**U.S. SECURITIES AND EXCHANGE COMMISSION**

 

**WASHINGTOND.C. 20549**

----

 

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

 
| **For  the fiscal year ended  December 31, 2002** | **Commission  file number: 0-18188** |
|---------------------------------------------------|--------------------------------------|

 

**FORM 10-KSB**

 

**PAULSON CAPITAL CORP.**

Name of small businessissuer as specified in its charter

 
| **Oregon**                                                      |   | **93-0589534**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |   |                                  |
| **811  S.W. Naito Parkway, Suite 200 Portland, OR**             |   | **97204**                             |
| (Address of principal  executive offices)                       |   | (Zip Code)                            |
|                                                            |   |                                  |
| Issuer’s telephone number: **(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 reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the past 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.    Yes   ý     No   o

 

Check if there is no disclosure of delinquentfilers in response to Item 405 of Regulation S-B is not contained in this form,and no disclosure will be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part IIof this Form 10-KSB or any amendment to this Form 10-KSB.  o

 

 

----

 

State issuer’s revenues for its most recentfiscal year:

 

$1,010,000

 

As of March 18, 2003, 3,117,811shares of the registrant’s common stock, no par value, were outstanding and theaggregate market value of the shares of common stock of the Registrant held bynon-affiliates (based upon the average of the closing bid and asked prices ofRegistrant’s shares in the over-the-counter market as of such date) was$4,296,623.

 

DOCUMENTS INCORPORATED BYREFERENCE

 

Portions of the Registrant’sdefinitive proxy statement for the 2003 annual meeting of shareholders to befiled with the Securities and Exchange Commission are incorporated by referenceinto Part III.

 

Transitional Small BusinessDisclosure Format:

 

Yes  o   No  ý

 

2

----

 

**PART I**

 

**FORWARD-LOOKING STATEMENTS**

 

**This report, including, withoutlimitation, “Item 6. Management’s Discussion and Analysis of FinancialCondition and Results of Operations,” contains or incorporates both historicaland “forward-looking” statements within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the Securities ExchangeAct 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:**

 

•                  **The performance of companieswhose securities we have underwritten or otherwise sold to our customers mayaffect our reputation with other potential syndicate and selling group membersand institutional and other retail accounts and may also affect the amount ofmoney in our customers’ portfolios available for the kinds of investments thatwe offer.**

 

•                  **The value of our investmentportfolio, including the value of securities without a readily ascertainablemarket value, that we have estimated for the purpose of reporting on ourfinancial 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 are subject to a very highdegree of regulation and are responsible for compliance with applicableregulations by all of our personnel.  Asignificant regulatory infraction by us or any of our registered representativescould result in significant penalties, including the loss of our license toconduct securities business in one or more jurisdictions.**

 

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

 

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

 

3

----

 

**ITEM 1.        DESCRIPTIONOF BUSINESS**

 

**General**

 

Paulson Capital Corp. (“PaulsonCapital” or the “Company”), established in 1970, is a holding company whoseonly operating subsidiary is Paulson Investment Company, Inc. (“PIC”), a fullservice brokerage firm engaged in the purchase and sale of securities from andto the public and for its own account and in investment bankingactivities.  The Company operates in oneindustry segment, the financial services industry.  At December 31, 2002, PIC employed 32 brokers and had independentcontractor arrangements with 90 brokers registered with the National Associationof Securities Dealers, Inc. (“NASD”). PIC also employed a support staff of 50 persons in its headquarters inPortland, Oregon and in certain of its branch offices.  At December 31, 2002, PIC had 43 branchoffices throughout the United States.

 

Paulson Capital is located at811 S.W. Naito Parkway, Suite 200, Portland, Oregon 97204.  Its telephone number is (503) 243-6000.

 

**Principal Products, Services andMarkets**

 

Virtually all of PaulsonCapital’s business is carried on through PIC. PIC is involved in the purchase and sale of most investment securitiesbut is not involved in commodities or futures. Four broad categories of securities activities contribute to revenues ofPIC: retail brokerage, corporate finance/investment banking, trading and marketmaking (or wholesale).  PIC alsoreceives revenues from gains and losses in investment accounts, fromunderwriter warrants received in connection with its corporate financeactivities, and from other sources.

 

The following table shows theportion of our revenues that was attributable to each category for the last twofiscal years:

 
|                     |   | **2002**   |      | **2001**   |   |
|--------------------------|--------|------------|-----------|------------|--------|
| **Securities Brokerage** |   | $          | 7,598,621 |       | $      | 7,561,535 |   |
| **Corporate Finance**    |   | 121,843    |      | 6,017,517  |   |
| **Investment Income**    |   | (6,559,142 | )         | 10,700,897 |   |
| **Trading Income**       |   | (203,835   | )         | 1,008,957  |   |
| **Other**                |   | 52,266     |      | 48,440     |   |
|                          |        |            |           |            |        |  |  |

 

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.

 

**Securities Brokerage**

 

As a securities broker, PIC acts as agent for itscustomers in the purchase and sale of common and preferred stocks, options,warrants and debt securities traded on securities exchanges or in theover-the-counter (“OTC”) market.  Aportion of its revenue is derived from commissions from customers on thesetransactions. In the OTC market, transactions with customers in securities notlisted on an exchange may be effected as principal, rather than agent,primarily in securities for which PIC is a market maker.  Customer transactions in securities areeffected either on a cash or margin basis.

 

4

----

 

PIC also enters into dealer agreements with mutualfund management companies and publicly registered limited partnerships.  Commissions on the sale of these securitiesare derived from the standard dealer discounts, which range from approximately1 percent to 8.5 percent of the purchase price of the securities, depending onthe terms of the dealer agreement and the amount of the purchase.  PIC does not generally sell interests inlimited partnerships that are not publicly registered.

 

In the case of corporate finance transactions,described below, a portion of the discount applicable to securities placed byPIC’s retail brokerage group is credited to securities brokerage and thecommission payable to the broker is recorded as securities brokerage expense.

 

Pursuant to an agreement between PIC and CorrespondentServices Corporation (“CSC”), a UBS PaineWebber Company, CSC carries all ofPIC’s customer securities accounts and performs the following services:(1) preparation and mailing of monthly statements to PIC customers; (2) settlementof contracts and transactions in securities between PIC and otherbroker-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) theexecution of customer orders placed on an exchange.  PIC determines the amount of commission to be charged to itscustomers on agency transactions and the price of securities purchased or soldin principal 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 to PIC in the ordinary course of PIC’s business, pursuant to anarrangement under which CSC agrees to finance PIC’s trading accounts.  At December 31, 2002, no net loans wereoutstanding pursuant to this arrangement.

 

**Corporate Finance**

 

PIC raises capital for its corporate finance clientsthrough public offerings of securities of corporations that are engaged in avariety of businesses.  PIC participatesin underwritings of corporate securities as managing underwriter and as asyndicate member.  Management of anunderwriting generates more revenue than participation as a member of anunderwriting syndicate.  Revenuesgenerated by syndicate participations have not been material.

 

PIC acts as the managing underwriter of publicofferings of securities that typically range in size from $5 million to $20million.  PIC underwrites theseofferings on a “firm commitment” basis, which means that it agrees to purchasea specific amount of securities from the issuer at a discount, after theregistration statement for the offering is declared effective by the Securitiesand Exchange Commission (the “SEC”), and resells the securities to the publicat a specified price. Managing these public offerings involves the risk of lossif PIC is unable to resell at a profit the securities it is committed topurchase.  This risk is usually reducedby accepting other stock brokerage firms as a part of an underwriting syndicatein which each member commits to purchase a specified amount of theoffering.  PIC and the otherunderwriters may also sell a portion of their commitment through a “sellinggroup” of other stock brokerage firms that participate in selling the offeringbut are not subject to an underwriter’s commitment.  As an underwriter, PIC is also subject to potential liability underfederal and state securities laws if the registration statement or prospectuscontains a material misstatement or omission. PIC has no insurance to cover its potential liabilities as anunderwriter.

 

5

----

 

The commitment of capital by PIC between the time afirm commitment underwriting agreement becomes effective and the time PICresells the securities 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, 2002, PICacted as the managing underwriter or co-managing underwriter for 143 securitiesofferings, raising approximately $920 million for corporate financeclients.  Of these, 88 were initialpublic offerings.  PIC typicallyreceives 2 to 3 percent of the aggregate amount of money raised in an offeringto cover nonaccountable 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.

 

**InvestmentIncome**

 

For a variety of reasons, PIC holds securities forinvestment.  Securities held forinvestment are maintained in investment accounts that are segregated from thetrading accounts.  PIC’s investmentportfolio principally consists of securities purchased for investment andunderwriter warrants.

 

From time to time, PIC makes investments as aprincipal in companies that are, or are expected to be, corporate financeclients.  The investment may be asconvertible debt in anticipation of a public offering, in which case, if theoffering is successful, the principal and interest are either converted toequity or repayable from the offering proceeds.  If the offering is not successful, the debt is typicallyconverted to equity.  PIC also makesinvestments in companies that are not anticipating an immediate publicoffering.  In such cases, the investmentis typically made in the form of the purchase of restricted equitysecurities.  Typical investmentsdescribed in this paragraph have ranged from $100,000 to $600,000.

 

**Trading and Market Making**

 

In addition to executing trades as an agent, PICregularly acts as a principal in executing trades in equity securities,corporate debt securities and municipal bonds. At December 31, 2002, PIC made a market in 50 securities of 44issuers.  Of these, 15 were corporationsfor which PIC has acted as managing or co-managing underwriter of publicfinancings.  In addition, atDecember 31, 2002, PIC held securities of 27 companies in its investmentaccount.  In 2002, the value ofsecurities held in the trading accounts and investment account ranged between$14,607,724 and $23,465,597  The levelof positions carried in PIC’s trading and investment accounts fluctuatessignificantly.  The size of thesecurities positions at any date may not be representative of PIC’s exposure onany other date, because the securities positions vary substantially dependingupon economic and market conditions, the allocation of capital among types ofinventories, underwriting commitments, customer demands and tradingvolume.  The aggregate value ofinventories that PIC may carry is limited by certain requirements under theSEC’s net capital rules.  See “NetCapital Requirements.”

 

6

----

 

PIC’s market making activities are conducted both withother dealers in the “wholesale market” and with PIC’s customers.  Transactions with customers are effected asprincipal at a net price equal to the current interdealer price plus or minusthe approximate equivalent of a brokerage commission.  In such transactions, the commission is recorded as securitiesbrokerage revenue while any profit or loss attributable to a change in value ofthe security in PIC’s trading account is recorded as trading profit or loss.PIC’s transactions as principal expose PIC to risk because securities positionsare subject to fluctuations in market value and liquidity.  Profits or losses 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.

