**U.S. SECURITIES AND EXCHANGECOMMISSION**

 

**WASHINGTON D.C. 20549**

 

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**AnnualReport Under Section 13 or 15(d) ofthe Securities Exchange Act of 1934**

 
| **For the fiscal year ended  December 31, 2003** | **Commission file number: 0-18188** |
|--------------------------------------------------|-------------------------------------|

 

**FORM10-KSB/A**

 

**PAULSON CAPITAL CORP.**

Name of small business issuer as specified inits charter

 

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

 

Securities registered under Section 12(b) of the Exchange Act:

 

**None**

 

Securities registered under Section 12(g) of the Exchange Act:

 

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

 

Check whether the issuer (1) filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.     Yes   ý     No   o

 

Check if there is no disclosure of delinquent filers in response toItem 405 of Regulation S-B is not contained in this form, and no disclosurewill be contained, to the best of registrant’s knowledge, in definitive proxyor information statements incorporated by reference in Part II of this Form10-KSB or any amendment to this Form 10-KSB. o

 

 

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State issuer’s revenues for its most recent fiscal year:

 

$28,059,159

 

As of March 22, 2004, 3,185,311 shares of the registrant’s commonstock, no par value, were outstanding and the aggregate market value of theshares of common stock of the Registrant held by non-affiliates (based upon theaverage of the closing bid and asked prices of Registrant’s shares in theover-the-counter market as of such date) was $11,666,402.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Registrant’s definitive proxy statement for the 2004annual meeting of shareholders to be filed with the Securities and ExchangeCommission are incorporated by reference into Part III.

 

Transitional Small Business Disclosure Format:

 

Yes  o   No  ý

 

**EXPLANATORY NOTE**

 

PaulsonCapital Corp. hereby amends its Annual Report on Form 10-KSB for the fiscalyear ended December 31, 2003 (originally filed as of March 30, 2004) to includereplacement Section 302 Certifications, incorrect versions of which wereinadvertently filed with the original filing. Except for the foregoing, no attempt has been made in this Form 10-KSB/Ato modify or update other disclosures as presented in the original Form 10-KSB.

 

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**PARTI**

 

**FORWARD-LOOKINGSTATEMENTS**

 

**Thisreport, including, without limitation, “Item 6. Management’s Discussion andAnalysis of Financial Condition and Results of Operations,” contains orincorporates both historical and “forward-looking” statements within themeaning of Section 27A of the Securities Act of 1933, as amended, and Section21E of the Securities Exchange Act of 1934, as amended. Words such as“anticipates”, “believes”, “expects”, “intends”, “future” and similarexpressions identify forward-looking statements.  Any such forward-looking statements in this report reflect ourcurrent views with respect to future events and financial performance and aresubject to a variety of factors that could cause our actual results to differmaterially from historical results or from anticipated results expressed orimplied by such forward-looking statements. Because of such factors, we cannot assure you that the resultsanticipated in this report will be realized. As noted elsewhere in this report, various aspects of our business aresubject to extreme volatility often as a result of factors beyond our abilityto 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.  Other factors that may affect our futurefinancial condition or results of operations include the following:**

 

•                  **Theperformance of companies whose securities we have underwritten or otherwisesold to our customers may affect our reputation with other potential syndicateand selling group members and institutional and other retail accounts and mayalso affect the amount of money in our customers’ portfolios available for the kindsof investments that we offer.**

 

•                  **The value ofour investment portfolio, including the value of securities without a readilyascertainable market value, that we have estimated for the purpose of reportingon our financial condition and results of operations, may be significantly andadversely affected by changes in the value of the companies themselves or ofcomparable companies whose stock values we use in estimating the value of ourportfolio securities.**

 

•                  **We aresubject to a very high degree of regulation and are responsible for compliancewith applicable regulations by all of our personnel.  A significant regulatory infraction by us or any of ourregistered representatives could result in significant penalties, including theloss of our license to conduct securities business in one or morejurisdictions.**

 

•                  **Alternativesavailable to our customers to transact securities trades could affect ourability to continue to execute our brokerage customers’ transactions.**

 

•                  **The loss ofour Chairman, Chester Paulson, could have a material adverse impact on ourbusiness.**

 

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**ITEM1.****                        DESCRIPTIONOF BUSINESS**

 

**General**

 

Paulson Capital Corp. (“Paulson Capital” or the “Company”), establishedin 1970, is a holding company whose only operating subsidiary is PaulsonInvestment Company, Inc. (“PIC”), a full service brokerage firm engaged in thepurchase and sale of securities from and to the public and for its own accountand in investment banking activities. The Company operates in one industry segment, the financial servicesindustry.  At December 31, 2003, PICemployed 39 brokers and had independent contractor arrangements with 69 brokersregistered with the National Association of Securities Dealers, Inc.(“NASD”).  PIC also employed a supportstaff of 54 persons in its headquarters in Portland, Oregon and in certain ofits branch offices.  At December 31,2003, PIC had 30 branch offices throughout the United States.

 

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

 

**PrincipalProducts, Services and Markets**

 

Virtually all of Paulson Capital’s business is carried on throughPIC.  PIC is involved in the purchaseand sale of most investment securities but is not involved in commodities orfutures.  Four broad categories ofsecurities activities contribute to revenues of PIC: retail brokerage,corporate finance/investment banking, trading and market making (orwholesale).  PIC also receives revenuesfrom gains and losses in investment accounts, from underwriter warrantsreceived in connection with its corporate finance activities, and from othersources.

 

The following table shows the portion of our revenues that wasattributable to each category for the last two fiscal years:

 
|                     |   | **2003**  |       | **2002**   |   |
|--------------------------|--------|-----------|------------|------------|--------|
| **Securities Brokerage** |   | $         | 16,597,119 |       | $      | 7,598,621 |   |
| **Corporate Finance**    |   | 6,801,330 |       | 121,843    |   |
| **Investment Income**    |   | 3,359,973 |       | (6,559,267 | )      |
| **Trading Income**       |   | 1,245,018 |       | (203,835   | )      |
| **Other**                |   | 55,719    |       | 64,023     |   |
|                          |        |           |            |            |        |  |  |

 

The table listed above reflects revenue categories and does not takeinto account any associated expenses. Because trading and investment income aredetermined by changes in the market value of PIC’s associated accounts, revenuein these categories can be either positive or negative.

 

**SecuritiesBrokerage**

 

As a securities broker, PIC acts as agent for its customers in thepurchase and sale of common and preferred stocks, options, warrants and debtsecurities traded on securities exchanges or in the over-the-counter (“OTC”)market.  A portion of its revenue isderived from commissions from customers on these transactions. In the OTCmarket, transactions with customers in securities not listed on an exchange maybe effected as principal, rather than agent, primarily in securities for whichPIC is a market maker.  Customertransactions in securities are effected either on a cash or margin basis.

 

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

 

In the case of corporate finance transactions, described below, aportion of the discount applicable to securities placed by PIC’s retailbrokerage group is credited to securities brokerage and the commission payableto the broker is recorded as securities brokerage expense.

 

Pursuant to an agreement between PIC and Correspondent Services Corporation(“CSC”), a subsidiary of National Financial Services, LLC, CSC carries all ofPIC’s customer securities accounts and performs the following services:(1) preparation and mailing of monthly statements to PIC customers;(2) settlement of contracts and transactions in securities between PIC andother broker-dealers and between PIC and its customers; (3) custody andsafe-keeping of securities and cash, the handling of margin accounts,dividends, exchanges, rights offerings and tender offers; and (4) the executionof customer orders placed on an exchange. PIC determines the amount of commission to be charged to its customerson agency transactions and the price of securities purchased or sold inprincipal transactions.  CSC receivescompensation based on the size of the transaction, subject to certain minimumand maximum amounts. The agreement between PIC and CSC may be canceled byeither party upon 60 days written notice, which period may be reduced incertain events.  In the event of aliability arising from a bad debt from a customer, PIC is required to indemnifyCSC against any loss.  This potentialliability is uninsured.

 

In addition to providing clearing services for PIC, CSC loans money toPIC in the ordinary course of PIC’s business, pursuant to an arrangement underwhich CSC agrees to finance PIC’s trading accounts.  At December 31, 2003, no net loans were outstanding pursuant tothis arrangement.

 

**CorporateFinance**

 

PIC raises capital for its corporate finance clients through publicofferings and, to a lesser extent, private offerings, of securities ofcorporations that are engaged in a variety of businesses.  PIC participates in underwritings ofcorporate securities as managing underwriter and as a syndicate member.  Management of an underwriting generates morerevenue than participation as a member of an underwriting syndicate.  Revenues generated by syndicateparticipations have not been material.

 

PIC acts as the managing underwriter of public offerings of securitiesthat typically range in size from $5 million to $30 million.  PIC underwrites these offerings on a “firmcommitment” basis, which means that it agrees to purchase a specific amount ofsecurities from the issuer at a discount, after the registration statement forthe offering is declared effective by the Securities and Exchange Commission(the “SEC”), and resells the securities to the public at a specified price.Managing these public offerings involves the risk of loss if PIC is unable toresell at a profit the securities it is committed to purchase.  This risk is usually reduced by acceptingother stock brokerage firms as a part of an underwriting syndicate in whicheach member commits to purchase a specified amount of the offering.  PIC and the other underwriters may also sella portion of their commitment through a “selling group” of other stockbrokerage firms that participate in selling the offering but are not subject toan underwriter’s commitment.  As anunderwriter, PIC is also subject to potential liability under federal and statesecurities laws if the registration statement or prospectus contains a materialmisstatement or omission.  PIC has noinsurance to cover its potential liabilities as an underwriter.

 

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The commitment of capital by PIC between the time a firm commitmentunderwriting agreement becomes effective and the time PIC resells thesecurities constitutes a charge against its net capital.  Accordingly, PIC’s participation in orinitiation of underwritings may be limited by the financial requirements of theSEC and NASD.  See “Net CapitalRequirements.”

 

Between June 1, 1978 and December 31, 2003, PIC acted as the managingunderwriter or co-managing underwriter for 146 securities offerings, raisingapproximately $986 million for corporate finance clients.  Of these, 88 were initial publicofferings.  PIC typically receives 2 to3 percent of the aggregate amount of money raised in an offering to covernonaccountable expenses and between 7 and 9 percent as compensation tounderwriters, selling group members and registered representatives, althoughthese percentages may be lower for larger transactions. PIC also typicallyreceives warrants to purchase securities, equal to 10 percent of the securitiessold in the offering, exercisable for a period of five years from the effectivedate of the public offering at a price equal to 120 percent of the publicoffering price.  A portion of theseunderwriter warrants is typically transferred as compensation to personsassociated with PIC and, in certain cases, to other major underwriters in thepublic offering.

 

**Investment Income**

 

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

 

From time to time, PIC makes investments as a principal in companiesthat are, or are expected to be, corporate finance clients.  The investment may be as convertible debt inanticipation of a public offering, in which case, if the offering issuccessful, the principal and interest are either converted to equity orrepayable from the offering proceeds. If the offering is not successful, the debt is typically converted toequity.  PIC also makes investments incompanies that are not anticipating an immediate public offering.  In such cases, the investment is typicallymade in the form of the purchase of restricted equity securities.  Typical investments described in thisparagraph have ranged from $100,000 to $600,000.

 

**Tradingand Market Making**

 

In addition to executing trades as an agent, PIC regularly acts as aprincipal in executing trades in equity securities, corporate debt securitiesand municipal bonds.  AtDecember 31, 2003, PIC made a market in 50 securities of 46 issuers.  Of these, 23 were corporations for which PIChas acted as managing or co-managing underwriter of public financings.  In addition, at December 31, 2003, PICheld securities of 18 companies in its investment account.  In 2003, the value of securities held in thetrading accounts and investment account ranged between $13,381,705 and$19,066,965. The level of positions carried in PIC’s trading and investmentaccounts fluctuates significantly.  Thesize of the securities positions at any date may not be representative of PIC’sexposure on any other date, because the securities positions vary substantiallydepending upon economic and market conditions, the allocation of capital amongtypes of inventories, underwriting commitments, customer demands and tradingvolume.  The aggregate value ofinventories that PIC may carry is limited by certain requirements under theSEC’s net capital rules.  See “Net CapitalRequirements.”

 

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PIC’s market making activities are conducted both with other dealers inthe “wholesale market” and with PIC’s customers.  Transactions with customers are effected as principal at a netprice equal to the current interdealer price plus or minus the approximateequivalent of a brokerage commission. In such transactions, the commission is recorded as securities brokeragerevenue while any profit or loss attributable to a change in value of thesecurity in PIC’s trading account is recorded as trading profit or loss. PIC’stransactions as principal expose PIC to risk because securities positions aresubject to fluctuations in market value and liquidity.  Profits or losses on trading and investmentpositions depend upon the skills of the employees in PIC’s trading departmentand employees responsible for taking investment positions.  The trading department is headquartered inPIC’s Portland, Oregon office.

