**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D. C. 20549**

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**FORM 10-K**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

**SECURITIESEXCHANGE ACT OF 1934**

** **

**For the Fiscal Year Ended: December 31, 2006**

 

**OR**

 

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

**SECURITIESEXCHANGE ACT OF 1934**

 

**Commission File Number: 0-15360**

**PAULSON CAPITAL CORP.**

(Exact name of registrant as specified in its charter)

| **Oregon**                                                      |   | **93-0589534**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |   |                                  |
| **811 SW  Naito Parkway, Suite 200, Portland, Oregon**          |   | **97204**                             |
| (Address of  principal executive offices)                       |   | (Zip Code)                            |

 

| Registrant’s telephone  number, including area code:**(503) 243-6000** |
|-----------------------------------------------------------------------------|

 

Securities Registered pursuant to Section 12(b) of the Act:

 

| Title of each class | ** ** | **Name of each exchange on which registered** |
|---------------------|------------|-----------------------------------------------|
| Common Stock        |       | NASDAQ Capital Market                         |

 

Securities registered pursuant to Section 12(g) of the Act: **None**

Indicate by check mark if the Registrant is a well-known seasonedissuer, as defined in Rule 405 of the Securities Act: Yes o     No x

Indicate by check mark if the Registrant is not required to file reportspursuant to Section 13 or Section 15(d) of the Act:Yes o     No x

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days: Yes x    No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-K,or any amendment to this Form 10-K.   x

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer or a non-accelerated filer. See definition of “acceleratedfiler” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. Largeaccelerated filer o   Accelerated filer o   Non-acceleratedfiler x

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act). Yes o    No x

 

The aggregate market value of the voting andnon-voting common equity held by non-affiliates of the registrant was$11,170,662, computed by reference to the last sales price ($6.10) as reportedby the Nasdaq Capital Market, as of the last business day of the Registrant’smost recently completed second fiscal quarter (June 30, 2006).

The number of shares outstanding of the registrant’scommon stock as of March 12, 2007 was 6,147,511 shares.

**Documents Incorporated byReference**

Portionsof the registrant’s definitive Proxy Statement for the 2007 Annual Meeting ofShareholders are incorporated by reference into Part III.

 

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**PAULSONCAPITAL CORP.**

**2006 FORM10-K ANNUAL REPORT**

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

 

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**PART I**

**ITEM1.   BUSINESS**

**Forward-LookingStatements**

This report, including, without limitation, Item 7. “Management’sDiscussion and Analysis of Financial Condition and Results of Operations,”contains or incorporates both historical and “forward-looking” statementswithin the meaning of Section 27A of the Securities Act of 1933, asamended, and Section 21E of the Securities Exchange Act of 1934, asamended. Words such as “anticipates,” “believes,” “expects,” “intends,” “future”and similar expressions identify forward-looking statements. Any suchforward-looking statements in this report reflect our current views withrespect to future events and financial performance and are subject to a varietyof factors that could cause our actual results to differ materially fromhistorical results or from anticipated results expressed or implied by suchforward-looking statements. Because of such factors, we cannot assure you thatthe results anticipated in this report will be realized. As noted elsewhere inthis report, various aspects of our business are subject to extreme volatilityoften as a result of factors beyond our ability to anticipate or control. Inparticular, factors, such as the condition of the securities markets, which arein turn based on popular perceptions of the health of the economy generally,can be expected to affect the volume of our business as well as the value ofthe securities maintained in our trading and investment accounts. Foradditional information regarding factors that may affect our business, see Item1A. “Risk Factors.”

**General**

Paulson Capital Corp., established in 1970, is a holding company whoseonly operating subsidiary is Paulson Investment Company, Inc., a fullservice brokerage firm engaged in operations in four principal categories,all of them in the financial services industry. These categories are:

·                  securities brokerage activities forwhich we earn commission revenues;

·                  corporate finance revenues consistingprincipally of underwriting discounts and underwriter warrants;

·                  securities trading from which werecord profit or loss, depending on trading results; and

·                  investment income resulting fromearnings on, and increases or decreases in the value of, our investmentportfolio.

**Overview**

Because we operate in the financial services industry, our revenues andearnings are substantially affected by general conditions in financial markets.In our securities brokerage business, the amount of our revenues depends onlevels of market activity requiring the services we provide. Our corporatefinance activity, which consists of acting as the managing underwriter ofinitial and follow-on public offerings, private investments in a public equity(“PIPEs”) and private placements for smaller companies, is similarly affectedby the strength 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 andcorporate finance revenues tend to result in sharper fluctuations, on apercentage basis, in net income or loss.

Our investment income or loss and, to a lesser extent, our trading incomeor loss is affected by changes in market valuation of securities generally and,in particular, by changes in valuation of the equity securities of microcapcompanies in which our investments and trading activities tend to beconcentrated. Equity markets in general, and microcap equity markets inparticular, have always experienced significant volatility and this volatilityhas, in recent years, been extreme. The result of this volatility on the valueof our investment portfolio and securities held in connection with our tradingand investment activities include large quarterly fluctuations in income orloss from these operations and substantial increases or decreases in our networth as our securities holdings are marked to market.

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The following table shows the portion of ourrevenues that was attributable to each revenue category for the last threefiscal years (in thousands):
| **Year Ended December 31,** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Commissions                                |       | $        | 15,725     |     | $          | 16,518   |       | $ | 18,304 |   |
| Corporate  finance                         |       | 5,036    |       | 3,259    |       | 11,213   |       |
| Investment  income (loss)                  |       | (6,345   | )          | 15,840   |       | 2,018    |       |
| Trading income  (loss)                     |       | (1,338   | )          | 2,926    |       | 1,351    |       |
| Interest and  dividends                    |       | 78       |       | 51       |       | 28       |       |
| Other                                      |       | 308      |       | 1,142    |       | 1        |       |
|                                       |       | $        | 13,464     |     | $          | 39,736   |       | $ | 32,915 |   |

 

The following table shows our revenue categories as a percentage of totalrevenue for the last three fiscal years:
| **Year Ended December 31,** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Commissions                                |       | 116.8    | %          | 41.5     | %          | 55.6     | %          |
| Corporate  finance                         |       | 37.4     |       | 8.2      |       | 34.1     |       |
| Investment  income (loss)                  |       | (47.1    | )          | 39.9     |       | 6.1      |       |
| Trading income  (loss)                     |       | (9.9     | )          | 7.4      |       | 4.1      |       |
| Interest and  dividends                    |       | 0.5      |       | 0.1      |       | 0.1      |       |
| Other                                      |       | 2.3      |       | 2.9      |       | —   |       |
|                                       |       | 100.0    | %          | 100.0    | %          | 100.0    | %          |

 

In 2004, 2005 and 2006, none of our revenue was from foreign sources andno customer represented 10% or more of our total revenue. In addition, all ofour long-lived assets were located within the United States.

**ClearingFirm**

Pursuant to our  agreement with RBCDain Correspondent Services (“DCS”), DCS carries all of our customer securitiesaccounts and performs the following services: (1) preparation and mailingof monthly statements to our customers; (2) settlement of contracts andtransactions in securities between us and other broker-dealers and between usand our customers; (3) custody and safe-keeping of securities and cash,the handling of margin accounts, dividends, exchanges, rights offerings andtender offers; and (4) the execution of customer orders placed on anexchange. We determine the amount of commission to be charged to our customerson principal and agency transactions, as well as the price of securitiespurchased or sold in principal transactions. DCS receives compensation based onthe number of transactions and revenue sharing arrangements. In the event of aliability arising from a bad debt from a customer, we are required to indemnifyDCS against any loss. This potential liability is uninsured.

**Commissions**

As a securities broker, we act as agent for our customers in the purchaseand sale of common and preferred stocks, options, warrants and debt securitiestraded on securities exchanges or in the over-the-counter (“OTC”) market. A portionof our revenue is derived from commissions from customers on thesetransactions. In the OTC market, transactions with customers in securitiesmay be effected as principal, rather than agent, primarily in securitiesfor which we are a market maker. Customer transactions in securities areeffected either on a cash or margin basis.

We also enter into dealer agreements with mutual fund managementcompanies and publicly registered limited partnerships. Commissions on the saleof these securities are derived from the standard dealer discounts, which rangefrom approximately 1% to 8.5% of the purchase price of the securities,depending on the terms of the dealer agreement and the amount of the purchase.We do not generally sell interests in limited partnerships that are notpublicly registered.

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In the case of corporate finance transactions, described below, a portionof the discount applicable to securities placed by our retail brokerage groupis credited to securities brokerage commissions and the commission payable tothe broker is recorded as securities brokerage commissions expense.

**CorporateFinance**

While a substantial portion of our corporate finance business consists ofacting as managing underwriter of initial and follow-on public offerings formicrocap and smallcap companies, we also act as a placement agent for PIPEsand private placements for smaller companies. We underwrite the public offerings on a “firm commitment” basis, whichmeans that we agree to purchase a specific amount of securities from the issuerat a discount and resell the securities to the public at a specified priceafter the registration statement for the offering is declared effective by theSecurities and Exchange Commission (the “SEC”). Managing these public offeringsinvolves the risk of loss if we are unable to resell at a profit the securitieswe are committed to purchase. This risk is usually reduced by including otherstock brokerage firms as a part of an underwriting syndicate in which eachmember commits to purchase a specified amount of the offering. We, and theother underwriters, may also sell a portion of our respective commitmentsthrough a “selling group” of other stock brokerage firms that participate inselling the offering but are not subject to an underwriter’s commitment. As anunderwriter, we are also subject to potential liability under federal and statesecurities laws if the registration statement or prospectus contains a materialmisstatement or omission. We do not have insurance to cover our potentialliabilities as an underwriter.

The commitment of our capital between the time a firm commitmentunderwriting agreement becomes effective and the time we resell the securitiesconstitutes a charge against our net capital. Accordingly, our participationin, or initiation of, underwritings may be limited by the financialrequirements of the SEC and the National Association of Securities Dealers (“NASD”).See “Net Capital Requirements” below.

Between June 1, 1978 and December 31, 2006, we acted as themanaging underwriter or co-managing underwriter for 159 securities offerings,raising approximately $1.15 billion for corporate finance clients. Of these, 98were initial public offerings. We typically receive 2% to 3% of the aggregateamount of money raised in an offering to cover nonaccountable expenses andbetween 7% and 9% as compensation to underwriters, selling group members andregistered representatives, although these percentages may be lower forlarger transactions.

As a part of our compensation for the underwriting activities, wealso typically receive warrants exercisable to purchase securities similar tothose that we offer and sell to the public. The warrants generally have afive-year expiration date and vest immediately. The warrants are generallysubject to a restricted period of six months to one-year in which we cannotexercise the warrants. The exercise price is typically 120% of the price atwhich the securities are initially sold to the public. Accordingly, unlessthere is at least a 20% increase in the price of these securities at some timemore than six months and less than five years after the offering, the warrantswill remain “under water” and will ultimately expire unexercised. We alsoreceive warrants in connection with our PIPEs, which have varying terms andconditions. A portion of these underwriter warrants are typically transferredas compensation to persons associated with us and, in certain cases, to otherco-managing underwriters in the public offering.

In 2006, we completed two initial public offerings with gross proceedsfor our clients totaling $36.0 million. In addition, during 2006 we completedone secondary public offering and two small private transactions.

**InvestmentIncome**

We hold securities for investment, which are maintained in investmentaccounts that are segregated from the trading accounts. Our investmentportfolio principally consists of securities purchased for investment andunderwriter warrants.

From time to time, we make investments as a principal in companies thatare, or are expected to be, corporate finance clients. The investmentmay be as convertible debt in anticipation of a public offering, in whichcase, if the offering is successful, the principal and interest are eitherconverted to equity or 

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repayable from the offering proceeds. If the offering is not successful,the debt is typically converted to equity. We also make investments incompanies that are not anticipating an immediate public offering. In suchcases, the investment is typically made in the form of the purchase ofrestricted equity securities. Typically, these type of investments have rangedfrom $50,000 to $1.0 million. At December 31, 2006, we held securities of nineprivately-held companies in our investment accounts with a fair value of $2.4million at December 31, 2006.

**TradingIncome and Market Making**

In addition to executing trades as an agent, we regularly act as aprincipal in executing trades in equity securities, corporate debt securitiesand municipal bonds. At December 31, 2006, we made a market in 49securities of 39 issuers. Of these, 23 were corporations for which we had actedas managing or co-managing underwriter of public financings.

Our market making activities are conducted both with other dealers in the“wholesale market” and with our customers. Transactions with customers areeffected as principal at a net price equal to the current interdealer priceplus or minus the approximate equivalent of a brokerage commission. In suchtransactions, the commission is recorded as securities brokerage commissionsrevenue while any profit or loss attributable to a change in value of thesecurity in our trading account is recorded as trading profit or loss. Ourtransactions as principal expose us to risk because securities positions aresubject to fluctuations in market value and liquidity. Profits or losses ontrading and investment positions depend upon the skills of the employees in ourtrading department and employees responsible for taking investment positions.The trading department is headquartered in our Portland, Oregon office.

**Limitationson Investment and Trading Securities**

The size of our investment and trading securities positions at any datemay not be representative of our exposure on any other date, because thesecurities positions vary substantially depending upon economic and marketconditions, the allocation of capital among types of inventories, underwritingcommitments, customer demands and trading volume. The aggregate value ofinventories that we may carry are limited by certain requirements underthe SEC’s net capital rules. See “Net Capital Requirements” below.

**BranchOffices**

Our branch offices are generally run by independent contractors whoassume liability for all the operating expenses of the branch. We typicallyreceive between 10% and 20% of the gross commission earned by the branch, withthe balance retained by the branch to pay its expenses and staff. Persons inthese branches are registered with us, and we assume the same compliance andregulatory obligations as would be the case if we were fully responsible forthe branch’s expenses. As of March 1, 2007, we had 28 branch offices inArizona, California, Georgia, Hawaii, New Jersey, New York, North Carolina,Oklahoma, Oregon, Utah and Washington. All of these branches, except ouroffices in Salem, Oregon and Manhattan, New York, operate as independentcontractor offices. We continue to be responsible for all expenses of the Salemand Manhattan offices.

**Regulation**

We are registered with the SEC as a broker-dealer under the SecuritiesExchange Act of 1934 and are a member of the NASD. We are also registered as abroker-dealer under the laws of all 50 states, Washington, D.C. and PuertoRico. We are registered as investment advisors in 15 states.

The securities business is subject to extensive regulation under federaland state laws. The principal purpose of regulation and discipline ofbroker-dealers is the protection of customers and the securities markets ratherthan protection of creditors and stockholders of broker-dealers. The SEC is thefederal agency charged with administration of the federal securities laws. Muchof the regulation of broker-dealers, however, has been delegated toself-regulatory organizations, principally the NASD. These self-regulatoryorganizations adopt rules (subject to approval by the SEC) that govern theindustry and conduct 

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periodic examinations of member broker-dealers. Securities firms are alsosubject to regulation and examination by state securities commissions in thestates in which they are registered.

The regulations to which broker-dealers are subject cover all aspects ofthe securities business, including sales methods, trading practices amongbroker-dealers, capital structure of securities firms, record keeping and theconduct of directors, officers and employees. Additional legislation, changesin rules promulgated by the SEC and by self-regulatory bodies or changesin the interpretation or enforcement of existing laws and rules oftendirectly affect the method of operation and profitability of broker-dealers.The SEC, NASD and state regulatory authorities may conduct administrativeproceedings that can result in censure, fine, suspension or expulsion of abroker-dealer, its officers or employees.

**NetCapital Requirements**

We are required to maintain minimum “net capital” under the SEC’s netcapital rule of not less than 6.67% of our “aggregate indebtedness.” Ingeneral, net capital consists of the broker-dealer’s net worth, adjusted bynumerous factors specified in the applicable regulations. In particular, thevalue of securities that can be included in net capital is subject to reductionin market value or principal amount. The amount of the required reduction, or “haircut,”depends on the nature of the security. As of December 31, 2006, we had netcapital of $15.9 million, which exceeded our minimum requirement of $115,863 by$15.8 million. The ratio of aggregate indebtedness of $1.7 million to netcapital of $15.9 million at December 31, 2006, was approximately 0.11 to1.

In a public offering in which we act as an underwriter, we must havesufficient net capital to cover the amount of securities underwritten, applyingthe applicable formula mandated by the SEC, during the period betweeneffectiveness and the closing of the transaction, usually 3 business days. Thisresults in a significant temporary increase in our required net capital. Insome cases, the amount of securities underwritten by us could be limited by ournet capital. Any significant reduction in our net capital, even if we werestill in compliance with the SEC’s net capital rule for its retail andtrading activities, could have a material adverse effect on our ability tocontinue our investment banking activities.

**Competition**

All aspects of our business are highly competitive. In our generalbrokerage activities, we compete directly with numerous other broker-dealers,many of which are large well-known firms with substantially greater financialand personnel resources than us. Many of our competitors employ extensiveadvertising and actively solicit potential clients in order to increasebusiness. In addition, brokerage firms compete by furnishing investmentresearch publications to existing clients, the quality and breadth of which areconsidered important in the development of new business and the retention ofexisting clients. We also compete with a number of smaller regional brokeragefirms.