 

**Branch Offices**

 

PIC branch offices are generally run by independentcontractors who assume liability for all the operating expenses of thebranch.  PIC typically receives between10 and 20 percent of the gross commission earned by the branch, with thebalance retained by the branch to pay its expenses and staff.  Persons in these branches are registeredwith PIC, and PIC assumes the same compliance and regulatory obligations aswould be the case if PIC were fully responsible for the branch’s expenses.  As of December 31, 2002, PIC had 43branch offices in California, Connecticut, District of Columbia, Florida,Georgia,  Michigan, Nevada, 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.

 

7

----

 

**Regulation**

 

PIC is registered with the SEC as a broker-dealerunder the Securities Exchange Act of 1934 and is a member of the NASD. It isalso registered as a broker-dealer under the laws of all 50 states andWashington, D.C.

 

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

 

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

 

**Net Capital Requirements**

 

PIC is required to maintain minimum “net capital”under the SEC’s net capital 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, 2002,PIC had net capital of $9,885,381, which exceeded its minimum requirement of$100,000 by $9,785,381.  The ratio ofaggregate indebtedness of $1,080,629 to net capital of $9,885,381 onDecember 31, 2002 was approximately 0.11 to 1.  In a public offering inwhich PIC acts as an underwriter, PIC must have sufficient net capital to coverthe amount of securities underwritten, applying applicable formulae mandated bythe SEC, during the period between effectiveness and the closing of thetransaction, usually 3-4 days. This results in a significant temporary increasein PIC’s required net capital.  In somecases, the amount of securities underwritten by PIC has been limited by its netcapital.  Any significant reduction inPIC’s net capital, even if PIC were still in compliance with the SEC’s netcapital rule for its retail and trading activities, could have a materialadverse impact on PIC’s ability to continue its investment banking activities.

 

8

----

 

**Competition**

 

All aspects of PIC’s business are highlycompetitive.  In its general brokerageactivities, PIC competes directly with numerous other broker-dealers, many ofwhich are large well-known firms with substantially greater financial andpersonnel resources than PIC.  Many ofPIC’s competitors employ extensive advertising and actively solicit potentialclients in order to increase business. In addition, brokerage firms compete by furnishing investment researchpublications to existing clients, the quality and breadth of which areconsidered important in the development of new business and the retention ofexisting clients.  PIC also competeswith a number of smaller regional brokerage firms.

 

Some commercial banks and thrift institutions offersecurities brokerage services.  Manycommercial banks offer a variety of investment banking services.  Competition among financial services firmsalso exists for investment representatives and other personnel.

 

The securities industry has become considerably moreconcentrated and more competitive since the Company was founded, as numeroussecurities firms have either ceased operations or have been acquired by ormerged into other firms.  This trend hasbeen particularly pronounced among firms similar in size and business mix toPIC.  In addition, companies not engagedprimarily in the securities business, but with substantial financial resources,have acquired 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 substantialcommission discounting 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 competeswith other brokerage firms, venture capital firms, banks and all other sourcesof capital for small, growing companies. Since PIC generally manages offerings smaller than $20 million, it doesnot typically compete with the investment banking departments of large,well-known national brokerage firms. Nevertheless, PIC occasionally manages larger offerings.  In addition, large national and regionalinvestment banking firms occasionally manage offerings of a size that iscompetitive with PIC, typically for fees and compensation less than thatcharged by PIC.  When the market forinitial public offerings is active, many small regional firms that do nottypically engage in investment banking activities also begin to compete withPIC.

 

9

----

 

**Employees**

 

At December 31, 2002, PIC had 82 employees, ofwhom 50 were executives and support staff and 32 were involved in brokerageactivities and compensated primarily on a commission basis.  PIC also had independent contractorarrangements with 90 independent contractors, all of whom are compensatedsolely on a commission basis.  PaulsonCapital had no employees separate from PIC.

 

**ITEM 2.        DESCRIPTIONOF PROPERTY**

 

PIC leases approximately 17,100square feet of space for its office in Portland, Oregon under a lease expiringMay 31, 2009.  The base monthlyrental rate on this lease is currently $25,704.  The rental rate increases every 2-3 years, from $25,704 beginningin June 2002 to $29,988 through the expiration of the lease in June 2009.   PIC’s Salem office leases space under alease that expires on October 31, 2005 at a monthly rent of $3,001, with rentsubject to increases based upon inflation. PIC ‘s Manhattan office leases space on a month-to-month basis at $5,400per month.  The Company believes theexisting leased space is suitable and adequate for its business for theforeseeable future.  PIC’s other branchoffices lease space but, under the terms of the relationship between PIC andthese offices, PIC is not responsible for these lease costs.

 

**ITEM 3.        LEGALPROCEEDINGS**

 

In January 2001, V.J.E. Enterprises, Inc. and Vincentand Diana Nartker, former PIC customers, filed a complaint with PIC regardingthe handling of their account by PIC and one of its registeredrepresentatives.  They have assertedthat their account was mismanaged and that PIC failed to supervise itsregistered representative.  They haverequested that PIC pay them $275,100. PIC is investigating this claim, but believes it has meritoriousdefenses and intends to defend this matter vigorously if an arbitration isfiled.

 

On November 7, 2001, the Company and PIC were named asdefendants in a lawsuit filed by Spirit Partners, L.P. and Tech-Trade CapitalLLC.  The lawsuit was filed in theSupreme Court of the State of New York for the County of New York.  The lawsuit alleges that PIC committed fraudand was unjustly enriched in connection with the redemption of warrants issuedin the initial public offering of audiohighway.com, for which PIC served asunderwriter.  According to plaintiffs,the warrant agreement and prospectus contain different provisions governing theredemption of the warrants.  Thisallegedly occurred because the redemption provisions were changed during theregistration process and the warrant agreement was not amended to reflect thechange in provisions. audiohighway.com’s redemption was proper under the terms of theprospectus, which contains the updated redemption provisions and allowed theissuer to redeem when the closing bid price of the common stock was at least$13.50 for 10 calendar days.  Plaintiffsallege that the redemption was improper under the terms of the warrantagreement, which they allege contains the original redemption provisions andallows the issuer to redeem when the closing bid price of the common stockexceeded $13.50 for 20 consecutive trading says. Plaintiffs also allege thatcounsel for audiohighway.com and PIC fraudulently concealed the allegeddiscrepancy between the prospectus and warrant agreement by amending thewarrant agreement to be consistent with the prospectus.  Plaintiffs claim unspecified monetarydamages and seek $3 million in punitive damages.  The lawsuit has been stayed, pending mandatory arbitration beforethe NASD.  This arbitration is in a veryearly stage, and PIC is currently conducting discovery.  However, the Company and PIC believe theyhave meritorious defenses to these claims and intend to defend the casevigorously.

 

10

----

 

In January 2002, PIC was served in an arbitrationbrought by a former customer, Patricia Weber, against PIC and its registeredrepresentative, Melvin Vukcevich.  Thearbitration claim alleges unsuitable securities recommendations,misrepresentation, breach of fiduciary duty and negligence.  The claimant is seeking damages of $255,000,interest, an additional return on her portfolio, punitive damages and attorneyfees.  PIC has filed its answer. PICbelieves it has meritorious defenses and intends to defend this mattervigorously.

 

In March 2002, PIC and one of its registeredrepresentatives, Marvin Cox, were named as defendants in lawsuits filed byLouis Barinaga and Stuart Mackenzie, former PIC customers. The claims of Barinaga and Mackenzie relate topurchases 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.  PIC asserted that the claims are subject toarbitration.  Plaintiffs have abatedtheir lawsuit and refiled their claims before the NASD.   PIC is currently conducting discovery andbelieves it has meritorious defenses and intends to defend these claimsvigorously. The arbitration hearing in this matter is scheduled to beginNovember 3, 2003 in Portland, Oregon.

 

In March 2002, PIC and one of its registeredrepresentatives, Melvin Vukcevich, were named as respondents in arbitrationclaims filed by former customers Paul and Mary Herold.  The Herolds claim they were misled intopurchasing unsuitable securities and allege damages of $70,000 plus unspecifiedpunitive damages.  This case is in theearly stages of discovery, but PIC believes it has meritorious defenses andintends to defend this matter vigorously. The arbitration hearing in thismatter is scheduled to begin June 24, 2003 in Los Angeles, California.

 

In October 2002, PIC was named as a defendant in alawsuit filed by Special Situations Fund III, LP and Special Situations CaymanFund, LP.  The lawsuit was filed in U.S.Federal District Court for the State of New Jersey.  It asserts various federal securities law claims and common lawfraud and negligence against numerous defendants, including PIC, arising out oftwo secondary offerings of Suprema Specialties, Inc.   PIC participated in one of the two offerings, the August 25,2000 secondary offering of Suprema Specialties, Inc. as a member of theunderwriting syndicate, underwriting 75,000 shares in total.  The plaintiffs seek damages for the purchaseof 399,151 shares of Suprema Specialties, Inc. stock between August 25, 2000and November 14, 2001.  On January 15,2003, PIC filed a motion to dismiss all claims brought by plaintiffs. Thehearing on PIC's motion to dismiss is scheduled for April 17, 2003.  PIC believes it has meritorious defenses andintends to defend this matter vigorously.

 

In December 2002, PIC and its former registeredrepresentative, Wayde Newman, were named as respondents in arbitration claimsfiled by Eugene V. Doty.  Mr. Dotyasserts claims for fraud, breach of fiduciary duty, and violations of Coloradoconsumer and securities acts and violations of NASD rules.  Mr. Doty seeks $2,300,000, interest,attorney fees and punitive and treble damages. PIC is investigating this claim,but believes it has meritorious defenses and intends to defend this mattervigorously.

 

In January 2003, Joanne Thies, a former PIC customer,filed an arbitration claim with the NASD, naming PIC and Peter Jones, a currentPIC registered representative, as respondents. Ms. Thies asserts claims for negligence, failure to supervise, fraud andsecurities law violations relating to her account.  The claimant seeks damages of $457,000, attorney fees, costs andexpenses. PIC has not had an opportunity to fully investigate this claim, butbelieves it has meritorious defenses and intends to defend this mattervigorously.

 

In February 2003, Brock and Julie Belt, former PICcustomers, filed an arbitration claim with the NASD, naming PIC and KenRousbett, a former PIC registered representative, as respondents.  The complaint alleges unsuitable securitiesrecommendations and seeks $700,000 in damages, plus attorney fees andinterest.  PIC has not had anopportunity to fully investigate this claim, but believes it has meritoriousdefenses and intends to defend this matter vigorously if any claims are filed.

 

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

 

An adverse outcome in certain of the matters describedabove could have a material adverse effect on PIC or the Company.  PIC has been named in certain other legalproceedings and has received notice that certain customers may commence legalproceedings against PIC.  The Companybelieves, based upon information received to date and, where the Companybelieves it appropriate, discussions with legal counsel, that resolution ofthis additional pending or threatened litigation will have no material adverseeffect on the consolidated financial condition, results of operations, orbusiness of the Company.