 

**BranchOffices**

 

PIC branch offices are generally run by independent contractors whoassume liability for all the operating expenses of the branch.  PIC typically receives between 10 and 20percent of the gross commission earned by the branch, with the balance retainedby the branch to pay its expenses and staff. Persons in these branches are registered with PIC, and PIC assumes thesame compliance and regulatory obligations as would be the case if PIC werefully responsible for the branch’s expenses. As of December 31, 2003, PIC had 30 branch offices in California,Connecticut, District of Columbia, Florida, Georgia, New Jersey, New York,Oregon, Utah, Vermont, and Washington. All of these branches, except our offices in Salem, Oregon andManhattan, New York, operate as independent contractor offices.  PIC continues to be responsible for allexpenses of the Salem and Manhattan offices.

 

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**Regulation**

 

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

 

The securitiesbusiness is subject to extensive regulation under federal and state laws.  The principal purpose of regulation and disciplineof broker-dealers is the protection of customers and the securities marketsrather than protection of creditors and stockholders of broker-dealers.  The SEC is the federal agency charged withadministration of the federal securities laws. Much of the regulation of broker-dealers, however, has been delegated toself-regulatory organizations, principally the NASD.  These self-regulatory organizations adopt rules (subject toapproval by the SEC) that govern the industry and conduct periodic examinationsof member broker-dealers.  Securitiesfirms are also subject to regulation and examination by state securitiescommissions in the states in which they are registered.

 

Theregulations to which broker-dealers are subject cover all aspects of thesecurities business, including sales methods, trading practices amongbroker-dealers, capital structure of securities firms, record keeping and theconduct of directors, officers and employees. Additional legislation, changes in rules promulgated by the SEC and byself-regulatory bodies or changes in the interpretation or enforcement ofexisting laws and rules often affect directly the method of operation andprofitability of broker-dealers.  TheSEC, 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**

 

PIC is required to maintain minimum “net capital” under the SEC’s netcapital rule of not less than 6.67 percent of its “aggregateindebtedness”.  In general, net capitalconsists of the broker-dealer’s net worth, adjusted by numerous factorsspecified in the applicable regulations. In particular, the value of securities that can be included in netcapital is subject to reduction in market value or principal amount. The amountof the required reduction or “haircut” depends on the nature of thesecurity.  As of December 31, 2003,PIC had net capital of $14,338,359, which exceeded its minimum requirement of$167,540 by $14,170,819.  The ratio ofaggregate indebtedness of $2,513,110 to net capital of $14,338,359 onDecember 31, 2003, was approximately 0.18 to 1.  In a public offering in which PIC acts as an underwriter, PICmust have sufficient net capital to cover the amount of securitiesunderwritten, applying applicable formula mandated by the SEC, during theperiod between effectiveness and the closing of the transaction, usually 3-4business days. This results in a significant temporary increase in PIC’s requirednet capital.  In some cases, the amountof securities underwritten by PIC could be limited by its net capital.  Any significant reduction in PIC’s netcapital, even if PIC were still in compliance with the SEC’s net capital rulefor its retail and trading activities, could have a material adverse impact onPIC’s ability to continue its investment banking activities.

 

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**Competition**

 

All aspects of PIC’s business are highly competitive.  In its general brokerage activities, PICcompetes directly with numerous other broker-dealers, many of which are largewell-known firms with substantially greater financial and personnel resourcesthan PIC.  Many of PIC’s competitors employextensive advertising and actively solicit potential clients in order toincrease business.  In addition,brokerage firms compete by furnishing investment research publications toexisting clients, the quality and breadth of which are considered important inthe development of new business and the retention of existing clients.  PIC also competes with a number of smallerregional brokerage firms.

 

Some commercial banks and thrift institutions offer securitiesbrokerage services.  Many commercialbanks offer a variety of investment banking services.  Competition among financial services firms also exists forinvestment representatives and other personnel.

 

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

 

The securities industry has experienced substantial commissiondiscounting by broker-dealers competing for brokerage business.  In addition, an increasing number ofspecialized firms offer “discount” services to individual customers.  These firms generally effect transactionsfor their customers on an “execution only” basis without offering otherservices such as portfolio valuation, investment recommendations andresearch.  A growing number of discountbrokerage firms offer their services over the Internet, further decreasingoffered commission rates and increasing ease of use for customers.  The continuation of such discounting and anincrease in the number of new and existing firms offering discounts couldadversely affect the Company.  Inaddition, rapid growth in the mutual fund industry is presenting potentialcustomers of PIC with an increasing number of alternatives to traditional stockbrokerage accounts.

 

In its investment banking activities, PIC competes with other brokeragefirms, venture capital firms, banks and all other sources of capital for small,growing companies.  Since PIC generallymanages offerings smaller than $30 million, it does not typically compete withthe investment banking departments of large, well-known national brokeragefirms.  Nevertheless, PIC occasionallymanages larger offerings.  In addition,large national and regional investment banking firms occasionally manageofferings of a size that is competitive with PIC, typically for fees andcompensation less than that charged by PIC. When the market for initial public offerings is active, many smallregional firms that do not typically engage in investment banking activitiesalso begin to compete with PIC.

 

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**Employees**

 

At December 31, 2003, PIC had 93 employees (of which 90 arefull-time), of whom 54 were executives and support staff and 39 were involvedin brokerage activities and compensated primarily on a commission basis.  PIC also had independent contractorarrangements with 69 independent contractors, all of whom are compensatedsolely on a commission basis.  PaulsonCapital had no employees separate from PIC.

 

**ITEM2.****                        DESCRIPTIONOF PROPERTY**

 

PIC leases approximately 17,100 square feet of space for its office inPortland, Oregon under a lease expiring May 31, 2009.  The base monthly rental rate on this leaseis currently $25,704.  The rental rateincreases every 2-3 years, from $25,704 beginning in June 2002 to $29,988through the expiration of the lease in June 2009.  PIC’s Salem office leases space under a lease that expires onOctober 31, 2005 at a monthly rent of $3,001, with rent subject to increasesbased upon inflation.  PIC’s Manhattanoffice leases space on a month-to-month basis at $5,400 per month.  The Company believes the existing leasedspace is suitable and adequate for its business for the foreseeablefuture.  PIC’s other branch officeslease space but, under the terms of the relationship between PIC and theseoffices, PIC is not responsible for these lease costs. The Company has noadditional leases other than through PIC.

 

**ITEM3.****                        LEGALPROCEEDINGS**

 

InJanuary 2002, PIC was served in an arbitration brought by one of itsformer customers, Patricia Weber, against PIC and its registered representativeMelvin Vukcevich.  The arbitration claimalleges unsuitable securities recommendations, misrepresentation, breach offiduciary duty and negligence.  The claimantis seeking damages of $255,000, interest, an additional return on herportfolio, punitive damages and attorney fees. PIC has filed its answer.  Thecase is scheduled for binding arbitration in Los Angeles, California beginning May 25, 2004.  PIC believes it has meritorious defenses and intends to defendthe matter vigorously.

 

In March 2002, PIC andone of its registered representatives, Marvin Cox, were named as defendants inlawsuits filed by Louis Barinaga and Stuart Mackenzie, former PIC customers.  The claims of Barinaga and Mackenzie relateto purchases of convertible notes of E.com, which were purchased directly fromE.com.  Barinaga and Mackenzie allegethat PIC and Mr. Cox participated in and materially aided the sale of the notesand, therefore, are liable under state securities law.  Barinaga and Mackenzie allege damages of$717,000 and $165,000, respectively, plus interest and attorney fees. PICasserted that the claims are subject to arbitration. Plaintiffs have abatedtheir lawsuit and refiled their claims before the NASD.  Claimant Barinaga amended his arbitrationstatement of claim to include claims for breach of fiduciary duty, violationsof federal and state securities laws, fraud and negligence relating totransactions in stock of e.Digital. Barinaga’s amended statement of claim also names UBS PaineWebber, Inc.as a respondent.  Barinaga claims thatCox, PIC and UBS PaineWebber, Inc.’s actions prevented him from realizing inexcess of 12 million dollars on sales of e.Digital stock.  The e.Digital stock in question was subjectto an agreement entered into between Barinaga and UBS PaineWebber, Inc.  Discovery into these new claims is in a veryearly stage.  No hearing date has yetbeen set.  PIC believes it hasmeritorious defenses and intends to defend this matter vigorously.

 

In October 2002, PIC wasnamed as a defendant in a lawsuit filed by Special Situations Fund III, LP andSpecial Situations Cayman Fund, LP.  Thelawsuit was filed in U.S. District Court for the District of New Jersey.  It asserts various federal securities lawclaims and common law fraud and negligence against numerous defendants,including PIC, arising out of two secondary offerings of Suprema Specialties,Inc.  PIC participated in one of the twoofferings, the August 25, 2000 secondary offering of Suprema Specialities,Inc., as a member of the underwriting syndicate, underwriting 75,000 shares intotal.  The plaintiffs seek damages forthe purchase of 399,151 shares of Suprema Specialities, Inc. stock between August 25,2000 and November 14, 2001. Plaintiffs currently are amending their complaint.  Discovery has not yet started.  PIC believes it has meritorious defenses andintends to defend this matter vigorously.

 

In November 2003, PIC broughtan arbitration claim with the NASD against some of its registeredrepresentatives for payment of a promissory note in the amount of $75,000.  The registered representatives have filedcounterclaims alleging that PIC made various misrepresentations and breachedits fiduciary and contractual obligations to them.  The registered representatives are seeking in excess of$500,000.  PIC has not had anopportunity to fully investigate this claim, but currently believes it hasmeritorious defenses and intends to defend this matter vigorously.

 

Anadverse outcome in certain of the matters described above could have a materialadverse effect on PIC or the Company. PIC also has been named in certain otherlegal proceedings and has received notice that certain customers may commencelegal proceedings against PIC. The Company has no additional legal proceedingsother than through PIC. The Company believes, based upon information receivedto date and, where the Company believes it appropriate, discussions with legalcounsel, that resolution of this additional pending or threatened litigationwill have no material adverse effect on the consolidated financial condition,results of operations, or business of the Company.

 

**ITEM4.****                        SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS.**

 

None

 

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**PARTII**

 

**ITEM5.****                        MARKET FORREGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.**

 

The Company’s common stock trades in the over-the-counter market.  The Company’s stock is quoted on the NasdaqSmallCap Market under the symbol “PLCC,” but it is not actively traded.  The following are high and low sales pricesfor the common stock for the periods shown.

 
|        |   | **2003  Prices** |   | **2002  Prices** |   |
|-------------|--------|------------------|--------|------------------|--------|
|        |   | **High**         |   | **Low**          |   | **High** |   | **Low** |   |
| 1st Quarter |   | $                | 5.21   |             | $      | 4.22 |   | $ | 8.00 |   | $ | 6.60 |   |
| 2nd Quarter |   | 5.04             |   | 4.02             |   | 8.23 |   | 6.02 |   |
| 3rd Quarter |   | 6.61             |   | 4.15             |   | 6.61 |   | 4.94 |   |
| 4th Quarter |   | 10.47            |   | 5.83             |   | 5.12 |   | 4.61 |   |
|             |        |                  |        |                  |        |  |  |  |  |  |  |  |  |

 

The closing high and low prices for the first quarter of 2004, throughMarch 22, 2004, were $15.30 and $9.85, respectively.

 

As of March 5, 2004, there were 3,185,311 shares of the Company’scommon stock outstanding and held of record by 111 holders.  The number of record holders includes assingle holders various institutions (such as brokerage firms) that hold sharesin “street name” for multiple shareholders. Based on the number of requests for the Company’s proxy materials forits 2003 annual meeting, the Company believes there are approximately 379beneficial holders of its common stock. The Company repurchased 15,000 shares of common stock during 2003.  Additional shares of common stock may berepurchased from time to time in the future.

 

The Company declared a $0.10 per share dividend on its common stock inDecember 2003, payable in January 2004. No dividend was declared during fiscalyear 2002. Net capital requirements may limit the ability of PIC to pay futuredividends to the Company, which would affect the Company’s ability to paydividends to its shareholders.

