profit or loss, depending on trading results;and

•                  investmentincome resulting from earnings on, and increases or decreases in the value of,PIC’s investment portfolio.

 

Because we operate in the financial servicesindustry, our revenues and earnings are substantially affected by generalconditions in financial markets. In our securities brokerage and corporatefinance business, the amount of our revenues depends on levels of marketactivity requiring the services we provide. Our investment banking activity,which consists primarily of acting as the managing underwriter of initial andfollow-on public offerings for smaller companies, is similarly affected by thestrength of the market for new equity offerings, which has historicallyexperienced substantial cyclical fluctuation. Although we attempt to matchoperating costs with activity levels, many of our expenses are either fixed ordifficult to change on short notice. Accordingly, fluctuations in brokerage andinvestment banking revenues tend to result in sharper fluctuations, on apercentage basis, in net income or loss.

 

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Our investment income or loss and, to alesser extent, our trading income or loss is affected by changes in marketvaluation of securities generally and, in particular, by changes in valuationof the equity securities of microcap companies in which our investments andtrading activities tend to be concentrated. Equity markets in general, andmicrocap equity markets in particular, have always experienced significantvolatility and this volatility has, in recent years, been extreme. The resultsof this volatility on the value of our investment portfolio and securities heldin connection with our trading and investment activities include largequarterly fluctuations in income or loss from these operations and substantialincreases or decreases in our net worth as our securities holdings are markedto market.

 

A substantial portion of our investmentbanking business consists of acting as managing underwriter of initial andfollow-on public offerings for microcap 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. Thewarrants generally have a five-year expiration date and vest immediately. Thewarrants are generally subject to a restriction period of six months to one-yearin which PIC cannot exercise the warrants. The exercise price is typically 120%of the price at which the securities are initially sold to the public.Accordingly, unless there is at least a 20% increase in the price of thesesecurities at some time more than six months and less than five years after theoffering, the warrants will remain “under water” and will ultimately expireunexercised.

 

**Results of Operations**

 

PIC’s revenues and operating results areinfluenced by fluctuations in the equity underwriting markets as well asgeneral economic and market conditions, particularly conditions in theover-the-counter market, where PIC’s investment account, trading inventorypositions and underwriter warrants are heavily concentrated. Significantfluctuations can occur in PIC’s revenues and operating results from one periodto another. PIC’s results of operations depend upon many factors, such as thenumber of companies that are seeking public financing, the quality andfinancial condition of those companies, market conditions in general, theperformance of previous PIC underwritings and interest in certain industries byinvestors. As a result, revenues and income derived from these activities may varysignificantly from year to year. In the tables below, “Corporate Finance”revenues are a function of total proceeds from offerings done during theperiod, compensation per offering, and the fair value of underwriter warrantsreceived. “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. “Trading Income” is the net gain or loss from trading positionsbefore commissions paid to the representatives in the trading department.

 

**Summary ofChanges in Major Categoriesof Revenues and Expense**

 
| ** **                    | ** ** | **2005 vs. 2004**       | ** ** | **2004 vs. 2003**  | ** ** |
|-------------------------------|------------|-------------------------|------------|--------------------|------------|
| ** **                    | ** ** | **Increase/(Decrease)** | ** ** | **Percent Change** | ** ** | **Increase/(Decrease)** | ** ** | **Percent Change** | ** ** |
| Revenues:                     |       |                    |       |               |       |   |   |   |   |
| Sales  Commissions            |       | $                       | (1,786,394 | )                  | (9.8       | ) | $ | 1,706,984 |   | 10.3 |   |
| Corporate  Finance            |       | (7,954,103              | )          | (70.9              | )          | 4,411,865 |   | 64.9 |   |
| Investment  Income            |       | 13,821,928              |       | 685.0              |       | (1,342,133 | ) | (39.9 | ) |
| Trading  Income               |       | 1,575,624               |       | 116.6              |       | 105,798 |   | 8.5 |   |
| Other                         |       | 1,164,018               |       | 3969.9             |       | (26,398 | ) | (47.4 | ) |
|                          |       |                    |       |               |       |   |   |   |   |
| Total                         |       | $                       | 6,821,073  |               | 20.7       |   | $ | 4,856,116 |   | 17.3 |   |
|                          |       |                    |       |               |       |   |   |   |   |
| Expenses:                     |       |                    |       |               |       |   |   |   |   |
| Commissions  and Salaries     |       | (561,825                | )          | (2.9               | )          | 2,304,029 |   | 13.6 |   |
| Underwriting  Expenses        |       | (649,569                | )          | (74.1              | )          | 348,584 |   | 66.0 |   |
| Professional  Fees            |       | 426,849                 |       | 41.5               |       | 378,969 |   | 52.8 |   |
| Other                         |       | 122,024                 |       | 2.1                |       | 2,072,081 |   | 54.9 |   |
|                          |       |                    |       |               |       |   |   |   |   |
| Total                         |       | $                       | (662,521   | )                  | (2.5       | ) | $ | 5,103,663 |   | 23.3 |   |
|                          |       |                    |       |               |       |   |   |   |   |
| Earnings  before income taxes |       | $                       | 7,483,594  |               | 126.9      |   | $ | (247,547 | ) | (4.0 | ) |

 

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**2005 Compared to 2004**

 

**Revenues**

 

Total revenues for 2005 increased $6.8 million. Asshown in the table above, sales commissions decreased $1.8 million as a resultof lackluster market performance. The Russell 2000 Index increased a modest 3.3percent during 2005 and the Nasdaq Composite Index increased 1.4 percent duringthe same period. In addition, sales commissions decreased as a result of thelack of commissions associated with corporate finance transactions. Salescommissions are also directly related to the number of brokers engaged by theCompany. The Company had 94 stock brokers as of December 31, 2005,as compared to 97 as of December 31, 2004.

 

Corporate finance revenue decreased $8.0 million for2005 as compared to 2004. The Company completed six corporate financetransactions in 2004 with gross proceeds totaling $83.9 million, compared withtwo corporate finance transactions during 2005 with gross proceeds totaling$13.4 million. In addition, during 2005 the Company completed several smallprivate placements and participated in a few small transactions in whichanother investment banking firm was the lead underwriter. Market conditionshave resulted in a more challenging IPO market during 2005 as compared to theprior year.

 

Investment income increased $13.8 million in 2005 ascompared to 2004. Investment income can be volatile period-over-period becauseit is driven by the market value or fair value of the securities andunderwriter warrants held by the Company. Investment income consists of (1) theunrealized appreciation and depreciation of securities held based on quotedmarket prices, (2) the unrealized appreciation and depreciation ofsecurities held that are not readily marketable, based upon the Company’sestimate of their fair value, (3) the realized gain and loss on the saleof securities with quoted market prices and securities that are not readilymarketable, and (4) the unrealized appreciation and depreciation ofunderwriter warrants held by the Company. The depreciation/expiration/exerciseof underwriter warrants totaling $4.6 million in 2005 exceeded thedepreciation/expiration/exercise of underwriter warrants of $2.1 million for2004. The Company exercised ten separate warrants in 2005 as compared to zero in2004. Generally, when the Company exercises a warrant to obtain the underlyingcommon stock, the common stock is subsequently sold in the near term. In 2005,the increase in the Company’s investment income included realized andunrealized gain on Charles & Colvard of $12.5 million and $5.1million, respectively. The Company may sell Charles & Colvard,Ltd., or any other security in its investment account at any time deemedappropriate. The Company realized a total of $20.2 million in 2005 on securitysales from its investment account. The remainder of the change in theinvestment account is unrealized gains and losses in securities with quotedmarket prices and securities not readily marketable.

 

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Trading income increased $1.6 million in 2005 ascompared to 2004, as a result of exceptional performance from a couple of thesecurities in which the Company makes a market. PIC’s focus is on very smallcapitalization issues, especially those tied to PIC’s corporate financeclients.

 

PIC was successful in a lawsuit filed suitagainst its former insurance carrier to recover settlement amounts paid in2004. Included in other income in 2005 is a $1.1 million settlement recovery.

 

**Expenses**

 

Total expenses decreased approximately $663,000 in2005 as compared to 2004, a decrease of 2.5 percent. The largest dollardecrease of approximately $650,000 was in underwriting expense as a result offewer corporate finance transactions in 2005 as compared to 2004. Commissionand salary expense decreased approximately $562,000 in 2005 as compared to2004. Commission expense increased approximately $396,000 primarily as a resultof higher commissions paid based on performance of the Company’s investments.Administrative salary expense decreased approximately $958,000 as a result of (1) anincrease in accrued bonus $550,000 for 2005 as compared to 2004, (2) adecrease of approximately $1.4 million in compensation expense associated withthe receipt of underwriter warrants during 2005 as compared to the same periodin the prior year, (3) a modest decrease in salary and expense and relatedpayroll taxes as PIC as has not filled certain vacant positions. Professionalfees increased approximately $427,000 as a result of legal activity related tosettlements. Other expenses increased approximately $122,000 or 2.1 percent.The increase in other expenses is primarily attributable to (1) anincrease of approximately $849,000 in charitable contributions, (2) adecrease of approximately $404,000 in estimated settlement expense, (3) adecrease of approximately $385,000 in bad debt expense and (4) increasesand decreases in various expense categories.

 

**Income**

 

The Company had pretax income of $13.4 million (33.7percent of revenues) in 2005 compared to pretax income of approximately $5.9million (17.9 percent of revenues) in 2004. Profitability, as a percentage ofrevenues, generally increases when a significant portion of the Company’srevenues is derived from investment income because fewer expenses areassociated with investment income relative to its other revenue sources.Independent of the change in the Black-Scholes value of the underwriterwarrants and the income and expense associated with the receipt of theunderwriter warrants, the Company would have had pretax income totaling $16.5million for 2005, compared with pretax income of approximately $2.8 million for2004. Because of the Black-Scholes value of underwriter warrants and otherfactors, significant fluctuations often occur in PIC’s revenues and operatingresults from one period to another.

 

**2004 Compared to 2003**

 

**Revenues**

 

Total revenues for 2004 increasedapproximately $4.8 million. Sales commissions increased approximately $1.7million, or 10.3 percent for 2004 as compared to 2003. This increase wasprimarily the result of increased trading activity and increased retailcommissions related to PIC’s corporate finance transactions. A largetransaction of a nanotechnology company (Lumera Corporation), completed in July 2004,resulted in additional retail commissions of approximately $700,000.

 

Corporate finance revenuesincreased approximately $4.4 million, or 64.9 percent, for 2004 as compared to2003. Six corporate finance transactions, totaling $83.9 million, werecompleted during 2004 compared with three corporate finance transactions,totaling $66.0 million, completed during 2003. The size of corporate financetransactions completed during 2004 ranged from $5 million to $41.7 million. Corporatefinance revenues are directly related to the amount of money raised incorporate finance transactions. The $41.7 million transaction completed in thethird quarter of 2004 for Lumera Corporation was one of the largesttransactions ever completed by PIC.

 

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Corporate finance revenues also include thereceipt of underwriter warrants as compensation for PIC’s underwriting efforts.During 2004, PIC received underwriter warrants, valued using the Black-Scholesoption-pricing model, resulting in unrealized revenue of approximately $7.3million, as compared to underwriter warrants received during 2003 valued at$4.2 million.

 

Investment income decreasedapproximately $1.3 million for 2004 compared to 2003, primarily as a result oflower market values of certain stocks in which PIC has a concentration.Realized loss in 2004 totaled approximately $410,000, compared to realized lossof $2.3 million in 2003. The remainder of total investment income is unrealizedgain and losses in securities with quoted market prices and securities notreadily marketable.

 

Trading income increased a modest $105,798 in2004 compared to 2003 as a result of the combination of increases in prices ofsecurities in which PIC makes a market and the relative volume of transactions.

 

**Expenses**

 

Total expenses for 2004increased approximately $5.1 million, or 23.3 percent as compared to 2003. Thelargest increase was in commissions and salaries. Commission and salaryexpenses combined increased 13.6 percent, or approximately $2.3 million. Commissionsincreased year-over-year approximately $900,000 due to larger retail andcorporate finance commissions paid on higher commission revenues during 2004.Administrative and salary expense expenses increased approximately $1.4 millionas a result of (1) anincrease in accrued bonus $150,000 for 2004 as compared to 2003, (2) anincrease of approximately $775,000 in compensation expense associated with thereceipt of underwriter warrants during 2004, (3) a increase in salary andexpense and related payroll taxes of $471,000 as PIC added additional staff tohandle the increasing burdens of operating in a regulated industry andas a publicly traded company. Underwriting expenses increased approximately $349,000 in thecomparative one year period as a result of completing six corporate financetransactions in 2004 compared to completing three corporate financetransactions in 2003. Professional fees increased $379,000 as a result ofincreased legal activity related to settlements. The aggregate of all otherexpenses increased approximately $2.1 million, or 54.9 percent, for 2004. Theincreases in other expense included: travel and entertainment increase ofapproximately $117,000 as a result of the investor conference held in June 2004with no comparable conference held in 2003 and advertising expense increase ofapproximately $90,000 as a result of PIC’s retention of a public relations firmduring 2004. PIC incurred bad debt expense of approximately $684,000 during2004, as compared to approximately $368,000 during 2003, an increase in of$316,000. The significant increase in bad debt expense is primarily the resultof an approximate $600,000 in settlement expense that was charged to theresponsible broker. The broker accounts receivable subsequently deemed uncollectiblebased on the broker’s inability to pay. Increases in other expensesyear-over-year include approximately $1.2 million in lawsuit settlement expenseand an increase in insurance expense of approximately $91,000 as the cost ofthe errors and omissions insurance and other coverage has increased. Theremainder of the net increase in other expenses consists of increases anddecreases in various expense categories.