 

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

 

None

 

11

----

 

**PART II**

 

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

 

The Company’s common stocktrades in the over-the-counter market. The Company’s stock is quoted on the Nasdaq SmallCap Market under thesymbol “PLCC,” but it is not actively traded. The following are high and low sales prices for the common stock for theperiods shown.

 
|            |   | **2002  Prices** |   | **2001  Prices** |   |
|-----------------|--------|------------------|--------|------------------|--------|
|            |   | **High**         |   | **Low**          |   | **High** |   | **Low** |   |
| **1st Quarter** |   | $                | 8.00   |             | $      | 6.60 |   | $ | 6.75 |   | $ | 4.44 |   |
| **2nd Quarter** |   | 8.23             |   | 6.02             |   | 5.30 |   | 4.36 |   |
| **3rd Quarter** |   | 6.61             |   | 4.94             |   | 6.05 |   | 5.25 |   |
| **4th Quarter** |   | 5.12             |   | 4.61             |   | 6.75 |   | 5.55 |   |
|                 |        |                  |        |                  |        |  |  |  |  |  |  |  |  |

 

The high and low prices for the first quarter of 2003, through March18, 2003, were $5.21 and $4.22, respectively.

 

As of March 18, 2003, there were 3,117,811 sharesof the Company’s common stock outstanding and held of record by 106holders.  The number of record holdersincludes as single holders various institutions (such as brokerage firms) thathold shares in “street name” for multiple shareholders.  Based on the number of requests for theCompany’s proxy materials for its 2002 annual meeting, the Company believesthere are approximately 373 beneficial holders of its common stock.  The Company repurchased 45,251 shares ofcommon stock during 2002.  Additionalshares of common stock may be repurchased from time to time in the future.

 

The Company has never paid a dividend on its commonstock.  Net capital requirements maylimit the ability of PIC to pay dividends to the Company, which would affectthe Company’s ability to pay dividends to its shareholders.  The Company anticipates that, for theforeseeable future, earnings will be retained for use in its business and doesnot anticipate the payment of dividends.

 

12

----

 

**ITEM 6.****        MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS**

 

**SELECTED FINANCIAL DATA**

 

**Income Statement Information**

 
|                                         |   | **Years  Ended December 31,**                |   |
|----------------------------------------------|--------|----------------------------------------------|--------|
|                                         |   | **2002**                                     |   | **2001** |   |
|                                         |   | **(in thousands, except per share amounts)** |   |
| Revenues                                     |   | $                                            | 1,010  |   | $ | 25,337 |   |
| Commissions and  Salaries                    |   | 8,266                                        |   | 9,563 |   |
| Other Expenses                               |   | 3,654                                        |   | 4,178 |   |
| Total Expenses                               |   | 11,920                                       |   | 13,741 |   |
| Pretax Income  (loss)                        |   | (10,910                                      | )      | 11,596 |   |
| Net Income  (loss)                           |   | (7,011                                       | )      | 7,037 |   |
| Diluted Earnings  (loss) per share           |   | $                                            | (2.23  | ) | $ | 2.17 |   |
| Average number  of common shares outstanding |   | 3,141                                        |   | 3,240 |   |

 

**Balance Sheet Information**

 
|                       |   | **December  31,**  |   |
|----------------------------|--------|--------------------|--------|
|                       |   | **2002**           |   | **2001** |   |
|                       |   | **(in thousands)** |   |
| Total Assets               |   | $                  | 29,112 |   | $ | 38,591 |   |
| Long-Term Debt             |   | —             |   | — |   |
| Shareholders’  Equity |   | 25,843             |   | 33,131 |   |
|                            |        |                    |        |  |  |  |  |

 

**Overview**

 

Substantially all of ourbusiness consists of the securities brokerage and investment banking activitiesof our wholly owned subsidiary, Paulson Investment Company, Inc., or PIC.  PIC has operations in four principalcategories, all of them in the financial services industry.  These categories are:

 

•                  securities brokerage activities for which PICearns commission revenues;

•                  corporate finance revenues consisting principallyof underwriting discounts and underwriter warrants;

•                  securities trading from which PIC records profitor loss, depending on trading results; and

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

 

13

----

 

Because we operate in thefinancial services industry, our revenues and earnings are substantiallyaffected by conditions in financial markets generally.  In our securities brokerage and corporatefinance business, the amount of our revenues depends on levels of marketactivity requiring the services we provide. Our investment banking activity, which consists primarily of acting asmanaging or participating underwriter of initial and follow-on public offeringsfor smaller companies, is similarly affected by the strength of the market fornew equity offerings, which has historically 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 lossand, to a lesser extent, our trading income or loss is affected by changes inmarket valuation of securities generally and, in particular, by changes invaluation of the equity securities of microcap companies in which ourinvestments and trading activities tend to be concentrated.  Equity markets in general, and microcapequity markets in particular, have always experienced significant volatilityand this volatility has, in recent years been extreme.  The results of this volatility on the valueof our investment portfolio and securities held in connection with our tradingand investment activities include large quarterly fluctuations in income orloss from these operations and substantial increases or decreases in our networth as our securities holdings are marked to market.

 

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

 

### **CriticalAccounting Policies**

 

The following discussion and analysis of our financialcondition and results of operations is based upon our consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States. In preparing our consolidated financial statements, we must makeestimates and judgments that affect the reported amounts of assets andliabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities at the date of our financial statements.  Actual results are likely to differ fromthese estimates under different assumptions and conditions.

 

The critical accounting policies described belowinclude those that reflect significant judgments and uncertainties, whichpotentially could produce materially different results under differentassumptions and conditions.  We believeour critical accounting policies are limited to those described below.

 

*Use of Estimates.*We are required to estimate thevalue of all derivative securities that we hold at the date of any financialstatements and to include that value, and changes in such value, in thosefinancial statements.  Accordingly, theaggregate estimated value of our warrants as of the date of any balance sheetis recorded as an asset on that balance sheet.   When a new warrant is received as a result of our investmentbanking activity, its estimated value is included in corporate finance revenueon the date on which it is earned. Subsequently, any change in estimated value is recorded as investmentincome or loss.  When a warrant isexercised, the book value is adjusted to reflect the value of the securitiespurchased, net of the exercise price, and the adjustment amount is recorded asincome or loss for the relevant period. If the warrant expires unexercised, thebook value is adjusted to zero and the decrease is recorded as a loss in therelevant period.

 

We estimate the value of ourunderwriter warrants using the Black-Scholes Option Pricing Model. TheBlack-Scholes model requires us to use historical price data combined withvarious assumptions and judgments as inputs for the model.  The most influential factor in this model isprice volatility, which we calculate for each company’s warrants based on eachcompany’s own historical stock price movements as well as an index ofhistorical prices for comparable companies. When we initially receive a new underwriter warrant from an initialpublic offering, its calculated volatility factor is entirely based on thevolatility of an index of comparable companies, since there is no price historyfor a new publicly traded company.  Aseach underwriter warrant approaches its expiration date, its volatility factoris derived primarily from the historical prices of its underlying common stock.   We cannot assure you that we willultimately be able to exercise any of our warrants in a way that will realizethe value that we attribute to them in our financial statements based on thismodel.

 

In addition to ourunderwriter warrants, we hold other securities, some of which have very limitedliquidity 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, with no discount for restricted or illiquid securities.

 

14

----

 

As a result of the factorsdescribed above, our revenues and earnings are subject to substantialfluctuation from period to period based on circumstances, many of which arebeyond our control.  An increase infinancial market activity generally, and/or an increase in equity valuationsgenerally, will normally result in increases in our revenues, earnings and networth as our activity levels and the value of our investment portfolioincrease.  Conversely, a general marketretrenchment will typically lead to decreased revenues, earnings and net worthas a result both of decreased activity and the need to adjust high investmentportfolio values to lower levels. Accordingly, results for any historical period are not necessarilyindicative of similar results for any future period.

 

**Results of Operations**

 

PIC’s revenues and operatingresults are influenced by fluctuations in the equity underwriting markets aswell as general economic and market conditions, particularly conditions in theover-the-counter market, where PIC’s investment account, trading inventorypositions and underwriter warrants are heavily concentrated.  Significant fluctuations can occur in PIC’srevenues and operating results from one period to another.  PIC’s results of operations depend upon manyfactors, such as the number of companies that are seeking public financing, thequality and financial condition of those companies, market conditions ingeneral, the performance of previous PIC underwritings and interest in certainindustries by investors.  As a result,revenues and income derived from these activities may vary significantly fromyear to year.  In the tables below,"Corporate Finance" revenues are a function of total proceeds fromofferings done during the period, compensation per offering, and the fair valueof 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 therepresentatives in the trading department.

 

15

----

 

**Summary of Changes in Major Categoriesof Revenues and Expense**

 
|                          |   | **2002**    | **vs.**     | **2001** |   |
|-------------------------------|--------|-------------|-------------|----------|--------|
| Revenues:                     |   |        |        |     |   |
| Sales  Commissions            |   | $           | 37,086      |     | .5     | % |
| Corporate  Finance            |   | (5,895,674  | )           | (98.0    | )%     |
| Investment  Income            |   | (17,260,039 | )           | N/A      |   |
| Trading Income                |   | (1,212,792  | )           | N/A      |   |
| Other                         |   | 3,826       |        | 7.9      | %      |
|                          |   |        |        |     |   |
| Total                         |   | $           | (24,327,593 | )        | (96.0  | )% |
|                          |   |        |        |     |   |
| Expenses:                     |   |        |        |     |   |
| Commissions and  Salaries     |   | $           | (1,297,042  | )        | (13.6  | )% |
| Underwriting  Expenses        |   | (445,876    | )           | (69.9    | )%     |
| Rent, Telephone  & Quotes |   | (14,932     | )           | (1.5     | )%     |
| Other                         |   | (63,356     | )           | (2.5     | )%     |
|                          |   |        |        |     |   |
| Total                         |   | $           | (1,821,206  | )        | (13.3  | )% |
|                          |   |        |        |     |   |
| Pretax Income                 |   | $           | (22,506,387 | )        | N/A    |   |

 

**2002 Compared to 2001**

 

Total revenues for 2002decreased by 96.0 percent from 2001, to $1,009,753 from $25,337,346.  As shown in the table above, salescommissions rose $37,086, or .5 percent, to $7,598,621 in 2002 from $7,561,535in 2001.  This increase resultedprimarily from the larger number of retail brokers in 2002  relative to 2001.  The Nasdaq Composite Index was down 31.5 percent in 2002, to1335.51 at December 31, 2002 from 1951.07 at year-end 2001.  PIC’s focus is on very small capitalizationissues, especially those tied to PIC’s corporate finance clients.  Corporate finance revenues decreased 98.0percent, or $5,895,674, in 2002 compared to 2001.  No transactions were completed in 2002 while four transactionswere completed in 2001, raising a total of $47 million for corporate financeclients.  Investment income decreased$17,260,039, from a profit of $10,700,897 in 2001 to a loss of $6,559,142 in2002, due to an increase in unrealized depreciation of underwriter warrantsheld by the Company, based upon the Company’s estimate of their fair value, andlosses on positions held. Trading income decreased $1,212,792 to a loss of $203,835in 2002 from a profit of $1,008,957 in 2001. This decrease was primarily due to reduced trading activity insecurities generally as well as in the securities of PIC’s corporate financeclients, resulting from continuing poor economic conditions in 2002 andpolitical uncertainties related to problems in the Middle East.