 

The following table provides certain information about the Company’sequity compensation plans in effect as of the end of fiscal year 2003.

 
| **Plan Category**                                       |   | **Number of  Securities to be  Issued Upon Exercise of  Outstanding Options,  Warrants and Rights** |   | **Weighted-Average  Exercise  Price of Outstanding Options,  Warrants and Rights** |   | **Number of  Securities Remaining  Available for Future Issuance under  Equity Compensation Plans  (excluding securities reflected in  column(a))** |    |
|---------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------|---------|
|                                                    |   | **(a)**                                                                                             |   | **(b)**                                                                            |   | **(c)**                                                                                                                                             |    |
|                                                    |   |                                                                                                |   |                                                                               |   |                                                                                                                                                |    |
| Equity Compensation Plans Approved by  Shareholders(1)  |   | 194,500                                                                                             |   | $                                                                                  | 6.43   |                                                                                                                                                | 260,500 |   |
| Equity Compensation Plans Not Approved by  Shareholders |   | —                                                                                              |   | —                                                                             |   | —                                                                                                                                              |    |
| Total                                                   |   | 194,500                                                                                             |   | $                                                                                  | 6.43   |                                                                                                                                                | 260,500 |   |

 

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

 

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

 

**SELECTEDFINANCIAL DATA**

 

**IncomeStatement Information**

 
|                                                   |   | **Years  Ended December 31,**                |   |
|--------------------------------------------------------|--------|----------------------------------------------|--------|
|                                                   |   | **2003**                                     |   | **2002** |   |
|                                                   |   | **(in thousands, except per share amounts)** |   |
| Revenues                                               |   | $                                            | 28,059 |   | $ | 1,021 |   |
| Commissions and Salaries                               |   | 16,959                                       |   | 8,196 |   |
| Other Expenses                                         |   | 4,956                                        |   | 3,735 |   |
| Total Expenses                                         |   | 21,915                                       |   | 11,931 |   |
| Pretax Income (Loss)                                   |   | 6,144                                        |   | (10,910 | ) |
| Net Income (Loss)                                      |   | 4,040                                        |   | (7,011 | ) |
| Diluted Earnings (Loss) per share                      |   | $                                            | 1.29   |   | $ | (2.23 | ) |
| Average Number of Common Shares Outstanding  (Diluted) |   | 3,132                                        |   | 3,141 |   |

 

**BalanceSheet Information**

 
|                      |   | **December  31,**  |   |
|---------------------------|--------|--------------------|--------|
|                      |   | **2003**           |   | **2002** |   |
|                      |   | **(in thousands)** |   |
| Total Assets              |   | $                  | 36,070 |   | $ | 29,112 |   |
| Long-Term Debt            |   | —             |   | — |   |
| Shareholders’ Equity |   | 29,595             |   | 25,843 |   |
|                           |        |                    |        |  |  |  |  |

 

**Overview**

 

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

 

•                  securitiesbrokerage activities for which PIC earns commission revenues;

•                  corporatefinance revenues consisting principally of underwriting discounts andunderwriter warrants;

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

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

 

12

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Because we operate in the financial services industry, our revenues andearnings are substantially affected by general conditions in financial markets.In our securities brokerage and corporate finance business, the amount of ourrevenues depends on levels of market activity requiring the services weprovide.  Our investment bankingactivity, which consists primarily of acting as the managing underwriter ofinitial and follow-on public offerings for smaller companies, is similarlyaffected by the strength of the market for new equity offerings, which hashistorically experienced substantial cyclical fluctuation.  Although we attempt to match operating costswith activity levels, many of our expenses are either fixed or difficult tochange on short notice.  Accordingly,fluctuations in brokerage and investment banking revenues tend to result insharper fluctuations, on a percentage basis, in net income or loss.

 

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

 

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

 

### **CriticalAccounting Policies**

 

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.  Inpreparing our consolidated financial statements, we must make estimates andjudgments that affect the reported amounts of assets and liabilities, revenuesand expenses, and related disclosure of contingent assets and liabilities atthe date of our financial statements. Actual results are likely to differ from these estimates under differentassumptions and conditions.

 

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 criticalaccounting policies are limited to those described below.

 

*Useof Estimates.*We are required to estimate the value of allderivative securities that we hold at the date of any financial statements andto include that value, and changes in such value, in those financialstatements.  Accordingly, the aggregateestimated value of our warrants as of the date of any balance sheet is recordedas an asset on that balance sheet.  Whena new warrant is received as a result of our investment banking activity, itsestimated value is included in corporate finance revenue on the date on whichit is earned.  Subsequently, any changein estimated value is recorded as investment income or loss.  When a warrant is exercised, the book valueis adjusted to reflect the value of the securities purchased, net of theexercise price, and the adjustment amount is recorded as income or loss for therelevant period. If the warrant expires unexercised, the book value is adjustedto zero and the decrease is recorded as a loss in the relevant period.

 

We estimate the value of our underwriter warrants using theBlack-Scholes Option Pricing Model. The Black-Scholes model requires us to usehistorical price data combined with various assumptions and judgments as inputsfor the model.  The most influentialfactor in this model is price volatility, which we calculate for each company’swarrants based on each company’s own historical stock price movements as wellas an index of historical prices 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 each underwriter warrant approaches itsexpiration date, its volatility factor is derived primarily from the historicalprices of its underlying common stock. We cannot assure you that we will ultimately be able to exercise any ofour warrants in a way that will realize the value that we attribute to them inour financial statements based on this model.

 

In addition toour underwriter warrants, we hold other securities, some of which have verylimited liquidity and some of which do not have a readily ascertainable marketvalue.  According to Generally AcceptedAccounting Principles, we are required to carry these securities at estimatedfair value.

 

13

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

 

**Results of Operations**

 

PIC’s revenues and operating results are influenced by fluctuations inthe equity underwriting markets as well as general economic and market conditions,particularly conditions in the over-the-counter market, where PIC’s investmentaccount, trading inventory positions and underwriter warrants are heavilyconcentrated.  Significant fluctuationscan occur in PIC’s revenues and operating results from one period toanother.  PIC’s results of operationsdepend upon many factors, such as the number of companies that are seekingpublic financing, the quality and financial condition of those companies,market conditions in general, the performance of previous PIC underwritings andinterest in certain industries by investors. As a result, revenues and income derived from these activities may varysignificantly from year to year.  In thetables below, “Corporate Finance” revenues are a function of total proceedsfrom offerings done during the period, compensation per offering, and the fairvalue of underwriter warrants received. “Investment Income” includes realized gains from the exercise ofunderwriter warrants, gains and losses from the sales of investment securities,and unrealized gains and losses from underwriter warrants and other investmentsecurities.  “Trading Income” is the netgain or loss from trading positions before commissions paid to the representativesin the trading department.

 

14

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**Summaryof Changes in Major Categoriesof Revenues and Expense**

 
|                         |   | **Dollar  Change** |       | **Percent  Change** |    | **2003**   | **vs.** | **2002**   |   |
|------------------------------|--------|--------------------|------------|---------------------|---------|------------|---------|------------|--------|
| Revenues:                    |   |               |       |                |    |       |    |       |   |
| Sales Commissions            |   | $                  | 8,998,498  |                | 118.4   |       | $       | 16,597,119 |   | $ | 7,598,621 |   |
| Corporate Finance            |   | 6,679,487          |       | 5,482.0             |    | 6,801,330  |    | 121,843    |   |
| Investment Income            |   | 9,919,240          |       | NA                  |    | 3,359,973  |    | (6,559,267 | )      |
| Trading Income               |   | 1,448,853          |       | NA                  |    | 1,245,018  |    | (203,835   | )      |
| Other                        |   | (8,304             | )          | (13.0               | )       | 55,719     |    | 64,023     |   |
|                         |   |               |       |                |    |       |    |       |   |
| Total                        |   | $                  | 27,037,774 |                | 2,647.2 |       | $       | 28,059,159 |   | $ | 1,021,385 |   |
|                         |   |               |       |                |    |       |    |       |   |
| Expenses:                    |   |               |       |                |    |       |    |       |   |
| Commissions and Salaries     |   | 8,763,475          |       | 106.9               |    | 16,959,056 |    | 8,195,581  |   |
| Underwriting Expenses        |   | 336,083            |       | 174.8               |    | 528,397    |    | 192,314    |   |
| Rent, Telephone & Quotes |   | 196,092            |       | 20.4                |    | 1,156,402  |    | 960,310    |   |
| Other                        |   | 687,760            |       | 26.6                |    | 3,271,291  |    | 2,583,531  |   |
|                         |   |               |       |                |    |       |    |       |   |
| Total                        |   | $                  | 9,983,410  |                | 83.7    |       | $       | 21,915,146 |   | $ | 11,931,736 |   |
|                         |   |               |       |                |    |       |    |       |   |
| Pretax Income (Loss)         |   | $                  | 17,054,364 |                | NA      |       | $       | 6,144,013  |   | $ | (10,910,351 | ) |

 

**2003 Compared to 2002**

 

**Revenues**

 

Total revenues for 2003 increased by 2,647.2 percent from 2002, to$28,059,159 from $1,021,385.  As shownin the table above, sales commissions rose $8,998,498, or 118.4 percent, to$16,597,119 in 2003 from $7,598,621 in 2002. This increase resulted primarilyfrom the increased trading activity in 2003 relative to 2002. The NasdaqComposite Index was up 50 percent in 2003, to 2003.37 at December 31, 2003 from1335.51 at year-end 2002.  PIC’s focusis on very small capitalization issues, especially those tied to PIC’scorporate finance clients.

 

 Corporate finance revenuesincreased 5,482 percent, to $6,801,330, in 2003 compared to $121,843 in 2002.Corporate finance revenues increased as a result of three transactionscompleted in 2003 compared with no transactions completed in 2002, and thereceipt of underwriter warrants as compensation for the Company’s underwritingefforts. The 2003 corporate finance transactions raised a total of $66 millionfor corporate finance clients. In addition, during 2003, the Company receivedunderwriter warrants valued using the Black-Scholes option-pricing model,resulting in unrealized revenue of $2,968,565 (net of $1,280,842 compensationexpense) at the time of receipt. Because the Company had no corporate financetransactions in 2002, there were no underwriter warrants received during thatyear.

 

Investment income increased $9,919,240, from a loss of $6,559,267 in2002 to a profit of $3,359,973 in 2003. Investment income consists of (1) theunrealized and realized appreciation and depreciation of securities held basedon quoted market prices, (2) the unrealized and realized appreciation anddepreciation of securities held that are not readily marketable, based upon theCompany’s estimate of their fair value, and (3) the unrealized appreciation anddepreciation of underwriter warrants held by the Company.  The unrealized appreciation of underwriterwarrants (net of warrant expiration) increased $628,435 during 2003. The unrealizeddepreciation of securities not readily marketable totaled $75,200 during 2003.The remainder of the net change is the result of the unrealized and realizedappreciation of securities with quoted market prices.

 

Trading income increased $1,448,853 to a gain of $1,245,018 in 2003from a loss of $203,835 in 2002. This increase was primarily due to increasedtrading activity in securities generally as well as in the securities of PIC’scorporate finance clients, resulting from robust activity in the stock market.Generally, favorable market conditions result in increased revenues for PIC.

 

**Expenses**

 

Total expenses increased by $9,983,410 in 2003 from 2002, an increaseof 83.7 percent to $21,915,146 from $11,931,736. The largest dollar increasewas in commissions and salaries. Commissions and salaries increased $8,763,475, or 106.9 percent, to$16,959,056 in 2003 from $8,195,581 in 2002. This increased was primarily dueto increased commission expense resulting from greater trading activity andincreased compensation related to corporate finance transactions. Underwritingexpenses increased by $336,083, or 174.8 percent, from 2002. Three underwritingtransactions were completed in 2003 while no transactions were completed in2002. Rent, telephone and quotation expenses increased to $1,156,402 in 2003from $960,310 in 2002, an increase of 20.4 percent, primarily as the result ofthe opening of the Manhattan office in mid-to-late 2002. Other expensesincreased 26.6 percent, to $3,271,291 in 2003 from $2,583,531 in 2002. Theincrease in other expenses is partially the result of an increase in bad debtexpense, from $95,369 in 2002 to $367,796 in 2003. The remainder of theincrease consists of increases in various other expenses.

 

15

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**Income**

 

The Company had a pretax income of $6,144,013 in 2003 compared to apretax loss of $10,910,351 in 2002 due to significant increases in all revenuecategories. Independent of investment income or loss, the Company would havehad pretax income of $2,784,040 in 2003 compared to a pretax loss of $4,351,084in 2002. Significant fluctuations can occur in PIC’s revenues and operatingresults from one period to another.  TheCompany also had income tax expense of $2,103,736 in 2003, compared to anincome tax benefit of $3,899,197 in 2002.

 

**Liquidity and CapitalResources**

 

Conducting business as a dealer in securities requires that asubstantial inventory of securities be maintained and that a large amount ofliquid assets be readily available.  PICis also required to maintain net capital as described in “Item 1 - Descriptionof Business — Net Capital Requirements” above. PIC’s equity at December 31, 2003 was $28,408,778. Of PIC’s totalassets (net of intercompany accounts) at December 31, 2003 of $34,683,220,approximately 72.8 percent consisted of securities in PIC’s investment account,trading inventory and underwriter warrant securities, at fair value, andapproximately 21.1 percent consisted of cash, certificates of deposit andreceivables from its correspondent broker.