 

**Income**

 

PIC had a decrease in earnings before incometaxes of approximately $248,000 for 2004 as compared to 2003. Earnings beforeincome taxes as a percentage of revenues totaled 17.9 percent for 2004 ascompared to 22 percent for 2003, as a result of the increase in expensesexceeding the increase in revenues. Independent of the change in theBlack-Scholes value of the underwriter warrants and the income and expenseassociated with the receipt of the underwriter warrants, PIC would have hadpretax income totaling $2.8 million for 2004, as compared to pretax income of$2.5 million for 2003. Because of the Black-Scholes value of underwriterwarrants and other factors, significant fluctuations often occur in PIC’srevenues and operating results from one period to another.

 

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**Liquidity and Capital Resources**

 

Conducting business as a dealer in securitiesrequires that a substantial inventory of securities be maintained and that alarge amount of liquid assets be readily available. The Company’s equity at December 31,2005 and 2004 was $39.8 million and $33.6 million, respectively. Of PaulsonCapital’s total assets (net of intercompany accounts) at December 31, 2005of $55 million, approximately 73.2 percent consisted of securities in theCompany’s investment account, trading inventory and underwriter warrantsecurities, at fair value, and approximately 23.2 percent consisted of cash andcash equivalents and receivables from its correspondent broker. At December 31,2004, of $44.3 million in total assets approximately 74.9 percent consisted ofsecurities in the Company’s investment account, trading inventory andunderwriter warrant securities, at fair value, and approximately 18 percentconsisted of cash and cash equivalents and receivables from its correspondentbroker.

 

PIC’s securities inventory is stated at fairvalue. The liquidity of the market for many of PIC’s securities holdings,however, varies with trends in the stock market. 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 pricesin OTC securities (which make up most of PIC’s trading positions) lead todecreased liquidity in the market for these issues, while rising prices in OTCissues tend to increase the liquidity of the market for these securities. Theoverall decline in prices for the very small capitalization OTC securitiestraded by PIC in 2002, 2001, and 2000 were combined with a general reduction inthe liquidity of the markets for these securities. This situation was thereverse of 2005, 2004 and 2003, when increases in prices of OTC securitiesincreased the liquidity of the markets for these securities. PIC’s investmentaccount and trading inventory accounts are stated at fair value. They includeshares of restricted stock held by PIC. As of December 31, 2005 therestricted shares with an original cost of $3,938,506, were valued at$4,186,064 and, as of December 31, 2004, the restricted shares with anoriginal cost of $1,495,974, were valued at $1,739,985, which PIC believes,based upon available evidence, approximates market value.

 

PIC borrows money from NFS in the ordinarycourse of its business, pursuant to an arrangement under which NFS agrees tofinance PIC’s trading accounts in an amount determined by the size of thoseaccounts and the type of securities held, with interest charged at prevailingmargin rates. As of December 31, 2005 and 2004, no net loans were owed byPIC to NFS pursuant to this arrangement. PIC and the Company are generally ableto meet their compensation and other obligations out of current liquid assets.

 

19

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Another source of capital to PIC and theCompany has been the underwriter warrants issued to PIC in connection with itscorporate finance activities. The recorded value of our underwriter 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 warrants and sold the underlying securities. Thereis no public market for our underwriter warrants and the warrants themselvesare transferable only under very limited circumstances. Accordingly, theirvalue cannot be realized by selling the warrants themselves. Underwriterwarrants exercisable to purchase securities having a value in excess of theexercise price are liquid, subject to restrictions on liquidity applicable toOTC securities generally. The securities issuable on exercise of ourunderwriter 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 no legal impediment to liquidity withrespect to these securities, except during the first year (the first six monthsfor new issues) following a company’s public offering. At December 31,2005, PIC owned 15 underwriter warrants (from 13 different issuers) of which 13were currently exercisable; five had an exercise price below the current marketprice of the securities receivable on exercise. If we had exercised the “in-the-money”warrants and sold the underlying securities on December 31, 2005, we wouldhave received approximately $1.5 million in net proceeds. As of December 31,2005, the computed value of our underwriter warrants, based on theBlack-Scholes Option Pricing Model, was $6,275,000, a significant decrease fromthe computed value of $9,416,000 at year-end 2004. The collective value of theunderwriter warrants increases significantly during the years in which PICcompletes corporate finance transactions as PIC receives underwriter warrantsas part of each transaction. There is little or no direct relationshipbetween the intrinsic value of PIC’s underwriter warrants at the end of anygiven period and the fair value calculated using the Black-Scholes OptionPricing Model, as described more fully in “Critical Accounting Policies” above.

 

In 2005, $1.5 million of net cash wasprovided by operating activities. The major adjustments to reconcile thisresult to the Company’s net income include the following items that arepositive adjustments to or provided cash to operating activities: noncashcompensation associated with underwriter warrants of approximately $651,000;unrealized depreciation and expiration of underwriter warrants totaling $4.6million; income taxes receivable/payable of approximately $3.2 million; andprepaid and deferred expenses of approximately $909,000. The following itemsare negative adjustments to or a use of cash for operating activities: anincrease in trading and investment securities of $10.2 million; receipt ofunderwriter warrants of $2.1 million; receivable from/payable to clearingorganization of $2.6 million; and accounts payable and accrued liabilities ofapproximately $898,000. Net cash used in investing activities in 2005 wasprimarily for additions to furniture and equipment of approximately $116,000.Net cash used in financing activities in 2005 totaled $1.4 million, primarilyresulting from dividends paid to common shareholders of approximately $477,000and payments to retire common stock of $1.0 million.

 

In 2004, approximately $144,000 of net cashwas provided by operating activities. The major adjustments to reconcile thisresult to the Company’s net income include the following items that arepositive adjustments to or provided cash to operating activities: noncashcompensation associated with underwriter warrants of $2.1 million; unrealizeddepreciation and expiration of underwriter warrants totaling $2.1 million; anddeferred income taxes of $2.5 million. The following items are negativeadjustments to or a use of cash for operating activities: an increase intrading and investment securities of $4.7 million; and the receipt ofunderwriter warrants of $7.3 million. Net cash used in investing activities in2004 was for additions to furniture and equipment of approximately $128,000.Net cash used in financing activities in 2004 totaled approximately $39,000,resulting from proceeds from the exercise of employee stock options, dividendspaid to common shareholders, and payments to retire common stock.

 

As a securitiesbroker-dealer, the Company’s wholly owned subsidiary, PIC, is required by SECregulations to meet certain liquidity and 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 onlyoperating business, such a failure could have a material adverse effect on theCompany.

 

At December 31, 2005 and 2004, theCompany had no material commitments for capital expenditures.

 

In general, the primary sources of PIC’s, andtherefore the Company’s, liquidity, includes PIC’s trading positions,borrowings on those positions and profits realized upon the exercise ofunderwriter warrants. All of these sources depend in large part on thetrend in the general markets for OTC securities. Rising OTC price levels willtend to increase the value and liquidity of PIC’s trading positions, the amountthat can be borrowed from NFS based upon those positions, and the value of PIC’sunderwriter warrants. The Company believes its liquidity is sufficient to meetits needs for both the short and long term horizon. The Company’s liquiditycould be affected by protracted unfavorable market conditions.

 

**ContractualObligations**

 

The Subsidiaryhas operating lease obligations related to office space and automobiles. As ofDecember 31, 2005, the operating lease obligations were as follows:

 
| ** **                   | ** ** | **Payments due by period** | ** ** |
|------------------------------|------------|----------------------------|------------|
| **Contractual Obligations**  | ** ** | **Total**                  | ** ** | **Less than 1  year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than 5  years** | ** ** |
| Operating  Lease Obligations |       | $                          | 2,029,800  |   | $ | 527,384 |   | $ | 1,083,388 |   | $ | 419,028 |   | — |   |
|                              |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

20

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### **CriticalAccounting Policies**

### ** **

The following discussion and analysis of ourfinancial condition and results of operations is based upon our consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States. In preparing ourconsolidated financial statements, we must make estimates and judgments thataffect the reported amounts of assets and liabilities, revenues and expenses, andrelated disclosure of contingent assets and liabilities at the date of ourfinancial statements. Actual results are likely to differ from these estimatesunder different assumptions and conditions.

 

The critical accounting policies describedbelow include those that reflect significant judgments and uncertainties, whichpotentially could produce materially different results under differentassumptions and conditions. We believe our critical accounting policies arelimited to those described below.

 

*Revenue Recognition*.Securities transactions and related revenue are recorded on a trade date basis.Manager’s fees, underwriter’s fees, and other underwriting revenues arerecognized at the time the underwriting is completed. Tax shelter revenue isrecognized at the time individual tax shelter units are sold. Revenue from thereceipt of underwriter warrants, received in corporate finance transactions, isrecognized on the date the warrants are received based on the estimated fairvalue of the securities received as estimated using the Black-Scholesoption-pricing model taking into account the exercise price, remaining life ofthe warrant, the current price of the underlying stock and its expectedvolatility, expected dividends on the stock and the risk-free interest rate forthe remaining term of the warrant.

 

*Use ofEstimates.*We are required to estimate the value of allderivative securities that we hold at the date of any financial statements andto include that value, and changes in such value, in those financial statements.Accordingly, the aggregate estimated value of our warrants as of the date ofany balance sheet is recorded as an asset on that balance sheet. When a newwarrant is received as a result of our investment banking activity, itsestimated value is included in corporate finance revenue on the date on whichit is earned. Subsequently, any change in estimated value is recorded asinvestment income or loss. When a warrant is exercised, the book value isadjusted to reflect the value of the securities purchased, net of the exerciseprice, and the adjustment amount is recorded as income or loss for the relevantperiod. If a warrant expires unexercised, the book value is adjusted to zeroand the decrease is recorded as a loss in the relevant period.

 

21

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We estimate the value of our underwriterwarrants using the Black-Scholes Option Pricing Model. The Black-Scholes modelrequires us to use historical price data combined with various assumptions andjudgments as inputs for the model. The most influential factor in this model isprice volatility, which we calculate for each company’s warrants based on eachcompany’s own historical stock price movements as well as an index ofhistorical prices for comparable companies. When we initially receive a newunderwriter warrant from an initial public offering, its calculated volatilityfactor is entirely based on the volatility of an index of comparable companies,since there is no price history for a new publicly traded company. As eachunderwriter warrant approaches its expiration date, its volatility factor isderived primarily from the historical prices of its underlying common stock. Wecannot assure you that we will ultimately be able to exercise any of our warrantsin a way that will realize the value that we attribute to them in our financialstatements based on this model.

 

In addition to our underwriter warrants, wehold other securities, some of which have very limited liquidity and some ofwhich do not have a readily ascertainable market value. According to accountingprinciples generally accepted in the United States of America (US GAAP), we arerequired to carry these securities at estimated fair value. The Company’sestimates regarding the fair value of not readily marketable securities aresignificant estimates and these estimates could change in the near term.

 

As a result of the factors described above,our revenues and earnings are subject to substantial fluctuation from period toperiod based on a variety of circumstances, many of which are beyond ourcontrol. An increase in financial market activity generally, and/or an increasein equity valuations generally, will normally result in increases in ourrevenues, earnings and net worth as our activity levels and the value of ourinvestment portfolio increase. Conversely, a general market retrenchment willtypically lead to decreased revenues, earnings and net worth as a result bothof decreased activity and the need to adjust high investment portfolio valuesto lower levels. Accordingly, results for any historical period are notnecessarily indicative of similar results for any future period.

 

**Recently Issued Accounting Pronouncements**

 

In September 2005, the Securities ExchangeCommission announced that the compliance date for non-accelerated filers andforeign private issuers pursuant to Section 404 of the Sarbanes-Oxley Acthas been extended. Under the latest extension, a company that is not requiredto file its annual and quarterly reports on an accelerated basis and a foreignprivate issuer filing its annual report on Form 20-F or 40-F, must beginto comply with the internal control over financial reporting requirements forits first fiscal year ending on or after July 15, 2007. This extension isthe second one-year extension from the originally established July 15,2005 compliance date. The Commission similarly has extended the compliance datefor these companies relating to requirements regarding evaluation of internalcontrol over financial reporting and management certification requirements. TheCompany will, therefore, be required to comply with Section 404 of theSarbanes-Oxley Act as of December 31, 2007.