 

Total expenses decreased by$1,821,206 in 2002 from 2001, a decrease of 13.3 percent to $11,920,104 from$13,741,310.  Commissions and salariesfell $1,297,042, or 13.6 percent, to $8,265,814 in 2002 from $9,562,856 in2001.  This decrease was primarily dueto a decrease in the accrual for officers' bonuses in 2002. Underwritingexpenses decreased by $445,876, or 69.9 percent, from 2001.  No underwriting transactions were completedin 2002 while four transactions were completed in 2001. Rent, telephone andquote expenses decreased to $960,310 in 2002 from $975,242 in 2001, a decreaseof 1.5 percent.  Other expensesdecreased 2.5 percent, to $2,501,666 in 2002 from $2,565,022 in 2001.

 

16

----

 

The Company had a pretax loss of$10,910,351 in 2002 compared to pretax income of $11,596,036 in 2001, dueprimarily to significant decreases in investment and corporate financeincome.  Independent of investmentincome, the Company would have had a pretax loss of $4,351,209 in 2002 comparedto a pretax profit of $895,139 in 2001. Significant fluctuations can occur in PIC’s revenues and operatingresults from one period to another.  TheCompany also had an income tax benefit of $3,899,197 in 2002, compared to a taxexpense of $4,558,974 in 2001.

 

**Liquidity and Capital Resources**

 

Conducting business as a dealerin securities requires that a substantial inventory of securities be maintainedand that a large amount of liquid assets be readily available.  PIC is also required to maintain net capitalas described in “Item 1 - Description of Business — Net Capital Requirements”above.  PIC’s equity atDecember 31, 2002 was $23,276,821. Of PIC’s total assets (net of intercompany accounts) atDecember 31, 2002 of $26,506,200, approximately 78  percent consisted of securities in PIC’sinvestment account, trading inventory and underwriter warrant securities, atfair value, and approximately 15 percent consisted of cash, certificates ofdeposit and receivables from its correspondent broker.

 

PIC’s securities inventory isstated at fair value.  The liquidity ofthe market for many of PIC’s securities holdings, however, varies with trendsin the stock market.  Since many of thesecurities held by PIC are thinly traded, and PIC is in many cases a primarymarket maker in the issues held, any significant sales of PIC’s positions couldadversely affect the liquidity and prices of the issues held.  In general, falling prices in OTC securities(which make up most of PIC’s trading positions) lead to decreased liquidity inthe market for these issues, while rising prices in OTC issues tends toincrease the liquidity of the market for these securities.  The overall decline in prices for the verysmall capitalization OTC securities traded by PIC in 2002, 2001, 2000 and 1998were combined with a general reduction in the liquidity of the markets forthese securities.  This situation wasthe reverse of 1999, 1997, 1996 and 1995, when increases in prices of OTCsecurities increased the liquidity of the markets for these securities.  PIC’s investment account and tradinginventory accounts are stated at fair value, which is at or below quoted marketprice.  They include shares of restrictedstock recorded by PIC, with an original cost of $4,135,542, currently valued at$1,021,841, which the Company believes, based upon available evidence,approximates market value.

 

PIC borrows money from CSC inthe ordinary course of its business, pursuant to an arrangement under which CSCagrees to finance PIC’s trading accounts in an amount determined by the size ofthose accounts and the type of securities held, with interest charged atprevailing margin rates. As of December 31, 2002, no net loans were owedby PIC to CSC pursuant to this arrangement. PIC and the Company are generally able to meet their compensation andother obligations out of current liquid assets.

 

17

----

 

Another source of capital to PICand the Company has been the underwriter warrants issued to PIC in connectionwith its corporate finance activities. The recorded value of our underwriter warrants is typically not readilyrealizable, either because the warrants are not currently exercisable orbecause their exercise price is more than the price that we could realize if weexercised the warrants and sold the underlying securities.  There is no public market for ourunderwriter warrants and the warrants themselves are transferable only undervery limited circumstances. Accordingly, their value cannot be realized by selling the warrantsthemselves.   Underwriter warrantsexercisable to purchase securities having a value in excess of the exerciseprice are liquid, subject to restrictions on liquidity applicable to OTCsecurities generally.  The securitiesissuable on exercise of our underwriter warrants are registered under theSecurities Act of 1933, as amended, and, in some cases, may also be resold underan exemption from registration.  Accordingly,there is no legal impediment to liquidity with respect to these securities,except during the first year following a company’s public offering.  At December 31, 2002, PIC owned 23underwriter warrants (from 21 different issuers), of which 23 were currentlyexercisable; one had an exercise price below the current market price of thesecurities receivable on exercise.  Ifwe had exercised that warrant and sold the underlying securities on December31, 2002, we would have received $3,542 in gross proceeds.  As of December 31, 2001, the computed valueof our underwriter warrants, based on the Black-Scholes Option Pricing Model,was $2.7 million, a significant decrease from the computed value of $6.2million at year-end 2001.  There islittle or no direct relationship between the intrinsic value of PIC’sunderwriter warrants at the end of any given period and the fair valuecalculated using the Black-Scholes Option Pricing Model, as described morefully in "Critical Accounting Policies" above.

 

In2002, $265,312 of net cash was provided by operating activities.  The major adjustments to reconcile thisresult to the Company’s net income include a change in receivable/payable fromclearing organization of $5,175,418, a decrease in trading and investment securitiesof $1,811,224 and unrealized depreciation in underwriter warrants of $3,519,000partially offset by decreases in deferred income taxes of $2,323,300 andaccounts payable of $585,510. Net cash used in financing activities in 2002totaled $276,846, resulting from payments to repurchase common stock of$312,346, exceeding $35,500 in proceeds from the issuance of common stock.

 

Asa securities broker-dealer, the Company’s wholly owned subsidiary, PIC, isrequired by SEC regulations to meet certain liquidity and capitalstandards.  In the unlikely event thatPIC was unable to meet these regulatory standards, it would be unable to paydividends to the Company.  Since PIC isthe Company’s only operating business, such a failure could have a materialadverse effect on the Company.

 

At December 31, 2002, theCompany had no material commitments for capital expenditures.

 

In general, the primary sourcesof PIC’s, and therefore the Company’s, liquidity, including PIC’s tradingpositions, borrowings on those positions and profits realized upon the exerciseof underwriter warrants, all depend in large part on the trend in the generalmarkets for OTC securities.  Rising OTCprice levels will tend to increase the value and liquidity of PIC’s tradingpositions, the amount that can be borrowed from CSC based upon those positions,and the value of PIC’s underwriter warrants. The Company believes its liquidity is sufficient to meet its needs forthe foreseeable future.

 

18

----

 

**Inflation**

 

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

 

 

19

----

 

**ITEM 7.****     FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.**

 
|                                                                                                      | **(a) Financial Statements** |
|-----------------------------------------------------------------------------------------------------------|------------------------------|
|                                                                                                      |
| Report  of Independent Certified Public Accountants                                                       |
|                                                                                                      |
| Consolidated Balance Sheet  as of December 31, 2002                                                  |
|                                                                                                      |
| Consolidated  Statements of Operations for the years ended December 31, 2002 and 2001                |
|                                                                                                      |
| Consolidated  Statement of Shareholders’ Equity for the years ended December 31, 2002  and 2001 |
|                                                                                                      |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2002 and 2001                |
|                                                                                                      |
| Notes to  Consolidated Financial Statements                                                               |
|                                                                                                      |
| Supplementary  Schedule of Warrants Owned                                                                 |
|                                                                                                      |
| Schedule II - Valuation and Qualifying  Accounts                                                          |

 

**ITEM 8.****     CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE**

** **

None

 

20

----

 

**PART III**

 

All information required byItems 9, 10, 11 and 12 of Part III of this Report will be included in theCompany’s definitive proxy statement for its 2003 annual meeting ofshareholders filed or to be filed not later than 120 days after the end of thefiscal year covered by this Report and is incorporated herein by reference.

 

 

21

----

 

**ITEM13.      EXHIBITS AND 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.                                                                                                                                                                  |
|       |   |                                                                                                                                                                                                                                   |
| 99.1       |   | 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.                                                 |
|       |   |                                                                                                                                                                                                                                   |
| 99.2       |   | Certification of Chief  Accounting 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 Form 8-K**

 

None

 

**ITEM 14. CONTROLS AND 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 significantchanges (including corrective actions with regard to significant deficienciesor material 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.

 

22

----

 

**SIGNATURES**

 

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

 
|                |   | PAULSON CAPITAL CORP.    |
|---------------------|--------|--------------------------|
|                |   |                     |
| Date:  3/28/03 | By:    | /s/ Chester L.F. Paulson |   |
|                |   | Chester L.F. Paulson     |
|                |   | President                |

 

23

----

 

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

 
| **Signature**                       |   | **Title**                             |   | **Date** |
|-------------------------------------|--------|---------------------------------------|--------|----------|
| **(1) Principal Executive Officer** |   |                                  |   |     |
|                                |   |                                  |   |     |
| /s/ Chester L.F. Paulson            |   |                                  |   |     |
| Chester L.F. Paulson                |   | Chairman  of the Board and  President |   | 3/27/03  |
|                                |   |                                  |   |     |
| **(2) Chief Accounting Officer**    |   |                                  |   |     |
|                                |   |                                  |   |     |
| /s/ Carol Rice                      |   |                                  |   |     |
| Carol Rice                          |   | Chief  Accounting Officer             |   | 3/27/03  |
|                                |   |                                  |   |     |
| **(3)  Directors**                  |   |                                  |   |     |
|                                |   |                                  |   |     |
| /s/ Jacqueline M. Paulson           |   |                                  |   |     |
| Jacqueline M. Paulson               |   | Secretary, Treasurer  and  Director   |   | 3/27/03  |
|                                |   |                                  |   |     |
| /s/ Glen Davis                      |   |                                  |   |     |
| Glen Davis                          |   | Director                              |   | 3/27/03  |
|                                |   |                                  |   |     |
| /s/ Steve Kleemann                  |   |                                  |   |     |
| Steve Kleemann                      |   | Director                              |   | 3/27/03  |
|                                |   |                                  |   |     |
| /s/ Shannon Pratt                   |   |                                  |   |     |
| Shannon Pratt                       |   | Director                              |   | 3/27/03  |
|                                |   |                                  |   |     |
| /s/ Paul Shoen                      |   |                                  |   |     |
| Paul Shoen                          |   | Director                              |   | 3/27/03  |
|                                |   |                                  |   |     |
|                                |   |                                  |   |     |
|                                |   |                                  |   |     |