 

PIC’s securities inventory is stated at fair value.  The liquidity of the market for many ofPIC’s securities holdings, however, varies with trends in the stockmarket.  Since many of the securitiesheld by PIC are thinly traded, and PIC is in many cases a primary market makerin the issues held, any significant sales of PIC’s positions could adverselyaffect the liquidity and prices of the issues held.  In general, falling prices in OTC securities (which make up mostof PIC’s trading positions) lead to decreased liquidity in the market for theseissues, while rising prices in OTC issues tend to increase the liquidity of themarket for these securities.  Theoverall decline in prices for the very small capitalization OTC securitiestraded by PIC in 2002, 2001, and 2000 were combined with a general reduction inthe liquidity of the markets for these securities.  This situation was the reverse of 2003 and 1999, when increasesin prices of OTC securities increased the liquidity of the markets for thesesecurities.  PIC’s investment accountand trading inventory accounts are stated at fair value. They include shares ofrestricted stock held by PIC, with an original cost of $1,552,575, currentlyvalued at $2,230,000, which the Company believes, based upon available evidence,approximates market value.

 

PIC borrows money from CSC in the ordinary course of its business,pursuant to an arrangement under which CSC agrees to finance PIC’s tradingaccounts in an amount determined by the size of those accounts and the type ofsecurities held, with interest charged at prevailing margin rates. As ofDecember 31, 2003, no net loans were owed by PIC to CSC pursuant to thisarrangement.  PIC and the Company aregenerally able to meet their compensation and other obligations out of currentliquid assets.

 

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Another source of capital to PIC and the Company has been theunderwriter warrants issued to PIC in connection with its corporate financeactivities.  The recorded value of our underwriterwarrants is typically not readily realizable, either because the warrants arenot currently exercisable or because their exercise price is more than theprice that we could realize if we exercised the warrants and sold theunderlying securities.  There is nopublic market for our underwriter warrants and the warrants themselves aretransferable only under very limited circumstances.  Accordingly, their value cannot be realized by selling thewarrants themselves.  Underwriterwarrants exercisable to purchase securities having a value in excess of theexercise price are liquid, subject to restrictions on liquidity applicable toOTC securities generally.  Thesecurities issuable on exercise of our underwriter warrants are registeredunder the Securities Act of 1933, as amended, and, in some cases, may also beresold under an exemption from registration. Accordingly, there is no legal impediment to liquidity with respect tothese securities, except during the first year following a company’s public offering.  At December 31, 2003, PIC owned 20underwriter warrants (from 14 different issuers), of which 16 were currentlyexercisable; four had an exercise price below the current market price of thesecurities receivable on exercise.  Ifwe had exercised the “in-the-money” warrants and sold the underlying securitieson December 31, 2003, we would have received $78,787 in gross proceeds.  As of December 31, 2003, the computed valueof our underwriter warrants, based on the Black-Scholes Option Pricing Model,was $6.3 million, a significant increase from the computed value of $2.7million at year-end 2002.  There islittle or no direct relationship between the intrinsic value of PIC’sunderwriter warrants at the end of any given period and the fair value calculatedusing the Black-Scholes Option Pricing Model, as described more fully in“Critical Accounting Policies” above.

 

In 2003, $121,176of net cash was provided by operating activities.  The major adjustments to reconcile this result to the Company’snet income include the following items that provided cash to operatingactivities: noncash compensation associated with underwriter warrants of$1,280,842; deferred income taxes of $3,125,700; and an increase in accountspayable and accrued liabilities of $1,401,872. The following items resulted ina use of cash for operating activities: an increase in receivable/payable fromclearing organization of $4,827,452, and the receipt of underwriter warrants of$4,249,407. Net cash used in invested investing activities in 2003 is additionsto furniture and equipment of $87,645. Net cash provided by financingactivities in 2003 totaled $24,153, resulting from proceeds from the exerciseof stock options and related tax benefit of $90,055, offset by payments toretire common stock of $65,902.

 

As a securitiesbroker-dealer, the Company’s wholly owned subsidiary, PIC, is required by SECregulations to meet certain liquidity and capital standards.  In the unlikely event that PIC was unable tomeet these regulatory standards, it would be unable to pay dividends to theCompany.  Since PIC is the Company’sonly operating business, such a failure could have a material adverse effect onthe Company.

 

At December 31, 2003, the Company had no material commitments forcapital expenditures.

 

In general, the primary sources of PIC’s, and therefore the Company’s,liquidity, includes PIC’s trading positions, borrowings on those positions andprofits realized upon the exercise of underwriter warrants. All of thesesources depend in large part on the trend in the general markets for OTCsecurities.  Rising OTC price levelswill tend to increase the value and liquidity of PIC’s trading positions, theamount that can be borrowed from CSC based upon those positions, and the valueof PIC’s underwriter warrants.  TheCompany believes its liquidity is sufficient to meet its needs for both theshort and long term horizon. The Company’s liquidity could be affected byprotracted unfavorable market conditions.

 

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**ITEM7.****     FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA.**

 
| **(a) Financial  Statements**                                                                            |   |
|----------------------------------------------------------------------------------------------------------|--------|
|                                                                                                     |   |
| Report of Independent Certified Public  Accountants                                                      |   |
|                                                                                                     |   |
| Consolidated Balance Sheet as of December 31, 2003                                                  |   |
|                                                                                                     |   |
| Consolidated Statements of Operations for  the years ended December 31, 2003 and 2002               |   |
|                                                                                                     |   |
| Consolidated Statement of Shareholders’  Equity for the years ended December 31, 2003 and 2002 |   |
|                                                                                                     |   |
| Consolidated Statements of Cash Flows for  the years ended December 31, 2003 and 2002               |   |
|                                                                                                     |   |
| Notes to Consolidated Financial Statements                                                               |   |
|                                                                                                     |   |
| Supplementary Schedule of Warrants Owned                                                                 |   |
|                                                                                                     |   |
| Schedule  II - Valuation and Qualifying Accounts                                                         |   |

 

**ITEM 8.****     CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTSON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None

 

**ITEM 8-A.****                                        CONTROLSAND PROCEDURES**

 

(a)                                  Under the supervision and with theparticipation of our management, including our principal executive officer andchief financial officer, we conducted an evaluation of our disclosure controlsand procedures, as such term is defined under Rule 13a-14(c) promulgated underthe Securities Exchange Act of 1934, as amended, within 90 days of the filingdate of this report.  Based on theirevaluation, our principal executive officer and principal accounting officerconcluded that our disclosure controls and procedures are effective.

 

(b)                                 There have been no significant changes(including corrective actions with regard to significant deficiencies ormaterial weaknesses) in our internal controls or in other factors that couldsignificantly affect these controls subsequent to the date of the evaluationreferenced in paragraph (a) above.

 

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**PARTIII**

 

# **PaulsonCapital Corporation**

# **Codeof Business Conduct and Ethics**

 

### **Introduction**

 

This Code of Business Conduct and Ethics (the “Code”) embodies thecommitment of Paulson Capital Corporation and its subsidiary Paulson InvestmentCompany, Inc. (together, “Paulson” or “we”) to conduct business in accordancewith all applicable laws, rules and regulations and the highest ethicalstandards. Integrity and honesty lie at the heart of Paulson’s business. Weexpect our people to maintain high ethical standards in everything they do, bothin their work for Paulson and in their personal lives. All employees,consultants, officers, and members of our Board of Directors (collectively,“Covered Persons”) are expected to adhere to these principles and to theprocedures set forth in this Code. (For purposes of Section 406 of theSarbanes-Oxley Act of 2002 and the rules promulgated thereunder, Section I ofthis Code shall be Paulson’s code of ethics for Senior Financial Officers (asdefined below).

 

Each Covered Person should also read and be familiar with the portionsof Paulson’s Firmwide Compliance Policies and Supervisory Procedures Manualapplicable to him or her. In addition to the aforementioned items, Paulson alsomay, in the future, issue more specific policies, procedures, rules or directivesthat reflect these standards while addressing the special requirements or needsof a particular Paulson business group or division.  If there are any inconsistencies between this Code and such otherpolicies, procedures, rules or directives, the provisions and requirements ofthis Code shall apply.

 

**SECTIONI**

 

### **A. Compliance andReporting**

 

Covered Persons should strive to identify and raise potential issuesbefore they lead to problems, and should ask about the application of this Codewhenever in doubt. Any Covered Person who becomes aware of any existing orpotential violation of this Code should promptly contact Paulson’s ChiefCompliance Officer. In the case of directors, the Chief Executive Officer, theChief Financial Officer, the controller or principal accounting officer, andthe Chief Compliance Officer (the “Senior Financial Officers”), Paulson’sGeneral Counsel should be contacted. (We refer to Paulson’s Chief ComplianceOfficer and General Counsel as “Appropriate Ethics Contacts”). Paulson willtake such disciplinary or preventive action as it deems appropriate to addressany existing or potential violation of this Code brought to its attention.

 

Any questions relating to how these policies should be interpreted orapplied should be addressed to an Appropriate Ethics Contact.

### ** **

### **B. Conflicts ofInterest**

 

A “conflict of interest” occurs when an individual’s private interestimproperly interferes, or gives the appearance of interfering, with theinterests of Paulson. Conflicts of interest are prohibited as a matter ofpolicy, unless they have been approved by an Appropriate Ethics Contact. Inparticular, a Covered Person must never use, or attempt to use, his or herposition at Paulson to obtain any improper personal benefit for himself orherself, for his or her family members, or for any other person, includingloans or guarantees of obligations, from any person or entity.

 

Service to Paulson should never be subordinated to personal gain andadvantage. Conflicts of interest should, to the extent possible, be avoided.Any Covered Person who is aware of a material transaction or relationship thatcould reasonably be expected to give rise to a conflict of interest shoulddiscuss the matter promptly with an Appropriate Ethics Contact.

### ** **

### **C. Public Disclosure**

 

It is Paulson’s policy that the information in its publiccommunications, including SEC filings, be full, fair, accurate, timely andunderstandable. All Covered Persons who are involved in the company’sdisclosure process, including the Senior Financial Officers, are responsiblefor acting in furtherance of this policy. In particular, these individuals arerequired to maintain familiarity with the disclosure requirements applicable toPaulson and are prohibited from knowingly misrepresenting, omitting, or causingothers to misrepresent or omit, material facts about Paulson to others, whetherwithin or outside of Paulson, including Paulson’s independent auditors. Inaddition, any Covered Person who has a supervisory role in Paulson’s disclosureprocess has an obligation to discharge his or her responsibilities diligently.

 

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### **D. Compliance withLaws, Rules and Regulations**

 

It is Paulson’s policy to comply with all applicable laws, rules andregulations. It is the personal responsibility of each Covered Person to adhereto the standards and restrictions imposed by those laws, rules and regulations.The Supervisory Procedures Manual provides guidance as to certain laws, rulesand regulations that apply to the Paulson’s activities.

 

Generally, it is both illegal and against Paulson policy for anyCovered Person who is aware of material nonpublic information relating toPaulson, any of Paulson’s clients or any other public, private or governmentalissuer of securities to buy or sell any securities of those issuers, orrecommend that another person buy, sell or hold the securities of thoseissuers.

 

More detailed rules governing the trading of securities by the CoveredPersons are set forth in the Supervisory Procedures Manual. Any Covered Personwho is uncertain about the legal rules involving his or her purchase or sale ofany securities or any securities in issuers that he or she is familiar with byvirtue of his or her work for Paulson should consult with an Appropriate EthicsContact before making any such purchase or sale.

 

**SECTIONII**

 

### **A. CorporateOpportunities**

 

Covered Persons owe a duty to advance Paulson’s legitimate businessinterests when the opportunity to do so arises. Covered Persons are prohibitedfrom taking for themselves (or directing to a third party) a businessopportunity that is discovered through the use of corporate property,information or position, unless Paulson has already been offered theopportunity and turned it down. More generally, Covered Persons are prohibitedfrom using corporate property, information or position for personal gain orcompeting with Paulson.

 

Sometimes the line between personal and company benefits is difficultto draw, and sometimes both personal and company benefits may be derived fromcertain activities. The only prudent course of conduct for Covered Persons isto make sure that any use of Paulson’s property or services that is not solelyfor the benefit of Paulson is approved beforehand through the Appropriate EthicsContact.