 

In December 2004, the FASB issued FAS123R, which requires that compensation costs relating to share-based paymentsbe recognized in the Company’s financial statements. The Company currentlyaccounts for those payments under the recognition and measurement principles ofAccounting Principles Board (APB) Opinion No. 25, “Accounting forStock Issued to Employees,” and related interpretations. The Company ispreparing to implement this standard effective January 1, 2006 and theresults will be included in the Form 10-Q for the quarter ended March 31,2006. Although we have made preliminary estimates regarding the financialstatement impact we have not concluded as to whether the adoption of 123(R)will result in amounts that are similar to the current pro form data (seeNote A10), we expect the adoption may have a material impact on futurefinancial statements. This estimate is based on preliminary information andcould materially change based on the actual facts and circumstances and theterms of future option grants.

 

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**ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK**

 

Market risk is the risk of loss to the Companyresulting primarily from changes in equity prices and to a significantly lesserextent, interest rates and foreign currency rates. The Company has exposure tomarket risk through the market-making and trading operations of PIC, itsbroker-dealer subsidiary. In connection with these activities, PIC maintainsinventories in order to ensure availability of securities and to facilitateclient transactions as well as trading for its own proprietary equityinvestment account. PIC was a market-maker for 45 equity securities from 41different issuers and no tax exempt or taxable debt obligations at December 31,2005.

 
| ** **                                                        | ** ** | **December 31, 2005** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                        | ** ** | **Investment Securities**  | ** ** | **Investment securities  sold but not yet  purchased** | ** ** | **Trading   securities** | ** ** | **Trading securities  sold but not yet  purchased** | ** ** |
| Marketable  equity and other securities at fair value             |       | $                          | 32,401,808 |   | $ | — |   | $ | 1,553,557 |   | $ | 23,033 |   |
|                                                              |       |                       |       |   |   |   |   |   |   |
| Marketable  debt securities                                       |       | —                     |       | — |   | 5,007 |   | — |   |
|                                                              |       |                       |       |   |   |   |   |   |   |
| Total  marketable equity, debt and other securities at fair value |       | $                          | 32,401,808 |   | $ | — |   | $ | 1,558,564 |   | $ | 23,033 |   |
|                                                                   |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |

 

Changes in the value of PIC’s trading inventoriesand its proprietary investment accounts result primarily from fluctuations inequity prices as well as changes in interest rates and general market andeconomic conditions. PIC’s primary method of controlling risk in its tradinginventories and investment accounts is through daily monitoring and use ofposition limits. PIC’s trading inventories consist primarily of Nasdaq equitysecurities. As of December 31, 2005, the equity trading inventory limitwas $2 million and the fixed income limit was $500,000. PIC’s tradingactivities were within these limits at December 31, 2005. Position limitsin trading inventory accounts are monitored on a daily basis as are limitexceptions. Debt obligation trading inventories are relatively small, since,for the most part, these securities are purchased only upon orders fromcustomers. Consolidated positions and exposure reports are prepared andreviewed monthly by the Senior Vice President of Trading. Trading also monitorsinventory levels and trading results on a monthly basis, with particular focuson position concentration, liquidity and volatility. Trading prepares summaryresults every month to record each position at fair market value, which canrequire adjustments for lack of liquidity, high concentration or other reasons.

 

**Value-at-Risk**

 

In addition to the management procedures and processeswe use to monitor and limit risk, we also apply an industry standardstatistical model known as Value-at-Risk (“VaR”) to the public securities inour portfolios to estimate the potential losses that could arise from changesin market conditions. VaR seeks to predict the risk of loss based on historicaland/or market-implied price and volatility patterns by estimating theprobability of the value of a financial instrument rising above or fallingbelow a specified amount. Our non-public investments are not included in theVaR analysis because the model requires historical trading prices as one of itsinputs and our very small bond position ($5,000) at year end December 31,2005 was immaterial. Our calculations are based on a methodology that uses aone-day interval and a 95% confidence level, which means that there was a 5%chance that our securities portfolios could suffer a loss equivalent to the VaRon any one trading day during the past year.

 

The following table sets forth the VaR for ouroverall portfolio of public equities for the year ended December 31, 2005:

 
| ** **                             | ** ** | **Investments** | ** ** | **Trading** | ** ** |
|----------------------------------------|------------|-----------------|------------|-------------|------------|
| VaR                                    |       | $               | 2,368,337  |        | $          | 81,328 |   |
| Portfolio value (net)                  |       | $               | 28,215,744 |        | $          | 1,517,298 |   |
| VaR as a percentage of portfolio value |       | 8.39            | %          | 5.36        | %          |

 

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The VaR on equities is based on a calculation of thevolatility of each equity, the current position value of each equity, and acorrelation matrix of all equities included in the portfolio. Both thevolatility and correlation in the formula are based on historical closingprices for the past year. Other inputs include selecting the confidence level(usually 95-99%) and time horizon (usually 1 day) for the measurement. We havehad to make adjustments to the formula for certain equities which are veryilliquid and do not trade every day; in these instances, we have used theclosing prices from the previous day as the price for the days when there wereno trades.

 

VaR calculations have inherent limitations,particularly in the case of low volume, small cap equities, which constitutes alarge percentage of our portfolio value. The historical data on which the VaRis based may not accurately predict future market risk and the calculationhas no input that reflects the liquidity of the equities in the portfolio, sothe VaR for a one-day horizon does not capture the market risk of positionsthat could not be liquidated , or that could only be liquidated at a very lowprice in any one-day period. There can be no assurance that the actual losseswould not exceed the VaR for any one-day period.

 

**Equity Price Risk**

 

PIC is exposed to significant equity price risk as aresult of its customer transactions and market-making activity in equitysecurities and its concentrations in a limited number of equities, many ofwhich are related to its investment banking projects. PIC’s broker-dealeractivities are client-driven, with the objective of meeting its clients’ needswhile earning a trading profit to compensate for the risk associated withcarrying inventories in equities, many of which are volatile, and some of whichare illiquid, micro and small cap securities. PIC attempts to reduce the riskof loss inherent in this activity by monitoring these securities positionscontinuously throughout each day. The average aggregate inventory held in PIC’sproprietary investment and trading accounts during the quarter ended December 31,2005 was approximately $ 34.3 million. Prices of the marketable equities heldin these accounts are readily available and monitored on a continuous basis.

 

**Interest Rate Risk**

 

PIC has little direct exposure to interest rate risk.A relatively minor amount of PIC’s trading inventory consists of debtobligations, and any of these positions PIC might have occasionally are in itstrading inventory for only a very short time. However, to the extent thatinterest rate fluctuations affect general market conditions and cause investorsto shift away from or more heavily into equity investing, interest rates canhave an effect on the value of PIC’s equity positions.

 

**Foreign Currency Risk**

 

PIC does not deal in securities denominated inforeign currencies and only trades foreign equities upon receipt of orders fromcustomers, so it does not have any significant exposure to foreign currencyrisk in its trading inventory or investment accounts.

 

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**ITEM 8.****     FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

 
| **(a) Financial Statements**                                                                                   | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                     | ** ** |
| Reference is made to the report and  financial statements beginning on page F-1                                | ** ** |
| ** **                                                                                                     | ** ** |
| Report of Independent Registered Public Accounting Firm                                                        |       |
|                                                                                                           |       |
| Consolidated Balance Sheets as of December 31, 2005 and 2004                                              |       |
|                                                                                                           |       |
| Consolidated Statements of Income for the years ended  December 31, 2005, 2004 and 2003                   |       |
|                                                                                                           |       |
| Consolidated Statement of Shareholders’ Equity for the years ended  December 31, 2005, 2004 and 2003 |       |
|                                                                                                           |       |
| Consolidated Statements of Cash Flows for the years ended  December 31, 2005, 2004 and 2003               |       |
|                                                                                                           |       |
| Notes to Consolidated Financial Statements                                                                     |       |
|                                                                                                           |       |
| Supplementary Schedule of Warrants Owned                                                                  |       |
|                                                                                                           |       |
| Supplementary Information—Quarterly Financial Data                                                        |       |
|                                                                                                           |       |
| Schedule II  - Valuation and Qualifying Accounts                                                          |       |

 

**ITEM 9.****  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTINGAND FINANCIAL DISCLOSURE**

 

Effective November 17, 2005,the Audit Committee of the Board of Directors of Paulson Capital Corp. approvedthe engagement of McGladrey & Pullen, LLP (“McGladrey & Pullen”) as theCompany’s independent auditors for the fiscal year ending December 31, 2005, toreplace Grant Thornton LLP (“Grant Thornton”), who were dismissed as theCompany’s auditors as of the same date. This action followed the Audit Committee’s determination that theCompany’s audit and tax services should be separated.  The Company intends to continue itsrelationship with Grant Thornton for tax services.

 

Grant Thornton’s audit reportson the Company’s financial statements as of and for the two most recent fiscalyears, which ended December 31, 2004 and 2003, did not contain an adverseopinion or a disclaimer of opinion, nor were they qualified or modified as touncertainty, audit scope or accounting principles.

 

During the Company’s two mostrecent fiscal years and the subsequent interim periods through September 30,2005:

 

(i) there were no disagreementsbetween the Company and Grant Thornton on any matter of accounting principlesor practices, financial statement disclosure or auditing scope or procedure,which disagreement, if not resolved to Grant Thornton’s satisfaction, wouldhave caused Grant Thornton to make reference thereto in their report on thefinancial statements;

 

(ii) none of the reportableevents described under Item 304(a)(1)(v) of Regulation S-K occurred; and

 

(iii) the Company did notconsult with McGladrey & Pullen regarding any of the matters or eventsdescribed in Item 304(a)(2)(i) and (ii) of Regulation S-K.

 

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**ITEM 9A.****               CONTROLS AND PROCEDURES**

 

(a)           Under the supervision and with the participation of our management,including our Chief Executive Officer and our Chief Financial Officer, weconducted an evaluation of our disclosure controls and procedures, as such termis defined under Rules 13a-15(e) and 15d-15(e) promulgated under the SecuritiesExchange Act of 1934, as amended. Based on this evaluation, our Chief ExecutiveOfficer and Chief Financial Officer concluded that our disclosure controls andprocedures were effective as of December 31, 2005, the end of the periodcovered by this report.

 

(b)           For the quarter ended December 31, 2005, there were no changes inour internal control over financial reporting that has materially affected, oris reasonably likely to materially affect, our internal control over financialreporting.

 

**ITEM 9B.****               OTHER INFORMATION**

 

None

 

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** **

**PART III**

 

**ITEM 10.****               DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT**

 

The informationrequired by this item is incorporated by reference to the information under thecaptions “Directors and Executive Officers,” “Additional Information Concerningthe Board of Directors” and “Section 16(a) Beneficial Ownership ReportingCompliance” in our Proxy Statement for the Annual Meeting of Shareholdersscheduled to be held in June 2006.

 

We haveadopted a code of ethics that applies to our officers (including our principalexecutive, financial and accounting officers), directors, employees andconsultants.  The text of our code ofethics is posted at our Internet website, located atwww.paulsoninvestment.com.  Furthermore,if disclosure of an amendment or waiver to our code of ethics is required byItem 5.05 of Form 8-K, we intend to satisfy such disclosure either by timelyfiling a Form 8-K or by posting such information at the same Internet website.

 

**ITEM 11.****               EXECUTIVE COMPENSATION**

 

Theinformation required by this item is incorporated by reference to theinformation under the captions “Executive Compensation,” “Summary CompensationTable,” “Option/SAR Grants in Last Fiscal Year,” “Equity Compensation PlanInformation” and “Aggregated Option Exercises in Last Fiscal Year and FiscalYear-End Option Values” in our Proxy Statement for the Annual Meeting ofShareholders scheduled to be held in June 2006.

 

**ITEM 12.****               SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS**

 

Theinformation required by this item is incorporated by reference to theinformation under the caption “Stock Ownership of Principal Owners andManagement” in our Proxy Statement for the Annual Meeting of Shareholdersscheduled to be held in June 2006. For information required by Item 201(d)of Regulation S-B, reference is made to Item 5 of this report.

 

**ITEM 13****.****               CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS**

 

To theextent there is information to report, the information required by this item isincorporated by reference to the information in our Proxy Statement for theAnnual Meeting of Shareholders scheduled to be held in June 2006.

 

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**ITEM 14****.****               PRINCIPAL****ACCOUNTANT FEES ANDSERVICES**

 

Theinformation required by this item is incorporated by reference to theinformation under the caption “Independent Public Accountants” in our ProxyStatement for the Annual Meeting of Shareholders scheduled to be held inJune 2006.