 

24

----

 

I, Chester L.F. Paulson, certify that:

 
|                   |   |                                                                                                                                                                                                                                                                                                                                                                                        |
|------------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 1.                     |   | I have reviewed this annual report on Form 10-KSB of  Paulson Capital Corp.;                                                                                                                                                                                                                                                                                                                |
|                   |   |                                                                                                                                                                                                                                                                                                                                                                                        |   |
| 2.                     |   | Based on my knowledge, this annual report does not  contain any untrue statement of a material fact or omit to state a material  fact necessary to make the statements made, in light of the circumstances  under which such statements were made, not misleading with respect to the  period covered by this annual report;                                                                |
|                   |   |                                                                                                                                                                                                                                                                                                                                                                                        |   |
| 3.                     |   | Based on my knowledge, the financial statements, and  other financial information included in this annual report, fairly present in  all material respects the financial condition, results or operations and cash  flows of the registrant as of, and for, the period presented in this annual  report;                                                                                    |
|                   |   |                                                                                                                                                                                                                                                                                                                                                                                        |   |
| 4.                     |   | The registrant's other certifying officers and I are  responsible for establishing and maintaining disclosure controls and  procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the  registrant and we have:                                                                                                                                                                |
|                   |   |                                                                                                                                                                                                                                                                                                                                                                                        |   |
|                   |   | a.                                                                                                                                                                                                                                                                                                                                                                                          | designed such disclosure controls and procedures to  ensure that material information relating to the registrant, including its  consolidated subsidiaries, is made known to us by others within those  entities, particularly during the period in which this annual report is being  prepared; |
|                   |   |                                                                                                                                                                                                                                                                                                                                                                                        |   |
|                   |   | b.                                                                                                                                                                                                                                                                                                                                                                                          | evaluated the effectiveness of the registrant's  disclosure controls and procedures as of a date within 90 days prior to the  filing of date of this annual report (the "Evaluation Date"); and |
|                   |   |                                                                                                                                                                                                                                                                                                                                                                                        |   |
|                   |   | c.                                                                                                                                                                                                                                                                                                                                                                                          | presented in this annual report our conclusions  about the effectiveness of the disclosure controls and procedures based on  our evaluation as of the Evaluation Date; |
|                   |   |                                                                                                                                                                                                                                                                                                                                                                                        |   |
| 5.                     |   | The registrant's other certifying officers and I  have disclosed, based on our most recent evaluation, to the registrant's  auditors and the audit committee of registrant's board of directors (or  persons performing the equivalent function):                                                                                                                                           |
|                   |   |                                                                                                                                                                                                                                                                                                                                                                                        |   |
|                   |   | a.                                                                                                                                                                                                                                                                                                                                                                                          | all significant deficiencies in the design or  operation of internal controls which could adversely affect the registrant's  ability to record, process, summarize and report financial data and have  identified for the registrant's auditors and the audit committee of  registrant's board of directors (or persons performing the equivalent  function): |
|                   |   |                                                                                                                                                                                                                                                                                                                                                                                        |   |
|                   |   | b.                                                                                                                                                                                                                                                                                                                                                                                          | any fraud, whether or not material, that involves  management or other employees who have a significant role in the registrant's  internal controls; and |
|                   |   |                                                                                                                                                                                                                                                                                                                                                                                        |
| 6.                     |   | The registrant's other certifying officers and I  have indicated in this annual report whether or not there were significant  changes in internal controls or in other factors that could significantly  affect internal controls subsequent to the date of our most recent  evaluation, including any corrective actions with regard to significant  deficiencies and material weaknesses. |
|                   |   |                                                                                                                                                                                                                                                                                                                                                                                        |   |
| Dated: March 28, 2003  |   |
|                   |   |
|                   |   |
|                   |   | /s/ Chester L.F. Paulson                                                                                                                                                                                                                                                                                                                                                                    |   |
| (Chester L.F. Paulson) |
| (President)            |
|                        |        |                                                                                                                                                                                                                                                                                                                                                                                             |  |  |  |  |  |  |  |

 

 

25

----

 

I, Carol A. Rice, certify that:

 
|                  |                       |                                                                                                                                                                                                                                                                                                                                                                                        |
|-----------------------|----------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 1.                    |                       | I have reviewed this annual report on Form 10-KSB of  Paulson Capital Corp.;                                                                                                                                                                                                                                                                                                                |
|                  |                       |                                                                                                                                                                                                                                                                                                                                                                                        |   |
| 2.                    |                       | Based on my knowledge, this annual report does not  contain any untrue statement of a material fact or omit to state a material  fact necessary to make the statements made, in light of the circumstances  under which such statements were made, not misleading with respect to the  period covered by this annual report;                                                                |
|                  |                       |                                                                                                                                                                                                                                                                                                                                                                                        |   |
| 3.                    |                       | Based on my knowledge, the financial statements, and  other financial information included in this annual report, fairly present in  all material respects the financial condition, results or operations and cash  flows of the registrant as of, and for, the period presented in this annual  report;                                                                                    |
|                  |                       |                                                                                                                                                                                                                                                                                                                                                                                        |   |
| 4.                    |                       | The registrant's other certifying officers and I are  responsible for establishing and maintaining disclosure controls and  procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the  registrant and we have:                                                                                                                                                                |
|                  |                       |                                                                                                                                                                                                                                                                                                                                                                                        |   |
|                  |                       | a.                                                                                                                                                                                                                                                                                                                                                                                          | designed such disclosure controls and procedures to  ensure that material information relating to the registrant, including its  consolidated subsidiaries, is made known to us by others within those  entities, particularly during the period in which this annual report is being  prepared; |
|                  |                       |                                                                                                                                                                                                                                                                                                                                                                                        |   |
|                  |                       | b.                                                                                                                                                                                                                                                                                                                                                                                          | evaluated the effectiveness of the registrant's  disclosure controls and procedures as of a date within 90 days prior to the  filing of date of this annual report (the "Evaluation Date"); and |
|                  |                       |                                                                                                                                                                                                                                                                                                                                                                                        |   |
|                  |                       | c.                                                                                                                                                                                                                                                                                                                                                                                          | presented in this annual report our conclusions  about the effectiveness of the disclosure controls and procedures based on  our evaluation as of the Evaluation Date; |
|                  |                       |                                                                                                                                                                                                                                                                                                                                                                                        |   |
| 5.                    |                       | The registrant's other certifying officers and I  have disclosed, based on our most recent evaluation, to the registrant's  auditors and the audit committee of registrant's board of directors (or  persons performing the equivalent function):                                                                                                                                           |
|                  |                       |                                                                                                                                                                                                                                                                                                                                                                                        |   |
|                  |                       | a.                                                                                                                                                                                                                                                                                                                                                                                          | all significant deficiencies in the design or operation  of internal controls which could adversely affect the registrant's ability to  record, process, summarize and report financial data and have identified for  the registrant's auditors and the audit committee of registrant's board of  directors (or persons performing the equivalent function): |
|                  |                       |                                                                                                                                                                                                                                                                                                                                                                                        |   |
|                  |                       | b.                                                                                                                                                                                                                                                                                                                                                                                          | any fraud, whether or not material, that involves  management or other employees who have a significant role in the registrant's  internal controls; and |
|                  |                       |                                                                                                                                                                                                                                                                                                                                                                                        |
| 6.                    |                       | The registrant's other certifying officers and I  have indicated in this annual report whether or not there were significant  changes in internal controls or in other factors that could significantly  affect internal controls subsequent to the date of our most recent  evaluation, including any corrective actions with regard to significant  deficiencies and material weaknesses. |
|                  |                       |                                                                                                                                                                                                                                                                                                                                                                                        |   |
| Dated: March 28, 2003 |                       |
|                  |                       |
|                  |                       |
|                  | /s/ Carol A. Rice          |                                                                                                                                                                                                                                                                                                                                                                                        |
|                  | (Carol A. Rice)            |                                                                                                                                                                                                                                                                                                                                                                                        |
|                  | (Chief Financial  Officer) |                                                                                                                                                                                                                                                                                                                                                                                        |
|                  |
|                  |
|                       |                            |                                                                                                                                                                                                                                                                                                                                                                                             |  |  |  |  |  |

 

 

26

----

**EXHIBITINDEX**

 
| **Exhibit  Number** |   | **Description**                                                                                                                                                                                                                        |
|---------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |   | Articles of Incorporation (incorporated by reference  to Exhibit 3.1 to the Company’s Registration Statement on Form 10 filed with  the Commission on December 18, 1989 (the “Form 10”))                           |
|                |   |                                                                                                                                                                                                                                   |
| 3.2                 |   | Bylaws (incorporated by reference to Exhibit 3.2 to  the Form 10)                                                                                                                                                                      |
|                |   |                                                                                                                                                                                                                                   |
| 10.1                |   | Office lease dated June 28, 1988 (incorporated by  reference to Exhibit 10.2 to the Form 10)                                                                                                                                           |
|                |   |                                                                                                                                                                                                                                   |
| 10.3                |   | 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.                                                                                                                                                                  |
|                |   |                                                                                                                                                                                                                                   |
| 99.1                |   | 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.                                                 |
|                |   |                                                                                                                                                                                                                                   |
| 99.2                |   | Certification of Chief Accounting 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.                                                    |
|                |   |                                                                                                                                                                                                                                   |

 

27

----

 

Financial Statements and Report of

IndependentCertified Public Accountants

 

**Paulson Capital Corp. and Subsidiary**

 

December31, 2002 and 2001

 

----

 

Report of Independent Certified Public Accountants

 

 

Boardof Directors and Shareholders

PaulsonCapital Corp.

 

Wehave audited the accompanying consolidated balance sheet of Paulson CapitalCorp. (an Oregon corporation) and Subsidiary as of December 31, 2002, and therelated consolidated statements of operations, shareholders’ equity and cashflows 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.

 

Weconducted our audits in accordance with auditing standards generally acceptedin the United States.  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

Inour opinion, the financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of Paulson Capital Corp.and Subsidiary as of December 31, 2002, and the consolidated results of theiroperations and their consolidated cash flows for each of the two years in theperiod then ended, in conformity with accounting principles generally acceptedin the United States.

 

Ouraudits 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, 2002 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.

 

Wehave also audited Schedule II for each of the two years in the period endedDecember 31, 2002.  In our opinion, thisschedule presents fairly, in all material respects, the information required tobe set forth therein.

