**Table
          of Contents**





**UNITES
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-Q**


**(mark
      one)**




x
            **QUARTERLY
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**





**** **FOR
      THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006, OR**





o
            **TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**





**Commission
      file No. 0-30066**





**SANDERS
      MORRIS HARRIS GROUP INC.**


(Exact
      name of registrant as specified in its charter)




**Texas**
            **76-0583569****(State
                or other jurisdiction of**
            **(I.R.S.
                Employer****incorporation
                or organization)**
            **Identification
                No.)**


**600
      Travis, Suite 3100**


**Houston,
      Texas 77002**


**(Address
      of principal executive office)**





Registrant’s
      telephone number, including area code: **(713) 993-4610**





Indicate
      by check mark if the registrant (1) has filed all reports required to be filed
      by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.


x Yes o No





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




Large
      accelerated filer o
      Accelerated filer x 
      Non-accelerated filer o





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).


o
      Yes x
      No





As
      of
      November 3, 2006, the registrant had 24,282,185 outstanding shares of Common
      Stock, par value $0.01 per share.







**Table
          of Contents**


**SANDERS
      MORRIS HARRIS GROUP INC. AND SUBSIDIARIES**





**INDEX**




Page**PART
                I.**
            **FINANCIAL
                INFORMATION**Item
                1.
            Financial
                Statements
            2Condensed
                Consolidated Balance Sheet as of September 30, 2006
                (unaudited) and December 31, 2005
            2Condensed
                Consolidated Statement of Income for the Three and
                Nine Months Ended September 30, 2006 and 2005 (unaudited)
            3Condensed
                Consolidated Statement of Shareholders' Equity for
                the Nine Months Ended September 30, 2006 (unaudited)
            4Condensed
                Consolidated Statement of Cash Flows for the Nine
                Months Ended September 30, 2006 and 2005 (unaudited)
            5Notes
                to Condensed Consolidated Financial Statements
                (unaudited)
            6Item
                2.
            Management's
                Discussion and Analysis of Financial Condition
                and Results of Operations
            23Item
                3.
            Quantitative
                and Qualitative Disclosures About Market
                Risk
            33Item
                4.
            Controls
                and Procedures
            33**PART
                II.**
            **OTHER
                INFORMATION**Item
                1.
            Legal
                Proceedings
            34Item
                6.
            Exhibits
            35




-1-
 **Table
          of Contents**


**PART
                  I. FINANCIAL INFORMATION****Item
                  1.*****Financial
                  Statements***
  **SANDERS
                  MORRIS HARRIS GROUP INC. AND SUBSIDIARIES****Condensed
                  Consolidated Balance
                  Sheet**(in
                  thousands, except share and per share
                  amounts)
  **September
                  30,**
              
              **December
                  31,****2006**
              
              **2005**(unaudited)**ASSETS**Cash
                  and cash equivalents
              
              $
              19,530
              
              $
              17,475Receivables,
                  net of allowance of $231 and $512, respectivelyBroker-dealers
              
              
              58,972
              
              
              753Customers
              
              
              12,770
              
              
              9,537Related
                  parties
              
              
              5,093
              
              
              6,227Other
              
              
              1,473
              
              
              1,815Deposits
                  with clearing brokers
              
              
              1,081
              
              
              1,073Securities
                  owned
              
              
              85,926
              
              
              73,657Securities
                  available for sale
              
              
              1,494
              
              
              1,884Furniture
                  and equipment, net
              
              
              11,539
              
              
              9,673Other
                  assets and prepaid expenses
              
              
              2,055
              
              
              2,050Goodwill,
                  net
              
              
              84,773
              
              
              84,398Total
                  assets
              
              $
              284,706
              
              $
              208,542**LIABILITIES
                  AND SHAREHOLDERS' EQUITY**Liabilities:Accounts
                  payable and accrued liabilities
              
              $
              21,578
              
              $
              21,881Borrowings
              
              
              15,355
              
              
              10,706Deferred
                  tax liability, net
              
              
              457
              
              
              2,408Securities
                  sold, not yet purchased
              
              
              17,791
              
              
              8,168Consideration
                  payable
              
              
              2,382
              
              
              —Payable
                  to clearing broker-dealers
              
              
              1,112
              
              
              2,880Net
                  liabilities of discontinued operations
              
              
              225
              
              
              33Total
                  liabilities
              
              
              58,900
              
              
              46,076Commitments
                  and contingenciesMinority
                  interests
              