 

**ITEM 15.****               EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**

 

(a) Our Financial Statements filed as part of this annual report onForm 10-K begin at page F-1. The following is a list of exhibits required byItem 601 of Regulation S-K:

 
| **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).                                                                                                                                                           |
|       |       |                                                                                                                                                                                                                                                         |
| 10.2       |       | Office Lease renewal for the period from  June 1, 1997 to May 31, 2002, 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). |
|       |       |                                                                                                                                                                                                                                                         |
| 10.3       |       | Amendment 1 to Office Lease dated as of May  6, 1997 (incorporated by reference to Exhibit 10.5 to Form 10-KSB for the  year ended December 31, 2001).                                                                                                  |
|       |       |                                                                                                                                                                                                                                                         |
| 10.4       |       | 1999 Stock Option Plan (incorporated by  reference to Exhibit 10.5 to the Form 10-KSB for the year ended  December 31, 1999).                                                                                                                           |
|       |       |                                                                                                                                                                                                                                                         |
| 10.5       |       | 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).                |
|       |       |                                                                                                                                                                                                                                                         |
| 21.1       |       | Subsidiaries of Paulson Capital Corp. Filed  herewith electronically.                                                                                                                                                                                        |
|       |       |                                                                                                                                                                                                                                                         |
| 23.1       |       | Consent of McGladrey &  Pullen, LLP.                                                                                                                                                                                                                     |
|       |       |                                                                                                                                                                                                                                                         |
| 23.2       |       | Consent of Grant Thornton LLP                                                                                                                                                                                                                                |
|       |       |                                                                                                                                                                                                                                                         |
| 31.1       |       | Section 302 Certification.  Filed herewith electronically.                                                                                                                                                                                              |
|       |       |                                                                                                                                                                                                                                                         |
| 31.2       |       | Section 302 Certification.  Filed herewith electronically.                                                                                                                                                                                              |
|       |       |                                                                                                                                                                                                                                                         |
| 32.1       |       | Certification of Principal  Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002. Filed herewith  electronically.                                                            |
|       |       |                                                                                                                                                                                                                                                         |
| 32.2       |       | Certification of Chief Financial  Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. Filed herewith  electronically.                                                                |

 

Theinformation required by this item is incorporated by reference to theinformation under the captions “Independent Public Accountants” and “AuditCommittee Report” in our Proxy Statement for the Annual Meeting of Shareholdersscheduled to be held in June 2006.

 

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**SIGNATURES**

 

Pursuant to the requirements ofSection 13 or 15(d) of the Securities Exchange Act of 1934, the Registranthas duly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 
|           |   |    PAULSON CAPITAL CORP. |
|----------------|--------|-----------------------------------------|
|           |   |                                    |
| Date: 03/29/06 | By:    | /s/ Chester L.F. Paulson                |   |
|           |   | Chester L.F. Paulson                    |
|           |   | President                               |

 

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Pursuant to the requirements of theSecurities Exchange Act of 1934, this report has been signed below by thefollowing persons on behalf of the Registrant in the capacities and on thedates indicated.

 
| **Signature**                   | ** ** | **Title**                                     | ** ** | **Date** |
|---------------------------------|------------|-----------------------------------------------|------------|----------|
| **(1) Chief Executive Officer** |       | (Principal  Executive Officer)                |       |     |
|                            |       |                                          |       |     |
| /s/ Chester L.F. Paulson        |       |                                          |       |     |
| Chester L.F. Paulson            |       | Chairman of  the Board and  President         |       | 3/29/06  |
|                            |       |                                          |       |     |
| **(2) Chief Financial Officer** |       | (Principal  Financial and Accounting Officer) |       |     |
|                            |       |                                          |       |     |
| /s/ Karen L. Johannes           |       |                                          |       |     |
| Karen L. Johannes               |       | Chief  Financial Officer                      |       | 3/29/06  |
|                            |       |                                          |       |     |
| **(3) Directors**               |       |                                          |       |     |
|                            |       |                                          |       |     |
| /s/ Jacqueline M. Paulson       |       |                                          |       |     |
| Jacqueline M. Paulson           |       | Secretary,  Treasurer and  Director           |       | 3/29/06  |
|                            |       |                                          |       |     |
| /s/ Steve Kleemann              |       |                                          |       |     |
| Steve Kleemann                  |       | Director                                      |       | 3/29/06  |
|                            |       |                                          |       |     |
| /s/ Shannon Pratt               |       |                                          |       |     |
| Shannon Pratt                   |       | Director                                      |       | 3/29/06  |
|                            |       |                                          |       |     |
| /s/ Paul Shoen                  |       |                                          |       |     |
| Paul Shoen                      |       | Director                                      |       | 3/29/06  |

 

30

----

 

**EXHIBITINDEX**

 
| **Exhibit  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).                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                         |
| 10.2                |       | Office Lease renewal for the period from  June 1, 1997 to May 31, 2002, 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). |
|                |       |                                                                                                                                                                                                                                                         |
| 10.3                |       | Amendment 1 to the Office Lease dated as of  May 6, 1997 (incorporated by reference to Exhibit 10.5 to Form 10-KSB for the  year ended December 31, 2001).                                                                                              |
|                |       |                                                                                                                                                                                                                                                         |
| 10.4                |       | 1999 Stock Option Plan (incorporated by  reference to Exhibit 10.5 to the Form 10-KSB for the year ended  December 31, 1999).                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                         |
| 10.5                |       | 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).                |
|                |       |                                                                                                                                                                                                                                                         |
| 21.1                |       | Subsidiaries of Paulson Capital Corp. filed  herewith electronically.                                                                                                                                                                                        |
|                |       |                                                                                                                                                                                                                                                         |
| 23.1                |       | Consent of McGladrey &  Pullen, LLP                                                                                                                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                         |
| 23.2                |       | Consent of Grant Thornton LLP                                                                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                         |
| 31.1                |       | Section 302 Certification.  Filed herewith electronically.                                                                                                                                                                                              |
|                |       |                                                                                                                                                                                                                                                         |
| 31.2                |       | Section 302 Certification.  Filed herewith electronically.                                                                                                                                                                                              |
|                |       |                                                                                                                                                                                                                                                         |
| 32.1                |       | Certification of Principal Executive  Officer pursuant to 18 U.S.C.  Section 1350 as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. Filed herewith electronically.                                                            |
|                |       |                                                                                                                                                                                                                                                         |
| 32.2                |       | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Filed  herewith electronically.                                                                 |

 

31

----

 

Financial Statements and Report of

Independent Certified Public Accountants

 

**Paulson Capital Corp. and Subsidiary**

 

December 31, 2005 and 2004

 

32

----

 

**Report of Independent Registered PublicAccounting Firm**

 

To the ShareholdersPaulson Capital Corp.

Portland, Oregon

 

We have audited theconsolidated balance sheet of Paulson Capital Corp. and Subsidiary as ofDecember 31, 2005 and the related consolidated statements of income,shareholders’ equity and cash flows for the year then ended. These financialstatements are the responsibility of the Company’s management. Our responsibilityis to express an opinion on these financial statements based on our audit.

 

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audit provides a reasonable basisfor our opinion.

 

In our opinion, the consolidatedfinancial statements referred to above present fairly, in all materialrespects, the financial position of Paulson Capital Corp. and Subsidiary as ofDecember 31, 2005, and the results of their operations and their cash flows foryear then ended in conformity with U.S. generally accepted accountingprinciples.

 

We have also auditedSchedule II as of and for the year ended December 31, 2005. In ouropinion, this schedule, when considered in relation to the basic consolidatedfinancial statements taken as a whole, presents fairly, in all materialrespects, the information therein.

 

 

Chicago, Illinois

March 27, 2006

 

F-1

----

 

Report ofIndependent Registered Public Accounting Firm

 

Board of Directors and Shareholders

Paulson Capital Corp.

 

We have audited the accompanying consolidated balance sheet of PaulsonCapital Corp. (an Oregon corporation) and Subsidiary as of December 31,2004, and the related consolidated statements of income, shareholders’ equityand cash flows for each of the two years in the period then ended.  These financial statements are theresponsibility 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 with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. The Company is notrequired to have, nor were we engaged to perform an audit of its internalcontrol over financial reporting. Our audit included consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statement, 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 referred to above presentfairly, in all material respects, the consolidated financial position ofPaulson Capital Corp. and Subsidiary as of December 31, 2004, and theconsolidated results of its operations and its consolidated cash flows for eachof the two years in the period then ended, in conformity with accountingprinciples generally accepted in the United States of America.

 

Our audits were made for the purpose of forming an opinion on the basicconsolidated financial statements taken as a whole.  The accompanying Supplementary Schedule ofWarrants Owned as of December 31, 2004 is presented for purposes ofadditional analysis and is not a required part of the basic consolidatedfinancial statements.  Such informationhas been subjected to the auditing procedures applied in the audits of thebasic consolidated financial statements and, in our opinion, is fairly stated,in all material respects, in relation to the basic consolidated financialstatements taken as a whole.

 

We have also audited Schedule II for each of the two years in theperiod ended December 31, 2004. In our opinion, this schedule presentsfairly, in all material respects, the information required to be set forththerein.

 
| Portland, Oregon                                                                                                    | /s/ GRANT THORNTON LLP |   |
|---------------------------------------------------------------------------------------------------------------------|------------------------|--------|
|  

February 24, 2005, except for the  second  paragraph of Note P as to which the date is  March 7, 2005. |                   |

 

 

 

F-2

----

 

PaulsonCapital Corp. and Subsidiary

 

CONSOLIDATEDBALANCE SHEETS

 

December 31,

 
| ** **                                                                                                                        | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| ASSETS                                                                                                                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash equivalents                                                                                                         |       | $          | 129,549    |       | $          | 132,845 |   |
| Receivable from clearing organization                                                                                             |       | 12,608,491 |       | 7,856,254  |       |
| Notes and other receivables                                                                                                       |       | 1,081,528  |       | 442,934    |       |
| Income taxes receivable                                                                                                           |       | —     |       | 851,000    |       |
| Trading securities, at market value                                                                                               |       | 1,558,564  |       | 3,029,326  |       |
| Investment securities, at market value and  estimated fair value                                                                  |       | 32,401,808 |       | 20,774,645 |       |
| Underwriter warrants, at estimated fair value                                                                                     |       | 6,275,000  |       | 9,416,000  |       |
| Prepaid and deferred expenses                                                                                                     |       | 674,328    |       | 1,583,346  |       |
| Furniture and equipment, net                                                                                                      |       | 265,791    |       | 239,028    |       |
|                                                                                                                              |       |       |       |       |       |
| Total assets                                                                                                                      |       | $          | 54,995,059 |       | $          | 44,325,378 |   |
|                                                                                                                              |       |       |       |       |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                         |       |       |       |       |       |
|                                                                                                                              |       |       |       |       |       |
| LIABILITIES                                                                                                                       |       |       |       |       |       |
| Accounts payable and accrued liabilities                                                                                          |       | $          | 1,243,866  |       | $          | 2,138,856 |   |
| Payable to clearing organization                                                                                                  |       | 3,182,347  |       | 1,021,860  |       |
| Compensation, employee benefits and payroll  taxes                                                                                |       | 2,105,259  |       | 2,108,056  |       |
| Securities sold, not yet purchased, at  market value                                                                              |       | 23,033     |       | 50,144     |       |
| Dividends payable – current                                                                                                  |       | 929,317    |       | —     |       |
| Income taxes payable – current                                                                                               |       | 2,338,218  |       | —     |       |
| Deferred income taxes payable                                                                                                     |       | 5,408,000  |       | 5,436,000  |       |
|                                                                                                                              |       |       |       |       |       |
| Total liabilities                                                                                                                 |       | 15,230,040 |       | 10,754,916 |       |
|                                                                                                                              |       |       |       |       |       |
| COMMITMENTS AND CONTINGENCIES (Notes J and  L)                                                                                    |       | —     |       | —     |       |
|                                                                                                                              |       |       |       |       |       |
| 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, 3,097,724 shares and 3,190,300,  respectively |       | 1,817,100  |       | 1,745,824  |       |
| Retained earnings                                                                                                                 |       | 37,947,919 |       | 31,824,638 |       |
|                                                                                                                              |       |       |       |       |       |
| Total shareholders’ equity                                                                                                   |       | 39,765,019 |       | 33,570,462 |       |
|                                                                                                                              |       |       |       |       |       |
| Total liabilities and shareholders’ equity                                                                                   |       | $          | 54,995,059 |       | $          | 44,325,378 |   |

 

The accompanying notes are an integral part of these statements.