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

The securities industry has become considerably more concentrated andmore competitive since we were founded, as numerous securities firms haveeither ceased operations or have been acquired by or merged into other firms.This trend has been particularly pronounced among firms similar in size andbusiness mix to us. In addition, companies not engaged primarily in thesecurities business, but with substantial financial resources, have acquiredleading securities firms. These developments have increased competition fromfirms with greater capital resources than ours. In addition, various recentlegislative and regulatory developments have tended to increase competitionwithin the industry or reduce profits for the industry.

The securities industry has experienced substantial commissiondiscounting by broker-dealers competing for brokerage business. In addition, anincreasing number of specialized firms offer “discount” services to individualcustomers. These firms generally effect transactions for their customers on an “executiononly” basis without offering other services such as portfolio valuation,investment recommendations and

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research. A growing number of discount brokerage firms offer theirservices over the Internet, further decreasing offered commission rates andincreasing ease of use for customers. The continuation of such discounting andan increase in the number of new and existing firms offering discounts couldadversely affect our business. In addition, rapid growth in the mutual fundindustry is presenting potential customers of ours with an increasing number ofalternatives to traditional stock brokerage accounts.

In our investment banking activities, we compete with other brokeragefirms, venture capital firms, banks and all other sources of capital for small,growing companies. Since we generally manage offerings smaller than $45million, we do not typically compete with the investment banking departments oflarge, well-known national brokerage firms. Nevertheless, we occasionallymanage larger offerings. In addition, large national and regional investmentbanking firms occasionally manage offerings of a size that is competitive withus, typically for fees and compensation less than that charged by us. When themarket for initial public offerings is active, many small regional firms thatdo not typically engage in investment banking activities also begin to competewith us.

**Employees**

At March 1, 2007, we had 86 employees (of which 80 were full-time).Of these, 52 were executives and support staff and 34 were involved inbrokerage activities and compensated primarily on a commission basis. We alsohad independent contractor arrangements with 54 independent contractors, all ofwhom are compensated solely on a commission basis.

**ITEM 1A.RISK FACTORS**

In the course ofoperating a financial services business, we are exposed to a variety of risks.These risks include:

***Aspects of our business arevolatile and affected by factors beyond our control.***

Our business depends heavily on the conditions of thefinancial and securities markets, which in turn are affected by domestic andforeign economic conditions generally. These conditions, which can be impactedby a variety of factors such as business trends, actual and proposedlegislation, political considerations, inflation, interest rates, and thepopular perceptions of the health of the economy, are outside of our control,and therefore inject significant amounts of uncertainty and volatility into ourbusiness and financial results. Volatility is compounded by our focus onsmall-cap companies. In sum, factors outside of our control significantlyinfluence our business and financial results from year to year, and a downturnin the financial markets, securities markets or economic conditions generallylikely would materially and adversely affect our business.

***Our ability to attract and retaincustomers may be affected by our reputation.***

The performance of companies whose securities we haveunderwritten or otherwise sold to our customers may affect our reputationwith other potential syndicate and selling group members and institutional andother retail accounts and may also affect the amount of money in ourcustomers’ portfolios available for the kinds of investments that we offer.

***We are subject to extensiveregulation that could result in investigations, fines or other penalties.***

We are subject to a very high degree of regulation andare responsible for compliance with applicable regulations by all of ourpersonnel. A significant 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.

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***We face intense competition inour industry.***

Our business will suffer if we do not competesuccessfully. All aspects of our business and of the securities industry ingeneral are intensely competitive. We expect competition to continue andintensify in the future. We compete directly with national full-servicebroker-dealers, investment banking firms, and commercial banks and, to a lesserextent, with discount brokers and dealers and investment advisors. We alsocompete indirectly for investment assets with insurance companies, real estatefirms, hedge funds, and others. Many of our competitors have greater resourcesand offer more services than we do.**If we areunable to compete effectively in any aspect of our business, our results ofoperations could suffer.

***Our future success depends onretaining existing management and hiring and assimilating new key employees,and our inability to attract or retain key personnel would materially harm ourbusiness and results of operations.***

Our success depends on the continuing efforts andabilities of Chester Paulson, our Chairman. Our success also will depend, inpart, on our ability to attract and retain highly skilled employees, includingmanagement. The loss of services of any of our key personnel, the inability toattract, retain or assimilate key personnel in the future, or delays in hiringrequired personnel could materially harm our business.

***We are subject to an increasedrisk of legal proceedings, which may result in significant losses to us that wecannot recover. Claimants in these proceedings may be customers, employees, orregulatory agencies, among others, seeking damages for mistakes, errors,negligence or acts of fraud by our employees.***

Many aspects of our business subject us to substantialrisks of potential liability to customers and to regulatory enforcementproceedings by state and federal regulators. Participants in the securitiesindustry face an increasing amount of litigation and arbitration proceedings.Dissatisfied clients regularly make claims against securities firms and theirbrokers for negligence, fraud, unauthorized trading and suitability, amongother claims. These types of claims expose us to the risk of significant loss.Acts of fraud are difficult to detect and deter, and we cannot assure investorsthat our risk management procedures and controls will prevent losses fromfraudulent activity. In our role as underwriter and selling agent, we may beliable if there are material misstatements or omissions of material informationin prospectuses and other communications regarding underwritten offerings ofsecurities. While we do not expect the outcome of any existing claims againstus to have a material adverse impact on our business, financial condition, or resultsof operations, we cannot assure you that these types of proceedings will notmaterially and adversely affect us. In addition to the foregoing financialcosts and risks associated with potential liability, the amount of attorneys’fees incurred in connection with the defense of litigation could be substantialand might materially and adversely affect our results of operations.

***As a public company, we aresubject to complex legal and accounting requirements that require us to incursubstantial expense and expose us to risk of non-compliance.***

As a public company, we are subject to numerous legaland accounting requirements. The cost of compliance with many of theserequirements is substantial, not only in absolute terms but, more importantly,in relation to the overall scope of the operations of our company. Failure tocomply with these requirements can have numerous adverse consequencesincluding, but not limited to, our inability to file required periodic reportson a timely basis, loss of market confidence, delisting of our securitiesand/or governmental or private actions against us. We cannot assure you that wewill be able to comply with all of these requirements in the future or that thecost of such compliance will not prove to be a substantial competitivedisadvantage vis-à-vis our competitors.

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***Our directors controlapproximately 60 percent of our common stock and may have interests differingfrom those of other stockholders.***

At December 31, 2006, two of our directors controlled approximately 60% of our outstanding common stock, directly as stockholders and indirectly through control relationships with other stockholders. Chester Paulson, directly and indirectly, controlled approximately 50 percent of our outstanding common stock. Chester Paulson independently, or with the other director holding 10 percent of the outstanding common stock, would be able to significantly influence all matters requiring approval by our stockholders, including the election of directors and approval of significant corporate transactions including mergers, consolidations and the sale of substantially all of our assets. This control could have the effect of delaying or preventing a third party from acquiring or merging with us, which could hinder stockholders’ ability to receive a premium for their shares.

##### **ITEM1B.  UNRESOLVEDSTAFF COMMENTS**

None.

##### **ITEM2.   PROPERTIES**

We leaseapproximately 17,100 square feet of office space in Portland, Oregon under alease expiring May 2009. The base monthly rental rate on this lease is currently$27,846. The rental rate increases every 2-3 years, from $25,704 beginning inJune 2002 to $29,988 through the expiration of the lease. Our Salem officeleases 3,759 square feet of space under a lease that expires inOctober 2008 at a monthly rent of $3,974, with rent subject to increasesbased upon inflation. We also lease approximately 2,500 square feet of spacefor our office in Manhattan under a lease expiring in September 2010. Thebase monthly rental rate on this lease is currently $12,542. Our operatingleases are accounted for on a straight-line basis. We believe the existingleased space in Portland, Salem and Manhattan is adequate for our business forthe foreseeable future. The other branch offices lease space but, under theterms of the relationship between us and these offices, we are not responsiblefor these lease costs.

##### **ITEM3.   LEGAL PROCEEDINGS**

# In October 2002, we were named as a defendant ina 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 us, arising out oftwo follow-on offerings of Suprema Specialties, Inc.  We 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 in total.The stock was sold in the August 25, 2000 offering at a price of $8.00 pershare. Plaintiffs seek damages for the purchase of 399,151 shares of SupremaSpecialties, Inc. stock between August 25, 2000 and November 14,2001. The federal district court dismissed the claims against us. On appeal,the U.S. Third Circuit Court of Appeals affirmed the dismissal of theplaintiffs’ claims for violation of Rule 10b-5 but reversed as to the dismissalof claims under Section 11 of the Securities Act of 1933. Subsequently, theplaintiffs stipulated that they will not be asserting a claim for common lawfraud against us. The negligent misrepresentation claim remains in the case. Webelieve our liability under Section 11 is limited to the amount of shareseither underwritten or actually retained by us in the offering. Discovery hasbegun, but has not yet been completed. We believe we have meritorious defenses and intend to defend this mattervigorously.

# In December 2005, we received notice of possibleclaims being asserted against us by two individuals who invested in Wood RiverPartners LP (“Wood River”). The investors purchased their interests in WoodRiver directly from Wood River. One of the individuals was a customer of ours.Along with his brother, they have indicated that they paid $1,050,000 for theirinterests in Wood River. The SEC sued Wood River in October 2005, and areceiver currently runs Wood River. At this point, it is not known how much theindividuals might recover through the receivership. The individuals haveindicated that they believe they may have claims against us under the OregonSecurities Law for rescission, interest and attorney fees.

9

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# We believe we have meritorious defenses and, iflitigation is filed, we intend to defend this matter vigorously.

# In January 2007, Timothy Touloukian (“Touloukian”)filed an NASD arbitration against us seeking $5 million in compensatory damagesbased upon alleged claims of breach of contract, breach of implied contractualduties, indemnification, negligent misrepresentation and negligence. Touloukianwas employed as a registered representative by us from November 2002 throughDecember 2003.  Touloukian’s claimsagainst us arise out of a NASD investigation of Touloukian regarding thetrading of mutual funds. Touloukian subsequently entered into an AcceptanceWaiver and Consent (“AWC”) with the NASD, resulting in a fine and suspension.Touloukian asserts that the NASD’s investigation and subsequent AWC have causedTouloukian to lose employment opportunities and damage his earning capacity inthe future. In his arbitration Statement of Claim, Touloukian seeks to hold usresponsible for the alleged damages resulting from his diminished earningcapacity. We have just started to respond to the arbitration claims. Our Answerto the Statement of Claim is due June 14, 2007. We believe we have meritoriousdefenses and intend to defend this matter vigorously.

Anadverse outcome in certain of the matters described above could have a materialadverse effect on us. We also have been named in or threatened with certainother legal proceedings. We believe, based upon information received to dateand, where we believe it appropriate, discussions with legal counsel, thatresolution of additional pending or threatened litigation will have no materialadverse effect on our consolidated financial condition, results of operationsor our business.

##### **ITEM4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

None.

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#### **PART II**

**ITEM5.**              MARKETFOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDERMATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

***StockPrices and Dividends***

Our common stock trades on the Nasdaq Capital Marketunder the symbol “PLCC,” but it is not actively traded. The following tablesets forth the high and low closing sale prices of our common stock for eachquarter in the two years ended December 31, 2006.

| Year Ended December 31, 2005 | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------------------------------|------------|----------|------------|---------|------------|
| Quarter 1                                        |       | $        | 4.29       |    | $          | 3.83 |   |
| Quarter 2                                        |       | 6.84     |       | 3.95    |       |
| Quarter 3                                        |       | 9.17     |       | 5.38    |       |
| Quarter 4                                        |       | 6.14     |       | 5.17    |       |
|                                                  |            |          |            |         |            |  |  |

 

| Year Ended December 31, 2006 | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------------------------------|------------|----------|------------|---------|------------|
| Quarter 1                                        |       | $        | 8.61       |    | $          | 5.65 |   |
| Quarter 2                                        |       | 8.00     |       | 5.85    |       |
| Quarter 3                                        |       | 5.92     |       | 5.12    |       |
| Quarter 4                                        |       | 6.40     |       | 4.78    |       |
|                                                  |            |          |            |         |            |  |  |

 

As of March 16, 2007,there were 65 shareholders of record and approximately 382 beneficialshareholders.

On March 1, 2006, we announced that the Board ofDirectors approved a two-for-one stock split of our common stock to be effectedin the form of a stock dividend. The stock split was effected by issuingone additional share of common stock for each outstanding share of commonstock. The record date of the forward split was March 15, 2006 and waspaid on March 29, 2006.

On December 22, 2005, we announced theauthorization by our Board of Directors of a $0.15 special cash dividend toshareholders of record on January 17, 2006. The dividend payment date wasFebruary 10, 2006 and totaled $0.9 million.

On January 27, 2005, we announced theauthorization by our Board of Directors of a $0.075 special cash dividend toshareholders of record on February 10, 2005. The dividend was paid onMarch 3, 2005 and totaled $0.5 million.

Net capital requirements may limit our ability topay future dividends to our shareholders.

***IssuerPurchases of Equity Securities***

We repurchased thefollowing shares of our common stock during the fourth quarter of 2006:
| ** **                 | ** ** | **Total number  of shares  purchased** | ** ** | **Average  price paid  per share** | ** ** | **Total number of  shares purchased  as part of publicly  announced plan** | ** ** | **Maximum number  of shares that may  yet be purchased  under the plan** | ** ** |
|----------------------------|------------|--------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|
| October 1 to October 31    |       | —                                           |       | $                                            | —     |                                                                                                          | —     |                                                                                                             | —     |   |
| November 1 to November  30 |       | —                                           |       | —                                       |       | —                                                                                                        |       | —                                                                                                           |       |
| December 1 to December  31 |       | 3,121                                            |       | 5.14                                         |       | 284,263                                                                                                       |       | 315,737                                                                                                          |       |
| Total                      |       | 3,121                                            |       | 5.14                                         |       | 284,263                                                                                                       |       | 315,737                                                                                                          |       |
|                            |            |                                                  |            |                                              |            |                                                                                                               |            |                                                                                                                  |            |  |

 

The plan to repurchaseup to a total of 600,000 shares of our common stock was approved by our Boardof Directors in September 2001 and does not have an expiration date.  

***EquityCompensation Plan Information***

See Item 12. for EquityCompensation Plan Information.

11

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***PerformanceGraph***

Thefollowing chart compares the yearly stock market (U.S.) percentage change inthe cumulative total stockholder return on our common stock during the fivefiscal years ended December 31, 2006 with the cumulative total return on theRussell 2000 Index and the Nasdaq Financial Stocks Index. The comparisonassumes $100 was invested on December 31, 2001 in our common stock and in eachof the foregoing indices and assumes reinvestment of dividends.
| ** **        | ** ** | **Base**     | ** ** | **Indexed Returns** | ** ** |
|-------------------|------------|--------------|------------|--------------------------|------------|
| ** **        | ** ** | **Period**   | ** ** | **Year Ended**      | ** ** |
| **Company/Index** | ** ** | **12/31/01** | ** ** | **12/31/02**             | ** ** | **12/31/03** | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** |
| Paulson Capital   |       | $            | 100.00     |                     | $          | 68.71 |   | $ | 137.12 |   | $ | 124.23 |   | $ | 179.14 |   | $ | 159.51 |   |
| Nasdaq Financial  |       | 100.00       |       | 102.98                   |       | 139.28 |   | 162.60 |   | 166.37 |   | 191.34 |   |
| Russell 2000      |       | 100.00       |       | 79.52                    |       | 117.09 |   | 138.55 |   | 144.86 |   | 171.47 |   |
|                   |            |              |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

12

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##### **ITEM6.   SELECTED CONSOLIDATED FINANCIAL DATA**

The consolidatedstatement of operations and balance sheet data set forth below have beenderived from our consolidated financial statements. The selected consolidatedfinancial data set forth below should be read in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andwith the consolidated financial statements and notes thereto included elsewherein this Form 10-K.

**SELECTED CONSOLIDATED FINANCIALINFORMATION**

**(inthousands, except per share data)**
| ** **                                        | ** ** | **For the year ended December 31,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                        | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Consolidated Statement of  Operations Data**    |       |                                                         |       |   |   |   |   |   |   |   |   |
| Revenues                                          |       | $                                                            | 13,464     |   | $ | 39,736 |   | $ | 32,915 |   | $ | 28,059 |   | $ | 1,021 |   |
| Commissions and  salaries                         |       | 14,985                                                       |       | 18,701 |   | 19,263 |   | 16,959 |   | 8,196 |   |
| Other expenses                                    |       | 5,785                                                        |       | 7,655 |   | 7,756 |   | 4,956 |   | 3,735 |   |
| Total expenses                                    |       | 20,770                                                       |       | 26,356 |   | 27,019 |   | 21,915 |   | 11,931 |   |
| Income (loss) before  income taxes                |       | (7,306                                                       | )          | 13,380 |   | 5,896 |   | 6,144 |   | (10,910 | ) |
| Net income (loss)                                 |       | (4,862                                                       | )          | 8,492 |   | 3,489 |   | 4,040 |   | (7,011 | ) |
| Basic net income (loss)  per share(1)             |       | (0.79                                                        | )          | 1.36 |   | 0.55 |   | 0.65 |   | (1.12 | ) |
| Shares used in basic  per share calculations(1)   |       | 6,179                                                        |       | 6,263 |   | 6,366 |   | 6,234 |   | 6,282 |   |
| Diluted net income  (loss) per share(1)           |       | (0.79                                                        | )          | 1.35 |   | 0.55 |   | 0.65 |   | (1.12 | ) |
| Shares used in diluted  per share calculations(1) |       | 6,179                                                        |       | 6,295 |   | 6,374 |   | 6,263 |   | 6,282 |   |
| Dividends declared per  share(1)                  |       | —                                                       |       | 0.225 |   | — |   | 0.05 |   | — |   |
|                                                   |            |                                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                          | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Consolidated Balance Sheet Data** | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total assets                        |       | $                     | 38,464     |   | $ | 54,995 |   | $ | 44,325 |   | $ | 36,070 |   | $ | 29,112 |   |
| Shareholders’ equity           |       | 34,776                |       | 39,765 |   | 33,570 |   | 29,595 |   | 25,843 |   |
|                                     |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

**(1)**          The2005, 2004, 2003 and 2002 amounts have been adjusted for the March 2006two-for-one stock split.

**ITEM7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

**OVERVIEW**

Substantially allof our business consists of the securities brokerage and corporate financeactivities of our wholly-owned subsidiary, Paulson Investment Company, Inc.,which has operations in four principal categories, all of them in the financialservices industry. These categories are:

·                  securities brokerage activities forwhich we earn commission revenues;

·                  corporate finance revenues consistingprincipally of underwriting discounts and underwriter warrants;

·                  securities trading from which werecord profit or loss, depending on trading results; and

·                  investment income resulting fromearnings on, and increases or decreases in the value of, our investmentportfolio.