 

 
| Portland,  Oregon | /s/  GRANT THORNTON LLP |   |
|-------------------|-------------------------|--------|
| February  3, 2003 |                    |   |
|              |                    |

 

F-1

----

 

Paulson Capital Corp. and Subsidiary

 

CONSOLIDATED BALANCE SHEET

 

December31, 2002

 
| ASSETS                                                                                               |   |       |       |
|------------------------------------------------------------------------------------------------------|--------|------------|------------|
|                                                                                                 |   |       |       |
| Cash and cash equivalents                                                                            |   | $          | 97,630     |   |
| Receivable from clearing organization                                                                |   | 3,926,749  |       |
| Notes and other receivables                                                                          |   | 681,655    |       |
| Income taxes receivable                                                                              |   | 1,894,000  |       |
| Trading securities, at market value                                                                  |   | 2,725,081  |       |
| Investment securities, at market value                                                               |   | 15,656,235 |       |
| Underwriter warrants, at estimated fair value                                                        |   | 2,714,000  |       |
| Prepaid and deferred expenses                                                                        |   | 1,158,738  |       |
| Furniture and equipment, net                                                                         |   | 257,559    |       |
|                                                                                                 |   |       |       |
| Total assets                                                                                         |   | $          | 29,111,647 |   |
|                                                                                                 |   |       |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                            |   |       |       |
|                                                                                                 |   |       |       |
| LIABILITIES                                                                                          |   |       |       |
| Accounts payable and accrued liabilities                                                             |   | $          | 524,886    |   |
| Payable to clearing organization                                                                     |   | 2,087,907  |       |
| Compensation, employee benefits and payroll taxes                                                    |   | 595,052    |       |
| Securities sold, not yet purchased, at market value                                                  |   | 60,843     |       |
|                                                                                                 |   |       |       |
| Total liabilities                                                                                    |   | 3,268,688  |       |
|                                                                                                 |   |       |       |
| 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, 3,125,811 shares |   | 1,086,740  |       |
| Retained earnings                                                                                    |   | 24,756,219 |       |
|                                                                                                 |   |       |       |
| Total shareholders’ equity                                                                      |   | 25,842,959 |       |
|                                                                                                 |   |       |       |
| Total liabilities and shareholders’ equity                                                      |   | $          | 29,111,647 |   |

 

The accompanying notes are an integral part of this statement.

 

F-2

----

 

Paulson Capital Corp. and Subsidiary

 

CONSOLIDATED STATEMENTSOF OPERATIONS

 

Yearended December 31,

 
|                                        |   | **2002**    |       | **2001**   |   |
|---------------------------------------------|--------|-------------|------------|------------|--------|
|                                        |   |        |       |       |   |
| Revenues                                    |   |        |       |       |   |
| Commissions                                 |   | $           | 7,598,621  |       | $      | 7,561,535 |   |
| Corporate finance                           |   | 121,843     |       | 6,017,517  |   |
| Investment income (loss)                    |   | (6,559,142  | )          | 10,700,897 |   |
| Trading income (loss)                       |   | (203,835    | )          | 1,008,957  |   |
| Interest and dividends                      |   | 62,375      |       | 44,428     |   |
| Other                                       |   | (10,109     | )          | 4,012      |   |
|                                        |   |        |       |       |   |
|                                        |   | 1,009,753   |       | 25,337,346 |   |
|                                        |   |        |       |       |   |
| Expenses                                    |   |        |       |       |   |
| Commissions and salaries                    |   | 8,265,814   |       | 9,562,856  |   |
| Underwriting expenses                       |   | 192,314     |       | 638,190    |   |
| Rent, telephone and quotation services      |   | 960,310     |       | 975,242    |   |
| Interest expense                            |   | 7,910       |       | 60,825     |   |
| Professional fees                           |   | 615,359     |       | 512,894    |   |
| Bad debt expense                            |   | 95,369      |       | 111,037    |   |
| Travel and entertainment                    |   | 335,640     |       | 351,926    |   |
| Settlements                                 |   | 85,000      |       | 68,500     |   |
| Other                                       |   | 1,362,388   |       | 1,459,840  |   |
|                                        |   |        |       |       |   |
|                                        |   | 11,920,104  |       | 13,741,310 |   |
|                                        |   |        |       |       |   |
| Earnings (loss) before income taxes         |   | (10,910,351 | )          | 11,596,036 |   |
|                                        |   |        |       |       |   |
| Income tax expense (benefit)                |   | (3,899,197  | )          | 4,558,974  |   |
|                                        |   |        |       |       |   |
| NET EARNINGS (LOSS)                         |   | $           | (7,011,154 | )          | $      | 7,037,062 |   |
|                                        |   |        |       |       |   |
| Basic earnings (loss) per share             |   | $           | (2.23      | )          | $      | 2.18 |   |
|                                        |   |        |       |       |   |
| Diluted earnings (loss) per share           |   | $           | (2.23      | )          | $      | 2.17 |   |
|                                        |   |        |       |       |   |
| Weighted average common shares outstanding: |   |        |       |       |   |
| Basic                                       |   | 3,141,294   |       | 3,234,157  |   |
| Diluted                                     |   | 3,141,294   |       | 3,239,604  |   |

 

The accompanying notes are an integral part of these statements.

 

F-3

----

 

Paulson Capital Corp. and Subsidiary

 

CONSOLIDATED STATEMENT OFSHAREHOLDERS’ EQUITY

 

Two year period endedDecember 31, 2002

 
|                         |   | **Common Stock** |   | **Retained  Earnings** |      |
|------------------------------|--------|------------------|--------|------------------------|-----------|
|                         |   | **Shares**       |   | **Amount**             |      |   |
|                         |   |             |   |                   |      |   |   |
| Balance at December 31, 2000 |   | 3,367,366        |   | $                      | 1,080,011 |   | $ | 26,104,819 |   |
|                         |   |             |   |                   |      |   |   |
| Stock options exercised      |   | 7,000            |   | 31,063                 |      | — |   |
|                         |   |             |   |                   |      |   |   |
| Redemption of common stock   |   | (211,304         | )      | (48,646                | )         | (1,073,350 | ) |
|                         |   |             |   |                   |      |   |   |
| Net earnings for the year    |   | —           |   | —                 |      | 7,037,062 |   |
|                         |   |             |   |                   |      |   |   |
| Balance at December 31, 2001 |   | 3,163,062        |   | 1,062,428              |      | 32,068,531 |   |
|                         |   |             |   |                   |      |   |   |
| Stock options exercised      |   | 8,000            |   | 35,500                 |      | — |   |
|                         |   |             |   |                   |      |   |   |
| Redemption of common stock   |   | (45,251          | )      | (11,188                | )         | (301,158 | ) |
|                         |   |             |   |                   |      |   |   |
| Net loss for the year        |   | —           |   | —                 |      | (7,011,154 | ) |
|                         |   |             |   |                   |      |   |   |
| Balance at December 31, 2002 |   | 3,125,811        |   | $                      | 1,086,740 |   | $ | 24,756,219 |   |

 

The accompanying notes are an integral part of this statement.

 

F-4

----

 

Paulson Capital Corp. and Subsidiary

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

Year ended December 31,

 
|                                                                                       |   | **2002**   |       | **2001**   |    |
|--------------------------------------------------------------------------------------------|--------|------------|------------|------------|---------|
|                                                                                       |   |       |       |       |    |
| Increase (Decrease) in Cash and Cash Equivalents                                           |   |       |       |       |    |
|                                                                                       |   |       |       |       |    |
| Cash flows from operating activities                                                       |   |       |       |       |    |
| Net earnings (loss)                                                                        |   | $          | (7,011,154 | )          | $       | 7,037,062 |   |
| Adjustments to reconcile net earnings (loss) to net  cash provided by operating activities |   |       |       |       |    |
| Receipt of underwriter warrants                                                            |   | (68,000    | )          | (4,017,000 | )       |
| Unrealized depreciation and expiration of underwriter  warrants                            |   | 3,519,000  |       | 554,000    |    |
| Loss on sale of investment in real estate                                                  |   | 11,634     |       | —     |    |
| Deferred income taxes                                                                      |   | (2,323,300 | )          | 6,546,200  |    |
| Depreciation and amortization                                                              |   | 178,830    |       | 197,465    |    |
| Write-down of notes receivable, net of recoveries                                          |   | —     |       | 111,037    |    |
| Interest accrued on notes receivable                                                       |   | —     |       | (7,486     | )       |
| Changes in assets and liabilities                                                          |   |       |       |       |    |
| Receivables                                                                                |   | (273,939   | )          | 97,951     |    |
| Receivable from/payable to clearing organization                                           |   | 5,175,418  |       | 1,034,964  |    |
| Trading and investment securities, net                                                     |   | 1,811,224  |       | (5,081,563 | )       |
| Income taxes receivable/payable                                                            |   | (47,900    | )          | (5,742,100 | )       |
| Prepaid and deferred expenses                                                              |   | (168,988   | )          | (123,764   | )       |
| Accounts payable and accrued liabilities                                                   |   | (585,510   | )          | 473,584    |    |
| Securities sold, not yet purchased                                                         |   | 47,997     |       | (18,650    | )       |
|                                                                                       |   |       |       |       |    |
| Net cash provided by operating activities                                                  |   | 265,312    |       | 1,061,700  |    |
|                                                                                       |   |       |       |       |    |
| Cash flows from investing activities                                                       |   |       |       |       |    |
| Additions to furniture and equipment                                                       |   | (92,040    | )          | (32,138    | )       |
| Proceeds from sale of investment in real estate                                            |   | 158,266    |       | —     |    |
|                                                                                       |   |       |       |       |    |
| Net cash provided by investing activities                                                  |   | 66,226     |       | (32,138    | )       |
|                                                                                       |   |       |       |       |    |
| Cash flows from financing activities                                                       |   |       |       |       |    |
| Proceeds from issuance of stock                                                            |   | $          | 35,500     |       | $       | 31,063 |   |
| Payments to retire common stock                                                            |   | (312,346   | )          | (1,121,996 | )       |
|                                                                                       |   |       |       |       |    |
| Net cash used in financing activities                                                      |   | (276,846   | )          | (1,090,933 | )       |
|                                                                                       |   |       |       |       |    |
| Net increase (decrease) in cash and cash equivalents                                       |   | 54,692     |       | (61,371    | )       |
|                                                                                       |   |       |       |       |    |
| Cash and cash equivalents at beginning of year                                             |   | 42,938     |       | 104,309    |    |
|                                                                                       |   |       |       |       |    |
| Cash and cash equivalents at end of year                                                   |   | $          | 97,630     |       | $       | 42,938 |   |
|                                                                                       |   |       |       |       |    |
| Cash paid during the year for                                                              |   |       |       |       |    |
|                                                                                       |   |       |       |       |    |
| Interest                                                                                   |   | $          | 7,910      |       | $       | 60,825 |   |
|                                                                                       |   |       |       |       |    |
| Income taxes                                                                               |   | $          | 2,219      |       | $       | 3,746,609 |   |
|                                                                                       |   |       |       |       |    |
| Non-cash  items                                                                            |   |       |       |       |    |
|                                                                                       |   |       |       |       |    |
| Conversion of note receivable  to investment securities                                    |   | $          | —     |       | 741,854 |   |

 

The accompanying notes are an integral part of these statements.