### ** **

### **B. Confidentiality**

 

In carrying out Paulson’s business, Covered Persons often learnconfidential or proprietary information about Paulson, its clients/customers,prospective clients/customers or other third parties. Covered Persons must maintainthe confidentiality of all information so entrusted to them, except whendisclosure is authorized or legally mandated. Confidential or proprietaryinformation includes, among other things, any non-public information concerningPaulson, including its businesses, financial performance, results or prospects,and any non-public information provided by a third party with the expectationthat the information will be kept confidential and used solely for the businesspurpose for which it was conveyed. Covered Persons should refer to the policiesset forth in the Supervisory Procedures Manual.

### ** **

### **C. Fair Dealing**

 

We have a history of succeeding through honest business competition. Wedo not seek competitive advantages through illegal or unethical business practices.Each Covered Person should endeavor to deal fairly with the Paulson’s clients,service providers, suppliers, competitors and employees. No Covered Personshould take unfair advantage of anyone through manipulation, concealment, abuseof privileged information, misrepresentation of material facts, or any unfairdealing practice.

### ** **

### **D. EqualEmployment Opportunity and Harassment**

 

Paulson’s focus in personnel decisions is on merit and contribution toPaulson’s success. Concern for the personal dignity and individual worth ofevery person is an indispensable element in the standard of conduct that wehave set for ourselves. Paulson affords equal employment opportunity to allqualified persons without regard to any impermissible criterion orcircumstance. This means equal opportunity in regard to each individual’s termsand conditions of employment and in regard to any other matter that affects inany way the working environment of the employee. We do not tolerate or condoneany type of discrimination prohibited by law, including harassment.

### ** **

### **E. Protection andProper Use of Company Assets**

 

All Covered Persons should protect Paulson’s assets and ensure theirefficient use. All assets should be used for legitimate business purposes only.

 

20

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**SECTIONIII**

 

### **Waivers of ThisCode**

 

From time to time, Paulson may waive certain provisions of this Code.Any Covered Person who believes that a waiver may be called for should discussthe matter with an Appropriate Ethics Contact. Waivers for executive officers(including Senior Financial Officers) or directors may be made only by theBoard of Directors or a committee of the Board.

 

### **AdditionalInformation**

 

Other information required by Items 9, 10, 11, 12, and 14 of Part IIIof this Report will be included in the Company’s definitive proxy statement forits 2004 annual meeting of shareholders filed or to be filed not later than 120days after the end of the fiscal year covered by this Report and isincorporated herein by reference.

 

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**ITEM 13.****                                              EXHIBITSAND REPORTS ON FORM 8-K**

 

**(a) Exhibits**

 
| **Number** |   | **Description**                                                                                                                                                                                                                        |
|------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1        |   | Articles of Incorporation (incorporated by reference to Exhibit 3.1  to the Company’s Registration Statement on Form 10 filed with the Commission  on December 18, 1989 (the “Form 10”)                            |
|       |   |                                                                                                                                                                                                                                   |
| 3.2        |   | Bylaws (incorporated by reference to Exhibit 3.2 to the Form 10)                                                                                                                                                                       |
|       |   |                                                                                                                                                                                                                                   |
| 10.1       |   | Office lease dated June 28, 1988 (incorporated by reference to  Exhibit 10.2 to the Form 10)                                                                                                                                           |
|       |   |                                                                                                                                                                                                                                   |
| 10.3       |   | Contract with Correspondent Services Corporation, dated July 24, 1992  (incorporated by reference to Exhibit 10.3 to the Form 10-Q for the quarter  ended September 30, 1992 filed with the Commission on November 13, 1992)           |
|       |   |                                                                                                                                                                                                                                   |
| 10.4       |   | Office Lease renewal for the period from 6/1/97 to 5/31/02, dated as  of May 6, 1997 (incorporated by reference to Exhibit 10.4 to the Form 10-QSB  for the quarter ended June 30, 1997 filed with the Commission on August 13,  1997) |
|       |   |                                                                                                                                                                                                                                   |
| 10.5       |   | Amendment 1 to Office Lease dated as of May 6, 1997 (incorporated by  reference to Exhibit 10.5 to Form 10-KSB for the year ended December 31,  2001)                                                                                  |
|       |   |                                                                                                                                                                                                                                   |
| 10.6       |   | 1999 Stock Option Plan (incorporated by reference to Exhibit 10.5 to  the Form 10-KSB for the year ended December 31, 1999)                                                                                                            |
|       |   |                                                                                                                                                                                                                                   |
| 21.1       |   | Subsidiaries of Paulson Capital Corp. Filed herewith electronically.                                                                                                                                                                   |
|       |   |                                                                                                                                                                                                                                   |
| 31.1       |   | Rule 13a-14(a)/15d-14(a)  Certification. Filed herewith electronically.                                                                                                                                                                |
|       |   |                                                                                                                                                                                                                                   |
| 31.2       |   | Rule 13a-14(a)/15d-14(a)  Certification. Filed herewith electronically.                                                                                                                                                                |
|       |   |                                                                                                                                                                                                                                   |
| 32.1       |   | Certification of Principal  Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. Filed herewith electronically.                                                 |
|       |   |                                                                                                                                                                                                                                   |
| 32.2       |   | Certification of Chief  Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. Filed herewith electronically.                                                     |

 

**(b) Reports on Form8-K**

 

None

 

22

----

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15 of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

 
|                |   | PAULSON CAPITAL CORP.    |
|---------------------|--------|--------------------------|
|                |   |                     |
| Date:  4/29/04 | By:    | /s/ Chester L.F. Paulson |   |
|                |   | Chester L.F. Paulson     |
|                |   | President                |

 

23

----

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theRegistrant in the capacities and on the dates indicated.

 
| **Signature**                        |                                 | **Title** |   | **Date** |   |
|--------------------------------------|--------------------------------------|-----------|--------|----------|--------|
| **(1) Principal  Executive Officer** |                                 |      |
|                                 |                                 |      |
| /s/ Chester L.F. Paulson             |                                 |      |   |
| Chester L.F. Paulson                 | Chairman of the Board and  President | 3/29/04   |
|                                 |                                 |      |
| **(2) Chief Financial  Officer**     |                                 |      |
|                                 |                                 |      |
| /s/ Carol Rice                       |                                 |      |   |
| Carol Rice                           | Chief Financial Officer              | 3/29/04   |
|                                 |                                 |      |
| **(3) Directors**                    |                                 |      |
|                                 |                                 |      |
| /s/ Jacqueline M. Paulson            |                                 |      |   |
| Jacqueline M. Paulson                | Secretary, Treasurer and  Director   | 3/29/04   |
|                                 |                                 |      |
| /s/ Glen Davis                       |                                 |      |   |
| Glen Davis                           | Director                             | 3/29/04   |
|                                 |                                 |      |
| /s/ Steve Kleemann                   |                                 |      |   |
| Steve Kleemann                       | Director                             | 3/29/04   |
|                                 |                                 |      |
| /s/ Shannon Pratt                    |                                 |      |   |
| Shannon Pratt                        | Director                             | 3/29/04   |
|                                 |                                 |      |
| /s/ Paul Shoen                       |                                 |      |   |
| Paul Shoen                           | Director                             | 3/29/04   |

 

24

----

 

**EXHIBIT INDEX**

 
| **Exhibit  Number** |   | **Description**                                                                                                                                                                                                                        |
|---------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |   | Articles of Incorporation (incorporated by reference to Exhibit 3.1  to the Company’s Registration Statement on Form 10 filed with the Commission  on December 18, 1989 (the “Form 10”))                           |
|                |   |                                                                                                                                                                                                                                   |
| 3.2                 |   | Bylaws (incorporated by reference to Exhibit 3.2 to the Form 10)                                                                                                                                                                       |
|                |   |                                                                                                                                                                                                                                   |
| 10.1                |   | Office lease dated June 28, 1988 (incorporated by reference to  Exhibit 10.2 to the Form 10)                                                                                                                                           |
|                |   |                                                                                                                                                                                                                                   |
| 10.3                |   | Contract with Correspondent Services Corporation, dated July 24, 1992  (incorporated by reference to Exhibit 10.3 to the Form 10-Q for the quarter  ended September 30, 1992 filed with the Commission on November 13, 1992)           |
|                |   |                                                                                                                                                                                                                                   |
| 10.4                |   | Office Lease renewal for the period from 6/1/97 to 5/31/02, dated as  of May 6, 1997 (incorporated by reference to Exhibit 10.4 to the Form 10-QSB  for the quarter ended June 30, 1997 filed with the Commission on August 13,  1997) |
|                |   |                                                                                                                                                                                                                                   |
| 10.5                |   | Amendment 1 to the Office Lease dated as of May 6, 1997 (incorporated  by reference to Exhibit 10.5 to Form 10-KSB for the year ended December 31,  2001)                                                                              |
|                |   |                                                                                                                                                                                                                                   |
| 10.6                |   | 1999 Stock Option Plan (incorporated by reference to Exhibit 10.5 to  the Form 10-KSB for the year ended December 31, 1999)                                                                                                            |
|                |   |                                                                                                                                                                                                                                   |
| 21.1                |   | Subsidiaries of Paulson Capital Corp. filed herewith electronically.                                                                                                                                                                   |
|                |   |                                                                                                                                                                                                                                   |
| 31.1                |   | Rule 13a-14(a)/15d-14(a)  Certifications. Filed herewith electronically.                                                                                                                                                               |
|                |   |                                                                                                                                                                                                                                   |
| 31.2                |   | Rule 13a-14(a)/15d-14(a)  Certifications. Filed herewith electronically.                                                                                                                                                               |
|                |   |                                                                                                                                                                                                                                   |
| 32.1                |   | Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002. Filed herewith electronically.                                                  |
|                |   |                                                                                                                                                                                                                                   |
| 32.2                |   | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002. Filed herewith electronically.                                                      |

 

25

----

 

Financial Statements and Report of

Independent Certified Public Accountants

 

**Paulson Capital Corp.and Subsidiary**

 

December 31, 2003 and 2002

 

----

 

Report of Independent Certified PublicAccountants

 

 

Board of Directors and Shareholders

Paulson Capital Corp.

 

We have audited the accompanying consolidated balance sheet of PaulsonCapital Corp. (an Oregon corporation) and Subsidiary as of December 31, 2003,and the related consolidated statements of operations, shareholders’ equity andcash flows for each of the two years in the period then ended.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our audits in accordance with auditing standards generallyaccepted in the United States of America. Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the consolidated financial position ofPaulson Capital Corp. and Subsidiary as of December 31, 2003, and theconsolidated results of their operations and their consolidated cash flows foreach of the two years in the period then ended, in conformity with accountingprinciples generally accepted in the United States of America.

 

Our audits were made for the purpose of forming an opinion on the basicconsolidated financial statements taken as a whole.  The accompanying Supplementary Schedule of Warrants Owned as ofDecember 31, 2003 is presented for purposes of additional analysis and is not arequired part of the basic consolidated financial statements.  Such information has been subjected to theauditing procedures applied in the audits of the basic consolidated financialstatements and, in our opinion, is fairly stated, in all material respects, inrelation to the basic consolidated financial statements taken as a whole.

 

We have also audited Schedule II for each of the two years in theperiod ended December 31, 2003.  In ouropinion, this schedule presents fairly, in all material respects, theinformation required to be set forth therein.

 

 
| Portland, Oregon  | /s/ GRANT THORNTON LLP |   |
|-------------------|------------------------|--------|
| February 27, 2004 |                   |   |
|              |                   |

 

F-1

----

 

Paulson Capital Corp. andSubsidiary

 

CONSOLIDATED BALANCE SHEET

 

December 31, 2003

 
| ASSETS                                                                                               |   |       |       |
|------------------------------------------------------------------------------------------------------|--------|------------|------------|
|                                                                                                 |   |       |       |
| Cash and cash equivalents                                                                            |   | $          | 155,314    |   |
| Receivable from clearing organization                                                                |   | 7,162,477  |       |
| Notes and other receivables                                                                          |   | 666,474    |       |
| Income taxes receivable                                                                              |   | 1,084,900  |       |
| Trading securities, at market value                                                                  |   | 1,474,649  |       |
| Investment securities, at market value                                                               |   | 17,588,454 |       |
| Underwriter warrants, at estimated fair  value                                                       |   | 6,311,000  |       |
| Prepaid and deferred expenses                                                                        |   | 1,418,537  |       |
| Furniture and equipment, net                                                                         |   | 208,327    |       |
|                                                                                                 |   |       |       |
| Total assets                                                                                         |   | $          | 36,070,132 |   |
|                                                                                                 |   |       |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                            |   |       |       |
|                                                                                                 |   |       |       |
| LIABILITIES                                                                                          |   |       |       |
| Accounts payable and accrued liabilities                                                             |   | $          | 446,076    |   |
| Dividends payble                                                                                     |   | 312,481    |       |
| Payable to clearing organization                                                                     |   | 496,181    |       |
| Compensation, employee benefits and payroll  taxes                                                   |   | 2,075,735  |       |
| Securities sold, not yet purchased, at market  value                                                 |   | 19,051     |       |
| Deferred income taxes payable                                                                        |   | 3,125,700  |       |
|                                                                                                 |   |       |       |
| Total liabilities                                                                                    |   | 6,475,224  |       |
|                                                                                                 |   |       |       |
| SHAREHOLDERS’ EQUITY                                                                            |   |       |       |
| Preferred stock, no par value; authorized,  500,000 shares; issued and outstanding, no shares        |   | —     |       |
| Common stock, no par value; authorized,  10,000,000 shares; issued and outstanding, 3,124,811 shares |   | 1,173,045  |       |
| Retained earnings                                                                                    |   | 28,421,863 |       |
|                                                                                                 |   |       |       |
| Total shareholders’ equity                                                                      |   | 29,594,908 |       |
|                                                                                                 |   |       |       |
| Total liabilities and shareholders’ equity                                                      |   | $          | 36,070,132 |   |

 

The accompanying notes are an integral part of this statement.