              
              9,239
              
              
              7,781Shareholders'
                  equity:Preferred
                  stock, $.10 par value; 10,000,000 sharesauthorized;
                  no shares issued and outstanding
              
              
              —
              
              
              —Common
                  stock, $.01 par value; 100,000,000 sharesauthorized;
                  25,021,325 and 19,634,260 shares issued, respectively
              
              
              250
              
              
              196Common
                  stock committed, 190,431 shares
              
              
              2,382
              
              
              —Additional
                  paid-in capital
              
              
              195,251
              
              
              134,004Retained
                  earnings
              
              
              22,124
              
              
              23,936Accumulated
                  other comprehensive income
              
              
              41
              
              
              30Treasury
                  stock at cost, 739,402 shares
              
              
              (3,481
              )
              
              (3,481
              )Total
                  shareholders' equity
              
              
              216,567
              
              
              154,685Total
                  liabilities and shareholders' equity
              
              $
              284,706
              
              $
              208,542


The
        accompanying notes are an integral part of these condensed consolidated
        financial statements.


-2-
 **Table
          of Contents**




**SANDERS
                    MORRIS HARRIS GROUP INC. AND SUBSIDIARIES****Condensed
                    Consolidated Statement of
                    Income**(in
                    thousands, except per share amounts)(unaudited)
  **Three
                    Months Ended**
                
                **Nine
                    Months Ended****September
                    30,**
                
                **September
                    30,****2006**
                
                **2005**
                
                **2006**
                
                **2005**Revenues:Commissions
                
                $
                12,868
                
                $
                11,827
                
                $
                42,869
                
                $
                33,264Investment
                    banking
                
                
                11,608
                
                
                8,322
                
                
                33,597
                
                
                22,503Investment
                    advisory and related services
                
                
                11,064
                
                
                9,225
                
                
                28,444
                
                
                22,332Principal
                    transactions
                
                
                3,284
                
                
                3,099
                
                
                13,662
                
                
                7,169Interest
                    and dividends
                
                
                1,467
                
                
                1,118
                
                
                4,514
                
                
                3,438Other
                    income
                
                
                1,413
                
                
                820
                
                
                4,396
                
                
                2,544Total
                    revenues
                
                
                41,704
                
                
                34,411
                
                
                127,482
                
                
                91,250Expenses:Employee
                    compensation and benefits
                
                
                26,370
                
                
                19,834
                
                
                78,433
                
                
                54,045Floor
                    brokerage, exchange and clearance fees
                
                
                1,723
                
                
                1,276
                
                
                5,471
                
                
                3,468Communications
                    and data processing
                
                
                2,024
                
                
                1,836
                
                
                6,260
                
                
                5,831Occupancy
                
                
                2,858
                
                
                2,206
                
                
                8,407
                
                
                6,218Interest
                
                
                291
                
                
                223
                
                
                804
                
                
                265Goodwill
                    impairment charge
                
                
                —
                
                
                —
                
                
                4,456
                
                
                —Other
                    general and administrative
                
                
                5,760
                
                
                4,250
                
                
                17,147
                
                
                10,554Total
                    expenses
                
                
                39,026
                
                
                29,625
                
                
                120,978
                
                
                80,381Income
                    from continuing operations before equity in(loss)
                    income of limited partnerships, minorityinterests
                    and income taxes
                
                
                2,678
                
                
                4,786
                
                
                6,504
                
                
                10,869Equity
                    in (loss) income of limited partnerships
                
                
                (1,671
                )
                
                4,168
                
                
                902
                
                
                6,569Income
                    from continuing operations before minority
                
                
                1,007
                
                
                8,954
                
                
                7,406
                
                
                17,438interests
                    and income taxesMinority
                    interests in net income of consolidatedcompanies
                
                
                (558
                )
                
                (2,814
                )
                
                (3,580
                )
                
                (4,438
                )Income
                    from continuing operations before income taxes
                
                
                449
                
                
                6,140
                
                
                3,826
                
                
                13,000Provision
                    for income taxes
                
                
                200
                
                
                2,484
                
                
                1,501
                
                
                5,285Income
                    from continuing operations
                
                
                249
                
                
                3,656
                
                
                2,325
                
                
                7,715Loss
                    from discontined operations, net of tax
                
                
                (547
                )
                
                —
                
                
                (1,565
                )
                
                —Net
                    (loss) income
                
                $
                (298
                )
                $
                3,656
                
                $
                760
                
                $
                7,715Basic
                    (loss) earnings per share:From
                    continuing operations
                