Because we operatein the financial services industry, our revenues and earnings are substantiallyaffected by general conditions in financial markets. In our securitiesbrokerage business, the amount of our revenues depends on levels of marketactivity requiring the services we provide. Our corporate finance activity,which consists of acting as the managing underwriter of initial and follow-onpublic offerings, private investments in a public equity (“PIPEs”) and privateplacements for smaller companies, 

13

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is similarlyaffected by the strength of the market for new equity offerings, which hashistorically experienced substantial cyclical fluctuation. Although we attemptto match operating costs with activity levels, many of our expenses are eitherfixed or difficult to change on short notice. Accordingly, fluctuations inbrokerage and corporate finance revenues tend to result in sharperfluctuations, on a percentage basis, in net income or loss.

Our investmentincome or loss and, to a lesser extent, our trading income or loss is affectedby changes in market valuation of securities generally and, in particular, bychanges in valuation of the equity securities of microcap companies in whichour investments and trading activities tend to be concentrated. Equity marketsin general, and microcap equity markets in particular, have always experiencedsignificant volatility and this volatility has, in recent years, been extreme.The result of this volatility on the value of our investment portfolio andsecurities held in connection with our trading and investment activitiesinclude large quarterly fluctuations in income or loss from these operationsand substantial increases or decreases in our net worth as our securitiesholdings are marked to market.

A substantialportion of our corporate finance business consists of acting as managingunderwriter of initial and follow-on public offerings for microcap and smallcapcompanies. As a part of our compensation for these activities, wetypically receive warrants exercisable to purchase securities similar to thosethat we offer and sell to the public. The warrants generally have a five-yearexpiration date and vest immediately. The warrants are generally subject to arestricted period of six months to one-year in which we cannot exercise thewarrants. The exercise price is typically 120% of the price at which thesecurities are initially sold to the public. Accordingly, unless there is atleast a 20% increase in the price of these securities at some time more thansix months and less than five years after the offering, the warrants willremain “under water” and will ultimately expire unexercised. We also receivewarrants in connection with our PIPEs, which have varying terms and conditions.

**CRITICALACCOUNTING POLICIES AND USE OF ESTIMATES**

The following discussion and analysis of our financial condition andresults of operations is based upon our consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States. In preparing our consolidated financialstatements, we must make estimates and judgments that affect the reportedamounts of assets and liabilities, revenues and expenses, and relateddisclosure of contingent assets and liabilities at the date of our financialstatements. Actual results are likely to differ from these estimates underdifferent assumptions and conditions.

As a result of the factors described below, our revenues and earnings aresubject to substantial fluctuation from period to period based on a variety ofcircumstances, many of which are beyond our control. An increase in financialmarket activity generally, and/or an increase in equity valuations generally,will normally result in increases in our revenues, earnings and net worth asour activity levels and the value of our investment portfolio increase.Conversely, a general market retrenchment will typically lead to decreasedrevenues, earnings and net worth as a result of both decreased activity and theneed to adjust high investment portfolio values to lower levels. Accordingly,results for any historical period are not necessarily indicative of similarresults for any future period.

The critical accounting policies described below include those thatreflect significant judgments and uncertainties, which potentially couldproduce materially different results under different assumptions andconditions. We believe our critical accounting policies are limited to thosedescribed below.

***Revenue Recognition***

Securities transactions and related revenue are recorded on a trade datebasis. 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 is recognized on the date the warrants arereceived based on the estimated fair value of the securities received asestimated using the Black-Scholes option-pricing model taking into account theexercise price, remaining life of the warrant, the current price of theunderlying 

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stock and its expected volatility, expected dividends on the stock andthe risk-free interest rate for the remaining term of the warrant.

***Value of Underwriter Warrants***

We are required to estimate the value of all derivative securities thatwe hold at the date of any financial statements and to include that value, andchanges in such value, in those financial statements. Accordingly, theaggregate estimated value of our underwriter warrants is recorded as an asseton our balance sheet. When a new warrant is received, its estimated value isincluded in corporate finance revenue on the date on which it is earned.Subsequently, any change in estimated value is recorded as investment income orloss. When a warrant is exercised, the book value is adjusted to reflect thevalue of the securities purchased, net of the exercise price, and theadjustment amount is recorded as income or loss for the relevant period. If awarrant expires unexercised, the book value is adjusted to zero and thedecrease is recorded as a loss in the relevant period.

We estimate thevalue of our underwriter warrants using the Black-Scholes Option Pricing Model.The Black-Scholes model requires us to use five inputs including: price, riskfree rate, exercise price, time remaining on the warrant and price volatility.After stock price, the most influential factor in this model is pricevolatility, which we calculate for each company’s warrants based on eachcompany’s own historical stock closing prices as well as an index of historicalprices for comparable companies. When we initially receive a new underwriterwarrant from an initial public offering, its calculated volatility factor isentirely based on the volatility of an index of comparable companies, sincethere 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 ourwarrants in a way that will realize the value that we attribute to them in ourfinancial statements based on this model. At December 31, 2006, the value ofunderwriter warrants was $5.7 million, which is included as a separate lineitem on our consolidated balance sheet.

***Fair Value of Investments***

In addition to our underwriter warrants, we hold othersecurities, some of which have very limited liquidity and some of which do nothave a readily ascertainable market value. According to accounting principlesgenerally accepted in the United States of America (“U.S. GAAP”), we arerequired to carry these securities at estimated fair value. The fair value ofnot readily marketable securities is estimated by management using availableinformation including the following: quoted market prices of similar securities(i.e., unrestricted shares of the same company); price of recent known tradesof the same or similar securities; the cost of the security, if recentlypurchased, adjusted for changes in the financial condition of the issuer; allother information available from review of available documents related to theissuer or discussions with management of the issuer. Changes in the value ofthese securities are reflected currently in our results of operations as acomponent of investment income. Our estimates regarding the fair value ofsecurities that are not readily marketable are significant estimates and theseestimates could change in the near term. At December 31, 2006, the value ofinvestments which do not have a readily ascertainable market value was $2.4million and was included as a component of investment securities on ourconsolidated balance sheet.

***Stock-Based Compensation***

Effective January1, 2006, we adopted Statement of Financial Accounting Standards (“SFAS”) No.123R, “Share-Based Payment,” which establishes accounting for equityinstruments exchanged for employee services. Under the provisions of SFAS No.123R, stock-based compensation cost for equity classified awards is measured atthe grant date, based on the fair value of the award, and is recognized as anexpense over the employee’s requisite service period (generally the vestingperiod of the equity award). Prior to January 1, 2006, we accounted forshare-based compensation to employees in accordance with Accounting PrinciplesBoard Option No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) andrelated interpretations. We also followed the disclosure requirements of SFASNo. 123, “Accounting for Stock-Based Compensation.”

We elected toadopt the modified prospective transition method as provided by SFAS No. 123Rand, accordingly, financial statement amounts for the prior periods presentedin this Form 10-K have not been 

15

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restated toreflect the fair value method of expensing stock-based compensation. Under thismethod, the provisions of SFAS No. 123R apply to all awards granted or modifiedafter the date of adoption. We did not have any unrecognized expense related toawards outstanding at the date of adoption since they were all fully vested.For future awards, expense calculated pursuant to SFAS No. 123R will berecognized as compensation expense using the Black-Scholes option pricing modelover the requisite service period. The cumulative effect of the change inaccounting principle from APB 25 to SFAS No. 123R was not material.

***Legal Reserves***

We record reserves related to legal proceedingsresulting from lawsuits and arbitrations, which arise from our businessactivities. Some of these lawsuits and arbitrations claim substantial amounts,including punitive damage claims. Management has determined that it is likelythat ultimate resolution in favor of the claimant will result in losses to uson certain of these claims. We have, after consultation with outside legalcounsel and consideration of facts currently known by management, recordedestimated losses to the extent we believe certain claims are probable of lossand the amount of the loss can be reasonably estimated. Factors considered bymanagement in estimating our liability are the loss and damages sought by theclaimant/plaintiff, the merits of the claim, the amount of loss in the client’saccount, the possibility of wrongdoing on the part of our employee, the totalcost of defending the litigation, the likelihood of a successful defenseagainst the claim, and the potential for fines and penalties from regulatoryagencies. Results of litigation and arbitration are inherently uncertain, andmanagement’s assessment of risk associated therewith is subject to change asthe proceedings evolve. After discussion with legal counsel, management, basedon its understanding of the facts, accrues what they consider appropriate toreserve against probable loss for certain claims, which is included in theConsolidated Balance Sheets under the caption “Accounts payable and accruedexpenses.”

##### **RESULTSOF OPERATIONS**

Our revenues andoperating results are influenced by fluctuations in the equity markets as wellas general economic and market conditions, particularly conditions in theover-the-counter market, where our investment and trading positions and theunderlying stock for the underwriter warrants are heavily concentrated.Significant fluctuations can occur in our revenues and operating results fromone period to another. Our results of operations depend upon many factors, suchas the number of companies that are seeking financing, the quality andfinancial condition of those companies, market conditions in general, theperformance of our previous underwritings and interest in certain industries byinvestors. As a result, revenues and income derived from these activities mayvary significantly from year to year. Our revenues include the following:

·                  Commissions, which represent amountsearned from our retail securities brokerage activities;

·                  Corporate finance revenues, which area function of total proceeds from offerings done during the period,compensation per offering and the fair value of underwriter warrants received;

·                  Investment income (loss), whichincludes (i) the unrealized appreciation and depreciation of securitiesheld based on quoted market prices, (ii) the unrealized appreciation anddepreciation of securities held that are not readily marketable, based upon ourestimate of their fair value, (iii) realized gains and losses on the saleof securities with quoted market prices and securities that are not readilymarketable, and (iv) the unrealized appreciation and depreciation ofunderwriter warrants held; and

·                  Trading income (loss), which is thegain or loss from trading positions before commissions paid to therepresentatives in the trading department.

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The following tables set forth the changes in our operating results in2006 compared to 2005 and in 2005 compared to 2004 (dollars in thousands):
| ** **                              | ** ** | **Year Ended December 31,** | ** ** | **Increase** | ** ** | **% Increase** | ** ** |
|-----------------------------------------|------------|--------------------------------------------|------------|--------------|------------|---------------------|------------|
| ** **                              | ** ** | **2006**                                   | ** ** | **2005**     | ** ** | **(Decrease)**      | ** ** | **(Decrease)** | ** ** |
| Revenues:                               | ** ** | ** **                                 | ** ** | ** **   | ** ** | ** **          | ** ** | ** ** | ** ** |
| Commissions                             |       | $                                          | 15,725     |         | $          | 16,518              |       | $ | (793 | ) | (4.8 | )% |
| Corporate  finance                      |       | 5,036                                      |       | 3,259        |       | 1,777               |       | 54.5 |   |
| Investment  income (loss)               |       | (6,345                                     | )          | 15,840       |       | (22,185             | )          | (140.1 | ) |
| Trading income  (loss)                  |       | (1,338                                     | )          | 2,926        |       | (4,264              | )          | (145.7 | ) |
| Interest and  dividends                 |       | 78                                         |       | 51           |       | 27                  |       | 52.9 |   |
| Other                                   |       | 308                                        |       | 1,142        |       | (834                | )          | (73.0 | ) |
| Total revenues                          |       | 13,464                                     |       | 39,736       |       | (26,272             | )          | (66.1 | ) |
| Expenses:                               |       |                                       |       |         |       |                |       |   |   |
| Commissions and  salaries               |       | 14,985                                     |       | 18,701       |       | (3,716              | )          | (19.9 | ) |
| Underwriting  expenses                  |       | 458                                        |       | 227          |       | 231                 |       | 101.8 |   |
| Rent, telephone  and quotation services |       | 1,205                                      |       | 1,281        |       | (76                 | )          | (5.9 | ) |
| Professional  fees                      |       | 784                                        |       | 1,457        |       | (673                | )          | (46.2 | ) |
| Bad debt expense                        |       | 5                                          |       | 300          |       | (295                | )          | (98.3 | ) |
| Travel and  entertainment               |       | 285                                        |       | 229          |       | 56                  |       | 24.5 |   |
| Advertising and  promotion expense      |       | 188                                        |       | 273          |       | (85                 | )          | (31.1 | ) |
| Settlement  expense                     |       | 396                                        |       | 871          |       | (475                | )          | (54.5 | ) |
| Depreciation and  amortization          |       | 103                                        |       | 91           |       | 12                  |       | 13.2 |   |
| Other                                   |       | 2,361                                      |       | 2,926        |       | (565                | )          | (19.3 | ) |
| Total expenses                          |       | 20,770                                     |       | 26,356       |       | (5,586              | )          | (21.2 | ) |
| Income (loss) before income taxes       |       | $                                          | (7,306     | )            | $          | 13,380              |       | $ | (20,686 | ) | (154.6 | )% |

 
| ** **                              | ** ** | **Year Ended December 31,** | ** ** | **Increase** | ** ** | **% Increase** | ** ** |
|-----------------------------------------|------------|--------------------------------------------|------------|--------------|------------|---------------------|------------|
| ** **                              | ** ** | **2005**                                   | ** ** | **2004**     | ** ** | **(Decrease)**      | ** ** | **(Decrease)** | ** ** |
| Revenues:                               | ** ** | ** **                                 | ** ** | ** **   | ** ** | ** **          | ** ** | ** ** | ** ** |
| Commissions                             |       | $                                          | 16,518     |         | $          | 18,304              |       | $ | (1,786 | ) | (9.8 | )% |
| Corporate  finance                      |       | 3,259                                      |       | 11,213       |       | (7,954              | )          | (70.9 | ) |
| Investment  income                      |       | 15,840                                     |       | 2,018        |       | 13,822              |       | 684.9 |   |
| Trading income                          |       | 2,926                                      |       | 1,351        |       | 1,575               |       | 116.6 |   |
| Interest and  dividends                 |       | 51                                         |       | 28           |       | 23                  |       | 82.1 |   |
| Other                                   |       | 1,142                                      |       | 1            |       | 1,141               |       | 1,141.0 |   |
| Total revenues                          |       | 39,736                                     |       | 32,915       |       | 6,821               |       | 20.7 |   |
| Expenses:                               |       |                                       |       |         |       |                |       |   |   |
| Commissions and  salaries               |       | 18,701                                     |       | 19,263       |       | (562                | )          | (2.9 | ) |
| Underwriting  expenses                  |       | 227                                        |       | 877          |       | (650                | )          | (74.1 | ) |
| Rent, telephone  and quotation services |       | 1,281                                      |       | 1,211        |       | 70                  |       | 5.8 |   |
| Professional  fees                      |       | 1,457                                      |       | 1,030        |       | 427                 |       | 41.5 |   |
| Bad debt expense                        |       | 300                                        |       | 684          |       | (384                | )          | 56.1 |   |
| Travel and  entertainment               |       | 229                                        |       | 368          |       | (139                | )          | (37.8 | ) |
| Advertising and  promotion expense      |       | 273                                        |       | 303          |       | (30                 | )          | (9.9 | ) |
| Settlement  expense                     |       | 871                                        |       | 1,275        |       | (404                | )          | (31.7 | ) |
| Depreciation and  amortization          |       | 91                                         |       | 97           |       | (6                  | )          | (6.2 | ) |
| Other                                   |       | 2,926                                      |       | 1,911        |       | 1,015               |       | 53.1 |   |
| Total expenses                          |       | 26,356                                     |       | 27,019       |       | (663                | )          | (2.5 | ) |
| Income before income taxes              |       | $                                          | 13,380     |         | $          | 5,896               |       | $ | 7,484 |   | 126.9 | % |

 

Commissionsdecreased 4.8% in 2006 compared to 2005 and decreased 9.8% in 2005 compared to2004. The total number of trades, including mutual fund trades, executed by ourbrokers were 100,307 and 105,755 in 2006 and 2005, respectively. We had 88brokers at December 31, 2006 compared to 94 at December 31, 2005 and 97 atDecember 31, 2004.