 

F-2

----

 

Paulson Capital Corp. andSubsidiary

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

Years ended December 31,

 
|                                        |   | **2003**   |       | **2002**    |    |
|---------------------------------------------|--------|------------|------------|-------------|---------|
|                                        |   |       |       |        |    |
| Revenues                                    |   |       |       |        |    |
| Commissions                                 |   | $          | 16,597,119 |        | $       | 7,598,621 |   |
| Corporate finance                           |   | 6,801,330  |       | 121,843     |    |
| Investment income (loss)                    |   | 3,359,973  |       | (6,559,267  | )  |
| Trading income (loss)                       |   | 1,245,018  |       | (203,835    | )       |
| Interest and dividends                      |   | 52,764     |       | 62,375      |    |
| Other                                       |   | 2,955      |       | 1,648       |    |
|                                        |   |       |       |        |    |
|                                        |   | 28,059,159 |       | 1,021,385   |    |
|                                        |   |       |       |        |    |
| Expenses                                    |   |       |       |        |    |
| Commissions and salaries                    |   | 16,959,056 |       | 8,195,581   |    |
| Underwriting expenses                       |   | 528,397    |       | 192,314     |    |
| Rent, telephone and quotation services      |   | 1,156,402  |       | 960,310     |    |
| Interest expense                            |   | 16,813     |       | 7,910       |    |
| Professional fees                           |   | 650,831    |       | 624,098     |    |
| Bad debt expense                            |   | 367,796    |       | 95,369      |    |
| Travel and entertainment                    |   | 250,973    |       | 335,640     |    |
| Depreciation and amortization               |   | 136,876    |       | 178,830     |    |
| Other                                       |   | 1,848,002  |       | 1,341,684   |    |
|                                        |   |       |       |        |    |
|                                        |   | 21,915,146 |       | 11,931,736  |    |
|                                        |   |       |       |        |    |
| Earnings (loss) before income taxes         |   | 6,144,013  |       | (10,910,351 | )       |
|                                        |   |       |       |        |    |
| Income tax expense (benefit)                |   | 2,103,736  |       | (3,899,197  | )       |
|                                        |   |       |       |        |    |
| NET EARNINGS (LOSS)                         |   | $          | 4,040,277  |        | $       | (7,011,154 | ) |
|                                        |   |       |       |        |    |
| Basic earnings (loss) per share             |   | $          | 1.30       |        | $       | (2.23 | )  |
|                                        |   |       |       |        |    |
| Diluted earnings (loss) per share           |   | $          | 1.29       |        | $       | (2.23 | ) |
|                                        |   |       |       |        |    |
| Weighted average common shares outstanding: |   |       |       |        |    |
| Basic                                       |   | 3,116,786  |       | 3,141,294   |    |
| Diluted                                     |   | 3,131,605  |       | 3,141,294   |    |

 

The accompanying notes are an integral part of these statements.

 

F-3

----

 

Paulson Capital Corp. andSubsidiary

 

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

 

Two year period ended December 31, 2003

 
|                                                                       |   | **Common  Stock** |   | **Retained  Earnings** |      |
|----------------------------------------------------------------------------|--------|-------------------|--------|------------------------|-----------|
|                                                                       |   | **Shares**        |   | **Amount**             |      |   |
|                                                                       |   |              |   |                   |      |   |   |
| Balance at December 31, 2001                                               |   | 3,163,062         |   | $                      | 1,062,428 |   | $ | 32,068,531 |   |
|                                                                       |   |              |   |                   |      |   |   |
| Stock options exercised                                                    |   | 8,000             |   | 35,500                 |      | — |   |
|                                                                       |   |              |   |                   |      |   |   |
| Redemption of common stock                                                 |   | (45,251           | )      | (11,188                | )         | (301,158 | ) |
|                                                                       |   |              |   |                   |      |   |   |
| Net earnings for the year                                                  |   | —            |   | —                 |      | (7,011,154 | )  |
|                                                                       |   |              |   |                   |      |   |   |
| Balance at December 31, 2002                                               |   | 3,125,811         |   | 1,086,740              |      | 24,756,219 |   |
|                                                                       |   |              |   |                   |      |   |   |
| Stock options exercised and income tax  benefit from stock option exercise |   | 14,000            |   | 90,055                 |      | — |   |
|                                                                       |   |              |   |                   |      |   |   |
| Redemption of common stock                                                 |   | (15,000           | )      | (3,750                 | )         | (62,152 | ) |
|                                                                       |   |              |   |                   |      |   |   |
| Dividends to common shareholders                                           |   | —            |   | —                 |      | (312,481 | ) |
|                                                                       |   |              |   |                   |      |   |   |
| Net income for the year                                                    |   | —            |   | —                 |      | 4,040,277 |   |
|                                                                       |   |              |   |                   |      |   |   |
| Balance at December 31, 2003                                               |   | 3,124,811         |   | $                      | 1,173,045 |   | $ | 28,421,863 |   |

 

The accompanying notes are an integral part of this statement.

 

F-4

----

 

Paulson Capital Corp. andSubsidiary

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

Years ended December 31, 2003 and 2002

 
|                                                                                       |   | **2003**   |      | **2002**   |   |
|--------------------------------------------------------------------------------------------|--------|------------|-----------|------------|--------|
|                                                                                       |   |       |      |       |   |
| Cash flows from operating activities                                                       |   |       |      |       |   |
| Net earnings (loss)                                                                        |   | $          | 4,040,277 |       | $      | (7,011,154 | )  |
| Adjustments to reconcile net earnings  (loss) to net cash provided by operating activities |   |       |      |       |   |
| Receipt of underwriter warrants                                                            |   | (4,249,407 | )         | (68,000    | )      |
| Unrealized (appreciation)  depreciation/expiration of underwriter warrants                 |   | (628,435   | )         | 3,519,000  |   |
| Noncash compensation associated with  underwriter warrants                                 |   | 1,280,842  |      | —     |   |
| Loss on sale of investment in real estate                                                  |   | —     |      | 11,634     |   |
| Deferred income taxes                                                                      |   | 3,125,700  |      | (2,323,300 | )      |
| Depreciation and amortization                                                              |   | 136,876    |      | 178,830    |   |
| Changes in assets and liabilities                                                          |   |       |      |       |   |
| Receivables                                                                                |   | 15,181     |      | (273,939   | )      |
| Receivable from/payable to clearing  organization                                          |   | (4,827,452 | )         | 5,175,418  |   |
| Trading and investment securities, net                                                     |   | (681,787   | )         | 1,811,224  |   |
| Income taxes receivable/payable                                                            |   | 809,100    |      | (47,900    | )      |
| Prepaid and deferred expenses                                                              |   | (259,799   | )         | (168,988   | )      |
| Accounts payable and accrued liabilities                                                   |   | 1,401,872  |      | (585,510   | )      |
| Securities sold, not yet purchased                                                         |   | (41,792    | )         | 47,997     |   |
|                                                                                       |   |       |      |       |   |
| Net cash provided by operating activities                                                  |   | 121,176    |      | 265,312    |   |
|                                                                                       |   |       |      |       |   |
| Cash flows from investing activities                                                       |   |       |      |       |   |
| Additions to furniture and equipment                                                       |   | (87,645    | )         | (92,040    | )      |
| Proceeds from sale of investment in real  estate                                           |   | —     |      | 158,266    |   |
|                                                                                       |   |       |      |       |   |
| Net cash provided by (used in) investing  activities                                       |   | (87,645    | )    | 66,226     |   |
|                                                                                       |   |       |      |       |   |
| Cash flows from financing activities                                                       |   |       |      |       |   |
| Proceeds from exercise of stock options and  related tax benefit                           |   |       | 90,055    |       |   | 35,500 |   |
| Payments to retire common stock                                                            |   | (65,902    | )         | (312,346   | )      |
|                                                                                       |   |       |      |       |   |
| Net cash provided by (used in) financing  activities                                       |   | 24,153     |      | (276,846   | )      |
|                                                                                       |   |       |      |       |   |
| Net increase in cash and cash equivalents                                                  |   | 57,684     |      | 54,692     |   |
|                                                                                       |   |       |      |       |   |
| Cash and cash equivalents at beginning of  year                                            |   | 97,630     |      | 42,938     |   |
|                                                                                       |   |       |      |       |   |
| Cash and cash equivalents at end of year                                                   |   | $          | 155,314   |       | $      | 97,630 |   |
|                                                                                       |   |       |      |       |   |
| Cash paid during the year for                                                              |   |       |      |       |   |
|                                                                                       |   |       |      |       |   |
| Interest                                                                                   |   | $          | 16,678    |       | $      | 7,910 |   |
|                                                                                       |   |       |      |       |   |
| Income taxes                                                                               |   | $          | 41,613    |       | $      | 2,219 |   |
|                                                                                       |   |       |      |       |   |
| Non-cash  item                                                                             |   |       |      |       |   |
|                                                                                       |   |       |      |       |   |
| Dividends  declared                                                                        |   | $          | 312,481   |       | $      | — |   |
|                                                                                            |        |            |           |            |        |  |  |  |  |

 

The accompanying notes are an integral part of these statements.

 

F-5

----

 

Paulson Capital Corp. andSubsidiary

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE A – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Paulson Capital Corp. (the Company) is a holding company whose wholly-ownedsubsidiary, Paulson Investment Company, Inc. (the Subsidiary), is a registeredbroker-dealer in securities under the Securities Exchange Act of 1934, asamended.  The Subsidiary providesbroker-dealer services in securities on both an agency and principal basis toits customers who are fully introduced to Correspondent Services Corporation(CSC), a subsidiary of National Financial Services, LLC.  The Subsidiary also acts as lead orparticipating selling group member for Nasdaq and American Stock Exchangesecurities offerings.  The Subsidiaryconducts business throughout the United States.  The Subsidiary is exempt from the reserve requirements under SECRule 15c3-3(k)(2)(ii), since it does not handle or carry customer securities orcash.

 

A summary of the significant accounting policies applied in thepreparation of the accompanying financial statements follows.

 

1.   Principles ofConsolidation

 

The accompanying consolidated financial statements include the accountsof Paulson Capital Corp. and its wholly-owned subsidiary, Paulson InvestmentCompany, Inc.  All significantintercompany balances and transactions have been eliminated in consolidation.

 

2.   Securities Transactions

 

Securities transactions and related revenue are recorded on a tradedate basis.  Underwriting revenues arerecognized at the time the underwriting is completed.  Revenue from the receipt of underwriter warrants received incorporate finance transactions is recognized based on the estimated fair valueof the securities received. Underwriter warrants are valued at estimated fairvalue using the Black-Scholes option-pricing model, taking into account theexercise price, remaining life of the warrant, the current price of theunderlying stock and its expected volatility, expected dividends on the stockand the risk-free interest rate for the remaining term of the warrant.  Changes in the estimated fair value of theseunderwriter warrants are reflected currently in the results of operations.  Marketable securities are valued at marketvalue and securities not readily marketable are valued at fair value asdetermined by management.  The fairvalue of not readily marketable securities is estimated by management usingavailable information including the following: quoted market prices of similarsecurities (i.e., unrestricted shares of the same company); price of recentknown trades of the same or similar securities; the cost of the security ifrecently purchased adjusted for changes in the financial condition of theissuer; all other information available from review of available documentsrelated to the issuer or discussions with management of the issuer.  Changes in the value of these securities arereflected currently in the results of operations.

 

3.   Fair Value of FinancialInstruments

 

The carrying amounts reflected in the balance sheet for cash, cashequivalents, notes and other receivables and payables approximate theirrespective fair values due to the short term nature of these instruments.