 

F-5

----

 

Paulson Capital Corp. and Subsidiary

 

NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

 

NOTEA – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

PaulsonCapital Corp. (the Company) is a holding company whose wholly-owned subsidiary,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 UBS PaineWebber Company.  TheSubsidiary also acts as lead or participating underwriter for over-the-counterand American Stock Exchange securities offerings.  The Subsidiary conducts business throughout the UnitedStates.  The Subsidiary is exempt fromthe reserve requirements under SEC Rule 15c3-3(k)(2)(ii), since it does nothandle or carry customer securities or cash.

 

A summary of thesignificant accounting policies consistently applied in the preparation of theaccompanying financial statements follows.

 

1.   Principles of Consolidation

 

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

 

2.   Securities Transactions

 

Securitiestransactions and related revenue are recorded on a trade date basis.  Underwriting revenues are recognized at thetime the underwriting is completed. Revenue from the receipt of underwriter warrants received in corporatefinance transactions is recognized based on the estimated fair value of thesecurities received as estimated using the Black-Scholes option-pricingmodel.  Underwriter warrants are valuedat estimated fair value using the Black-Scholes option-pricing model, takinginto account the exercise price, remaining life of the warrant, the currentprice of the underlying stock and its expected volatility, expected dividendson the stock and the risk-free interest rate for the remaining term of thewarrant.  Changes in the estimated fairvalue of these underwriter warrants are reflected currently in the results ofoperations.  Marketable securities arevalued at market value and securities not readily marketable are valued at fairvalue as determined by management.  Thefair value of not readily marketable securities is estimated by managementusing available information including the following: quoted market prices ofsimilar securities (i.e., unrestricted shares of the same company); price ofrecent known trades of the same or similar securities; the cost of the securityif recently 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 Financial Instruments

 

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

 

4.   Furniture and Equipment

 

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

 

F-6

----

 

5.   Cash Flows

 

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

 

6.   Use of Estimates

 

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

 

7.   Earnings Per Share

 

Basicearnings (loss) per share is computed based on the weighted average number ofcommon shares outstanding during the year. Diluted earnings (loss) per share iscomputed using the weighted average number of common and dilutive commonequivalent shares outstanding during the year. Common equivalent shares from stock options are excluded from thecomputation when their effect is antidilutive. (Note I).

 

8.   Income Taxes

 

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

 

9.   Advertising

 

Advertisingcosts are charged to expense when incurred.

 

10. Stock Options

 

At December 31, 2002, theCompany had a stock-based employee compensation plan, which is described morefully in Note H.  The Company accountsfor its stock option plan under SFAS No. 123 “Accounting for Stock-BasedCompensation.”  As allowed under thisstatement, the Company continues to account for stock options for employeesunder APB No. 25, “Accounting for Stock Issued to Employees,” and has adoptedthe disclosure only requirements of SFAS No. 123.

 

F-7

----

 

No stock-based employeecompensation cost is reflected in net income in 2002, as all options grantedunder the plan had an exercise price equal to the market value of theunderlying common stock on the date of grant. There were no grants in 2001. The following table illustrates the effect on net income and earningsper share if the Company had applied the fair value recognition provisions ofSFAS No. 123, *Accounting for Stock-BasedCompensation*, to stock-based employee compensation for the yearended December 31, 2002.  The fair value of each option grant is estimatedon the date of grant using the Black-Scholes option-pricing model with thefollowing weighted-average assumptions: no dividends; expected volatility of68%; risk-free interest rate of 4.8% and expected life of 5 years.  There would be no effect on netincome and earnings per share for the year ended December 31, 2001 becausethere was no vesting of options during the year.

 
| Net loss, as reported                                                                                                                            |   | $        | (7,011,154 | ) |
|--------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|------------|---|
| Deduct:  Total  stock-based employee compensation expensedetermined under fair value based method for all awards,net of related tax effects |   | (130,000 | )          |
| Pro forma net loss                                                                                                                               |   | $        | (7,141,154 | ) |
| Loss per share:                                                                                                                                  |   |     |       |
| Basic and diluted – as reported                                                                                                             |   | $        | (2.23      | ) |
| Basic and diluted – pro forma                                                                                                               |   | $        | (2.27      | ) |

 

NOTEB – RECEIVABLE FROM AND PAYABLE TO CLEARING ORGANIZATION

 

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

 

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

 

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

 

F-8

----

 

NOTEC – NOTES AND OTHER RECEIVABLES

 

Notesand other receivables consist of the following at December 31, 2002:

 
| Officers            |   | $       | 185,060 |   |
|---------------------|--------|---------|---------|--------|
| Employees           |   | 80,823  |    |
| Independent brokers |   | 380,377 |    |
| Other               |   | 35,395  |    |
|                |   |    |    |
|                |   | $       | 681,655 |   |

 

Employeeand independent broker receivables relate principally to advances, expenses,inventory losses and settlements charged to the registered representatives ofthe Subsidiary in excess of commission earnings.  For the years ended December 31, 2002 and 2001, receivables fromemployees and independent brokers of $95,369 and $131,383, respectively, weredetermined by management to be uncollectible and written off to other operatingexpenses.

 

NOTED – TRADING AND INVESTMENT SECURITIES

 

Tradingsecurities and securities sold not yet purchased represent the market value ofsecurities held long and short by the Subsidiary.

 

Thecategories of trading securities and their related market values at December31, 2002 are as follows:

 
|                            |   | **Owned** |      | **Sold,****Not YetPurchased** |   |
|---------------------------------|--------|-----------|-----------|-------------------------------|--------|
|                            |   |      |      |                          |   |
| Common equities                 |   | $         | 2,576,662 |                          | $      | 60,843 |   |
| State and municipal obligations |   | 145,029   |      | —                        |   |
| Corporate obligations           |   | 3,390     |      | —                        |   |
|                            |   |      |      |                          |   |
|                            |   | $         | 2,725,081 |                          | $      | 60,843 |   |

 

As asecurities broker-dealer, the Subsidiary is engaged in various securities tradingand brokerage activities as principal. In the normal course of business, the Subsidiary has sold securitiesthat it does not currently own and will therefore be obligated to purchase suchsecurities at a future date.  Thisobligation is recorded in the financial statements at the market value of therelated securities and will result in a trading loss on the securities if themarket price increases and a trading gain if the market price decreasessubsequent to December 31, 2002.

 

F-9

----

 

Investment securities held by the Subsidiary which arereadily marketable 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 31,2002 these securities consisted of corporate stocks and warrants at estimatedfair value of approximately $1,022,000. A summary of the investment securities portfolio at December 31, 2002follows:

 
| Corporate equities |   | $       | 15,282,655 |   |
|--------------------|--------|---------|------------|--------|
| Corporate warrants |   | 373,580 |       |
|               |   |    |       |
|               |   | $       | 15,656,235 |   |

 

Realizedgain (loss) included in the determination of net earnings was $(393,040) and$(1,478,240) for the years ended December 31, 2002 and 2001, respectively.

 

NOTEE – UNDERWRITER WARRANTS

 

Theestimated fair value of warrants is determined by management using theBlack-Scholes option-pricing model, taking into account the exercise price,remaining contractual life of the warrant, the current price of the underlyingstock and its expected volatility, expected dividends on the stock and therisk-free interest rate for the remaining term of the warrant (see 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 tablesummarized activity in underwriter warrants:

 
| Estimated fair value at  December 31, 2001  |   | $          | 6,165,000 |   |
|---------------------------------------------|--------|------------|-----------|--------|
| Warrants received                           |   | 68,000     |      |
| Warrants expired                            |   | (6,000     | )         |
| Unrealized depreciation  in estimated value |   | (3,513,000 | )         |
| Estimated fair value at  December 31, 2002  |   | $          | 2,714,000 |   |

 

F-10

----

 

NOTEF – FURNITURE AND EQUIPMENT

 

Furnitureand equipment are stated at cost and consist of the following at December 31,2002:

 
| Office equipment                               |   | $         | 1,426,858 |   |
|------------------------------------------------|--------|-----------|-----------|--------|
| Vehicles                                       |   | 65,619    |      |
|                                           |   | 1,492,477 |      |
| Less accumulated depreciation and amortization |   | 1,234,918 |      |
|                                           |   |      |      |
|                                           |   | $         | 257,559   |   |

 

NOTEG – INCOME TAXES

 

Incometax expense (benefit) consists of the following:

 
|                           |   | **2002**   |       | **2001**   |   |
|--------------------------------|--------|------------|------------|------------|--------|
|                           |   |       |       |       |   |
| Current tax expense (benefit)  |   |       |       |       |   |
| Federal                        |   | $          | (1,341,968 | )          | $      | (1,626,854 | ) |
| State and local                |   | (233,929   | )          | (360,372   | )      |
|                           |   |       |       |       |   |
|                           |   | (1,575,897 | )          | (1,987,226 | )      |
|                           |   |       |       |       |   |
| Deferred tax expense (benefit) |   |       |       |       |   |
| Federal                        |   | (2,446,926 | )          | 5,295,400  |   |
| State and local                |   | 123,626    |       | 1,250,800  |   |
|                           |   |       |       |       |   |
|                           |   | (2,323,300 | )          | 6,546,200  |   |
|                           |   |       |       |       |   |
|                           |   | $          | (3,899,197 | )          | $      | 4,558,974 |   |

 

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

 
|                                                        |   | **2002** |       | **2001** |   |
|-------------------------------------------------------------|--------|----------|------------|----------|--------|
|                                                        |   |     |       |     |   |
| Income tax expense (benefit) at statutory federal tax  rate |   | $        | (3,709,500 | )        | $      | 3,942,700 |   |
| State and local taxes net of federal benefit                |   | (646,600 | )          | 775,300  |   |
| Permanent and other differences                             |   | (11,597  | )          | (159,026 | )      |
| Increase in valuation allowance on net deferred tax  asset  |   | 468,500  |       | —   |   |
|                                                        |   |     |       |     |   |
|                                                        |   | $        | (3,899,197 | )        | $      | 4,558,974 |   |

 

F-11

----

 

The deferred income taxasset (liability) consists of the following at December 31, 2002:

 
| Unrealized appreciation on securities              |   | $        | (138,900 | )      |
|----------------------------------------------------|--------|----------|----------|--------|
| Accrued expenses                                   |   | 29,200   |     |
| State net operating loss carryforwards and credits |   | 571,000  |     |
| Fixed asset depreciation                           |   | (1,200   | )        |
| Contribution carryover                             |   | 8,400    |     |
| Valuation allowance                                |   | (468,500 | )        |
|                                               |   |     |     |
|                                               |   | $        | —   |   |

 

The Company has recordeda valuation allowance in the amount of $468,500 based upon management’sassessment that it is more likely than not that the net deferred tax asset willnot be realized.  The entire valuationallowance was recorded in the fourth quarter of 2002.  Management will continue to review the net deferred tax asset andmay adjust the valuation allowance in future periods based upon theirassessment.

 

The state net operatingloss carryforwards begin to expire in 2004.