The decrease inthe number of brokers in 2006 compared to 2005 was due to our strategy ofhaving fewer, but higher producing brokers. As lower producing brokers haveleft, we have not replaced the positions. The decrease in the number of tradesin 2006 compared to 2005 was due to poor market conditions in 2006 as comparedto 2005.

The decrease incommissions in 2005 compared to 2004 was primarily a result of lacklustermarket performance. The Russell 2000 Index increased a modest 3.3% during 2005and the Nasdaq Composite Index increased 1.4% during the same period. Inaddition, the lack of commissions associated with 

17

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corporate financetransactions also contributed to the decrease in 2005 compared to 2004. Salescommissions are also directly related to the number of brokers.

Corporatefinance income of $5.0 million in 2006 included underwriting compensationearned from the following:

·                  aninitial public offering in which we raised $16.5 million for Ascent Solar Technologies, Inc., aswell as the Black-Scholes value of the underwriter warrants received inconnection with that offering;

·                  an initial public offering in whichwe raised $19.5 million for American Mold Guard, Inc., as well as theBlack-Scholes value of the underwriter warrants received in connection withthat offering;

·                  asecondary public offering in which we raised $6.9 million for ICOP Digital,Inc.; and

·                  acouple of private transactions, including one PIPE.

Corporate financeincome of $3.3 million in 2005 included underwriting compensation earned fromthe following:

·                  aninitial public offering in which we raised $10.7 million for ICOP Digital, Inc., as well as theBlack-Scholes value of the underwriter warrants received inconnection with that offering;

·                  asmall initial public offering in which we raised $3.0 million for Nuvim, Inc.,as well as the Black-Scholes value of the underwriter warrants received inconnection with that offering; and

·                  othersmall private transactions.

Corporate financeincome of $11.2 million in 2004 included underwriting compensation earned fromsix corporate finance transactions with gross proceeds totaling $83.9 million.Market conditions for public offerings were more favorable in 2004 than in2005.

Investment incomedecreased $22.2 million to a loss in 2006 compared to income in 2005 andincreased $13.8 million in 2005 compared to 2004.  Investment income (loss) was comprised of thefollowing (in thousands):
| ** **                                                                                                                                                                          | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                                                                          | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net unrealized gain  (loss) related to underwriter warrants                                                                                                                         |       | $                                          | (2,505     | ) | $ | (4,613 | ) | $ | (2,127 | ) |
| Net unrealized  appreciation (depreciation) of securities held based on quoted market prices  or, for securities that are not readily marketable, our estimate of their  fair value |       | (9,521                                     | )          | 243 |   | 4,545 |   |
| Net realized gains on the  sale of securities with quoted market prices and securities that are not  readily marketable                                                             |       | 5,681                                      |       | 20,210 |   | (400 | ) |
|                                                                                                                                                                                |       | $                                          | (6,345     | ) | $ | 15,840 |   | $ | 2,018 |   |

 

We exercised oneunderwriter warrant in 2006 compared to eight in 2005 and none 2004. Generally,when we exercise a warrant to obtain the underlying common stock, the commonstock is subsequently sold in the near term and the related gain is reflectedas a component of investment income.

Investment income(loss) is volatile from period to period due to the fact that it is driven bythe market value or fair value of the securities and underwriter warrants held.In addition, the performance of the securities in which we have a concentrationcan significantly affect our investment income from period to period.

Trading incomedecreased $4.3 million to a loss in 2006 compared to income in 2005 andincreased $1.6 million in 2005 compared to 2004.

The decrease in2006 compared to 2005 was primarily due to lower prices for several of thesecurities we hold in our trading inventories. Certain securities were sold ata loss as we believed the decline in value was other-than-temporary. Inaddition, during 2006, we experienced the untimely death of our Vice Presidentof Trading, which, in the short-term, affected the trading department’sprofitability. This position has since been refilled.

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The increase in2005 compared to 2004 was the result of exceptional performance from a coupleof the securities in which we make a market. Our focus is on very smallcapitalization issues, especially those tied to our corporate finance clients.Trading income can be volatile from period to period based on the fact that itis driven by the market value of the securities in which we make a market.

Other income in 2006 included $280,000 in insurancerecovery related to legal and settlement expense from prior years. Other incomein 2005 included a $1.1 million settlement recovery related to a lawsuit filedagainst our former insurance carrier to recover settlement amounts paid in2004.

***Expenses***

Total expensesdecreased $5.6 million in 2006 compared to 2005 and $0.7 million in 2005compared to 2004 as detailed below.

Commissions andsalaries decreased $3.7 million in 2006 compared to 2005, primarily due to thefact that we do not pay trading and investment commissions on trading andinvestment losses. Salary expense decreased approximately $0.5 million in 2006compared to 2005, due to the fact that we paid a bonus totaling $0.5 million in2005 compared to no bonus in 2006. Commissions and salaries decreased $0.6million in 2005 compared to 2004, primarily due an approximately $1.4 milliondecrease in compensation expense associated with the value of underwriterwarrants given to employees involved in the related transactions during 2005 ascompared to 2004 and a modest decrease in salary and related expense as vacantpositions were not refilled during 2005. These decreases were partially offsetby a $0.4 million increase in commissions as a result of higher commissionspaid based on the performance of our investments and a $0.6 million increase inaccrued bonuses.

Professional feesdecreased $0.7 million in 2006 compared to 2005, primarily due to significantdecreases in legal activity as a result of the settlement of certain casesduring the 2005 period. Professional fees increased $0.4 million in 2005compared to 2004, primarily due to the level of legal activity and settlementsin 2005 compared to 2004.

Bad debt expenseis recorded for specific amounts when they are determined by management to beuncollectible. For the years ended December 31, 2006, 2005 and 2004, receivablesof $5,300, $300,000 and $685,000, respectively, were determined bymanagement to be uncollectible and written off to bad debt expense.

Settlement expenseincludes amounts to settle legal matters. Insurance recoveries related tosettled legal matters are included as a component of other income.

Other expenseincludes items such as dues and subscriptions, charitable contributions andother office expenses. Other expense decreased $0.6 million in 2006 compared to2005 and increased $1.0 million in 2005 compared to 2004. The decrease in 2006compared to 2005 was primarily due to a decrease in charitable contributions.The increase in 2005 compared to 2004 was primarily due to a $0.8 millionincrease in charitable contributions.

**LIQUIDITYAND CAPITAL RESOURCES**

Our primary sources of liquidity include our cash andcash equivalents and receivables from our clearing organization, offset bypayables to our clearing organization.

In addition, our sources of liquidity include ourtrading positions, investment positions, borrowings on those positions andprofits realized upon the sale of the securities underlying underwriterwarrants exercised. The liquidity of the market for many of our securitiesholdings, however, varies with trends in the stock market. Since many of thesecurities we hold are thinly traded, and we are, in many cases, a primarymarket maker in the issues held, any significant sales of our positions couldadversely affect the liquidity of the issues held. In general, falling pricesin OTC securities (which make up most of our 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.

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We believe our liquidity is sufficient to meet ourneeds for both the short and long-term horizon. Our liquidity could benegatively affected by protracted unfavorable market conditions.

As a securities broker-dealer, we are required by SECregulations to meet certain liquidity and capital standards. We believe we werein compliance with these standards at December 31, 2006.

Following the lapse of restrictions upon issuance,capital available from the sale of the underlying securities of underwriterwarrants exercised can fluctuate significantly from period to period as thevalue of the underlying securities fluctuates with overall market andindividual company financial condition or performance. There is no publicmarket for the underwriter warrants. The securities receivable upon exercise ofthe underwriter warrants cannot be resold unless the issuer has registeredthese securities with the SEC and with the states in which the securities willbe sold unless exemptions are available. Any delay or other problem in theregistration of these securities would have an adverse impact upon our abilityto obtain funds from the exercise of the underwriter warrants and the resale ofthe underlying securities. At December 31, 2006, we owned 14 underwriterwarrants from 13 issuers, all but two of which were exercisable. One of thewarrants had an exercise price below the December 31, 2006 market price of thesecurities receivable upon exercise. The intrinsic value of this warrant was$0.7 million at December 31, 2006. There is little or no direct relationship betweenthe intrinsic value of our underwriter warrants at the end of any given periodand the fair value calculated using the Black-Scholes option pricing model. Theprices of the securities underlying the underwriter warrants are very volatile,and substantial fluctuations in our estimate of their value can be expected inthe future. In 2006, we exercised one underwriter warrant, which resulted innet proceeds of $0.7 million upon the sale of the related securities.

Cash provided by operating activities in 2006 totaled$1.3 million, primarily due to our net loss of $4.9 million and net non-cashincome items of $3.0 million being offset by changes in our operating assetsand liabilities as discussed in more detail below.

Our net receivable from our clearing organizationdecreased $1.7 million to $7.7 million at December 31, 2006 from $9.4 millionat December 31, 2005, primarily due to the results of the activity in ourtrading and investment accounts, as well as the timing of general corporateexpenditures.

Notes and other receivables, which primarily representemployee and independent broker advances and expenses in excess of commissionearnings, commissions receivable and amounts receivable from corporate financeclients, increased $0.6 million to $1.7 million at December 31, 2006 from $1.1million at December 31, 2005, primarily due to additional advances to corporatefinance clients, offset by payments received.

Trading and investment securities combined decreased$12.1 million to $21.9 million at December 31, 2006 compared to $34.0 millionat December 31, 2005. Changes in our trading and investment securities aredependent on the purchase and sale of securities during the period, as well aschanges in their fair market values during the period.

Underwriter warrants decreased $0.6 million to $5.7million at December 31, 2006 compared to $6.3 million at December 31,2005.  A roll-forward of the value of thewarrants was as follows (in thousands):

| **Balance, December 31, 2005**                                 |   | $      | 6,275  |   |
|----------------------------------------------------------------|--------|--------|--------|--------|
| Fair value of  warrants received, net of employee compensation |   | 1,880  |   |
| Net unrealized  loss on value of warrants                      |   | (621   | )      |
| Value of  warrants exercised and expired                       |   | (1,884 | )      |
| **Balance, December 31, 2006**                                 |   | $      | 5,650  |   |

 

Accounts payable and accrued liabilities decreased$0.6 million to $0.6 million at December 31, 2006 from $1.2 million at December31, 2005, primarily due to the payment of $0.5 million of settlements during2006, which were accrued as of December 31, 2005 and related to fiscal 2005settlements.

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Compensation, employee benefits and payroll taxesdecreased $1.1 million to $1.0 million at December 31, 2006 from $2.1 millionat December 31, 2005, primarily due to the payment of commissions that wereaccrued at December 31, 2005. Accruals for commissions were lower in 2006 dueto weaker results from operations.

Dividends payable of $0.9million at December 31, 2005 represented a special dividend, which wasauthorized by the Board of Directors, of $0.15 per share to shareholders ofrecord on January 17, 2006. The dividend payment was made on February 10, 2006.

Income taxes payable decreased $2.6 million to areceivable of $0.3 million at December 31, 2006 from a payable of $2.3 millionat December 31, 2005, primarily due to $1.8 million of income tax payments madeduring 2006, partially offset by the accrual for fiscal 2006 taxes payablerelated to realized gains on investments.

Deferred revenue of $0.5 million at December 31, 2006related to amounts received from DCS based on the execution of a five-year agreement,which is being amortized at the rate of $8,333 per month through September2011.

Deferred income taxes payable decreased $3.7 millionto $1.7 million at December 31, 2006 from $5.4 million at December 31, 2005,primarily due to a $10.1 million net unrealized loss on securities andunderwriter warrants during 2006.

Capital expenditures of $117,000 in 2006 wereprimarily for leasehold improvements at our Salem, Oregon office. At December31, 2006, we did not have any material commitments for capital expenditures.

In September 2001,our Board of Directors approved a stock repurchase program pursuant to which weare authorized to repurchase up to 600,000 shares of our common stock. ThroughDecember 31, 2006, we had repurchased a total of 284,263 shares and 315,737shares remained available for repurchase. This repurchase program does not havean expiration date.

**CONTRACTUAL PAYMENT OBLIGATIONS**

A summary of our contractual commitments andobligations, which consisted solely of operating leases, as of December 31,2006 was as follows (in thousands):
| ** **                      | ** ** | **Payments Due By Period** | ** ** |
|---------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligation** | ** ** | **Total**                                 | ** ** | **2007** | ** ** | **2008 and 2009** | ** ** | **2010 and 2011** | ** ** | **2012 and beyond** | ** ** |
| Operating leases                |       | $                                         | 1,561      |   | $ | 562 |   | $ | 882 |   | $ | 117 |   | $ | — |   |
|                                 |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**OFF-BALANCESHEET ARRANGEMENTS**

We do not have anyoff-balance sheet arrangements that have or are reasonably likely to have amaterial current or future effect on our financial condition, changes infinancial condition, revenues or expenses, results of operations, liquidity,capital expenditures or capital resources.

**NEWACCOUNTING PRONOUNCEMENTS**

See Note T. ofNotes to Consolidated Financial Statements included under Part II, Item 8. ofthis Annual Report on Form 10-K.

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**ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKETRISK**

Market risk is therisk of loss to us resulting primarily from changes in equity prices and, to asignificantly lesser extent, interest rates and foreign currency rates. We haveexposure to market risk through our market-making and trading operations. Inconnection with these activities, we maintain inventories in order to ensureavailability of securities and to facilitate client transactions as well astrading for our own equity investment account. We were a market-maker for 49equity securities from 39 different issuers at December 31, 2006. We didnot make a market for any tax exempt or taxable debt obligations at December31, 2006.  All of our securities as ofDecember 31, 2006 were marketable equity and other securities which werereported at fair value on our consolidated balance sheet.

Changes in thevalue of our trading inventories and our investment accounts result primarilyfrom fluctuations in equity prices as well as changes in interest rates andgeneral market and economic conditions. Our primary method of controlling riskin our trading inventories and investment accounts is through daily monitoringand use of position limits. Our trading inventories consist primarily of Nasdaqequity securities. As of December 31, 2006, the equity trading inventorylimit was $2 million and the fixed income limit was $500,000. Our tradingactivities were within these limits at December 31, 2006. 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. The trading departmentalso monitors inventory levels and trading results on a monthly basis, withparticular focus on position concentration, liquidity and volatility. Thetrading department prepares summary results every month to record each positionat fair market value, which can require adjustments for lack of liquidity, highconcentration or other reasons.

**Value-at-Risk**

In addition to themanagement procedures and processes we use to monitor and limit risk, we alsoapply an industry standard statistical model known as Value-at-Risk (“VaR”) tothe public securities in our portfolios to estimate the potential losses thatcould arise from changes in market conditions. VaR seeks to predict the risk ofloss based on historical and/or market-implied price and volatility patterns byestimating the probability of the value of a financial instrument rising aboveor falling below a specified amount. Our non-public investments are notincluded in the VaR analysis because the model requires historical tradingprices as one of its inputs. In addition, our restricted investments are notincluded because they are not freely traded. Our calculations are based on amethodology that uses a one-day interval and a 95% confidence level, whichmeans that there was a 5% chance that our securities portfolios could suffer aloss equivalent to the VaR on any one trading day during the past year.

The followingtables sets forth the VaR for our overall portfolio of public equities as ofDecember 31, 2006 and 2005 (dollars in thousands):
| ** **                              | ** ** | **December 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|-----------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                              | ** ** | **Investment**                  | ** ** | **Trading**                     | ** ** | **Investment** | ** ** | **Trading** | ** ** |
| VaR                                     |       | $                               | 587        |                            | $          | 90 |   | $ | 2,368 |   | $ | 81 |   |
| Portfolio value (net)                   |       | $                               | 15,975     |                            | $          | 2,308 |   | $ | 28,216 |   | $ | 1,517 |   |
| VaR  as a percentage of portfolio value |       | 3.7                             | %          | 3.9                             | %          | 8.4 | % | 5.4 | % |

 

The VaR onequities is based on a calculation of the volatility of each equity, thecurrent position value of each equity, and a correlation matrix of all equitiesincluded in the portfolio. Both the volatility and correlation in the formulaare based on historical closing prices for the past year. Other inputs includeselecting the confidence level (usually 95-99%) and time horizon (usually 1day) for the measurement. We have had to make adjustments to the formula forcertain equities which are very illiquid and do not trade every day; in theseinstances, we have used the closing prices from the previous day as the pricefor the days when there were no trades.

VaR calculationshave inherent limitations, particularly in the case of low volume, small capequities, which constitute a large percentage of our portfolio value. Thehistorical data on which the VaR is based may not 

22

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accurately predictfuture market risk and the calculation has no input that reflects the liquidityof the equities in the portfolio, so the VaR for a one-day horizon does notcapture the market risk of positions that could not be liquidated, or thatcould only be liquidated at a very low price in any one-day period. There canbe no assurance that the actual losses would not exceed the VaR for any one-dayperiod.

**EquityPrice Risk**

We are exposed tosignificant equity price risk as a result of our customer transactions andmarket-making activity in equity securities and our concentrations in a limitednumber of equities, many of which are related to our investment bankingprojects. Our broker-dealer activities are client-driven, with the objective ofmeeting our clients’ needs while earning a trading profit to compensate for therisk associated with carrying inventories in equities, many of which arevolatile, and some of which are illiquid, micro and small cap securities. Weattempt to reduce the risk of loss inherent in this activity by monitoringthese securities positions continuously throughout each day. The averageaggregate inventory held in our proprietary investment and trading accountsduring the quarter ended December 31, 2006 was approximately $22.9million. Prices of the marketable equities held in these accounts are readilyavailable and monitored on a continuous basis.