 

 

F-3

----

 

PaulsonCapital Corp. and Subsidiary

 

CONSOLIDATED STATEMENTS OF INCOME

 

Years ended December 31,

 
| ** **                                  | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                        |       |       |       |       |       |       |       |
| Revenues                                    |       |       |       |       |       |       |       |
| Commissions                                 |       | $          | 16,517,709 |       | $          | 18,304,103 |       | $ | 16,597,119 |   |
| Corporate finance                           |       | 3,259,092  |       | 11,213,195 |       | 6,801,330  |       |
| Investment income                           |       | 15,839,768 |       | 2,017,840  |       | 3,359,973  |       |
| Trading income                              |       | 2,926,440  |       | 1,350,816  |       | 1,245,018  |       |
| Interest and dividends                      |       | 51,062     |       | 27,686     |       | 52,764     |       |
| Other                                       |       | 1,142,277  |       | 1,635      |       | 2,955      |       |
|                                        |       |       |       |       |       |       |       |
|                                        |       | 39,736,348 |       | 32,915,275 |       | 28,059,159 |       |
|                                        |       |       |       |       |       |       |       |
| Expenses                                    |       |       |       |       |       |       |       |
| Commissions and salaries                    |       | 18,701,260 |       | 19,263,085 |       | 16,959,056 |       |
| Underwriting expenses                       |       | 227,412    |       | 876,981    |       | 528,397    |       |
| Rent, telephone and quotation services      |       | 1,281,293  |       | 1,211,383  |       | 1,156,402  |       |
| Interest expense                            |       | 421        |       | 10,093     |       | 16,813     |       |
| Professional fees                           |       | 1,456,649  |       | 1,029,800  |       | 650,831    |       |
| Bad debt expense                            |       | 299,745    |       | 684,429    |       | 367,796    |       |
| Travel and entertainment                    |       | 229,055    |       | 368,044    |       | 250,973    |       |
| Depreciation and amortization               |       | 90,814     |       | 96,914     |       | 136,876    |       |
| Advertising and promotion expense           |       | 273,430    |       | 302,486    |       | 280,387    |       |
| Settlement expense                          |       | 870,535    |       | 1,274,540  |       | 96,849     |       |
| Other                                       |       | 2,925,674  |       | 1,901,054  |       | 1,470,766  |       |
|                                        |       |       |       |       |       |       |       |
|                                        |       | 26,356,288 |       | 27,018,809 |       | 21,915,146 |       |
|                                        |       |       |       |       |       |       |       |
| Earnings before income taxes                |       | 13,380,060 |       | 5,896,466  |       | 6,144,013  |       |
|                                        |       |       |       |       |       |       |       |
| Income tax expense                          |       | 4,888,000  |       | 2,406,866  |       | 2,103,736  |       |
|                                        |       |       |       |       |       |       |       |
| NET EARNINGS                                |       | $          | 8,492,060  |       | $          | 3,489,600  |       | $ | 4,040,277 |   |
|                                        |       |       |       |       |       |       |       |
| Basic earnings per share                    |       | $          | 2.71       |       | $          | 1.10       |       | $ | 1.30 |   |
|                                        |       |       |       |       |       |       |       |
| Diluted earnings per share                  |       | $          | 2.70       |       | $          | 1.09       |       | $ | 1.29 |   |
|                                        |       |       |       |       |       |       |       |
| Weighted average common shares outstanding: |       |       |       |       |       |       |       |
| Basic                                       |       | 3,131,443  |       | 3,183,194  |       | 3,116,786  |       |
| Diluted                                     |       | 3,147,632  |       | 3,186,889  |       | 3,131,605  |       |

 

The accompanying notes are an integral part of these statements.

 

 

F-4

----

 

PaulsonCapital Corp. and Subsidiary

 

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

 

Three year period endedDecember 31, 2005

 
| ** **                                                                 | ** ** | **Common Stock** | ** ** | **Retained** | ** ** | ** **   | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------|------------|--------------|------------|--------------|------------|
| ** **                                                                 | ** ** | **Shares**            | ** ** | **Amount**   | ** ** | **Earnings** | ** ** | **Total** | ** ** |
|                                                                       |       |                  |       |         |       |         |       |   |   |
| Balance at December 31, 2002                                          |       | 3,125,811             |       | $            | 1,086,740  |         | 24,756,219 |   | $ | 25,842,959 |   |
|                                                                       |       |                  |       |         |       |         |       |   |   |
| Stock options exercised and income tax  benefit from stock option exercise |       | 14,000                |       | 90,055       |       | —       |       | 90,055 |   |
|                                                                       |       |                  |       |         |       |         |       |   |   |
| Redemption of common stock                                                 |       | (15,000               | )          | (3,750       | )          | (62,152      | )          | (65,902 | ) |
|                                                                       |       |                  |       |         |       |         |       |   |   |
| Dividends to common shareholders (0.10 per  share)                         |       | —                |       | —       |       | (312,481     | )          | (312,481 | ) |
|                                                                       |       |                  |       |         |       |         |       |   |   |
| Net earnings for the year                                                  |       | —                |       | —       |       | 4,040,277    |       | 4,040,277 |   |
|                                                                       |       |                  |       |         |       |         |       |   |   |
| Balance at December 31, 2003                                          |       | 3,124,811             |       | 1,173,045    |       | 28,421,863   |       | 29,594,908 |   |
|                                                                       |       |                  |       |         |       |         |       |   |   |
| Stock options exercised and income tax  benefit from stock option exercise |       | 78,500                |       | 577,518      |       | —       |       | 577,518 |   |
|                                                                       |       |                  |       |         |       |         |       |   |   |
| Redemption of common stock                                                 |       | (13,011               | )          | (4,739       | )          | (86,825      | )          | (91,564 | ) |
|                                                                       |       |                  |       |         |       |         |       |   |   |
| Net earnings for the year                                                  |       | —                |       | —       |       | 3,489,600    |       | 3,489,600 |   |
|                                                                       |       |                  |       |         |       |         |       |   |   |
| Balance at December 31, 2004                                          |       | 3,190,300             |       | 1,745,824    |       | 31,824,638   |       | 33,570,462 |   |
|                                                                       |       |                  |       |         |       |         |       |   |   |
| Stock options exercised and income tax  benefit from stock option exercise |       | 13,500                |       | 111,284      |       | —       |       | 111,284 |   |
|                                                                       |       |                  |       |         |       |         |       |   |   |
| Redemption of common stock                                                 |       | (106,076              | )          | (40,008      | )          | (962,898     | )          | (1,002,906 | ) |
|                                                                       |       |                  |       |         |       |         |       |   |   |
| Dividends to common shareholders (0.45 per  share)                         |       | —                |       | —       |       | (1,405,881   | )          | (1,405,881 | ) |
|                                                                       |       |                  |       |         |       |         |       |   |   |
| Net earnings for the year                                                  |       | —                |       | —       |       | 8,492,060    |       | 8,492,060 |   |
|                                                                       |       |                  |       |         |       |         |       |   |   |
| Balance at December 31, 2005                                          |       | 3,097,724             |       | $            | 1,817,100  |         | $          | 37,947,919 |   | $ | 39,765,019 |   |
|                                                                            |            |                       |            |              |            |              |            |  |  |  |  |  |

 

The accompanying notes are an integral part of these statements.

 

 

F-5

----

 

PaulsonCapital Corp. and Subsidiary

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

Years ended December 31,

 
| ** **                                                                          | ** ** | **2005**    | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------------------------------------------------------------------|------------|-------------|------------|------------|------------|------------|------------|
| Cash flows from operating activities                                                |       |        |       |       |       |       |       |
| Net earnings                                                                        |       | $           | 8,492,060  |       | $          | 3,489,600  |       | $ | 4,040,277 |   |
| Adjustments to reconcile net earnings to  net cash provided by operating activities |       |        |       |       |       |       |       |
| Receipt of underwriter warrants                                                     |       | (2,123,014  | )          | (7,288,588 | )          | (4,249,407 | )          |
| Unrealized (appreciation)  depreciation/expiration of underwriter warrants          |       | 4,612,960   |       | 2,127,636  |       | (628,435   | )          |
| Noncash compensation associated with  underwriter warrants                          |       | 651,054     |       | 2,055,952  |       | 1,280,842  |       |
| Deferred income taxes                                                               |       | (19,526     | )          | 2,522,600  |       | 3,125,700  |       |
| Depreciation and amortization                                                       |       | 90,815      |       | 96,914     |       | 136,876    |       |
| Gain on sale of vehicle                                                             |       | (2,000      | )          | —     |       | —     |       |
| Changes in assets and liabilities                                                   |       |        |       |       |       |       |       |
| Notes and other receivables                                                         |       | (638,594    | )          | 223,540    |       | 15,181     |       |
| Receivable from/payable to clearing  organization                                   |       | (2,591,750  | )          | (168,098   | )          | (4,827,452 | )          |
| Trading and investment securities, net                                              |       | (10,156,401 | )          | (4,740,868 | )          | (681,787   | )          |
| Income taxes receivable/payable                                                     |       | 3,189,218   |       | 233,900    |       | 809,100    |       |
| Prepaid and deferred expenses                                                       |       | 909,018     |       | (164,809   | )          | (259,799   | )          |
| Accounts payable, accrued liabilities and  compensation payable                     |       | (897,787    | )          | 1,725,101  |       | 1,401,872  |       |
| Securities sold, not yet purchased                                                  |       | (27,111     | )          | 31,093     |       | (41,792    | )          |
|                                                                                |       |        |       |       |       |       |       |
| Net cash provided by operating activities                                           |       | 1,488,942   |       | 143,973    |       | 121,176    |       |
|                                                                                |       |        |       |       |       |       |       |
| Cash flows from investing activities                                                |       |        |       |       |       |       |       |
| Sale of vehicle                                                                     |       | 2,000       |       | —     |       | —     |       |
| Additions to furniture and equipment                                                |       | (117,578    | )          | (127,615   | )          | (87,645    | )          |
|                                                                                |       |        |       |       |       |       |       |
| Net cash (used in) investing activities                                             |       | (115,578    | )          | (127,615   | )          | (87,645    | )          |
|                                                                                |       |        |       |       |       |       |       |
| Cash flows from financing activities                                                |       |        |       |       |       |       |       |
| Proceeds from exercise of stock options                                             |       | 102,810     |       | 365,218    |       | 90,055     |       |
| Dividends paid to common shareholders                                               |       | (476,564    | )          | (312,481   | )          | —     |       |
| Payments to retire common stock                                                     |       | (1,002,906  | )          | (91,564    | )          | (65,902    | )          |
|                                                                                |       |        |       |       |       |       |       |
| Net cash provided by (used in) financing  activities                                |       | (1,376,660  | )          | (38,827    | )          | 24,153     |       |
|                                                                                |       |        |       |       |       |       |       |
| Net (decrease) increase in cash and cash  equivalents                               |       | (3,296      | )          | (22,469    | )          | 57,684     |       |
|                                                                                |       |        |       |       |       |       |       |
| Cash and cash equivalents at beginning of  year                                     |       | 132,845     |       | 155,314    |       | 97,630     |       |
|                                                                                |       |        |       |       |       |       |       |
| Cash and cash equivalents at end of year                                            |       | $           | 129,549    |       | $          | 132,845    |       | $ | 155,314 |   |
|                                                                                |       |        |       |       |       |       |       |
| SUPPLEMENTAL DISCLOSURE OF CASH FLOW  INFORMATION:                                  |       |        |       |       |       |       |       |
|                                                                                |       |        |       |       |       |       |       |
| Cash paid during the year for                                                       |       |        |       |       |       |       |       |
| Interest                                                                            |       | $           | 421        |       | $          | 10,093     |       | $ | 16,678 |   |
|                                                                                |       |        |       |       |       |       |       |
| Income taxes                                                                        |       | $           | 2,710,114  |       | $          | 664,330    |       | $ | 41,613 |   |
|                                                                                |       |        |       |       |       |       |       |
| Non-cash items                                                                      |       |        |       |       |       |       |       |
| Dividends declared                                                                  |       | $           | 1,405,881  |       | $          | —     |       | $ | 312,481 |   |
| Deferred tax benefit from stock option  exercise                                    |       | 8,474       |       | 212,300    |       | —     |       |

 

The accompanying notes are an integral part of these statements.

 

 

F-6

----

 

PaulsonCapital Corp. and Subsidiary

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE A – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Paulson Capital Corp. (the Company) is aholding company whose wholly-owned subsidiary, Paulson Investment Company, Inc.(the Subsidiary), is a registered broker-dealer in securities under theSecurities Exchange Act of 1934, as amended and is a member of the NationalAssociation of Securities Dealers.  TheSubsidiary provides broker-dealer services in securities on both an agency andprincipal basis to its customers who are fully introduced to National FinancialServices, LLC (NFS), a Fidelity Investments Company. The Subsidiary also actsas lead or participating selling group member for securities offerings.  The Subsidiary conducts business throughoutthe United States.

 

The Subsidiary operates under the provisionof paragraph (k)(2)(ii) of rule 15c3-3 of the Securities and Exchange Act of1934 and, accordingly, is exempt from the remaining provisions of that rule.Essentially, the requirements of paragraph (k)(2)(ii) provide that theSubsidiary clear all transactions on behalf of customers on a fully disclosedbasis with a clearing broker-dealer and promptly transmit all customer fundsand securities to the clearing broker-dealer. The clearing broker-dealercarries all of the accounts of the customers and maintains and preserves allrelated books and records as are customarily kept by a clearing broker-dealer.

 

Significant accounting policies applied inthe preparation of the accompanying financial statements follows.