 

NOTEH – COMMON STOCK

 

TheSubsidiary has a key employee stock purchase plan.  Under the plan, the Subsidiary will match funds (up to $25,000)committed by key employees for the purchase of shares of the Company’s commonstock.  The committed and matching fundswill be used by the Subsidiary to purchase stock of the Company in the openmarket or by negotiated transactions. One half of the shares will be resold to the participating employee andone half of the shares will be transferred to the employee for no cashconsideration.  The named participants,the number of shares purchased in the open market and the amount of matchingfunds will be at the discretion of the Board of Directors of theSubsidiary.  No participants were namedand no purchases of common stock under this plan were made during 2002 or 2001.

 

F-12

----

 

The Company’s 1999 StockOption Plan reserves 500,000 shares of the Company’s common stock for issuanceupon exercise of the options.  AtDecember 31, 2002, 328,000 were available for grant.  The Plan provides for the grant of incentive options andnonqualified options.  The optionsgranted during 2002 have an exercise price of $7.01 and $7.71, vestimmediately, and expire on March 18, 2007. The market price of the Company’s stock at the date of grant was$7.01.  The weighted average fair valueof the options at the date of grant, as calculated using the Black-Scholesoption-pricing model, was $4.25 per share.

 
|                                                                                |   | **Number****ofShares** |   | **Weighted****AverageFairValue** |   | **Weighted****AverageExercisePrice** |   |
|-------------------------------------------------------------------------------------|--------|------------------------|--------|----------------------------------|--------|--------------------------------------|--------|
|                                                                                |   |                   |   |                             |   |                                 |   |
| Options whose exercise price equals the market priceof the stock on the grant date  |   | 48,000                 |   | $                                | 4.26   |                                 | $      | 7.01 |   |
|                                                                                |   |                   |   |                             |   |                                 |   |
| Options whose exercise price exceeds the market valueof the stock on the grant date |   | 3,000                  |   | 4.12                             |   | 7.71                                 |   |
|                                                                                     |        |                        |        |                                  |        |                                      |        |  |  |

 

The following tablesummarizes activity under the Plan for the years ended December 31, 2002 and2001:

 
|                         |   | **Shares  Under****Option** |   | **Weighted****AverageExercisePrice** |   | **Weighted****AverageRemainingLife** |        |
|------------------------------|--------|-----------------------------|--------|--------------------------------------|--------|--------------------------------------|-------------|
|                         |   |                        |   |                                 |   |                                 |        |
| Balance at December 31, 2000 |   | 108,000                     |   | $                                    | 4.44   |                                 | 3.625 years |   |
| Granted                      |   | —                      |   | —                               |   |                                 |        |
| Exercised                    |   | (7,000                      | )      | 4.44                                 |   |                                 |        |
| Canceled                     |   | —                      |   | —                               |   |                                 |        |
|                         |   |                        |   |                                 |   |                                 |        |
| 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                          |        |
|                              |        |                             |        |                                      |        |                                      |             |  |

 

Alloutstanding options at December 31, 2002 and 2001 were exercisable.

 

F-13

----

 

NOTEI – EARNINGS PER SHARE

 

The following table is areconciliation of the numerators and denominators of the basic and diluted pershare computations for each of the two years in the period ended December 31,2002:

 
|                                      |   | **Income  (Numerator)** |       | **Weighted  Average****Shares  (Denominator)** |      | **Per  Share  Amount** |   |
|-------------------------------------------|--------|-------------------------|------------|------------------------------------------------|-----------|------------------------|--------|
|                                      |   |                    |       |                                           |      |                   |   |
| 2001                                      |   |                    |       |                                           |      |                   |   |
| Basic earnings per share                  |   |                    |       |                                           |      |                   |   |
| Earnings available to common stockholders |   | $                       | 7,037,062  |                                           | 3,234,157 |                   | $      | 2.18 |   |
|                                      |   |                    |       |                                           |      |                   |   |
| Effect of dilutive securities             |   |                    |       |                                           |      |                   |   |
| Stock options                             |   | —                  |       | 5,447                                          |      |                   |   |
|                                      |   |                    |       |                                           |      |                   |   |
| Diluted earnings per share                |   |                    |       |                                           |      |                   |   |
| Earnings available to common stockholders |   | $                       | 7,037,062  |                                           | 3,239,604 |                   | $      | 2.17 |   |
|                                      |   |                    |       |                                           |      |                   |   |
| 2002                                      |   |                    |       |                                           |      |                   |   |
| Basic and diluted loss per share          |   |                    |       |                                           |      |                   |   |
| Loss allocable to common stockholders     |   | $                       | (7,011,154 | )                                              | 3,141,294 |                   | $      | (2.23 | ) |

 

NOTEJ – LEASES

 

Futureminimum payments required under non-cancelable operating leases with remainingterms of one year or more consist of the following:

 
| **Year ending  December 31,** |   |    |      |
|-------------------------------|--------|---------|-----------|
|                          |   |    |      |
| 2003                          |   | $       | 379,111   |   |
| 2004                          |   | 344,923 |      |
| 2005                          |   | 353,838 |      |
| 2006                          |   | 334,152 |      |
| Thereafter                    |   | 858,942 |      |
|                          |   | $       | 2,270,966 |   |

 

Theleases provide for payment of taxes and other expenses by the Company.  Rental expense for the years ended December31, 2002 and 2001 approximated $372,000 and $280,000, respectively.

 

F-14

----

 

NOTEK – EMPLOYEE BENEFIT PLANS

 

Retirementbenefits for employees of the Company, who have completed certain servicerequirements, are provided by a defined contribution profit-sharingplan.  Plan contributions are determinedby the Board of Directors. Contributions to the plan for the years ended December 31, 2002 and2001 were $0 and $400,000, respectively.

 

NOTEL – CONTINGENCIES

 

The Company and itsSubsidiary have been named by individuals in certain legal actions, some ofwhich allege state and federal securities law violations and claim compensatoryand punitive damages.  As preliminaryhearings and discovery in these cases is not complete, it is not possible toassess the degree of liability, the probability of an unfavorable outcome orthe impact on the Company’s financial statements, if any.  Management believes it has meritorious defensesin these legal actions and is vigorously defending itself.  No provision for liability, if any, that mayresult from the above contingencies has been made in the financial statements.

 

NOTEM – NET CAPITAL REQUIREMENT

 

TheSubsidiary is subject to the net capital rule (Rule 15c3-1) of the Securitiesand Exchange Commission.  This ruleprohibits the Subsidiary from engaging in any securities transaction at a timewhen its “aggregate indebtedness” exceeds fifteen times its “net capital” asthose terms are defined by the rule.  AtDecember 31, 2002, the Subsidiary’s net capital and required net capital were$9,885,381 and $100,000, respectively, and its ratio of aggregate indebtednessto net capital was .11 to 1.  TheSubsidiary’s absolute minimum net capital requirement is $100,000.  Trading and investment securities representpotentially volatile components of net capital.

 

NOTEN – CONCENTRATION OF RISK

 

TheCompany held equity positions in two companies of approximately $7,793,000, or38%, and $7,047,000, or 34%, of its total trading securities, investmentsecurities and underwriter warrants.

 

F-15

----

 
| Paulson Capital  Corp. and Subsidiary     | Schedule I |
|-------------------------------------------|------------|
|                                      |       |
| SUPPLEMENTARY  SCHEDULE OF WARRANTS OWNED |       |
|                                      |       |
| December 31,  2002                        |       |

 
| **Description**                                      |   | **Number  of  Warrants** |   | **Exercise  Price Per  Share/Unit** |     | **Expiration  Date** |        |
|------------------------------------------------------|--------|--------------------------|--------|-------------------------------------|----------|----------------------|-------------|
|                                                 |   |                     |   |                                |     |                 |        |
| AdStar, Inc. (units) ERC*12-17-00                    |   | 60,500                   |   | $                                   | 7.20     |                 | 2004, 12/16 |   |
| AdStar, Inc. ERC 9-25-01                             |   | 149,000                  |   | $                                   | 1.80     |                 | 2005, 09/25 |   |
| Advantage Marketing Systems (units) ERC 11-12-98     |   | 65,520                   |   | $                                   | 5.40     |                 | 2003, 11/12 |   |
| audiohighway.com (units) ERC 12-17-99                |   | 163,900                  |   | $                                   | 7.80     |                 | 2003, 12/17 |   |
| AVI Biopharma, Inc. (units) ERC 6-3-98 (ANTIVIRALS)  |   | 112,700                  |   | $                                   | 10.80    |                 | 2003, 08/15 |   |
| 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 |   |
| Cell Robotics International, Inc. (units) ERC 2-2-99 |   | 29,800                   |   | $                                   | 9.90     |                 | 2003, 02/01 |   |
| Creative Products Intl. ERC 7-01-01                  |   | 30,000                   |   | $                                   | 1.50     |                 | 2006, 06/30 |   |
| Dag Media, Inc. ERC 05-12-00                         |   | 90,562                   |   | $                                   | 7.80     |                 | 2004, 05/12 |   |
| 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 |   |
| Hometown Auto Retailers ERC 7-28-99                  |   | 120,690                  |   | $                                   | 10.80    |                 | 2003, 07/28 |   |
| Imageware Systems, Inc. (units) ERC 3-30-01          |   | 106,323                  |   | $                                   | 9.60     |                 | 2005, 03/30 |   |
| Medinex Systems, Inc. ERC 1-31-02                    |   | 169,050                  |   | $                                   | 0.23     |                 | 2005, 01/31 |   |
| microHelix, Inc. ERC 11-16-02                        |   | 127,462                  |   | $                                   | 7.20     |                 | 2006, 11/16 |   |
| Pacific Mercantile Bancorp ERC 6-15-01               |   | 158,350                  |   | $                                   | 9.60     |                 | 2005, 06/14 |   |
| Taser International, Inc. ERC 5-07-02                |   | 49,649                   |   | $                                   | 15.60    |                 | 2006, 05/07 |   |
| 3D shopping.com (units) ERC 07-20-00                 |   | 73,466                   |   | $                                   | 14.40    |                 | 2004, 07/20 |   |
| WSG Systems, Inc. ERC 4-8-99                         |   | 11.026                   |   | $                                   | 6,000.00 |                 | 2003, 03/31 |   |

 

----

*Date exercisable

 

F-16

----

 
| Paulson Capital  Corp. and Subsidiary   | Schedule II |
|-----------------------------------------|-------------|
|                                    |        |
| Valuation and  Qualifying Accounts      |        |
|                                    |        |
| Years ended  December 31, 2002 and 2001 |        |

 
| **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, 2002         |   | $                               | — |                                         | $      | 95,369                     |   | $                            | 95,369 |   | $ | — |   |
| Year ended Dec. 31, 2001         |   | —                          |   | 111,037                                      |   | 111,037                    |   | —                       |   |
|                                  |        |                                 |        |                                              |        |                            |        |                              |        |  |  |  |  |

 

F-17

----