**InterestRate Risk**

We have littledirect exposure to interest rate risk. A relatively minor amount of our tradinginventory consists of debt obligations, and any of these positions we mighthave on occasion are in our trading inventory for only a very short time.However, to the extent that interest rate fluctuations affect general marketconditions and cause investors to shift away from or more heavily into equityinvesting, interest rates can have an effect on the value of our equitypositions.

**ForeignCurrency Risk**

We do not deal insecurities denominated in foreign currencies and only trade foreign equitiesupon receipt of orders from customers, so we do not have any significantexposure to foreign currency risk in our trading inventory or investmentaccounts.

**ITEM 8.  CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARYDATA**

The financialstatements and notes thereto required by this item begin on page F-1 of thisdocument, as listed in Item 15 of Part IV. Unaudited quarterly financial data**for each of the eight quarters in the two-year period endedDecember 31, 2006 is as follows (unaudited):
| **In thousands, except per share data** | ** ** | **1st Quarter** | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th Quarter** | ** ** |
|------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|
| **2005**                                                         |       |                 |       |                 |       |                 |       |                 |       |
| Revenue                                                          |       | $                    | 10,134     |                 | $          | 17,996               |       | $                    | 8,105      |   | $ | 3,501 |   |
| Earnings (loss)  before income taxes                             |       | 4,280                |       | 10,121               |       | 1,203                |       | (2,224               | )          |
| Net income  (loss)                                               |       | 2,568                |       | 6,072                |       | 738                  |       | (886                 | )          |
| Basic net income  (loss) per share(1)                            |       | 0.41                 |       | 0.97                 |       | 0.12                 |       | (0.14                | )          |
| Diluted net  income (loss) per share(1)                          |       | 0.41                 |       | 0.96                 |       | 0.12                 |       | (0.14                | )          |
|                                                             |       |                 |       |                 |       |                 |       |                 |       |
| **2006**                                                         |       |                 |       |                 |       |                 |       |                 |       |
| Revenue (loss)                                                   |       | $                    | (958       | )                    | $          | 7,090                |       | $                    | (181       | ) | $ | 7,513 |   |
| Earnings (loss)  before income taxes                             |       | (5,670               | )          | 1,064                |       | (4,823               | )          | 2,123                |       |
| Net income  (loss)                                               |       | (3,527               | )          | 721                  |       | (3,216               | )          | 1,160                |       |
| Basic net income  (loss) per share                               |       | (0.57                | )          | 0.12                 |       | (0.52                | )          | 0.18                 |       |
| Diluted net income  (loss) per share                             |       | (0.57                | )          | 0.12                 |       | (0.52                | )          | 0.18                 |       |

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(1)             Theamounts have been adjusted for the March 2006 two-for-one stock split.

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**ITEM 9.CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND   FINANCIALDISCLOSURE**

None.

**ITEM 9A.CONTROLS AND PROCEDURES**

***Disclosure Controls and Procedures***

Our management hasevaluated, under the supervision and with the participation of our Presidentand our Chief Financial Officer, the effectiveness of our disclosure controlsand procedures as of the end of the period covered by this report as defined inRule 13a-15(e) or Rule 15d-15(e) under the Securities Exchange Act of 1934 (the“Exchange Act”). Based on that evaluation, our President and our ChiefFinancial Officer have concluded that, as of the end of the period covered bythis report, our disclosure controls and procedures are effective in ensuringthat information required to be disclosed in our Exchange Act reports is (1)recorded, processed, summarized and reported in a timely manner, and (2)accumulated and communicated to our management, including our President and ourChief Financial Officer, as appropriate, to allow timely decisions regardingrequired disclosure.

***Changesin Internal Controls***

There has been nochange in our internal control over financial reporting that occurred duringour last fiscal quarter that has materially affected, or is reasonably likelyto materially affect, our internal control over financial reporting.

**ITEM 9B.OTHER INFORMATION**

None.

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**PART III**

**ITEM 10.  DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE**

The information required by this item is incorporatedby reference to the information under the captions “Election of Directors,” “ExecutiveOfficers,” “Meetings and Committees of the Board of Directors,” “AuditCommittee Financial Expert” and “Section 16(a) Beneficial OwnershipReporting Compliance” in our Proxy Statement for our 2007 Annual Meeting ofShareholders.

We have adopted a code of ethics that applies to ourofficers (including our principal executive, financial and accountingofficers), directors, employees and consultants. The text of our code ofethics is posted at our Internet website, located atwww.paulsoninvestment.com. Furthermore, if disclosure of an amendment orwaiver to our code of ethics is required by Item 5.05 of Form 8-K, we intend tosatisfy such disclosure either by timely filing a Form 8-K or by posting suchinformation at the same Internet website.

##### **ITEM11.  EXECUTIVE COMPENSATION**

The information required by this item is incorporatedby reference to the information under the captions “Director Compensation,” “CompensationCommittee Report,” “Compensation Discussion and Analysis,” “CompensationCommittee Interlocks and Insider Participation” and “Executive Compensation” inour Proxy Statement for our 2007 Annual Meeting of Shareholders.

##### **ITEM12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS ANDMANAGEMENT AND RELATED STOCKHOLDER MATTERS**

**Equity Compensation Plan Information**

Thefollowing table summarizes equity securities authorized for issuance pursuantto compensation plans as of December 31, 2006.
| **Plan Category**                                   | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and rights (a)** | ** ** | **Weighted average  exercise price of  outstanding options,  warrants and rights (b)** | ** ** | **Number of securities  remaining available for future  issuance under equity  compensation plans  (excluding securities  reflected in column (a)) (c)** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity compensation

plans approved by

shareholders(1)  |       | 161,000                                                                                                                                                   |       | $                                                                                                                         | 3.93       |                                                                                                                                                                                                                      | 532,000    |   |
|                                                     |       |                                                                                                                                                      |       |                                                                                                                      |       |                                                                                                                                                                                                                      |       |
| Equity compensation

plans not approved by

shareholders |       | —                                                                                                                                                    |       | —                                                                                                                    |       | —                                                                                                                                                                                                                    |       |
| Total                                                    |       | 161,000                                                                                                                                                   |       | $                                                                                                                         | 3.93       |                                                                                                                                                                                                                      | 532,000    |   |

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(1) Includes our 1999 Stock Option Plan.

Additional information required by this item isincorporated by reference to the information under the caption “Stock Ownershipof Principal Owners and Management” in our Proxy Statement for our 2007 AnnualMeeting of Shareholders.

##### **ITEM13. CERTAIN RELATIONSHIPS ANDRELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE**

Information required by this item is incorporated byreference to the information under the caption “Director Independence” in our Proxy Statement for our 2007 AnnualMeeting of Shareholders.

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**ITEM 14.  PRINCIPAL ACCOUNTANTFEES AND SERVICES**

The information required by this item is incorporatedby reference to the information under the caption “Independent RegisteredPublic Accountants” in our Proxy Statement for our 2007 Annual Meeting ofShareholders.

##### **PART IV**

##### **ITEM15.  EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**

**Financial Statements and Schedules**

TheConsolidated Financial Statements and Schedules, together with the reportsthereon of McGladrey & Pullen, LLP and Grant Thornton LLP, are included onthe pages indicated below:
|                                                                                                             | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|------------|
| Report of  McGladrey & Pullen, LLP, Independent Registered Public Accounting Firm                       |       |       |
|                                                                                                        |       |       |
| Report of Grant  Thornton LLP, Independent Registered Public Accounting Firm                                |       |       |
|                                                                                                        |       |       |
| Consolidated Balance  Sheets as of December 31, 2006 and 2005                                               |       |       |
|                                                                                                        |       |       |
| Consolidated  Statements of Operations for the years ended December 31, 2006, 2005 and 2004                 |       |       |
|                                                                                                        |       |       |
| Consolidated  Statements of Shareholders’ Equity for the years ended December 31, 2006,  2005 and 2004 |       |       |
|                                                                                                        |       |       |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2006, 2005 and 2004                 |       |       |
|                                                                                                        |       |       |
| Notes to  Consolidated Financial Statements                                                                 |       |       |
|                                                                                                        |       |       |
| Supplemental  Schedule of Warrants Owned                                                                    |       |       |
|                                                                                                        |       |       |
| Schedule II — Valuation and  Qualifying Accounts                                                       |       |       |

 

**Exhibits**

The followingexhibits are filed herewith and this list is intended to constitute the exhibitindex. Exhibit numbers marked with an asterisk (*) represent management orcompensatory arrangements.
| Number | ** ** | **Description**                                                                                                                                                                                                    | ** ** |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| 3.1    |       | Articles of Incorporation (incorporated by reference  to Exhibit 3.1 to our Registration Statement on Form 10 filed with the  Securities and Exchange Commission on December 18, 1989 (“Form 10”)). |       |
|   |       |                                                                                                                                                                                                               |       |
| 3.2    |       | Bylaws (incorporated by reference to Exhibit 3.2 to  Form 10).                                                                                                                                                     |       |
|   |       |                                                                                                                                                                                                               |       |
| 10.1   |       | 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 Form 10-QSB for the quarter ended June 30, 1997).              |       |
|   |       |                                                                                                                                                                                                               |       |
| 10.2   |       | 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).                                                        |       |
|   |       |                                                                                                                                                                                                               |       |
| 10.3*  |       | 1999 Stock Option Plan (incorporated by reference to  Exhibit 10.5 to Form 10-KSB for the year ended December 31, 1999).                                                                                      |       |
|   |       |                                                                                                                                                                                                               |       |
| 10.4   |       | Fully Disclosed Clearing Agreement between RBC Dain  Correspondent Services and Paulson Investment Company, Inc. (incorporated by  reference to Exhibit 10.1 to Form 10-Q for the quarter ended June 30, 2006).    |       |
|   |       |                                                                                                                                                                                                               |       |
| 16     |       | Letter re change in certifying accountant  (incorporated by reference to Exhibit 16 to Form 8-K dated November 17, 2005  and filed with the Securities and Exchange Commission on November 23, 2005).              |       |

 

26

----

 
| Number | ** ** | **Description**                                                                                                                                                |
|--------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 21.1   |       | Subsidiaries of Paulson Capital Corp. Incorporated  by reference to Exhibit 21.1 to Form 10-K for the year ended December 31,  2005.                           |
|   |       |                                                                                                                                                           |
| 23.1   |       | Consent of McGladrey & Pullen, LLP.                                                                                                                        |
|   |       |                                                                                                                                                           |
| 23.2   |       | Consent of Grant Thornton LLP.                                                                                                                                 |
|   |       |                                                                                                                                                           |
| 31.1   |       | Certification of Principal Executive Officer  pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act  of 1934.                            |
|   |       |                                                                                                                                                           |
| 31.2   |       | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934.                                 |
|   |       |                                                                                                                                                           |
| 32.1   |       | Certification of Principal Executive Officer  pursuant to Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act  of 1934 and 18 U.S.C. Section 1350. |
|   |       |                                                                                                                                                           |
| 32.2   |       | Certification of Chief Financial Officer pursuant to  Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 and  18 U.S.C. Section 1350.     |

 

27

----

**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,Paulson Capital Corp. has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized on March 30, 2007:
|        | PAULSON CAPITAL CORP.                 |
|--------|---------------------------------------|
|   | (Registrant)                          |
|   |                                  |
|   |                                  |
|   | By                                    | /s/ CHESTER L. F. PAULSON |
|   | Chester L. F. Paulson                 |
|   | President and Chief Executive Officer |
|   | (Principal Executive Officer)         |

 

Pursuant to therequest of the Securities Exchange Act of 1934, this report has been signedbelow on behalf of the Registrant and in the capacities indicated on March 30,2007.
| SIGNATURE                 | ** ** | **TITLE**                         |
|---------------------------|------------|-----------------------------------|
| ** **                | ** ** | ** **                        |
| /s/ CHESTER L. F. PAULSON |       | Chairman of the Board, President  |
| Chester L. F. Paulson     |       | and Chief Executive Officer       |
|                      |       | (Principal Executive Officer)     |
|                      |       |                              |
| /s/ KAREN L. JOHANNES     |       | Chief Financial Officer           |
| Karen L. Johannes         |       | (Principal Financial Officer)     |
|                      |       |                              |
| /s/ JACQUELINE M. PAULSON |       | Secretary, Treasurer and Director |
| Jacqueline M. Paulson     |       |                              |
|                      |       |                              |
| /s/ STEVE KLEEMANN        |       | Director                          |
| Steve Kleemann            |       |                              |
|                      |       |                              |
| /s/ SHANNON PRATT         |       | Director                          |
| Shannon Pratt             |       |                              |
|                      |       |                              |
| /s/ PAUL SHOEN            |       | Director                          |
| Paul Shoen                |       |                              |

 

28

----

**Reportof Independent Registered Public Accounting Firm**

To the Shareholders

Paulson Capital Corp.

Portland, Oregon

We have audited the consolidated balance sheets ofPaulson Capital Corp. and Subsidiary as of December 31, 2006 and 2005, and therelated consolidated statements of operations, shareholders’ equity and cashflows for the years then ended. Our audits also included the financialstatement schedule II of Paulson Capital Corp. These financial statements andfinancial statement schedule are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In our opinion,the consolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Paulson Capital Corp. andSubsidiary as of December 31, 2006 and 2005, and the results of theiroperations and their cash flows for the years then ended in conformity withU.S. generally accepted accounting principles. Also, in our opinion, therelated financial statement schedule, when considered in relation to the basicconsolidated financial statements taken as a whole, presents fairly in allmaterial respects the information set forth therein.

As discussed inNote A of the consolidated financial statements, effective January 1, 2006, theCompany adopted the provisions of Statement of Financial Accounting StandardsNo. 123 (revised 2004), “Share-Based Payment.”
| /s/ McGladrey & Pullen, LLP |
|---------------------------------|
| Chicago, Illinois               |
| March 30, 2007                  |

#  

F-1

----

# **Report ofIndependent Registered Public Accounting Firm**

Board of Directors and Shareholders

PaulsonCapital Corp.

We have auditedthe consolidated statements of operations, shareholders’ equity and cash flowsof Paulson Capital Corp. (an Oregoncorporation) and Subsidiary for the year ended December 31, 2004.  These financial statements are the responsibilityof the Company’s management.  Ourresponsibility is to express an opinion on these financial statements based onour audit.

We conducted ouraudit in accordance with the standards of the Public Company AccountingOversight Board (United States).  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement.  The Company is notrequired to have, nor were we engaged to perform an audit of its internalcontrol over financial reporting.  Ouraudit included consideration of internal control over financial reporting as abasis for designing audit procedures that are appropriate in the circumstances,but not for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit also includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation.  We believe that our auditprovides a reasonable basis for our opinion.

In our opinion,the financial statements referred to above present fairly, in all materialrespects, Paulson Capital Corp.’s consolidated results of operations and itsconsolidated cash flows for the year ended December 31, 2004 in conformity withaccounting principles generally accepted in the United States of America.

We have alsoaudited Schedule II for the year ended December 31, 2004.  In our opinion, this schedule presentsfairly, in all material respects, the information required to be set forththerein.
| /s/ GRANT THORNTON LLP |
|------------------------|
|                   |
| Portland, Oregon       |
| February 24, 2005      |

 

F-2

----

**Paulson Capital Corp. and SubsidiaryConsolidated Balance Sheets**
| ** **                                                                                                         | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                         | ** ** | **2006**              | ** ** | **2005** | ** ** |
|                                                                                                               |       |                  |       |   |   |
| **Assets**                                                                                                         | ** ** | ** **            | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                         |       | $                     | 219,341    |   | $ | 129,549 |   |
| Receivable from  clearing organization                                                                             |       | 7,748,968             |       | 12,608,491 |   |
| Notes and other  receivables                                                                                       |       | 1,651,002             |       | 1,081,528 |   |
| Income taxes  receivable                                                                                           |       | 304,695               |       | — |   |
| Trading  securities, at market value                                                                               |       | 2,363,824             |       | 1,558,564 |   |
| Investment  securities, at market or estimated fair value                                                          |       | 19,542,643            |       | 32,401,808 |   |
| Underwriter  warrants, at estimated fair value                                                                     |       | 5,650,000             |       | 6,275,000 |   |
| Prepaid and  deferred expenses                                                                                     |       | 711,827               |       | 674,328 |   |
| Furniture and  equipment, at cost, net of accumulated depreciation and amortization of  $747,759 and $962,943      |       | 271,766               |       | 265,791 |   |
| Total Assets                                                                                                       |       | $                     | 38,464,066 |   | $ | 54,995,059 |   |
|                                                                                                               |       |                  |       |   |   |
| **Liabilities and Shareholders’  Equity**                                                                     | ** ** | ** **            | ** ** | ** ** | ** ** |
| Accounts payable  and accrued liabilities                                                                          |       | $                     | 570,823    |   | $ | 1,243,866 |   |
| Payable to  clearing organization                                                                                  |       | —                |       | 3,182,347 |   |
| Compensation,  employee benefits and payroll taxes                                                                 |       | 954,981               |       | 2,105,259 |   |
| Securities sold,  not yet purchased, at market value                                                               |       | 17,244                |       | 23,033 |   |
| Dividends  payable                                                                                                 |       | —                |       | 929,317 |   |
| Income taxes  payable                                                                                              |       | —                |       | 2,338,218 |   |
| Deferred revenue                                                                                                   |       | 475,000               |       | — |   |
| Deferred income  taxes                                                                                             |       | 1,670,000             |       | 5,408,000 |   |
| Total  Liabilities                                                                                                 |       | 3,688,048             |       | 15,230,040 |   |
|                                                                                                               |       |                  |       |   |   |
| **Commitments and Contingencies**                                                                                  |       | —                |       | — |   |
|                                                                                                               |       |                  |       |   |   |
| **Shareholders’ Equity**                                                                                      | ** ** |                  |       |   | ** ** |
| Preferred stock,  no par value; 500,000 shares authorized; none issued                                             |       | —                |       | — |   |
| Common stock, no  par value; 20,000,000 shares authorized; shares issued and outstanding: 6,179,011  and 6,195,448 |       | 1,920,293             |       | 1,817,100 |   |
| Retained  earnings                                                                                                 |       | 32,855,725            |       | 37,947,919 |   |
| Total  Shareholders’ Equity                                                                                   |       | 34,776,018            |       | 39,765,019 |   |
|                                                                                                               |       |                  |       |   |   |
| Total  Liabilities and Shareholders’ Equity                                                                   |       | $                     | 38,464,066 |   | $ | 54,995,059 |   |

 

See accompanyingNotes to Consolidated Financial Statements.