                $
                0.01
                
                $
                0.19
                
                $
                0.12
                
                $
                0.42From
                    discontinued operations
                
                $
                (0.03
                )
                $
                —
                
                $
                (0.08
                )
                $
                -Net
                    (loss) earnings per share
                
                $
                (0.02
                )
                $
                0.19
                
                $
                0.04
                
                $
                0.42Diluted
                    (loss) earnings per share:From
                    continuing operations
                
                $
                0.01
                
                $
                0.19
                
                $
                0.12
                
                $
                0.40From
                    discontinued operations
                
                $
                (0.03
                )
                $
                —
                
                $
                (0.08
                )
                $
                —Net
                    (loss) earnings per share
                
                $
                (0.02
                )
                $
                0.19
                
                $
                0.04
                
                $
                0.40Weighted
                    average common shares outstanding:Basic
                
                
                19,561,310
                
                
                18,845,323
                
                
                19,225,038
                
                
                18,587,184Diluted
                
                
                19,993,844
                
                
                19,401,206
                
                
                19,688,017
                
                
                19,192,485
 The
            accompanying notes are an integral part of these condensed consolidated
            financial statements.
 
 -3-
 **Table
          of Contents**


**SANDERS
                    MORRIS HARRIS GROUP INC. AND SUBSIDIARIES****Condensed
                    Consolidated Statement of Shareholders'
                    Equity****For
                    the nine months ended September 30, 2006**(in
                    thousands, except shares)(unaudited)
  Amounts
                
                
                
                Shares**Common
                    stock**Balance,
                    beginning of period
                
                $
                196
                
                
                
                
                
                19,634,260Sale
                    of stock
                
                
                50
                
                
                
                
                
                5,000,000Stock
                    issued pursuant to employee benefit plan
                
                
                4
                
                
                
                
                
                387,065Balance,
                    end of period
                
                
                250
                
                
                
                
                
                25,021,325**Common
                    stock committed**Balance,
                    beginning of period
                
                
                —Committed
                    for acquisition
                
                
                2,382
                
                
                
                
                
                190,431Balance,
                    end of period
                
                
                2,382
                
                
                
                
                
                190,431**Additional
                    paid-in capital**Balance,
                    beginning of period
                
                
                134,004Sale
                    of stock
                
                
                57,897Stock
                    issued pursuant to employee benefit plan,including
                    tax benefit
                
                
                1,583Amortization
                    of restricted stock grants
                
                
                1,752Collection
                    of receivable for shares issued
                
                
                15Balance,
                    end of period
                
                
                195,251**Retained
                    earnings**Balance,
                    beginning of period
                
                
                23,936Dividends
                    ($0.135 per share)
                
                
                (2,572
                )Net
                    income
                
                
                760
                
                
                760Balance,
                    end of period
                
                
                22,124
                
                
                760**Accumulated
                    other comprehensive income**Balance,
                    beginning of period
                
                
                30Net
                    change in unrealized appreciationon
                    securities available for sale
                
                
                17
                
                
                17Income
                    tax expense on change in unrealizedappreciation
                    on securities available for sale
                
                
                (6
                )
                
                (6
                )Balance,
                    end of period
                
                
                41
                
                
                11**Comprehensive
                    income**
                
                
                
                
                
                771**Treasury
                    stock**Balance,
                    beginning of period
                
                
                (3,481
                )
                
                
                
                
                (739,402
                )Balance,
                    end of period
                
                
                (3,481
                )
                
                
                
                
                (739,402
                )**Total
                    shareholders' equity and common shares
                    outstanding**
                
                **$**
                **216,567**
                
                
                
                
                
                **24,472,354**
 The
          accompanying notes are an integral part of these condensed consolidated
          financial statements.
 
 -4-
 **Table
          of Contents**


**SANDERS
                  MORRIS HARRIS GROUP INC. AND SUBSIDIARIES****Condensed
                  Consolidated Statement of Cash
                  Flows****For
                  the nine months ended September 30, 2006 and
                  2005**(in
                  thousands)(unaudited)
  **2006**
              
              **2005**CASH
                  FLOWS FROM OPERATING ACTIVITIES:Net
                  income
              
              $
              760
              
              $
              7,715Adjustments
                  to reconcile net income to net cash provided byoperating
                  activities:Realized
                  gain on securities available for sale
              
              
              (11
              )
              
              (2
              )Depreciation
              
              
              2,135
              
              
              1,511Provision
                  for bad debts
              
              
              360
              
              
              163Compensation
                  expense related to amortization of restricted stock grants
              