 

4.   Furniture and Equipment

 

Depreciation of furniture and equipment is generally computed by thestraight-line method over their estimated useful lives (5 years).  Leasehold improvements are amortized overthe lesser of their estimated useful life or the lives of their respectiveleases.

 

F-6

----

 

5.   Cash Flows

 

For purposes of reporting cash flows, cash and cash equivalents includecash on hand, cash due from banks and brokerage accounts, certificates ofdeposit and highly liquid debt instruments purchased with a maturity of threemonths or less.

 

6.   Use of Estimates

 

In preparing the Company’s financial statements, management is requiredto make estimates and assumptions that affect the reported amounts of assetsand liabilities, the disclosure of contingent assets and liabilities at thedate of the financial statements and the reported amounts of revenues andexpenses during the reporting period. Actual results could differ from thoseestimates.

 

7.   Earnings Per Share

 

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

 

8.   Income Taxes

 

The Company provides for income taxes under the liability method.  Deferred tax assets and liabilities aredetermined based on differences between the financial reporting and tax basisof assets and liabilities as measured by the enacted tax rates which areexpected to be in effect when these differences reverse.  Income tax expense (benefit) is the currenttax payable (recoverable) for the period and the change during the period innet deferred tax assets and liabilities.

 

9.   Advertising

 

Advertising costs of are charged to expense when incurred. Advertisingexpenses for the year ended December 31, 2003, totaled $52,335.

 

10. Stock Options

 

The Company has a stock-based employee compensation plan. As allowedunder SFAS No. 123, “Accounting for Stock-Based Compensation,” the Companycontinues to account for stock options for employees under APB No. 25, “Accountingfrom Stock Issued to Employees,” and has adopted the disclosure onlyrequirements of SFAS No. 123.

 

F-7

----

 

No stock-based employee compensation cost is reflected in net income in2003, as all options granted under the plan had an exercise price equal to themarket value of the underlying common stock on the date of grant.  The following table illustrates the effecton net income and earnings per share if the Company had applied the fair valuerecognition provisions of SFAS No. 123, *Accountingfor Stock-Based Compensation*, to stock-based employee compensationfor the years ended December 31, 2003 and 2002. The fair value of each optiongrant during 2002, is estimated on the date of grant using the Black-Scholesoption-pricing model with the following weighted-average assumptions: nodividends; expected volatility of 68%; risk-free interest rate of 4.8% andexpected life of 5 years. The assumptions used in the Black-Scholesoption-pricing model to determine the fair value of each option grant during2003, are as follows: annual expected dividend yield 1.23%; expected volatility57.3%; risk-free interest rate of 3.49%; and expected life of 5 years.

 
|                                                                                                                                          |   | **Year Ended  December 31, 2003** |      | **Year Ended  December 31, 2002** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|-----------|-----------------------------------|--------|
| Net income (loss), as reported                                                                                                                |   | $                                 | 4,040,277 |                              | $      | (7,011,154 | ) |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |   | (154,700                          | )         | (130,000                          | )      |
| Pro forma net income (loss)                                                                                                                   |   | $                                 | 3,885,577 |                              | $      | (7,141,154 | ) |
| Income (loss) per share:                                                                                                                      |   |                              |      |                              |   |
| Basic - as reported                                                                                                                           |   | $                                 | 1.30      |                              | $      | (2.23 | ) |
| Diluted – as reported                                                                                                                    |   | $                                 | 1.29      |                              | $      | (2.23 | ) |
| Basic - pro forma                                                                                                                             |   | $                                 | 1.25      |                              | $      | (2.27 | ) |
| Diluted - pro forma                                                                                                                           |   | $                                 | 1.24      |                              | $      | (2.27 | ) |

 

11. Reclassifications

 

Certain 2002 amounts have been reclassified to conform to the 2003presentation.

 

 

NOTE B – RECEIVABLE FROM AND PAYABLE TO CLEARING ORGANIZATION

 

The Subsidiary introduces all customer transactions in securitiestraded on U.S. securities markets to CSC on a fully-disclosed basis.  The agreement between the Subsidiary and itsclearing broker provides that the Subsidiary is obligated to assume anyexposure related to nonperformance by customers or counterparties.  The Subsidiary monitors clearance andsettlement of all customer transactions on a daily basis.

 

The exposure to credit risk associated with the nonperformance ofcustomers and counterparties in fulfilling their contractual obligationspursuant to these securities transactions is directly affected by volatiletrading markets which may impair the customer’s or counterparty’s ability tosatisfy their obligations to the Subsidiary. In the event of nonperformance, the Subsidiary may be required topurchase or sell financial instruments at unfavorable market prices resultingin a loss.  Management does notanticipate nonperformance by customers and counterparties in the abovesituations.

 

In addition to the clearing services provided, CSC also lends money tothe Subsidiary to finance its trading accounts.

 

F-8

----

 

NOTE C – NOTES AND OTHER RECEIVABLES

 

Notes and other receivables consist of the following at December 31,2003:

 
| Officers            |   | $       | 67,299  |   |
|---------------------|--------|---------|---------|--------|
| Employees           |   | 228,274 |    |
| Independent brokers |   | 28,385  |    |
| Other               |   | 342,516 |    |
|                |   |    |    |
|                |   | $       | 666,474 |   |

 

Employee and independent broker receivables relate principally toadvances, expenses, inventory losses and settlements charged to the registeredrepresentatives of the Subsidiary in excess of commission earnings.  For the years ended December 31, 2003 and2002, receivables from employees and independent brokers of $367,796 and$95,369, respectively, were determined by management to be uncollectible andwritten off to bad debt expense.

 

NOTE D – TRADING AND INVESTMENT SECURITIES

 

Trading securities and securities sold not yet purchased represent themarket value of securities held long and short by the Subsidiary.

 

The categories of trading securities and their related market values atDecember 31, 2003 are as follows:

 
|                            |   | **Owned** |      | **Sold,  Not Yet  Purchased** |   |
|---------------------------------|--------|-----------|-----------|-------------------------------|--------|
|                            |   |      |      |                          |   |
| Corporate equities              |   | $         | 1,288,139 |                          | $      | 19,051 |   |
| State and municipal obligations |   | 186,510   |      | —                        |   |
|                            |   |      |      |                          |   |
|                            |   | $         | 1,474,649 |                          | $      | 19,051 |   |

 

As a securities broker-dealer, the Subsidiary is engaged in varioussecurities trading and brokerage activities as principal.  In the normal course of business, theSubsidiary has sold securities that it does not currently own and willtherefore be obligated to purchase such securities at a future date.  This obligation is recorded in the financialstatements at the market value of the related securities and will result in atrading loss on the securities if the market price increases and a trading gainif the market price decreases subsequent to December 31, 2003.

 

F-9

----

 

Investment securities held by the Subsidiary which are readilymarketable are stated at market value. Included in investment securities are certain securities which are notreadily marketable.  Securities notreadily marketable include investment securities (a) for which there is nomarket on a securities exchange or no independent publicly quoted market, (b)that cannot be publicly offered or sold unless registration has been effectedunder the Securities Act of 1933, or (c) that cannot be offered or sold becauseof other arrangements, restrictions, or conditions applicable to the securitiesor to the Subsidiary.  At December 31,2003 these securities consisted of corporate stocks and warrants at estimatedfair value of approximately $2,230,000. A summary of the investment securities portfolio at December 31, 2003follows:

 
| Corporate equities |   | $       | 16,934,574 |   |
|--------------------|--------|---------|------------|--------|
| Corporate warrants |   | 653,880 |       |
|               |   |    |       |
|               |   | $       | 17,588,454 |   |

 

Realized loss included in the determination of net earnings was$2,317,543 and $393,040 for the years ended December 31, 2003 and 2002,respectively.

 

NOTE E – UNDERWRITER WARRANTS

 

The estimated fair value of warrants is determined by management usingthe Black-Scholes option-pricing model, taking into account the exercise price,remaining contractual life of the warrant, the current price of the underlyingstock and its expected volatility, expected dividends on the stock and therisk-free interest rate for the remaining term of the warrant (see Note A2).  The warrants generally have a five-yearexpiration date and vest immediately. The warrants are generally subject to a one-year restriction period inwhich the Company cannot exercise the warrants.  The expected volatility factors were determined using historicalvolatility of the underlying stock if available and historical volatility of apeer group if volatility for the underlying stock is not available.

 

The following table summarized activity in underwriter warrants:

 
| Estimated fair value at December 31, 2002  |   | $         | 2,714,000 |   |
|--------------------------------------------|--------|-----------|-----------|--------|
| Warrants received, net                     |   | 2,968,565 |      |
| Warrants expired                           |   | (532,533  | )         |
| Unrealized appreciation in estimated value |   | 1,160,968 |      |
| Estimated fair value at December 31, 2003  |   | $         | 6,311,000 |   |

 

The net increase in the estimated fair value of the underwriterwarrants is reflected currently in income. The fair value of the underwriterwarrants received during 2003 of $4,249,407 is included in the Company’scorporate finance revenues. Additionally, $1,280,842 was recognized ascompensation expense related to the receipt of the warrants, resulting in netwarrants received of $2,968,565. The amount of the underwriter warrants expiredof $532,533, and the unrealized appreciation in the fair value of theunderwriter warrants of $1,160,968 is included in investment income for 2003.

 

F-10

----

 

NOTE F – FURNITURE AND EQUIPMENT

 

Furniture and equipment are stated at cost and consist of the followingat December 31, 2003:

 
| Office equipment                                |   | $         | 1,514,502 |   |
|-------------------------------------------------|--------|-----------|-----------|--------|
| Vehicles                                        |   | 65,619    |      |
|                                            |   | 1,580,121 |      |
| Less accumulated depreciation and  amortization |   | 1,371,794 |      |
|                                            |   |      |      |
|                                            |   | $         | 208,327   |   |

 

NOTE G – INCOME TAXES

 

Income tax expense (benefit) consists of the following:

 
|                           |   | **2003**   |      | **2002**   |    |
|--------------------------------|--------|------------|-----------|------------|---------|
|                           |   |       |      |       |    |
| Current tax expense (benefit)  |   |       |      |       |    |
| Federal                        |   | $          | (868,670  | )          | $       | (1,341,968 | ) |
| State and local                |   | (153,294   | )         | (233,929   | )       |
|                           |   |       |      |       |    |
|                           |   | (1,021,964 | )         | (1,575,897 | )       |
|                           |   |       |      |       |    |
| Deferred tax expense (benefit) |   |       |      |       |    |
| Federal                        |   | 3,020,150  |      | (2,446,926 | )  |
| State and local                |   | 105,550    |      | 123,626    |    |
|                           |   |       |      |       |    |
|                           |   | 3,125,700  |      | (2,323,300 | )  |
|                           |   |       |      |       |    |
|                           |   | $          | 2,103,736 |       | $       | (3,899,197 | )  |

 

Income tax expense (benefit) for each year varies from the amountcomputed by applying the statutory federal income tax rate to earnings (loss)before income taxes as follows:

 
|                                                        |   | **2003** |      | **2002** |   |
|-------------------------------------------------------------|--------|----------|-----------|----------|--------|
|                                                        |   |     |      |     |   |
| Income tax expense (benefit) at statutory  federal tax rate |   | $        | 2,089,000 |     | $      | (3,709,500 | )  |
| State and local taxes net of federal  benefit               |   | 368,000  |      | (646,600 | )      |
| Permanent and other differences                             |   | 10,036   |      | (11,597  | )      |
| Change in valuation allowance on net  deferred tax asset    |   | (363,300 | )         | 468,500  |   |
|                                                        |   |     |      |     |   |
|                                                        |   | $        | 2,103,736 |     | $      | (3,899,197 | )  |

 

F-11

----

 

 

The deferred income tax asset (liability) consists of the following atDecember 31, 2003:

 
| Unrealized appreciation on securities         |   | $        | (3,596,700) |   |
|-----------------------------------------------|--------|----------|-------------|--------|
| Accrued expenses                              |   | 64,900   |        |
| Net operating loss carryforwards and  credits |   | 502,900  |        |
| Fixed asset depreciation                      |   | (500     | )           |
| Contribution carryover                        |   | 8,900    |        |
| Valuation allowance                           |   | (105,200 | )           |
|                                          |   |     |        |
|                                          |   | $        | (3,125,700) |   |

 

The Company has recorded a valuation allowance in the amount of$105,200 based upon management’s assessment that it is more likely than notthat the net deferred tax asset will not be fully realized.  Management will continue to review the netdeferred tax asset and may adjust the valuation allowance in future periodsbased upon their assessment.

 

The state net operating loss carryforwards of approximately $7.5million begin to expire in 2004.