F-3

----

**Paulson Capital Corp. and SubsidiaryConsolidated Statements of Operations**
| ** **                              | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                              | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                              | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Revenues**                            | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Commissions                             |       | $                                                            | 15,724,699 |   | $ | 16,517,709 |   | $ | 18,304,103 |   |
| Corporate finance                       |       | 5,035,929                                                    |       | 3,259,092 |   | 11,213,195 |   |
| Investment income (loss)                |       | (6,345,099                                                   | )          | 15,839,768 |   | 2,017,840 |   |
| Trading income (loss)                   |       | (1,337,726                                                   | )          | 2,926,440 |   | 1,350,816 |   |
| Interest and dividends                  |       | 77,845                                                       |       | 51,062 |   | 27,686 |   |
| Other                                   |       | 307,936                                                      |       | 1,142,277 |   | 1,635 |   |
|                                    |       | 13,463,584                                                   |       | 39,736,348 |   | 32,915,275 |   |
|                                    |       |                                                         |       |   |   |   |   |
| **Expenses**                            | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Commissions and salaries                |       | 14,984,974                                                   |       | 18,701,260 |   | 19,263,085 |   |
| Underwriting expenses                   |       | 457,974                                                      |       | 227,412 |   | 876,981 |   |
| Rent, telephone and quotation services  |       | 1,205,000                                                    |       | 1,281,293 |   | 1,211,383 |   |
| Professional fees                       |       | 784,150                                                      |       | 1,456,649 |   | 1,029,800 |   |
| Bad debt expense                        |       | 5,280                                                        |       | 299,745 |   | 684,429 |   |
| Travel and entertainment                |       | 284,661                                                      |       | 229,055 |   | 368,044 |   |
| Advertising and promotion expense       |       | 187,417                                                      |       | 273,430 |   | 302,486 |   |
| Settlement expense                      |       | 396,282                                                      |       | 870,535 |   | 1,274,540 |   |
| Depreciation and amortization           |       | 103,129                                                      |       | 90,814 |   | 96,914 |   |
| Other                                   |       | 2,361,144                                                    |       | 2,926,095 |   | 1,911,147 |   |
|                                    |       | 20,770,011                                                   |       | 26,356,288 |   | 27,018,809 |   |
|                                    |       |                                                         |       |   |   |   |   |
| Income (loss)  before income taxes      |       | (7,306,427                                                   | )          | 13,380,060 |   | 5,896,466 |   |
|                                    |       |                                                         |       |   |   |   |   |
| Income tax  expense (benefit):          |       |                                                         |       |   |   |   |   |
| Current                                 |       | 1,294,000                                                    |       | 4,916,000 |   | (115,734 | ) |
| Deferred                                |       | (3,738,000                                                   | )          | (28,000 | ) | 2,522,600 |   |
|                                    |       | (2,444,000                                                   | )          | 4,888,000 |   | 2,406,866 |   |
|                                    |       |                                                         |       |   |   |   |   |
| Net income  (loss)                      |       | $                                                            | (4,862,427 | ) | $ | 8,492,060 |   | $ | 3,489,600 |   |
|                                    |       |                                                         |       |   |   |   |   |
| Basic net income  (loss) per share      |       | $                                                            | (0.79      | ) | $ | 1.36 |   | $ | 0.55 |   |
|                                    |       |                                                         |       |   |   |   |   |
| Diluted net income  (loss) per share    |       | $                                                            | (0.79      | ) | $ | 1.35 |   | $ | 0.55 |   |
|                                    |       |                                                         |       |   |   |   |   |
| Shares used in  per share calculations: |       |                                                         |       |   |   |   |   |
| Basic                                   |       | 6,179,858                                                    |       | 6,262,886 |   | 6,366,388 |   |
| Diluted                                 |       | 6,179,858                                                    |       | 6,295,264 |   | 6,373,778 |   |
|                                    |       |                                                         |       |   |   |   |   |

 

See accompanyingNotes to Consolidated Financial Statements.

F-4

----

**Paulson Capital Corp. and SubsidiaryConsolidated Statements of Shareholders’ EquityFor the Three Years In the Period Ended December 31, 2006**
| ** **                                      | ** ** | ** **            | ** ** | ** **   | ** ** | ** **       | ** ** | **Total**  | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|--------------|------------|------------------|------------|------------|------------|
| ** **                                      | ** ** | **Common Stock** | ** ** | **Retained** | ** ** | **Shareholders** | ** ** |
| ** **                                      | ** ** | **Shares**            | ** ** | **Amount**   | ** ** | **Earnings**     | ** ** | **Equity** | ** ** |
| **Balance  at December 31, 2003**               |       | 6,249,622             |       | $            | 1,173,045  |             | $          | 28,421,863 |       | $ | 29,594,908 |   |
|                                            |       |                  |       |         |       |             |       |       |       |
| Stock options  exercised and income tax benefit |       |                  |       |         |       |             |       |       |       |
| from stock option exercises                     |       | 157,000               |       | 577,518      |       | —           |       | 577,518    |       |
| Redemption of  common stock                     |       | (26,022               | )          | (4,739       | )          | (86,825          | )          | (91,564    | )          |
| Net income                                      |       |                  |       |         |       | 3,489,600        |       | 3,489,600  |       |
| **Balance  at December 31, 2004**               |       | 6,380,600             |       | 1,745,824    |       | 31,824,638       |       | 33,570,462 |       |
|                                            |       |                  |       |         |       |             |       |       |       |
| Stock options  exercised and income tax benefit |       |                  |       |         |       |             |       |       |       |
| from stock option exercises                     |       | 27,000                |       | 111,284      |       | —           |       | 111,284    |       |
| Redemption of  common stock                     |       | (212,152              | )          | (40,008      | )          | (962,898         | )          | (1,002,906 | )          |
| Dividends to  common shareholders               |       | —                |       | —       |       | (1,405,881       | )          | (1,405,881 | )          |
| Net income                                      |       | —                |       | —       |       | 8,492,060        |       | 8,492,060  |       |
| **Balance  at December 31, 2005**               |       | 6,195,448             |       | 1,817,100    |       | 37,947,919       |       | 39,765,019 |       |
|                                            |       |                  |       |         |       |             |       |       |       |
| Stock options  exercised and income tax benefit |       |                  |       |         |       |             |       |       |       |
| from stock option exercises                     |       | 21,000                |       | 110,680      |       | —           |       | 110,680    |       |
| Redemption of  common stock                     |       | (37,437               | )          | (7,487       | )          | (229,767         | )          | (237,254   | )          |
| Net loss                                        |       |                  |       |         |       | (4,862,427       | )          | (4,862,427 | )          |
| **Balance  at December 31, 2006**               |       | 6,179,011             |       | $            | 1,920,293  |             | $          | 32,855,725 |       | $ | 34,776,018 |   |

 

See accompanyingNotes to Consolidated Financial Statements.

F-5

----

**Paulson Capital Corp. and SubsidiaryConsolidated Statements of Cash Flows**
| ** **                                                                                      | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                            |       |                                                         |       |   |   |   |   |
| **Cash  flows from operating activities:**                                                      | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss)                                                                               |       | $                                                            | (4,862,427 | ) | $ | 8,492,060 |   | $ | 3,489,600 |   |
| Adjustments to reconcile net income (loss) to net  cash flows provided by operating activities: |       |                                                         |       |   |   |   |   |
| Receipt of underwriter warrants                                                                 |       | (2,771,248                                                   | )          | (2,123,014 | ) | (7,288,588 | ) |
| Unrealized (appreciation) depreciation/expiration of  underwriter warrants                      |       | 2,504,358                                                    |       | 4,612,960 |   | 2,127,636 |   |
| Non-cash compensation associated with underwriter  warrants                                     |       | 891,890                                                      |       | 651,054 |   | 2,055,952 |   |
| Depreciation and amortization                                                                   |       | 103,129                                                      |       | 90,815 |   | 96,914 |   |
| (Gain) loss on asset disposition                                                                |       | 7,655                                                        |       | (2,000 | ) | — |   |
| Deferred revenue                                                                                |       | 475,000                                                      |       | — |   | — |   |
| Deferred income taxes (net of income tax benefit of  stock option exercise)                     |       | (3,709,100                                                   | )          | (19,526 | ) | 2,522,600 |   |
| Change in assets and liabilities:                                                               |       |                                                         |       |   |   |   |   |
| Notes and other receivables                                                                     |       | (569,474                                                     | )          | (638,594 | ) | 223,540 |   |
| Receivables from/payable to clearing organization                                               |       | 1,677,176                                                    |       | (2,591,750 | ) | (168,098 | ) |
| Trading and investment securities                                                               |       | 12,053,905                                                   |       | (10,156,401 | ) | (4,740,868 | ) |
| Prepaid and deferred expenses                                                                   |       | (37,499                                                      | )          | 909,018 |   | (164,809 | ) |
| Accounts payable, accrued liabilities and  compensation payables                                |       | (1,823,321                                                   | )          | (897,787 | ) | 1,725,101 |   |
| Securities sold, not yet purchased                                                              |       | (5,789                                                       | )          | (27,111 | ) | 31,093 |   |
| Income tax receivable                                                                           |       | (304,695                                                     | )          |   |   |   |   |
| Income taxes payable                                                                            |       | (2,338,218                                                   | )          | 3,189,218 |   | 233,900 |   |
| Net cash provided by operating activities                                                       |       | 1,291,342                                                    |       | 1,488,942 |   | 143,973 |   |
|                                                                                            |       |                                                         |       |   |   |   |   |
| **Cash  flows from investing activities:**                                                      | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Sale of vehicle                                                                                 |       | —                                                       |       | 2,000 |   | — |   |
| Additions to furniture and equipment                                                            |       | (116,759                                                     | )          | (117,578 | ) | (127,615 | ) |
| Net cash used in investing activities                                                           |       | (116,759                                                     | )          | (115,578 | ) | (127,615 | ) |
|                                                                                            |       |                                                         |       |   |   |   |   |
| **Cash  flows from financing activities:**                                                      | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Proceeds from stock option exercise                                                             |       | 81,780                                                       |       | 102,810 |   | 365,218 |   |
| Dividends paid to common shareholders                                                           |       | (929,317                                                     | )          | (476,564 | ) | (312,481 | ) |
| Payments to retire common stock                                                                 |       | (237,254                                                     | )          | (1,002,906 | ) | (91,564 | ) |
| Net cash used in financing activities                                                           |       | (1,084,791                                                   | )          | (1,376,660 | ) | (38,827 | ) |
|                                                                                            |       |                                                         |       |   |   |   |   |
| Increase  (decrease) in cash and cash equivalents                                               |       | 89,792                                                       |       | (3,296 | ) | (22,469 | ) |
|                                                                                            |       |                                                         |       |   |   |   |   |
| **Cash  and cash equivalents:**                                                                 | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Beginning of year                                                                               |       | 129,549                                                      |       | 132,845 |   | 155,314 |   |
|                                                                                            |       |                                                         |       |   |   |   |   |
| End of year                                                                                     |       | $                                                            | 219,341    |   | $ | 129,549 |   | $ | 132,845 |   |
|                                                                                            |       |                                                         |       |   |   |   |   |
| **Supplemental  cash flow information:**                                                        | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid during  the period for income taxes                                                   |       | $                                                            | 4,277,163  |   | $ | 2,710,114 |   | $ | 664,330 |   |
| Cash paid during  the period for interest                                                       |       | —                                                       |       | 421 |   | 10,093 |   |
| ** **                                                                                      | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Supplemental  non-cash information:**                                                         | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Dividends  declared                                                                             |       | $                                                            | —     |   | $ | 1,405,881 |   | $ | — |   |
| Deferred tax  benefit from stock option exercise                                                |       | 28,900                                                       |       | 8,474 |   | 212,300 |   |

 

See accompanying Notes toConsolidated Financial Statements.

 

 

 

 

 

 

 

 

F-6

----

**PAULSONCAPITAL CORP. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**NOTE A — ORGANIZATION AND SUMMARY OF SIGNIFICANTACCOUNTING POLICIES**

**Organization**

Paulson Capital Corp. is a holding company whosewholly-owned subsidiary, Paulson Investment Company, Inc., is a registeredbroker-dealer in securities under the Securities Exchange Act of 1934, asamended, and is a member of the National Association of SecuritiesDealers. We provide broker-dealer services in securities on both an agencyand a principal basis to our customers who are introduced to RBC Dain Correspondent Services (“DCS”), ourclearing organization, on a fully-disclosed basis. We also act as leador participating selling group member for securities offerings. We conductbusiness throughout the United States.

We operate under the provision of paragraph (k)(2)(ii)of rule 15c3-3 of the Securities and Exchange Act of 1934 and, accordingly, areexempt from the remaining provisions of that rule. Essentially, therequirements of paragraph (k)(2)(ii) provide that we clear all transactions onbehalf of our customers on a fully disclosed basis with a clearingbroker-dealer and promptly transmit all customer funds and securities to theclearing broker-dealer. The clearing broker-dealer carries all of the accountsof the customers and maintains and preserves all related books and records asare customarily kept by a clearing broker-dealer.

**Summary of Significant Accounting Policies**

***Principles of Consolidation***

The accompanying consolidated financial statementsinclude the accounts of Paulson Capital Corp. and its wholly-owned subsidiary,Paulson Investment Company, Inc.  All significant intercompany balancesand transactions have been eliminated in consolidation.

***StockSplit***

On March 1, 2006, we announced that our Board ofDirectors approved a two-for-one stock split of our common stock to be effectedin the form of a stock dividend. The stock split was effected on March 29, 2006by issuing one additional share of common stock for each share of common stockoutstanding on March 15, 2006. All prior share and per share amounts have beenadjusted for this stock split.

***Use of Estimates***

The preparation of financial statements in conformitywith U.S. generally accepted accounting principles requires management to makeestimates 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. Our estimates regarding the fair value ofunderwriter warrants, not readily marketable securities and legal reserves aresignificant estimates and these estimates could change in the near term. Actual results could differ from those estimates.

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***Revenue Recognition***

Our revenuesinclude the following:

·                  Commissions, which represent amountsearned from our retail securities brokerage activities and are recorded on atrade-date basis;

·                  Corporate finance revenues, which area function of total proceeds from offerings done during the period,compensation per offering and the fair value of underwriter warrants receivedare recorded at the time the underwriting is complete;

·                  Investment income (loss), whichincludes (i) the unrealized appreciation and depreciation of securitiesheld based on quoted market prices, (ii) the unrealized appreciation anddepreciation of securities held that are not readily marketable, based upon ourestimate of their fair value, (iii) realized gains and losses on the saleof securities with quoted market prices and securities that are not readilymarketable, and (iv) the unrealized appreciation and depreciation ofunderwriter warrants held, all of which are recorded in the relevant period;and

·                  Trading income (loss), which is thegain or loss from trading positions before commissions paid to therepresentatives in the trading department and is recorded on a trade-datebasis.

***Value of Underwriter Warrants***

We are required to estimate the value of all derivative securities thatwe hold at the date of any financial statements and to include that value, andchanges in such value, in those financial statements. Accordingly, theaggregate estimated value of our underwriter warrants is recorded as an asseton our balance sheet. When a new warrant is earned, its estimated value isincluded in corporate finance revenue on that date. Subsequently, any change inestimated value is recorded currently as investment income or loss. When awarrant is exercised, the book value is adjusted to reflect the value of thesecurities purchased, net of the exercise price, and the adjustment amount isrecorded as income or loss for the relevant period. If a warrant expiresunexercised, the book value is adjusted to zero and the decrease is recorded asa loss in the relevant period.