 

1.   Principlesof Consolidation

 

The accompanying consolidated financialstatements include the accounts of Paulson Capital Corp. and its wholly-ownedsubsidiary, Paulson Investment Company, Inc. All significant intercompany balances and transactions have been eliminatedin consolidation.

 

2.               Use of estimates

 

The preparation of financial statements inconformity with generally accepted accounting principles requires management tomake estimates and assumptions that affect the reported amounts of assets,liabilities and disclosures of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period.  TheSubsidiary’s estimates regarding the fair value of not readily marketable securitiesare significant estimates and these estimates could change in the nearterm.  Actual results could differ fromthose estimates.

 

3.   SecuritiesTransactions

 

Security transactions:  Security transactions and related revenue andexpenses are recorded on a trade date basis. Manager’s fees, underwriter’sfees, and other underwriting revenues are recognized at the time theunderwriting is completed. Tax shelter revenue is recognized at the timeindividual tax shelter units are sold. Revenue from the receipt of underwriterwarrants, received in corporate finance transactions, is recognized on the datethe warrants are received based on the estimated fair value of the securitiesreceived as estimated using the Black-Scholes option-pricing model.

 

Marketable securities are valued at fair marketvalue, and securities not readily marketable are valued at fair value asdetermined by management. The fair value of not readily marketable securitiesis estimated by management using available information including the following:quoted market prices of similar securities (i.e., unrestricted shares of thesame company); price of recent known trades of the same or similar securities;the cost of the security if recently purchased adjusted for changes in thefinancial condition of the issuer; all other information available from reviewof available documents related to the issuer or discussions with management ofthe issuer. Changes in the value of these securities are reflected currently inthe 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. Changesin the estimated fair value of these underwriter warrants are reflectedcurrently in the results of operations.

 

 

F-7

----

 

4.   FairValue of Financial Instruments

 

The carrying amounts reflected in the financialstatements for cash and cash equivalents, receivables and payables approximatetheir respective fair values due to the short-term nature of these items. Thefair values of securities owned and securities sold, not yet purchased areequal to the carrying value. Changes in the market value of these securitiesare reflected currently in the results of operations for the year.

 

5.   Furnitureand Equipment

 

Depreciation of furniture and equipment isgenerally computed by the straight-line method over their estimated usefullives (5 years).  Leasehold improvementsare amortized over the lesser of their estimated useful life or the lives oftheir related leases.

 

6.  IncomeTaxes

 

Income taxes are accounted for under theasset and liability method.  Deferred taxassets and liabilities are recognized for the estimated future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax basis and operatingloss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax ratesin effect for the year in which those temporary differences are expected to berecovered or settled.  The effect ondeferred tax assets and liabilities of a change in tax rates is recognized inincome in the period that includes the enactment date.

 

7.               Cash and CashEquivalents

 

Cash and cash equivalents include cash on hand,cash on deposit with banks, and highly liquid debt instruments with a maturityof three months or less when purchased.

 

Balances maintained within accounts on depositwith banks, at times, may exceed federally insured limits.  The Company or the Subsidiary has notexperienced any losses in such accounts.

 

8.   EarningsPer Share

 

Basic earnings per share is computed based onthe weighted average number of common shares outstanding during the year.Diluted earnings per share is computed using the weighted average number ofcommon and dilutive common equivalent shares outstanding during the year.  Common equivalent shares from stock optionsare excluded from the computation when their effect is antidilutive.  (Note I).

 

9.   Advertising

 

Advertising costs are charged to expense whenincurred. Advertising expense for the years ended December 31, 2005, 2004and  2003, totaled $127,301, $142,336 and$52,335, respectively.

 

10. Stock Options

 

The Company has a stock-based employeecompensation plan. As allowed under SFAS No. 123, “Accounting for Stock-BasedCompensation,” the Company continues to account for stock options for employeesunder APB No. 25, “Accounting from Stock Issued to Employees,” and has onlyadopted the disclosure requirements of SFAS No. 123.

 

 

F-8

----

 

There were no stock option awards duringfiscal 2005 or 2004. The Company granted stock options in 2003, however, nostock-based employee compensation cost is reflected in net income in 2003, asall options granted under the plan had an exercise price equal to the marketvalue of the underlying common stock on the date of grant.  The following table illustrates the effect onnet income and earnings per share if the Company had applied the fair value recognitionprovisions of SFAS No. 123, *Accounting forStock-Based Compensation*, to stock-based employee compensation forthe year ended December 31, 2003. The fair value of each option grantduring 2003, is estimated on the date of grant using the Black-Scholesoption-pricing model with the following weighted-average assumptions: annualexpected dividend yield 1.23%; expected volatility 57.3%; risk-free interestrate of 3.49%; and expected life of 5 years.

 
| ** **                                                                                                                                    | ** ** | **Year Ended  December 31, 2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| Net income, as reported                                                                                                                       |       | $                                                | 4,040,277  |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | (154,700                                         | )          |
| Pro forma net income                                                                                                                          |       | $                                                | 3,885,577  |   |
| Income per share:                                                                                                                             |       |                                             |       |
| Basic - as reported                                                                                                                           |       | $                                                | 1.30       |   |
| Diluted – as reported                                                                                                                    |       | $                                                | 1.29       |   |
| Basic – pro forma                                                                                                                        |       | $                                                | 1.25       |   |
| Diluted – pro forma                                                                                                                      |       | $                                                | 1.24       |   |

 

11. Reclassifications

 

Certain 2003 and 2004 amounts have beenreclassified to conform to the 2005 presentation.

 

NOTE B - RECEIVABLE FROM AND PAYABLE TO CORRESPONDENT BROKER-DEALER

 

The Subsidiary introduces all customertransactions in securities traded on U.S. securities markets to NFS on afully-disclosed basis. The agreement between the Subsidiary and its clearingbroker provides that the Subsidiary is obligated to assume any exposure relatedto nonperformance by customers or counterparties. The Subsidiary monitorsclearance and settlement of all customer transactions on a daily basis. Theexposure to credit risk associated with the nonperformance of customers andcounterparties in fulfilling their contractual obligations pursuant to thesesecurities transactions can be directly impacted by volatile trading marketswhich may impair the customer’s or counterparty’s ability to satisfy theirobligations to the Subsidiary. In the event of nonperformance, the Subsidiarymay be required to purchase or sell financial instruments at unfavorable marketprices resulting in a loss. Management does not anticipate significantnonperformance by customers and counterparties in the above situations.

 

In addition to the clearing services provided,NFS also loans money to the Subsidiary to finance trading accounts. Such loansare collateralized by trading and investment securities on deposit with NFS.

 

F-9

----

 

NOTE C – NOTES AND OTHER RECEIVABLES

 

Notes and other receivables consist of thefollowing at December 31, 2005 and 2004:

 

| ** **          | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------|------------|----------|------------|----------|------------|
| Officers            |       | $        | 37,431     |     | $          | 40,253 |   |
| Employees           |       | 99,108   |       | 137,473  |       |
| Independent brokers |       | 16,756   |       | 46,393   |       |
| Other               |       | 928,233  |       | 218,815  |       |
|                |       |     |       |     |       |
|                |       | $        | 1,081,528  |     | $          | 442,934 |   |

 

Employee and independent broker receivablesrelate principally to advances and expenses in excess of commission earningsand inventory losses charged to the Subsidiary’s employees and registeredrepresentatives. Other receivables are primarily related to commissionsreceivable and amounts receivable from insurance companies as reimbursement forinsured losses. An allowance is recorded for specific amounts when they are determinedby management to be uncollectible. For the years ended December 31, 2005,2004 and 2003, receivables of  $299,745,$684,429 and $367,796, respectively, were determined by management to beuncollectible and written off to bad debt expense.

 

NOTE D – TRADING AND INVESTMENT SECURITIES AND SECURITIES SOLD, NOT YETPURCHASED

 

Trading securities and securities sold, notyet purchased, represent the market value of securities held long and short bythe Subsidiary.

 

The categories of trading securities andtheir related market values at December 31, 2005 and 2004 are as follows:

 

| ** **                      | ** ** | **2005**  | ** ** | **2004**                           | ** ** |
|---------------------------------|------------|-----------|------------|------------------------------------|------------|
| ** **                      | ** ** | **Owned** | ** ** | **Sold,  Not Yet  Purchased** | ** ** | **Owned** | ** ** | **Sold,  Not Yet  Purchased** | ** ** |
|                            |       |      |       |                               |       |   |   |   |   |
| Corporate equities              |       | $         | 1,553,557  |                               | $          | 23,033 |   | $ | 2,809,083 |   | $ | 50,144 |   |
| State and municipal obligations |       | 5,007     |       | —                             |       | 220,243 |   | — |   |
|                            |       |      |       |                               |       |   |   |   |   |
|                            |       | $         | 1,558,564  |                               | $          | 23,033 |   | $ | 3,029,326 |   | $ | 50,144 |   |

 

As a securities broker-dealer, the Subsidiaryis engaged in various securities trading and brokerage activities asprincipal.  In the normal course ofbusiness, the Subsidiary has sold securities that it does not currently own andwill therefore be obligated to purchase such securities at a future date.  This obligation is recorded in the financialstatements at the market value of the related securities and will result in atrading loss on the securities if the market price increases and a trading gainif the market price decreases subsequent to calendar year end.

 

F-10

----

 

Investment securities held by the Subsidiarywhich are readily marketable are stated at market value.  Included in investment securities are certainsecurities which are not readily marketable. Securities not readily marketable include investment securities (a) forwhich there is no market on a securities exchange or no independent publiclyquoted market, (b) that cannot be publicly offered or sold unless registrationhas been effected under the Securities Act of 1933, or (c) that cannot beoffered or sold because of other arrangements, restrictions, or conditionsapplicable to the securities or to the Subsidiary.  At December 31, 2005 and 2004, thesesecurities consisted of corporate stocks and warrants at estimated fair valueof approximately $4,186,064 and $1,739,984, respectively. A summary of theinvestment securities portfolio at December 31, 2005 and 2004 follows:

 

| ** **                      | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|---------------------------------|------------|-----------|------------|-----------|------------|
| Corporate equities and warrants |       | $         | 32,401,808 |      | $          | 20,774,645 |   |
| Corporate underwriter warrants  |       | 6,275,000 |       | 9,416,000 |       |
|                            |       |      |       |      |       |
|                            |       | $         | 38,676,808 |      | $          | 30,190,645 |   |

 

The cost basis related to the investmentsecurity portfolio as of December 31, 2005 and 2004 was approximately$22,622,000 and $12,702,000, respectively.

 

Realized gain included in the determinationof net earnings was $20,210,372 for the year ended December 31, 2005. Realizedloss included in the determination of net earnings was $410,233 and $2,317,543for the years ended December 31, 2004 and 2003, respectively.

 

NOTE E – UNDERWRITER WARRANTS

 

The estimated fair value of warrants isdetermined by management using the Black-Scholes option-pricing model, takinginto account the exercise price, remaining contractual life of the warrant, thecurrent price of the underlying stock and its expected volatility, expecteddividends on the stock and the risk-free interest rate for the remaining termof the warrant (see Note A3).  Thewarrants generally have a five-year expiration date and vest immediately.  The warrants are generally subject to arestriction period of six months to one-year in which the Subsidiary cannotexercise the warrants.  The expectedvolatility factors were determined using historical volatility of theunderlying stock if available and historical volatility of a peer group ifvolatility for the underlying stock is not available.

 

The following table summarized activity inunderwriter warrants:

 

| Estimated fair value at December 31, 2003        |   | $          | 6,311,000 |   |
|--------------------------------------------------|--------|------------|-----------|--------|
| Warrants received, net of employee  compensation |   | 5,232,636  |      |
| Warrants expired/exercised                       |   | (3,294     | )         |
| Unrealized depreciation in estimated value       |   | (2,124,342 | )         |
| Estimated fair value at December 31,  2004  |   | 9,416,000  |      |
| Warrants received, net of employee  compensation |   | 1,471,960  |      |
| Warrants expired/exercised                       |   | (3,300,090 | )         |
| Unrealized depreciation in estimated value       |   | (1,312,870 | )         |
| Estimated fair value at December 31,  2005  |   | $          | 6,275,000 |   |

 

The net change in the estimated fair value ofthe underwriter warrants is reflected currently in earnings. The fair value ofthe underwriter warrants received during 2005 and 2004 is $2,123,014 and$7,288,588, respectively. The fair value is included in the Subsidiary’scorporate finance revenues. Additionally, in 2005 and 2004, $651,054 and$2,055,952, respectively, was recognized as compensation expense related to thereceipt of the warrants. The amount of the underwriter warrantsexpired/exercised in 2005 and 2004 of $3,300,090 and $3,294, respectively, andthe unrealized depreciation in the fair value of the underwriter warrants in2005 and 2004 of $1,312,870 and $2,124,342, respectively, is included in investmentincome.