 

F-12

----

 

NOTE H – COMMON STOCK

 

The Company’s 1999 Stock Option Plan reserves 500,000 shares of theCompany’s common stock for issuance upon exercise of options granted under theplan.  At December 31, 2003, 260,500options were available for grant.  ThePlan provides for the grant of incentive options and nonqualified options.  The options granted during 2003 have anexercise price of $8.10 and $8.91, vest immediately, and expire on November 9,2008. The market price of the Company’s stock at the date of the grant in 2003was $8.10. The options granted during 2002 have an exercise price of $7.01 and$7.71, vest immediately, and expire on March 18, 2007.  The market price of the Company’s stock atthe date of grant in 2002 was $7.01. The weighted average fair value of the options at the date of grant in2003, as calculated using the Black-Scholes option-pricing model, was $3.82 pershare.

 

The following table presents the options granted under the plan during2003:

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

 

The following table presents the options granted under the plan during2002:

 
|                                                                                  |   | **Number  of  Shares** |   | **Weighted  Average  Fair  Value** |   | **Weighted  Average  Exercise  Price** |   |
|---------------------------------------------------------------------------------------|--------|------------------------|--------|------------------------------------|--------|----------------------------------------|--------|
|                                                                                  |   |                   |   |                               |   |                                   |   |
| Options whose exercise price equals the  market price of the stock on the grant date  |   | 48,000                 |   | $                                  | 4.26   |                                   | $      | 7.01 |   |
|                                                                                  |   |                   |   |                               |   |                                   |   |
| Options whose exercise price exceeds the  market value of the stock on the grant date |   | 3,000                  |   | 4.12                               |   | 7.71                                   |   |
|                                                                                       |        |                        |        |                                    |        |                                        |        |  |  |

 

The following table summarizes activity under the Plan for the yearsended December 31, 2003 and 2002:

 
|                         |   | **Shares  Under  Option** |   | **Weighted  Average  Exercise  Price** |   | **Weighted  Average  Remaining  Life** |        |
|------------------------------|--------|---------------------------|--------|----------------------------------------|--------|----------------------------------------|-------------|
|                         |   |                      |   |                                   |   |                                   |        |
| Balance at December 31, 2001 |   | 101,000                   |   | $                                      | 4.44   |                                   | 2.625 years |   |
| Granted                      |   | 51,000                    |   | 7.05                                   |   |                                   |        |
| Exercised                    |   | (8,000                    | )      | 4.44                                   |   |                                   |        |
| Canceled                     |   | (3,000                    | )      | 7.01                                   |   |                                   |        |
|                         |   |                      |   |                                   |   |                                   |        |
| Balance at December 31, 2002 |   | 141,000                   |   | 5.33                                   |   | 2.469 years                            |        |
| Granted                      |   | 67,500                    |   | 8.31                                   |   |                                   |        |
| Exercised                    |   | (14,000                   | )      | 4.44                                   |   |                                   |        |
| Canceled                     |   | —                    |   |                                   |   |                                   |        |
|                         |   |                      |   |                                   |   |                                   |        |
| Balance at December 31, 2003 |   | 194,500                   |   | 6.43                                   |   | 2.735 years                            |        |
|                              |        |                           |        |                                        |        |                                        |             |  |

 

All outstanding options at December 31, 2003 and 2002 were exercisable.

 

F-13

----

 

As of December 31, 2003, outstanding stock options consist of thefollowing:

 
| **Exercise Price Range** |   | **Options** |   | **Weighted  Average** |   | **Remaining  Life** |   |
|--------------------------|--------|-------------|--------|-----------------------|--------|---------------------|--------|
|                     |   |        |   |                  |   |                |   |
| $                        | 4.44   |        |   | 79,000                |   | $                   | 4.44   |   | 0.6247 |   |
| 7.01 – 7.71         |   |        | 48,000 |                  | 7.05   |                | 3.2137 |   |
| 8.10 – 8.91         |   |        | 67,500 |                  | 8.31   |                | 4.8630 |   |
| Total                    |   | 194,500     |   |                  |   |                |   |
|                          |        |             |        |                       |        |                     |        |  |  |  |

 

 

NOTE I – EARNINGS PER SHARE

 

The following table is a reconciliation of the numerators anddenominators of the basic and diluted per share computations for each of thetwo years in the period ended December 31, 2003

 
|                                      |   | **Income  (Numerator)** |       | **Weighted  Average  Shares  (Denominator)** |      | **Per  Share  Amount** |   |
|-------------------------------------------|--------|-------------------------|------------|----------------------------------------------|-----------|------------------------|--------|
|                                      |   |                    |       |                                         |      |                   |   |
| 2002                                      |   |                    |       |                                         |      |                   |   |
| Basic and diluted loss per share          |   |                    |       |                                         |      |                   |   |
| Loss available to common stockholders     |   | $                       | (7,011,154 | )                                            | 3,141,294 |                   | $      | (2.23 | ) |
|                                      |   |                    |       |                                         |      |                   |   |
| 2003                                      |   |                    |       |                                         |      |                   |   |
| Basic earnings per share                  |   |                    |       |                                         |      |                   |   |
| Income available to common stockholders   |   | $                       | 4,040,277  |                                         | 3,116,786 |                   | 1.30   |   |
|                                      |   |                    |       |                                         |      |                   |   |
| Effect of dilutive securities             |   |                    |       |                                         |      |                   |   |
| Stock options                             |   | —                  |       | 14,819                                       |      |                   |   |
|                                      |   |                    |       |                                         |      |                   |   |
| Diluted earnings per share                |   |                    |       |                                         |      |                   |   |
| Earnings available to common stockholders |   | $                       | 4,040,277  |                                         | 3,131,605 |                   | $      | 1.29 |   |

 

NOTE J – LEASES

 

Future minimum payments required under non-cancelable operating leaseswith remaining terms of one year or more consist of the following:

 
| **Year ending  December 31,** |   |    |      |
|-------------------------------|--------|---------|-----------|
|                          |   |    |      |
| 2004                          |   | $       | 344,923   |   |
| 2005                          |   | 353,838 |      |
| 2006                          |   | 334,152 |      |
| 2007                          |   | 349,146 |      |
| Thereafter                    |   | 509,796 |      |
|                          |   | $       | 1,891,855 |   |

 

The leases provide for payment of taxes and other expenses by theCompany.  Rental expense for the yearsended December 31, 2003 and 2002 approximated $494,383 and $372,000,respectively.

 

F-14

----

 

NOTE K – EMPLOYEE BENEFIT PLANS

 

Retirement benefits for employees of the Company, who have completedcertain service requirements, are provided by a defined contributionprofit-sharing plan.  Plan contributionsare determined by the Board of Directors. Contributions to the plan for the years ended December 31, 2003 and2002 were $150,000 and $0, respectively.

 

NOTE L – CONTINGENCIES

 

The Company and its Subsidiary have been named by individuals incertain legal actions, some of which allege state and federal securities lawviolations and claim compensatory and punitive damages.  As preliminary hearings and discovery inthese cases is not complete, it is not possible to assess the degree ofliability, the probability of an unfavorable outcome or the impact on theCompany’s financial statements, if any. Management believes it has meritorious defenses in these legal actionsand is vigorously defending itself.  Noprovision for liability, if any, that may result from the above contingencieshas been made in the financial statements.

 

NOTE M – NET CAPITAL REQUIREMENT

 

The Subsidiary is subject to the net capital rule (Rule 15c3-1) of theSecurities and Exchange Commission. This rule prohibits the Subsidiary from engaging in any securitiestransaction at a time when its “aggregate indebtedness” exceeds fifteen timesits “net capital” as those terms are defined by the rule.  At December 31, 2003, the Subsidiary’s netcapital and required net capital were $14,338,359 and $167,540, respectively,and its ratio of aggregate indebtedness to net capital was .18 to 1.  The Subsidiary’s absolute minimum netcapital requirement is $100,000. Trading and investment securities represent potentially volatilecomponents of net capital.

 

NOTE N – CONCENTRATION OF RISK

 

Approximately $9,395,936 or 49.6 percent of the Company’s trading andinvestment securities are invested in the common stock of two companies.

 

F-15

----

 

Schedule I

 

PaulsonCapital Corp. and Subsidiary

 

SUPPLEMENTARY SCHEDULE OF WARRANTS OWNED

 

December 31,2003

 
| **Description**                                  |   | **Number  of  Warrants** |   | **Exercise  Price Per  Share/Unit** |   | **Expiration  Date** |        |
|--------------------------------------------------|--------|--------------------------|--------|-------------------------------------|--------|----------------------|-------------|
|                                             |   |                     |   |                                |   |                 |        |
| AdStar, Inc. (units) ERC*12-17-00                |   | 60,500                   |   | $                                   | 7.20   |                 | 2004, 12/16 |   |
| AdStar, Inc. ERC 9-25-01                         |   | 149,000                  |   | $                                   | 1.80   |                 | 2005, 09/25 |   |
| Adstar, Inc. ERC 1-17-02                         |   | 22,137                   |   | $                                   | 0.75   |                 | 2007, 01/16 |   |
| Adstar, Inc. ERC 03-31-04                        |   | 78,705                   |   | $                                   | 1.87   |                 | 2009, 03/31 |   |
| AVI Biopharma, Inc. ERC 7-26-01                  |   | 151,014                  |   | $                                   | 8.70   |                 | 2005, 07/26 |   |
| Beta Oil & Gas, Inc. ERC 7-30-00             |   | 9,300                    |   | $                                   | 7.50   |                 | 2004, 07/30 |   |
| Beta Oil & Gas, Inc. #2 ERC 6-29-01          |   | 1,850                    |   | $                                   | 9.25   |                 | 2006, 06/29 |   |
| Careside, Inc. (units) ERC 06-15-00              |   | 92,650                   |   | $                                   | 9.00   |                 | 2004, 06/15 |   |
| Creative Products Intl. ERC 7-01-01              |   | 30,000                   |   | $                                   | 1.50   |                 | 2006, 06/30 |   |
| Dag Media, Inc. ERC 05-12-00                     |   | 90,562                   |   | $                                   | 7.80   |                 | 2004, 05/12 |   |
| GMX Resources (units) ERC 2-12-01                |   | 76,475                   |   | $                                   | 9.60   |                 | 2006, 02/12 |   |
| GMX Resources #2 ERC 7-18-02                     |   | 126,650                  |   | $                                   | 6.60   |                 | 2006, 07/18 |   |
| Imageware Systems, Inc. (units) ERC 3-30-01      |   | 106,323                  |   | $                                   | 9.60   |                 | 2005, 03/30 |   |
| Medinex Systems, Inc. ERC 1-31-02                |   | 169,050                  |   | $                                   | 0.23   |                 | 2005, 01/31 |   |
| microHelix, Inc. (units) ERC 11-16-02            |   | 127,462                  |   | $                                   | 7.20   |                 | 2006, 11/16 |   |
| Pacific Mercantile Bancorp ERC 6-15-01           |   | 158,350                  |   | $                                   | 9.60   |                 | 2005, 06/14 |   |
| Pacific Mercantile Bancorp ERC 12-08-04          |   | 136,118                  |   | $                                   | 11.10  |                 | 2008, 12/08 |   |
| Path 1 Network Technologies (units) ERC  7-31-04 |   | 87,292                   |   | $                                   | 12.96  |                 | 2008, 07/30 |   |
| Q Comm International, Inc. (units) ERC  6-25-04  |   | 61,552                   |   | $                                   | 15.60  |                 | 2008, 06/24 |   |
| 3D shopping.com (units) ERC 07-20-00             |   | 73,466                   |   | $                                   | 14.40  |                 | 2004, 07/20 |   |

 

----

* Date exercisable

 

F-16

----

 

Schedule II

 

PaulsonCapital Corp. and Subsidiary

 

Valuation andQualifying Accounts

 

Years endedDecember 31, 2003 and 2002

 
| **Description**                  |   | **Balance  Beginning  of Year** |   | **Additions-Charges  to Cost and  Expenses** |   | **Deductions  Write-offs** |   | **Balance  at End  of Year** |    |
|----------------------------------|--------|---------------------------------|--------|----------------------------------------------|--------|----------------------------|--------|------------------------------|---------|
|                             |   |                            |   |                                         |   |                       |   |                         |    |
| Allowance for doubtful accounts: |   |                            |   |                                         |   |                       |   |                         |    |
|                             |   |                            |   |                                         |   |                       |   |                         |    |
| Year ended Dec. 31, 2003         |   | $                               | — |                                         | $      | 367,796                    |   | $                            | 367,796 |   | $ | — |   |
| Year ended Dec. 31, 2002         |   | —                          |   | 95,369                                       |   | 95,369                     |   | —                       |    |
|                                  |        |                                 |        |                                              |        |                            |        |                              |         |  |  |  |  |

 

F-17

----