We estimate thevalue of our underwriter warrants using the Black-Scholes Option Pricing Model.The Black-Scholes model requires us to use five inputs including: price, riskfree interest rate, exercise price, time remaining on the warrant and pricevolatility. After stock price, the most influential factor in this model isprice volatility, which we calculate for each company’s warrants based on eachcompany’s own historical stock closing prices as well as an index of historicalprices for comparable companies. When we initially receive a new underwriterwarrant from an initial public offering, its calculated volatility factor isentirely based on the volatility of an index of comparable companies, sincethere 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 ourwarrants in a way that will realize the value that we attribute to them in ourfinancial statements based on this model. At December 31, 2006, the value ofunderwriter warrants was $5.7 million, which is included as a separate lineitem on our consolidated balance sheet.

***Fair Value of MarketableSecurities***

Marketable securities are valued at fair market value,and securities not readily marketable are valued at fair value as determined bymanagement. The fair value of not readily marketable securities is estimated bymanagement using available information including the following: quoted marketprices of similar securities (i.e., unrestricted shares of the same company);price of recent known trades of the same or similar securities; the cost of thesecurity, if recently purchased, adjusted for changes in the financialcondition of the issuer; all other information available from review ofavailable documents related to the issuer or discussions with management of theissuer. Changes in the value of these securities are reflected currently in ourresults of operations as a component of investment income.

F-8

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***Cash and Cash Equivalents***

Cash and cash equivalents include cash on hand, cashon deposit with banks and highly liquid investments with a maturity of threemonths or less when purchased.

Balances maintained within accounts on deposit withbanks, at times, may exceed federally insured limits. We have notexperienced any losses in such accounts.

***Fair Value of FinancialInstruments***

Substantially allof our financial instruments are carried at fair value or amounts thatapproximate fair value. 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 our results of operations. Other than thoseseparately disclosed in the Notes to Consolidated Financial Statements, ourremaining financial instruments are generally short-term in nature and theircarrying values approximate fair value.

***Furniture and Equipment***

Depreciation of furniture and equipment is generallycomputed using the straight-line method over their estimated useful lives (5years). Leasehold improvements are amortized over the lesser of theirestimated useful life or the remaining lives of their related leases.

***Income Taxes***

Income taxes are accounted for under the asset andliability method. Deferred tax assets and liabilities are recognized forthe estimated future tax consequences attributable to differences between thefinancial statement carrying amounts of existing assets and liabilities andtheir respective tax basis and operating loss and tax creditcarryforwards. Deferred tax assets and liabilities are measured usingenacted tax rates in effect for the year in which those temporary differencesare expected to be recovered or settled. The effect on deferred tax assetsand liabilities of a change in tax rates is recognized in results of operationsin the period that includes the enactment date.

***Earnings Per Share***

Basic earnings per share is computed based on theweighted average number of common shares outstanding during the year. Dilutedearnings per share is computed using the weighted average number of common anddilutive common equivalent shares outstanding during the year. Commonequivalent shares from stock options are excluded from the computation whentheir effect is antidilutive.

***Advertising***

Advertising costs are charged to expense whenincurred. Advertising expense for the years ended December 31, 2006, 2005and 2004 totaled $127,000, $127,000 and $142,000, respectively.

***Stock-BasedCompensation***

Effective January1, 2006, we adopted Statement of Financial Accounting Standards (“SFAS”) No.123R, “Share-Based Payment,” which establishes accounting for equityinstruments exchanged for employee services. Under the provisions of SFAS No.123R, stock-based compensation cost for equity classified awards is measured atthe grant date, based on the fair value of the award, and is recognized as anexpense over the employee’s requisite service period (generally the vesting periodof the equity award). Prior to January 1, 2006, we accounted for share-basedcompensation to employees in accordance with Accounting Principles Board OptionNo. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and relatedinterpretations. We also followed the disclosure requirements of SFAS No. 123, “Accountingfor Stock-Based Compensation.”

F-9

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We elected toadopt the modified prospective transition method as provided by SFAS No. 123Rand, accordingly, financial statement amounts for the prior periods presentedin this Form 10-K have not been restated to reflect the fair value method ofexpensing stock-based compensation. Under this method, the provisions of SFAS No. 123R apply to all awardsgranted or modified after the date of adoption. We did not have anyunrecognized expense related to awards outstanding at the date of adoptionsince they were all fully vested. For future awards, expense calculatedpursuant to SFAS No. 123R will be recognized as compensation expense using theBlack-Scholes option pricing model over the requisite service period. Thecumulative effect of the change in accounting principle from APB 25 to SFAS No.123R was not material.

There were no optionsgranted and no pro forma stock-based compensation expense as if the methodprescribed by SFAS No. 123, “Accounting for Stock-Based Compensation,” had been applied in measuringcompensation expense in the prior periods presented.

***ComprehensiveIncome***

We had no othercomprehensive income items; accordingly, net income and other comprehensiveincome are the same.

***Reclassifications***

Certain amounts in the prior period financialstatements have been reclassified to conform to the 2006 presentation.

**NOTE B - RECEIVABLE FROM AND PAYABLE TO CLEARINGORGANIZATION**

We introduce all customer transactions in securitiestraded on U.S. securities markets to DCS on a fully-disclosed basis. Theagreement with our clearing broker provides that we are obligated to assume anyexposure related to nonperformance by customers or counterparties. We monitorclearance 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. In the event of nonperformance, we may be required to purchase orsell financial instruments at unfavorable market prices resulting in a loss. Wehave not experienced in the past, and we do not anticipate experiencing in thefuture, significant nonperformance by our customers and counterparties.

**NOTE C — NOTES AND OTHER RECEIVABLES**

 Notes and other receivables consisted of thefollowing (in thousands):
| ** **          | ** ** | **Year Ended December 31,** | ** ** |
|---------------------|------------|--------------------------------------------|------------|
| ** **          | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| Officers            |       | $                                          | 12         |   | $ | 38 |   |
| Employees           |       | 127                                        |       | 99 |   |
| Independent brokers |       | 82                                         |       | 17 |   |
| Other               |       | 1,430                                      |       | 928 |   |
|                |       | $                                          | 1,651      |   | $ | 1,082 |   |

 

Employee and independent broker receivables relateprincipally to advances and expenses in excess of commission earnings andinventory losses charged to our employees and registered representatives. Otherreceivables are primarily related to advances to underwriting clients, as wellas to commissions receivable and amounts receivable from insurance companies asreimbursement for insured losses. An allowance is recorded for specific amountswhen they are determined by management to be uncollectible. For the years endedDecember 31, 2006, 2005 and 2004, receivables of $5,000, $300,000 and$684,000, respectively, were determined by management to be uncollectible andwritten off to bad debt expense.

F-10

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**NOTE D - TRADING SECURITIES AND SECURITIES SOLD,NOT YET PURCHASED**

Trading securities and securities sold, not yetpurchased, represent the market value of securities held long and short by us.

The categories of trading securities and their relatedmarket values were as follows (in thousands):
| ** **                       | ** ** | **December 31, 2006** | ** ** | **December 31, 2005**        | ** ** |
|----------------------------------|------------|---------------------------------|------------|----------------------------------------|------------|
| ** **                       | ** ** | **Owned**                       | ** ** | **Sold, Not Yet  Purchased** | ** ** | **Owned** | ** ** | **Sold, Not Yet  Purchased** | ** ** |
| Corporate equities               |       | $                               | 2,036      |                                   | $          | 17 |   | $ | 1,477 |   | $ | 23 |   |
| State and municipal  obligations |       | —                          |       | —                                 |       | 5 |   | — |   |
| Corporate  options/warrants      |       | 328                             |       | —                                 |       | 77 |   | — |   |
|                             |       | $                               | 2,364      |                                   | $          | 17 |   | $ | 1,559 |   | $ | 23 |   |

 

As a securities broker-dealer, we are engaged invarious securities trading and brokerage activities as principal. In thenormal course of business, we have sold securities that we do not currently ownand will therefore be obligated to purchase such securities at a futuredate. This obligation is recorded on our balance sheet at the market valueof the related securities and will result in a trading loss on the securitiesif the market price increases and a trading gain if the market price decreasesbetween the balance sheet date and the purchase date.

**NOTE E - INVESTMENT SECURITIES**

Investment securities which are readily marketable arestated at market value with unrealized gains and losses included currently inearnings as a component of investment income (loss) on our consolidatedstatements of operations.

Included in investment securities are also certainsecurities which are not readily marketable. Securities not readilymarketable include investment securities (a) for which there is no market on asecurities exchange or no independent publicly quoted market, (b) that cannotbe publicly offered or sold unless registration has been effected under theSecurities Act of 1933, or (c) that cannot be offered or sold because of otherarrangements, restrictions, or conditions applicable to the securities or tous. Securities that are not readily marketable are stated at estimatedfair value with unrealized gains and losses included currently in earnings as acomponent of investment income (loss) on our consolidated statements ofoperations.

The cost basis related to our investment securityportfolio was $20.4 million and $22.6 million as of December 31, 2006 and 2005,respectively.

The fair market value or estimated fair value of ourinvestment securities was as follows (in thousands):
| ** **                  | ** ** | **December 31,** | ** ** |
|-----------------------------|------------|-----------------------|------------|
| ** **                  | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Corporate equities          |       | $                     | 18,770     |   | $ | 30,718 |   |
| Corporate  options/warrants |       | 773                   |       | 1,684 |   |
|                        |       | $                     | 19,543     |   | $ | 32,402 |   |

 

Realized and unrealized gains (losses) related to ourinvestment securities included in the determination of net earnings was asfollows (in thousands):
| ** **                 | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------|------------|--------------------------------------------|------------|
| ** **                 | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Realized gains (losses)    |       | $                                          | 5,681      |   | $ | 20,210 |   | $ | (400 | ) |
| Unrealized gains  (losses) |       | (9,521                                     | )          | 243 |   | 4,545 |   |
|                       |       | $                                          | (3,840     | ) | $ | 20,453 |   | $ | 4,145 |   |

 

F-11

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**NOTE F — UNDERWRITER WARRANTS**

The estimated fair value of underwriter warrants isdetermined by management using the Black-Scholes option-pricing model (see NoteA). The warrants generally have a five-year expiration date and vestimmediately. The warrants are generally subject to a restriction period ofsix months to one-year in which we cannot exercise thewarrants. Underwriter warrant activity was as follows (in thousands):
| **Estimated fair value at  December 31, 2003**   |   | $      | 6,311  |   |
|--------------------------------------------------|--------|--------|--------|--------|
| Warrants received, net  of employee compensation |   | 5,232  |   |
| Warrants exercised and  expired                  |   | (3     | )      |
| Unrealized depreciation  in estimated value      |   | (2,124 | )      |
| **Estimated fair value at  December 31, 2004**   |   | 9,416  |   |
| Warrants received, net  of employee compensation |   | 1,472  |   |
| Warrants exercised and  expired                  |   | (3,300 | )      |
| Unrealized depreciation  in estimated value      |   | (1,313 | )      |
| **Estimated fair value at  December 31, 2005**   |   | 6,275  |   |
| Warrants received, net  of employee compensation |   | 1,880  |   |
| Warrants exercised and  expired                  |   | (1,884 | )      |
| Unrealized depreciation  in estimated value      |   | (621   | )      |
| **Estimated fair value at December 31, 2006**    |   | $      | 5,650  |   |

 

The fair value of the underwriter warrants received isreflected currently in earnings as a component of corporate finance income. Theunrealized depreciation and the estimated fair value of underwriter warrantsexpired is reflected currently in earnings as a component of investment income(loss). The gain recognized from the sale of the underlying securities relatedto the exercise of underwriter warrants is reflected currently in earnings as acomponent of investment income (loss). The fair value of underwriter warrantsgiven to employees is recognized currently as a component of compensationexpense.

**NOTE G — FURNITURE AND EQUIPMENT, NET**

Furnitureand equipment are stated at cost and consisted of the following (in thousands):
| ** **                     | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Office equipment               |       | $                     | 919        |   | $ | 1,196 |   |
| Leasehold improvements         |       | 101                   |       | 33 |   |
|                           |       | 1,020                 |       | 1,229 |   |
| Less accumulated  depreciation |       | (748                  | )          | (963 | ) |
|                           |       | $                     | 272        |   | $ | 266 |   |

 

**NOTE H — INCOME TAXES**

Income tax expense (benefit) consisted of thefollowing (in thousands):
| ** **                          | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|
| ** **                          | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Current tax expense (benefit):**  |       |                                       |       |   |   |   |   |
| Federal                             |       | $                                          | 1,139      |   | $ | 4,510 |   | $ | (141 | ) |
| State and local                     |       | 155                                        |       | 406 |   | 25 |   |
|                                |       | 1,294                                      |       | 4,916 |   | (116 | ) |
| **Deferred tax expense (benefit):** |       |                                       |       |   |   |   |   |
| Federal                             |       | (3,319                                     | )          | (25 | ) | 1,975 |   |
| State and local                     |       | (419                                       | )          | (3 | ) | 548 |   |
|                                |       | (3,738                                     | )          | (28 | ) | 2,523 |   |
|                                |       | $                                          | (2,444     | ) | $ | 4,888 |   | $ | 2,407 |   |

 

F-12

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Income tax expense (benefit) for each year varies fromthe amount computed by applying the statutory federal income tax rate toearnings before income taxes as follows (in thousands):
| ** **                                               | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Income tax  (benefit) at statutory federal tax rate      |       | $                                          | (2,495     | ) | $ | 4,549 |   | $ | 2,005 |   |
| State and local  taxes, net of federal benefit           |       | (295                                       | )          | 517 |   | 353 |   |
| Change in  valuation allowance on net deferred tax asset |       | 50                                         |       | (146 | ) | 52 |   |
| Other                                                    |       | 296                                        |       | (32 | ) | (3 | ) |
|                                                     |       | $                                          | (2,444     | ) | $ | 4,888 |   | $ | 2,407 |   |

 

The deferred income tax asset (liability) consisted ofthe following (in thousands):
| ** **                                    | ** ** | **December 31,** | ** ** |     |
|-----------------------------------------------|------------|-----------------------|------------|----------|
| ** **                                    | ** ** | **2006**              | ** ** | **2005** | ** ** |   |
| Accrued expenses                              |       | $                     | 115        |     | $ | 247 |   |   |
| Fixed asset  depreciation                     |       | 2                     |       | —   |   |   |
| Deferred revenue                              |       | 182                   |       | —   |   |   |
| Net operating  loss carryforwards and credits |       | 83                    |       | 114      |   |   |
|                                          |       | 382                   |       | 361      |   |   |
| Valuation  allowance                          |       | (61                   | )          | (11      | ) |   |
|                                          |       | 321                   |       | 350      |   |   |
|                                          |       |                  |       |     |   |   |
| Unrealized  appreciation on securities        |       | (1,829                | )          | (5,577   | ) |   |
| Fixed asset  depreciation                     |       | —                |       | (9       | ) |   |
| Prepaid expense                               |       | (162                  | )          | (172     | ) |   |
|                                          |       | (1,991                | )          | (5,758   | ) |   |
|                                          |       | $                     | (1,670     | )        | $ | (5,408 | ) |

 

We recorded an increase (decrease) to our valuationallowance for 2006, 2005 and 2004 in the amount of $50,000, $(146,000) and$52,000, respectively, based upon management’s assessment that it is morelikely than not that a portion of the net deferred tax asset related to certainstate net operating loss carryforwards will not be fullyrealized. Management will continue to review the net deferred tax assetand may adjust the valuation allowance in future periods based upon theirassessment.

State net operating loss carryforwards ofapproximately $1.6 million at December 31, 2006 expire from 2007 through 2024.

**NOTE I — STOCK-BASED COMPENSATION PLANS**

***1999 Stock Option Plan***

Our 1999 Stock Option Plan (the “Plan”) reserves 1.0million shares of our common stock for issuance upon exercise of optionsgranted under the Plan. At December 31, 2006, 532,000 options wereavailable for grant and 693,000 shares of our common stock were reserved forissuance related to the Plan. The Plan provides for the grant of incentivestock options and nonqualified stock options. Activity under the Plan in2006 was as follows:
| ** **                                 | ** ** | **Options  Outstanding** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|--------------------------------------------|------------|--------------------------|------------|--------------------------------------------|------------|
| **Outstanding  at December 31, 2005** |       | 193,000                  |       | $                                          | 3.92       |   |
| Granted                                    |       | —                   |       | —                                     |       |
| Exercised                                  |       | (21,000                  | )          | 3.89                                       |       |
| Forfeited                                  |       | (11,000                  | )          | 3.75                                       |       |
| **Outstanding at December 31,  2006**      |       | 161,000                  |       | 3.93                                       |       |
|                                            |            |                          |            |                                            |            |  |

 

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Certain information regarding options outstanding andexercisable as of December 31, 2006 was as follows:
| ** **                                   | ** ** | **Options  Outstanding and  Exercisable** | ** ** |
|----------------------------------------------|------------|------------------------------------------------|------------|
| Number                                       |       | 161,000                                        |       |
| Weighted average  per share exercise price   |       | $                                              | 3.93       |   |
| Aggregate  intrinsic value                   |       | $                                              | 205,000    |   |
| Weighted average  remaining contractual term |       | 1.2 years                                      |       |

 

As of December 31,2006, there was no unrecognized stock-based compensation.

***Stock-Based Compensation***

We estimate thefair value of stock options using the Black-Scholes option pricing model. Thisvaluation model takes into account the exercise price of the award, as well asa variety of significant assumptions. We believe that the valuation techniqueand the approach utilized to develop the underlying assumptions are appropriatein calculating the fair values of our stock options. Estimates of fair valueare not intended to predict actual future events or the value ultimatelyrealized by persons who receive equity awards. There were no stock options granted during 2006, 2005 or 2004.