 

F-11

----

 

NOTE F – FURNITURE AND EQUIPMENT

 

Furniture and equipment are stated at costand consist of the following:

 
| ** **                                      | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|-------------------------------------------------|------------|-----------|------------|-----------|------------|
| Office equipment                                |       | $         | 1,195,469  |      | $          | 1,635,700 |   |
| Vehicles                                        |       | —    |       | 65,619    |       |
| Leasehold Improvements                          |       | 33,265    |       | 6,418     |       |
|                                            |       | 1,228,734 |       | 1,707,737 |       |
| Less accumulated depreciation and  amortization |       | 962,943   |       | 1,468,709 |       |
|                                            |       |      |       |      |       |
|                                            |       | $         | 265,791    |      | $          | 239,028 |   |

 

NOTE G – INCOME TAXES

 

Income tax expense (benefit) consists of thefollowing:

 
| ** **                    | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003**   | ** ** |
|-------------------------------|------------|-----------|------------|-----------|------------|------------|------------|
|                          |       |      |       |      |       |       |       |
| Current tax expense (benefit) |       |      |       |      |       |       |       |
| Federal                       |       | $         | 4,510,000  |      | $          | (140,657   | )          | $ | (868,670 | ) |
| State and local               |       | 406,000   |       | 24,923    |       | (153,294   | )          |
|                          |       |      |       |      |       |       |       |
|                          |       | 4,916,000 |       | (115,734  | )          | (1,021,964 | )          |
|                          |       |      |       |      |       |       |       |
| Deferred tax expense          |       |      |       |      |       |       |       |
| Federal                       |       | (25,200   | )          | 1,974,306 |       | 3,020,150  |       |
| State and local               |       | (2,800    | )          | 548,294   |       | 105,550    |       |
|                          |       |      |       |      |       |       |       |
|                          |       | (28,000   | )          | 2,522,600 |       | 3,125,700  |       |
|                          |       |      |       |      |       |       |       |
|                          |       | $         | 4,888,000  |      | $          | 2,406,866  |       | $ | 2,103,736 |   |

 

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

 
| ** **                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003**  | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
|                                                     |       |     |       |     |       |      |       |
| Income tax expense at statutory federal tax  rate        |       | $        | 4,549,000  |     | $          | 2,004,798 |       | $ | 2,089,000 |   |
| State and local taxes net of federal  benefit            |       | 517,000  |       | 353,098  |       | 368,000   |       |
| Permanent and other differences                          |       | (32,000  | )          | (2,830   | )          | 10,036    |       |
| Change in valuation allowance on net  deferred tax asset |       | (146,000 | )          | 51,800   |       | (363,300  | )          |
|                                                     |       |     |       |     |       |      |       |
|                                                     |       | $        | 4,888,000  |     | $          | 2,406,866 |       | $ | 2,103,736 |   |

 

F-12

----

 

The deferred income tax asset (liability)consists of the following:

 
| ** **                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|
| Unrealized appreciation on securities         |       | $        | (5,577,000 | )        | $          | (6,870,760 | ) |
| Accrued expenses                              |       | 247,500  |       | 435,670  |       |
| Net operating loss carryforwards and  credits |       | 114,000  |       | 934,063  |       |
| Capital loss carryfowards                     |       | —   |       | 183,775  |       |
| Fixed asset depreciation                      |       | (9,500   | )          | (17,025  | )          |
| Contribution carryover                        |       | —   |       | 55,277   |       |
| Prepaid expense                               |       | (172,000 | )          | —   |       |
| Valuation allowance                           |       | (11,000  | )          | (157,000 | )          |
|                                          |       |     |       |     |       |
|                                          |       | $        | (5,408,000 | )        | $          | (5,436,000 | ) |

 

The Company has recorded a valuationallowance for 2005 and 2004 in the amount of $11,000 and $157,000,respectively, based upon management’s assessment that it is more likely thannot that a portion of the net deferred tax asset related to certain state netoperating loss carryforwards will not be fully realized.  Management will continue to review the netdeferred tax asset and may adjust the valuation allowance in future periodsbased upon their assessment.

 

State net operating loss carryforwards ofapproximately $2.7 million expire 2005 through 2024.

 

F-13

----

 

NOTE H – COMMON STOCK

 

The Company’s 1999 Stock Option Plan reserves500,000 shares of the Company’s common stock for issuance upon exercise ofoptions granted under the plan.  AtDecember 31, 2005, 260,500 options were available for grant.  The Plan provides for the grant of incentiveoptions and nonqualified options.  Therewere no options granted during 2005 and 2004. The options granted during 2003have an exercise price of $8.10 and $8.91, vested immediately, and expire onNovember 9, 2008. The market price of the Company’s stock at the date ofthe grant in 2003 was $8.10. The weighted average fair value of the options atthe date of grant in 2003, as calculated using the Black-Scholes option-pricingmodel, was $3.82 per share.

 

The following table presents the optionsgranted under the plan during 2003:

 
| ** **                                                                            | ** ** | **Number  of  Shares** | ** ** | **Weighted  Average  Fair  Value** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------------------|------------|----------------------------------------|------------|
|                                                                                  |       |                   |       |                               |       |                                   |       |
| Options whose exercise price equals the  market price of the stock on the grant date  |       | 50,000                 |       | $                                  | 3.8687     |                                   | $          | 8.10 |   |
|                                                                                  |       |                   |       |                               |       |                                   |       |
| Options whose exercise price exceeds the  market value of the stock on the grant date |       | 17,500                 |       | 3.6800                             |       | 8.91                                   |       |
|                                                                                       |            |                        |            |                                    |            |                                        |            |  |  |

 

The following table summarizes activity underthe Plan for the years ended December 31, 2005, 2004 and 2003:

 
| ** **                        | ** ** | **Shares  Under  Option** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Life** | ** **  |
|-----------------------------------|------------|---------------------------|------------|----------------------------------------|------------|----------------------------------------|-------------|
| Balance at December 31, 2002      |       | 141,000                   |       | $                                      | 5.33       |                                   | 2.469 years |   |
| Granted                           |       | 67,500                    |       | 8.31                                   |       |                                   |        |
| Exercised                         |       | (14,000                   | )          | 4.44                                   |       |                                   |        |
| Canceled                          |       | —                    |       |                                   |       |                                   |        |
|                              |       |                      |       |                                   |       |                                   |        |
| Balance at December 31, 2003 |       | 194,500                   |       | 6.43                                   |       | 2.735 years                            |        |
| Granted                           |       | —                    |       |                                   |       |                                   |        |
| Exercised                         |       | (78,500                   | )          | 4.66                                   |       |                                   |        |
| Canceled                          |       | (6,000                    | )          | 4.44                                   |       |                                   |        |
|                              |       |                      |       |                                   |       |                                   |        |
| Balance at December 31, 2004 |       | 110,000                   |       | 7.80                                   |       | 3.188 years                            |        |
| Granted                           |       | —                    |       |                                   |       |                                   |        |
| Exercised                         |       | (13,500                   | )          | 7.62                                   |       |                                   |        |
| Canceled                          |       | —                    |       |                                   |       |                                   |        |
|                              |       |                      |       |                                   |       |                                   |        |
| Balance at December 31, 2005 |       | 96,500                    |       | $                                      | 7.83       |                                   | 2.196 years |   |

 

F-14

----

 

As of December 31, 2005, outstandingstock options consist of the following:

 
| **Exercise Price Range** | ** **       | **Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Life** | ** ** |
|------------------------------------|------------------|-------------|------------|--------------------------------------------|------------|----------------------------------------|------------|
|                               |             |        |       |                                       |       |                                   |       |
| $                                  | 7.01 – 7.71 |        |       | 39,000                                     |       | $                                      | 7.06       |   | 1.2137 |   |
| 8.10 - 8.91                        |             |        | 57,500     |                                       | 8.35       |                                   | 2.8630     |   |
| Total                              |             | 96,500      |       |                                       |       |                                   |       |
|                                    |                  |             |            |                                            |            |                                        |            |  |  |  |

 

NOTE I – EARNINGS PER SHARE

 

The following table is a reconciliation ofthe numerators and denominators of the basic and diluted per share computationsfor each of the three years in the period ended December 31, 2005

 
| ** **                                                            | ** ** | **Income  (Numerator)** | ** ** | **Weighted  Average  Shares  (Denominator)** | ** ** | **Per  Share  Amount** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------|------------|----------------------------------------------|------------|------------------------|------------|
| 2003                                                                  |       |                    |       |                                         |       |                   |       |
| Basic earnings per share  Income available to common stockholders     |       | $                       | 4,040,277  |                                         | 3,116,786  |                   | $          | 1.30 |   |
|                                                                  |       |                    |       |                                         |       |                   |       |
| Effect of dilutive securities  Stock options                          |       | —                  |       | 14,819                                       |       |                   |       |
|                                                                  |       |                    |       |                                         |       |                   |       |
| Diluted earnings per share  Earnings available to common stockholders |       | $                       | 4,040,277  |                                         | 3,131,605  |                   | $          | 1.29 |   |
|                                                                  |       |                    |       |                                         |       |                   |       |
| 2004                                                                  |       |                    |       |                                         |       |                   |       |
| Basic earnings per share  Income available to common stockholders     |       | $                       | 3,489,600  |                                         | 3,183,194  |                   | $          | 1.10 |   |
|                                                                  |       |                    |       |                                         |       |                   |       |
| Effect of dilutive securities  Stock options                          |       | —                  |       | 3,695                                        |       |                   |       |
|                                                                  |       |                    |       |                                         |       |                   |       |
| Diluted earnings per share  Earnings available to common stockholders |       | $                       | 3,489,600  |                                         | 3,186,889  |                   | $          | 1.09 |   |
|                                                                  |       |                    |       |                                         |       |                   |       |
| 2005                                                                  |       |                    |       |                                         |       |                   |       |
| Basic earnings per share  Income available to common stockholders     |       | $                       | 8,492,060  |                                         | 3,131,443  |                   | $          | 2.71 |   |
|                                                                  |       |                    |       |                                         |       |                   |       |
| Effect of dilutive securities  Stock options                          |       | —                  |       | 16,189                                       |       |                   |       |
|                                                                  |       |                    |       |                                         |       |                   |       |
| Diluted earnings per share  Earnings available to common stockholders |       | $                       | 8,492,060  |                                         | 3,147,632  |                   | $          | 2.70 |   |

 

F-15

----

 

NOTE J – LEASES

 

The Company leases office space under theterms of various non-cancelable operating leases.  The future minimum payments, by year and inaggregate, required for leases with initial or remaining terms of one year ormore consist of the following:

 
| **Year ending  December 31,** | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------|------------|
|                                    |       |       |       |
| 2006                                    |       | $          | 516,509    |   |
| 2007                                    |       | 533,753    |       |
| 2008                                    |       | 538,800    |       |
| 2009                                    |       | 301,572    |       |
| 2010                                    |       | 117,456    |       |
|                                    |       | $          | 2,008,090  |   |

 

The leases, accounted for on a straight-linebasis, provide for payment of taxes and other expenses by the Subsidiary.  Occupancy expense for the years endedDecember 31, 2005, 2004 and 2003 approximated $605,468, $518,779 and$494,383, respectively.

 

NOTE K – EMPLOYEE BENEFIT PLANS

 

Retirement benefits for employees of theSubsidiary, who have completed certain service requirements, are provided by adefined contribution profit-sharing plan. Plan contributions are determined by the Board of Directors.  Contributions to the plan for the years endedDecember 31, 2005, 2004 and 2003 approximated $605,000, $348,000 and$235,000, respectively.

 

NOTE L – CONTINGENCIES

 

The Subsidiary has been named by individualsin certain legal actions, some of which claim state and federal securities lawviolations and claim principal and punitive damages. As preliminary hearingsand discovery in the remaining cases is not complete, it is not possible toassess the degree of liability, the probability of an unfavorable outcome orthe impact on the Subsidiary’s financial statements, if any.  The Subsidiary’s management denies thecharges in the remaining legal actions and is vigorously defending againstthem.  No provision for any liabilitythat may result from the remaining contingencies has been made in the financialstatements. A summary of legal activity is as follows:

 

In October 2002, PIC was named as adefendant in a lawsuit filed by Special Situations Fund III, LP and SpecialSituations Cayman Fund, LP.  The lawsuitwas filed in U.S. District Court for the District of New Jersey.  It asserts various federal securities lawclaims and common law fraud and negligence against numerous defendants,including PIC, arising out of two follow-on offerings of Suprema Specialties, Inc.  PIC participated in one of the two offerings,the August 25, 2000 follow-on offering of Suprema Specialties, Inc.,as a member of the underwriting syndicate, underwriting 75,000 shares intotal.  The stock was sold in theAugust 25, 2000 offering at a price of $8.00 per share.  Plaintiffs seek damages for the purchase of399,151 shares of Suprema Specialties, Inc. stock between August 25,2000 and November 14, 2001.  Thefederal district court dismissed the claims against PIC.  In February 2006, the United States ThirdCircuit Court of Appeals affirmed the dismissal in part and reversed thedismissal in part.  With respect to PIC,the Third Circuit affirmed the dismissal of the Rule 10b-5 claim and reversedthe dismissal of the Section 11 claim. Therefore, PIC now faces claims for Section 11 violations, common lawfraud and negligence.  The Third Circuithas not yet issued its mandate, returning the case to the district court,although it should do so shortly.  PICbelieves it has meritorious defenses and intends to defend this mattervigorously.