Since our options are fully vested upon the date ofgrant, we recognize the related stock-based compensation expense at that time.Shares to be issued upon the exercise of stock options will come from newlyissued shares.

Certaininformation regarding our stock-based compensation plan was as follows (inthousands):
| ** **                                                                 | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted average  grant-date per share fair value of share options granted |       | $                                          | —     |   | $ | — |   | $ | — |   |
| Total intrinsic  value of share options exercised                          |       | 51                                         |       | 47 |   | 461 |   |
| Stock-based  compensation recognized in results of operations              |       | —                                     |       | — |   | — |   |
| Cash received  from options exercised                                      |       | 82                                         |       | 103 |   | 365 |   |
| Tax deduction realized  related to stock options exercised                 |       | 51                                         |       | 47 |   | 461 |   |
|                                                                            |            |                                            |            |  |  |  |  |  |  |  |

 

**NOTE J — EARNINGS PER SHARE**

Following is areconciliation of our shares used for our basic net income (loss) per share andour diluted net income (loss) per share:
| ** **                                                                                                            | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Shares used for  basic income (loss) per share                                                                        |       | 6,179,858                                  |       | 6,262,886 |   | 6,366,388 |   |
| Effect of  dilutive stock options                                                                                     |       | —                                     |       | 32,378 |   | 7,390 |   |
| Shares used for  diluted net income (loss) per share                                                                  |       | 6,179,858                                  |       | 6,295,264 |   | 6,373,778 |   |
|                                                                                                                  |       |                                       |       |   |   |   |   |
| Stock options not  included in diluted net income (loss) per share because their effect would  have been antidilutive |       | 36,416                                     |       | — |   | 35,000 |   |

 

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**NOTE K — LEASES**

We lease office space under the terms of variousnon-cancellable operating leases.  The future minimum payments for each ofthe next five years and thereafter required for leases were as follows atDecember 31, 2006 (in thousands):
| **Year Ending December 31,** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
| 2007                                        |       | $          | 562        |   |
| 2008                                        |       | 568        |       |
| 2009                                        |       | 314        |       |
| 2010                                        |       | 117        |       |
| 2011                                        |       | —     |       |
| Thereafter                                  |       | —     |       |
|                                        |       | $          | 1,561      |   |

 

The leases are accounted for on a straight-line basisand provide for payment of taxes and other expenses by us. Rent expensefor the years ended December 31, 2006, 2005 and 2004 approximated$522,000, $605,000 and $519,000, respectively.

**NOTE L — EMPLOYEE BENEFIT PLANS**

Retirement benefits for our employees who havecompleted certain service requirements are provided by a defined contributionprofit-sharing plan. Plan contributions are determined by the Board ofDirectors.  Contributions to the plan for the years endedDecember 31, 2006, 2005 and 2004 approximated $91,000, $605,000 and$348,000, respectively.

**NOTE M — CONTINGENCIES**

In the ordinary course of business, we are named in andsubject to various proceedings and claims arising primarily from our securitiesbusiness activities, including lawsuits, arbitration claims, and regulatorymatters. Some of these claims seek substantial or indeterminate damages, andregulatory investigations can result in substantial fines and penalties.

# In October 2002, wewere named as a defendant in a lawsuit filed by Special Situations Fund III, LPand Special Situations Cayman Fund, LP. The lawsuit was filed in U.S. DistrictCourt for the District of New Jersey. It asserts various federal securities lawclaims and common law fraud and negligence against numerous defendants,including us, arising out of two follow-on offerings of SupremaSpecialties, Inc.  We participatedin one 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 betweenAugust 25, 2000 and November 14, 2001. The federal district courtdismissed the claims against us. On appeal, the U.S. Third Circuit Court ofAppeals affirmed the dismissal of the plaintiffs’ claims for violation of Rule10b-5 but reversed as to the dismissal of claims under Section 11 of theSecurities Act of 1933. Subsequently, the plaintiffs stipulated that they willnot be asserting a claim for common law fraud against us. The negligentmisrepresentation claim remains in the case. We believe our liability underSection 11 is limited to the amount of shares either underwritten or actuallyretained by us in the offering. Discovery has begun, but has not yet beencompleted.  We believe we havemeritorious defenses and intend to defend this matter vigorously.

# In December 2005, wereceived notice of possible claims being asserted against us by two individualswho invested in Wood River Partners LP (“Wood River”). The investors purchasedtheir interests in Wood River directly from Wood River. One of the individualswas a customer of ours. Along with his brother, they have indicated that theypaid $1,050,000 for their interests in Wood River. The SEC sued Wood River inOctober 2005, and a receiver currently runs Wood River. At this point, it isnot known how much the individuals might recover through the receivership. Theindividuals have indicated that they believe they may have claims against usunder the Oregon Securities Law for rescission, interest and attorney fees. Webelieve we have meritorious defenses and, if litigation is filed, we intend todefend this matter vigorously.

F-15

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# In January 2007, TimothyTouloukian (“Touloukian”) filed an NASD arbitration against us seeking $5million in compensatory damages based upon alleged claims of breach ofcontract, breach of implied contractual duties, indemnification, negligentmisrepresentation and negligence. Touloukian was employed as a registeredrepresentative by us from November 2002 through December 2003.  Touloukian’s claims against us arise out of aNASD investigation of Touloukian regarding the trading of mutual funds.Touloukian subsequently entered into an Acceptance Waiver and Consent (“AWC”)with the NASD, resulting in a fine and suspension. Touloukian asserts that theNASD’s investigation and subsequent AWC have caused Touloukian to loseemployment opportunities and damage his earning capacity in the future. In hisarbitration Statement of Claim, Touloukian seeks to hold us responsible for thealleged damages resulting from his diminished earning capacity. We have juststarted to respond to the arbitration claims. Our Answer to the Statement ofClaim is due June 14, 2007. We believe we have meritorious defenses and intendto defend this matter vigorously.

An adverse outcome in certain of thematters described above could have a material adverse effect on us. We alsohave been named in or threatened with certain other legal proceedings. Webelieve, based upon information received to date and, where we believe itappropriate, discussions with legal counsel, that resolution of additionalpending or threatened litigation will have no material adverse effect on ourconsolidated financial condition, results of operations or our business.

**NOTE N — NET CAPITAL REQUIREMENT**

We are subject to the Securities and ExchangeCommission Uniform Net Capital rule (Rule 15c3-1), which requires themaintenance 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 31,2006, we had net capital of $15.9 million, which was $15.8 million in excess ofour required net capital of $115,863. Our net capital ratio was 0.11 to 1 atDecember 31, 2006. The minimum requirements may effectively restrict thepayment of cash dividends.

**NOTE O — SHARE REPURCHASE PLAN**

In September 2001, our Board of Directors approved a share repurchaseplan for the repurchase of up to a total of 600,000 shares of our common stock.The share repurchase plan does not have an expiration date. Through December31, 2006, we had purchased a total of 284,263 shares pursuant to this plan and315,737 remained available for repurchase.

**NOTE P — DIVIDENDS**

Pursuant to aDecember 22, 2005 authorization by our Board of Directors, in February 2006, wepaid a special cash dividend of $0.15 per share to shareholders of record onJanuary 17, 2006. The dividend paid totaled $0.9 million.

Pursuant to aJanuary 27, 2005 authorization by our Board of Directors, on March 3, 2005, wepaid a special cash dividend of $0.075 per share to shareholders of record onFebruary 10, 2005. The dividend paid totaled $0.5 million.

Pursuant to aDecember 3, 2003 authorization by our Board of Directors, in January 14, 2004,we paid a special cash dividend of $0.05 per share to shareholders of record onDecember 22, 2003. The dividend paid totaled $0.3 million.

 

F-16

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**NOTE Q — CONCENTRATION OF RISK AND GEOGRAPHICINFORMATION**

Our trading and investment securities includeinvestments in the common stock of the following companies, which representmore than 10% of trading and investment securities at December 31, 2006and 2005 (dollars in thousands):
| **As of December 31, 2006:  Company** | ** ** | **Investment  at Fair  Market  Value** | ** ** | **Percentage  of Total** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------|------------|
| Charles and Colvard,  Ltd.                                |       | $                                           | 7,438      |                          | 34.0       | % |
| Lumera Corporation                                        |       | 3,526                                       |       | 16.1                          | %          |
| ICOP Digital                                              |       | 2,771                                       |       | 12.6                          | %          |
|                                                      |       | $                                           | 13,735     |                          | 62.7       | % |

 
| **As of December 31, 2005:  Company** | ** ** | **Investment  at Fair  Market  Value** | ** ** | **Percentage  of Total** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------|------------|
| Charles and Colvard,  Ltd.                                |       | $                                           | 16,890     |                          | 49.7       | % |
| ICOP Digital                                              |       | 4,435                                       |       | 13.1                          | %          |
|                                                      |       | $                                           | 21,325     |                          | 62.8       | % |

 

In 2006, 2005 and 2004, none of our revenue was from foreign sources andno customer represented 10% or more of our total revenue. In addition, all ofour long-lived assets were located within the United States.

**NOTE R — RELATED PARTY TRANSACTIONS**

During the years ended December 31, 2006 and 2005, wepaid approximately $190,000 and $408,000, respectively, of legal costs onbehalf of our officers and employees.

**NOTE S — OTHER INCOME**

Other income in 2006 included $280,000 in insurancerecovery related to legal and settlement expense from prior years.

In March 2005, we paid $1.1 million to settle alawsuit related to eDigital. We paid the settlement amount because ourinsurance company, which previously agreed to pay the settlement, refused topay. We were successful in the lawsuit filed against the insurance carrier torecover the settlement amount.  Included in other income in 2005 is $1.1million settlement recovery.

**NOTE T — NEW ACCOUNTING PRONOUNCEMENTS**

***SFAS No. 159***

In February2007,******the FASB issuedSFAS No. 159, “The Fair Value Option for Financial Assets and FinancialLiabilities,” which permits entities to choose to measure many financialinstruments and certain other items at fair value. SFAS No. 159 is effective asof the beginning of an entity’s first fiscal year that begins after November15, 2007. We are currently analyzing the effects of adopting SFAS No. 159.

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***SFAS No. 157***

In September2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” whichestablishes a single authoritative definition of fair value, sets out aframework for measuring fair value and requires additional disclosures aboutfair-value measurements. SFAS No. 157 is effective for fiscal years beginningafter November 15, 2007. We are currently evaluating the provisions of SFAS No.157 and the potential effect on our financial position and results of operations.

***Staff AccountingBulletin No. 108***

In September2006, the Securities and Exchange Commission issued Staff Accounting Bulletin (“SAB”)No. 108, “Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements,” which addresses how theeffects of prior-year uncorrected misstatements should be considered whenquantifying misstatements in current-year financial statements. SAB No. 108requires companies to quantify misstatements using both the balance sheet andincome statement approaches and to evaluate whether either approach results inquantifying an error that is material in light of relevant quantitative andqualitative factors. SAB No. 108 is effective for annual financial statementscovering the first fiscal year ending after November 15, 2006. We are notcurrently aware of any material misstatements and, accordingly, we believe thatthe implementation of SAB No. 108 will not have any material effect on ourfinancial position or results of operations.

***FASBInterpretation No. 48***

In June 2006,the FASB issued Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes — an interpretation of FASB Statement No. 109” (“FIN 48”), which providesguidance on the accounting for uncertain tax positions. FIN 48 defines thethreshold for recognizing the benefits of tax positions taken or expected to betaken on a tax return in the financial statements as “more-likely-than-not” tobe sustained by the taxing authority. FIN 48 also provides guidance on derecognition,measurement, classification, interest and penalties, accounting in interimperiods, disclosure and transition. FIN 48 is effective for fiscal yearsbeginning after December 15, 2006. The differences between the amountsrecognized in the statements of financial position prior to the adoption of FIN48 and the amounts reported after adoption will be accounted for as acumulative-effect adjustment recorded to the beginning balance of retainedearnings. We are currently evaluating the impact of the adoption of FIN 48 anddo not believe the cumulative-effect adjustment, if any, will be materialto  our consolidated financial positionor results of operations.

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**Paulson Capital Corp. and Subsidiary**

**SUPPLEMENTARY SCHEDULE OFWARRANTS OWNED**

**As of December 31, 2006**
| **Description**                                 | ** ** | **Number of  Warrants** | ** ** | **Date  Exercisable** | ** ** | **Exercise  Price per  Warrant** | ** ** | **Expiration  Date** | ** ** |
|-------------------------------------------------|------------|------------------------------|------------|-----------------------|------------|---------------------------------------|------------|----------------------|------------|
| American Mold  Guard (units)                    |       | 86,024                       |       | 04/26/07              |       | $                                     | 15.60      |                 | 04/26/11   |   |
| Ascent Solar  Technologies (units)              |       | 232,500                      |       | 07/10/07              |       | 6.60                                  |       | 07/10/11             |       |
| ICOP Digital  (units)                           |       | 100,750                      |       | 01/04/06              |       | 9.90                                  |       | 07/08/10             |       |
| ICOP Digital  (common and warrant)              |       | 17,875                       |       | 01/08/06              |       | 5.92                                  |       | 07/08/10             |       |
| INX (formerly  known as I-Sector Corp.) (units) |       | 29,653                       |       | 05/07/05              |       | 19.92                                 |       | 05/07/09             |       |
| JJ Pharma                                       |       | 37,350                       |       | 07/18/06              |       | 1.00                                  |       | 07/18/16             |       |
| Lumera Corporation                              |       | 346,085                      |       | 07/23/05              |       | 8.34                                  |       | 07/22/09             |       |
| Milestone  Scientific (units)                   |       | 99,857                       |       | 02/17/05              |       | 7.82                                  |       | 02/16/09             |       |
| Nuvim (units)                                   |       | 184,950                      |       | 12/18/05              |       | 1.20                                  |       | 06/20/10             |       |
| Pacific  Mercantile Bancorp                     |       | 136,118                      |       | 12/08/04              |       | 11.10                                 |       | 12/08/08             |       |
| Path 1 Network  Technologies (units)            |       | 87,292                       |       | 07/31/04              |       | 12.96                                 |       | 07/30/08             |       |
| Q Comm  International (units)                   |       | 61,552                       |       | 06/25/04              |       | 15.60                                 |       | 06/24/08             |       |
| Smart Pros Ltd.  (units)                        |       | 32,970                       |       | 04/17/05              |       | 15.30                                 |       | 10/19/09             |       |
| Universal Guardian  (units)                     |       | 95,800                       |       | 06/20/06              |       | 1.50                                  |       | 06/19/11             |       |
|                                                 |            |                              |            |                       |            |                                       |            |                      |            |  |

 

 

F-19

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**SCHEDULE II**

**Paulson Capital Corp. andSubsidiary**

**Vaulation and Qualifying Accounts**

**For theThree Years in the Period Ended December 31, 2006**
| **Column A**                     | ** ** | **Column B**     | ** ** | **Column C**          | ** ** | **Column D**              | ** ** | **Column E**     | ** ** |
|---------------------------------------|------------|-----------------------|------------|----------------------------|------------|--------------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **Balance**           | ** ** | **Charged**                | ** ** | **Charged to**            | ** ** | ** **            | ** ** | **Balance** | ** ** |
| ** **                            | ** ** | **at Beginning** | ** ** | **to Costs and** | ** ** | **Other Accounts -** | ** ** | **Deductions -** | ** ** | **at End** | ** ** |
| **Description**                       | ** ** | **of Period**    | ** ** | **Expenses**               | ** ** | **Describe**                   | ** ** | **Describe (a)** | ** ** | **of Period** | ** ** |
| ** **                            | ** ** | ** **            | ** ** | ** **                 | ** ** | ** **                     | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Year Ended December 31, 2004:**     | ** ** | ** **            | ** ** | ** **                 | ** ** | ** **                     | ** ** | ** **            | ** ** | ** ** | ** ** |
|                                  |       |                  |       |                       |       |                           |       |                  |       |   |   |
| Allowance for  uncollectible accounts |       | $                     | —     |                       | $          | 684,429                        |       | $                     | —     |   | $ | (684,429 | ) | $ | — |   |
|                                  |       |                  |       |                       |       |                           |       |                  |       |   |   |
| **Year Ended December 31, 2005:**     | ** ** | ** **            | ** ** | ** **                 | ** ** | ** **                     | ** ** | ** **            | ** ** | ** ** | ** ** |
|                                  |       |                  |       |                       |       |                           |       |                  |       |   |   |
| Allowance for  uncollectible accounts |       | $                     | —     |                       | $          | 299,745                        |       | $                     | —     |   | $ | (299,745 | ) | $ | — |   |
|                                  |       |                  |       |                       |       |                           |       |                  |       |   |   |
| **Year Ended December 31, 2006:**     | ** ** | ** **            | ** ** | ** **                 | ** ** | ** **                     | ** ** | ** **            | ** ** | ** ** | ** ** |
|                                  |       |                  |       |                       |       |                           |       |                  |       |   |   |
| Allowance for  uncollectible accounts |       | $                     | —     |                       | $          | 5,280                          |       | $                     | —     |   | $ | (5,280 | ) | $ | — |   |

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(a) Charges to theaccount included in this column are for the purpose for which the reserve wascreated.

F-20

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