 

In December 2005, PIC received notice of possibleclaims being asserted against it by three individuals who invested in WoodRiver Partners LP(“Wood River”).  All ofthe investors purchased their interests in Wood River directly from WoodRiver.  One of the individuals was acustomer of PIC.  He and his brother haveindicated that they paid $1,050,000 for their interests in Wood River.  The other individual has indicated that hepaid $2,700,000 for his interest in Wood River. The SEC sued Wood River in October 2005, and a receiver currently runsWood River.  At this point, it is notknown how much the individuals might recover through the receivership.  The individuals have indicated that they believethey may have claims against PIC under the Oregon law for rescission, interestand attorneys fees.  PIC believes it hasmeritorious defenses and, if litigation is filed, PIC intends to defend thismatter vigorously.

 

F-16

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In January 2006, PIC received notice of a customercomplaint against a former PIC registered representative.  The customer has indicated that her accountsdeclined in value by approximately $500,000. The customer has asserted that the former registered representativefailed to implement strategies and techniques to provide for safety andpreservation of capital in her accounts and asserts that the registeredrepresentative made misrepresentations regarding the handling of her accounts.  The customer has not indicated that she plansto pursue litigation against PIC.  Atthis time, the customer has requested that the former registered representativecompensate her for the decline in value of her account and return any feesearned by the former registered representative. PIC has not had an opportunity to investigate this complaint.

 

An adverse outcome in certain of the mattersdescribed above could have a material adverse effect on PIC or the Company.From time to time, PIC is named in certain other legal proceedings and receivesnotice that certain customers may commence legal proceedings against PIC.  The Company has no additional legalproceedings other than through PIC. The Company believes, based uponinformation received to date and, where the Company believes it appropriate,discussions with legal counsel, that resolution of any additional pending orthreatened litigation will have no material adverse effect on the consolidatedfinancial condition, results of operations, or business of the Company.

 

NOTE M – NET CAPITAL REQUIREMENT

 

The Subsidiary is subject to the Securitiesand Exchange Commission Uniform Net Capital rule (Rule 15c3-1), which requiresthe maintenance of minimum net capital and requires that the ratio of aggregateindebtedness to net capital, both as defined, shall not exceed 15 to 1. Therule also provides that equity capital may not be withdrawn or cash dividendspaid if the resulting net capital ratio would exceed 10 to 1. At December 31,2005, the Subsidiary had net capital of $22,696,747, which was $22,308,476 inexcess of its required net capital of $388,271. The Subsidiary’s net capitalratio was 0.26 to 1. The minimum requirements may effectively restrict thepayment of cash dividends to the Company.

 

NOTE N – CONCENTRATION OF RISK

 

The Subsidiary’s trading and investmentsecurities include investments in the common stock of the following companies,which represent more than 10 percent of trading and investment securities atDecember 31, 2005 and 2004:

 

As of December 31, 2005:

 
| **Company**                | ** ** | **Investment Amount  Dec. 31, 2005** | ** ** | **Percentage of Total** | ** ** |
|----------------------------|------------|--------------------------------------|------------|-------------------------|------------|
| ICOP Digital               |       | $                                    | 4,435,039  |                    | 13.1       |   |
| Charles and  Colvard, Ltd. |       | 16,890,351                           |       | 49.7                    |       |
| Total                      |       | $                                    | 21,325,390 |                    | 62.8       |   |

 

As of December 31, 2004:

 
| **Company**                | ** ** | **Investment Amount  Dec. 31, 2004** | ** ** | **Percentage of Total** | ** ** |
|----------------------------|------------|--------------------------------------|------------|-------------------------|------------|
| AVI  Biopharma             |       | $                                    | 2,760,511  |                    | 11.6       |   |
| Charles and  Colvard, Ltd. |       | 11,479,719                           |       | 48.2                    |       |
| Total                      |       | $                                    | 14,240,230 |                    | 59.8       |   |

 

NOTE O – NEW ACCOUNTING STANDARDS

 

In December 2004, the FASB issued FAS123R, which requires that compensation costs relating to share-based paymentsbe recognized in the Company’s financial statements. The Company currentlyaccounts for those payments under the recognition and measurement principles ofAccounting Principles Board (APB) Opinion No. 25, “Accounting forStock Issued to Employees,” and related interpretations. The Company ispreparing to implement this standard effective January 1, 2006.  Although we have not yet determined whetherthe adoption of 123(R) will result in amounts that are similar to the currentpro form data (see Note A10), we expect the adoption may have a material impacton future financial statements.  Thisestimate is based on preliminary information and could materially change basedon the actual facts and circumstances and the terms of future option grants.

 

 

F-17

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NOTE P – SUBSEQUENT EVENTS

 

On December 22, 2005, the Company announcedthe authorization by the Board of Directors of a $0.30 special cash dividend toshareholders of record on January 17, 2006. The dividend payment date isFebruary 10, 2006.

 

On March 1, 2006, the Company announced thatthe Board of Directors approved a two-for-one stock split of the common stockto be effected in the form of a stock dividend. The stock split will beeffected by issuing one additional share of common stock for each outstandingshare of common stock. The record date of the forward split is March 15, 2006and payable on March 29, 2006. The common stock will trade on a split basisbeginning at market open on March 30, 2006. The effect of the stock split onearnings per share for fiscal years ended December 31, 2003 through 2005 is asfollows:

 
| ** **                                   | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|----------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Basic  earnings per share                    |       | 1.36      |       | 0.55      |       | 0.65      |       |
| Diluted  earnings per share                  |       | 1.35      |       | 0.55      |       | 0.65      |       |
| Weighted  average common shares outstanding: |       |      |       |      |       |      |       |
| Basic                                        |       | 6,262,886 |       | 6,366,388 |       | 6,233,572 |       |
| Diluted                                      |       | 6,295,264 |       | 6,373,778 |       | 6,263,210 |       |

 

NOTE Q – NONOPERATING INCOME

 

In March 2005 the Subsidiary paid $1.1million to settle a lawsuit (eDigital). This amount was included in accountspayable and accrued liabilities as of December 31, 2004. The Subsidiary paidthe settlement amount because the insurance company, who previously agreed topay the settlement, refused to pay. The Subsidiary was successful in thelawsuit filed against the insurance carrier to recover the settlementamount.  Included in other income in 2005is $1.1 million settlement recovery.

 

 

F-18

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Paulson Capital Corp. and Subsidiary

 

SUPPLEMENTARY SCHEDULE OF WARRANTS OWNED

 

December 31, 2005

 
| **Description**                                   | ** ** | **Number  of  Warrants** | ** ** | **Exercise  Price Per  Share/Unit** | ** ** | **Expiration  Date** | ** **  |
|---------------------------------------------------|------------|--------------------------|------------|-------------------------------------|------------|----------------------|-------------|
|                                              |       |                     |       |                                |       |                 |        |
| Beta Oil & Gas, Inc. ERC* 06-29-01            |       | 1,850                    |       | $                                   | 9.25       |                 | 2006, 06/29 |   |
| Creative Products Intl. ERC 07-01-01              |       | 30,000                   |       | $                                   | 1.50       |                 | 2006, 06/30 |   |
| Daystar Technologies, Inc. (units) ERC  02-05-05  |       | 25,000                   |       | $                                   | 6.00       |                 | 2009, 02/05 |   |
| ICOP Digital, Inc. (units) ERC 01-04-06           |       | 100,750                  |       | $                                   | 9.90       |                 | 2010, 07/08 |   |
| ICOP Digital, Inc. (common+warrant) ERC  01-08-06 |       | 25,187                   |       | $                                   | 5.92       |                 | 2010, 07/08 |   |
| I-Sector Corp. (units) ERC 05-07-05               |       | 29,653                   |       | $                                   | 19.92      |                 | 2009, 05/07 |   |
| Lumera Corporation ERC 7-23-05                    |       | 346,085                  |       | $                                   | 8.34       |                 | 2009, 07/22 |   |
| microHelix, Inc. (units) ERC 11-16-02             |       | 127,462                  |       | $                                   | 7.20       |                 | 2006, 11/16 |   |
| Milestone Scientific, Inc. ERC 02-17-05           |       | 34,610                   |       | $                                   | 4.89       |                 | 2009, 02/16 |   |
| Milestone Scientific, Inc. (units) ERC  2-17-05   |       | 99,857                   |       | $                                   | 7.82       |                 | 2009, 02/16 |   |
| Nuvim, Inc. (units) ERC 12-18-05                  |       | 184,950                  |       | $                                   | 1.20       |                 | 2010, 06/20 |   |
| Pacific Mercantile Bancorp ERC 12-08-04           |       | 136,118                  |       | $                                   | 11.10      |                 | 2008, 12/08 |   |
| Path 1 Network Technologies (units) ERC  07-31-04 |       | 87,292                   |       | $                                   | 12.96      |                 | 2008, 07/30 |   |
| Q Comm International, Inc. (units) ERC  06-25-04  |       | 61,552                   |       | $                                   | 15.60      |                 | 2008, 06/24 |   |
| Smart Pros Ltd. (units) ERC 04-17-05              |       | 32,970                   |       | $                                   | 15.30      |                 | 2009, 10/19 |   |

 

----

* Date exercisable

 

F-19

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Paulson Capital Corp. andSubsidiary

 

SUPPLEMENTARY INFORMATION—QUARTERLY FINANCIAL DATA (Unaudited)

 

December 31, 2005

 

Thefollowing table summarizes the Company’s quarterly financial data for the pasttwo years ended December 31, 2005 (in thousands, except per shareamounts):

 
| **2005**                                       | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
|------------------------------------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|
| ** **                                     | ** ** | ** **         | ** ** | ** **          | ** ** | ** **         | ** ** | ** **          | ** ** |
| Revenue                                        |       | $                  | 10,134     |                | $          | 17,996             |       | $                   | 8,105      |   | $ | 3,501 |   |
|                                           |       |               |       |                |       |               |       |                |       |
| Revenue less  commissions/underwriting expense |       | 6,794              |       | 13,525              |       | 4,113              |       | 705                 |       |
|                                           |       |               |       |                |       |               |       |                |       |
| Net income  (loss)                             |       | 2,568              |       | 6,072               |       | 738                |       | (886                | )          |
|                                           |       |               |       |                |       |               |       |                |       |
| Earnings per  share (loss)                     |       |               |       |                |       |               |       |                |       |
|                                           |       |               |       |                |       |               |       |                |       |
| Basic                                          |       | $                  | 0.81       |                | $          | 1.94               |       | $                   | 0.24       |   | $ | (0.29 | ) |
|                                           |       |               |       |                |       |               |       |                |       |
| Diluted                                        |       | 0.81               |       | 1.93                |       | 0.24               |       | (0.29               | )          |

 
| **2004**                                      | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
|-----------------------------------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|
| ** **                                    | ** ** | ** **         | ** ** | ** **          | ** ** | ** **         | ** ** | ** **          | ** ** |
| Revenue                                       |       | $                  | 7,696      |                | $          | 4,747              |       | $                   | 9,564      |   | $ | 10,908 |   |
|                                          |       |               |       |                |       |               |       |                |       |
| Revenue less  commission/underwriting expense |       | 3,328              |       | 1,777               |       | 6,143              |       | 6,814               |       |
|                                          |       |               |       |                |       |               |       |                |       |
| Net income  (loss)                            |       | 358                |       | (252                | )          | 2,004              |       | 1,380               |       |
|                                          |       |               |       |                |       |               |       |                |       |
| Earnings  (loss) per share                    |       |               |       |                |       |               |       |                |       |
|                                          |       |               |       |                |       |               |       |                |       |
| Basic                                         |       | $                  | 0.11       |                | $          | (0.08              | )          | $                   | 0.63       |   | $ | 0.43 |   |
|                                          |       |               |       |                |       |               |       |                |       |
| Diluted                                       |       | 0.11               |       | (0.08               | )          | 0.62               |       | 0.43                |       |

 

 

F-20

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Schedule II

 

Paulson Capital Corp. andSubsidiary

 

Valuation and QualifyingAccounts

 

Years ended December 31,2005, 2004 and 2003

 
| **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, 2005         |       | $                               | —     |                                         | $          | 299,745                    |       | $                            | 299,745    |   | $ | — |   |
| Year ended  Dec. 31, 2004         |       | —                          |       | 684,429                                      |       | 684,429                    |       | —                       |       |
| Year ended  Dec. 31, 2003         |       | —                          |       | 367,796                                      |       | 367,796                    |       | —                       |       |
|                                   |            |                                 |            |                                              |            |                            |            |                              |            |  |  |  |  |

 

 

F-21

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