              
              1,752
              
              
              1,466Goodwill
                  impairment charge
              
              
              4,456
              
              
              —Deferred
                  income taxes
              
              
              (1,957
              )
              
              402Equity
                  in income of limited partnerships
              
              
              (902
              )
              
              (6,569
              )Minority
                  interests in income of consolidated companies
              
              
              3,580
              
              
              4,438Change
                  in receivables
              
              
              (1,792
              )
              
              (1,572
              )Change
                  in deposits with clearing brokers
              
              
              (8
              )
              
              (731
              )Change
                  in securities owned
              
              
              (11,367
              )
              
              (994
              )Change
                  in other assets and prepaid expenses
              
              
              (505
              )
              
              212Change
                  in accounts payable and accrued liabilities
              
              
              (467
              )
              
              (3,924
              )Change
                  in securities sold, not yet purchased
              
              
              9,623
              
              
              834Change
                  in payable to clearing broker-dealers
              
              
              (1,768
              )
              
              9Change
                  in net liabilities of discontinued operations
              
              
              192
              
              
              (34
              )Net
                  cash provided by operating activities
              
              
              4,081
              
              
              2,924CASH
                  FLOWS FROM INVESTING ACTIVITIES:Capital
                  expenditures
              
              
              (4,001
              )
              
              (1,876
              )Acquisitions,
                  net of cash acquired of $0 and $421, respectively
              
              
              —
              
              
              (16,106
              )Purchase
                  of securities available for sale
              
              
              —
              
              
              (1,132
              )Proceeds
                  from sales and maturities of securities available for sale
              
              
              418
              
              
              268Net
                  cash used in investing activities
              
              
              (3,583
              )
              
              (18,846
              )CASH
                  FLOWS FROM FINANCING ACTIVITIES:Proceeds
                  from shares issued pursuant to employee benefit plan
              
              
              1,163
              
              
              2,102Tax
                  benefit of stock options exercised
              
              
              424
              
              
              568Collection
                  of receivable for shares issued
              
              
              15
              
              
              —Proceeds
                  from borrowings
              
              
              8,119
              
              
              10,500Repayment
                  of borrowings
              
              
              (3,470
              )
              
              —Investments
                  by minority interests
              
              
              47
              
              
              41Distributions
                  to minority interests
              
              
              (2,169
              )
              
              (1,083
              )Payments
                  of cash dividends
              
              
              (2,572
              )
              
              (2,342
              )Net
                  cash provided by financing activities
              
              
              1,557
              
              
              9,786Net
                  increase (decrease) in cash and cash equivalents
              
              
              2,055
              
              
              (6,136
              )CASH
                  AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
              
              
              17,475
              
              
              21,678CASH
                  AND CASH EQUIVALENTS AT END OF PERIOD
              
              $
              19,530
              
              $
              15,542


The
        accompanying notes are an integral part of the condensed consolidated financial
        statements.




-5-






**SANDERS
      MORRIS HARRIS GROUP INC. AND SUBSIDIARIES**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL
      STATEMENTS**


**(Unaudited)**






**1.**
            **BASIS
                OF PRESENTATION**





*Nature
      of Operations*




Through
      its operating subsidiaries Sanders Morris Harris Inc. (“Sanders Morris Harris”
or “SMH”), Salient Capital Management, LLC (“Salient”), SMH Capital Advisors,
      Inc. (“SMCA”), Charlotte Capital, LLC, The Edelman Financial Center, LLC
      (“Edelman”), and Select Sports Group, Ltd (“SSG”), Sanders Morris Harris Group
      Inc. (“SMHG” or “the Company”) provides a broad range of financial and other
      professional services, including asset and wealth management (including
      investment advice and management, financial planning, trust related services,
      sports representation and management), investment and merchant banking, and
      institutional services (including institutional sales and trading, prime
      brokerage, and research). The Company serves a diverse group of institutional,
      corporate, and individual clients.





The
      Company merged with and acquired its operating subsidiaries from 1999 through
      2005. The acquisitions were accounted for using the purchase method and
      accordingly, results of an acquired entity are included in the Company’s
      condensed consolidated financial statements from the date of acquisition. As
      a
      result the current period results are not comparable to the prior periods.





During
      the third quarter of 2006, the Company made the decision to close and closed
      most of the activities of the division known as Fixed Income National, which
      began operations during the first quarter of 2006. Fixed Income National
      provided fixed income brokerage services to institutional clients. The operating
      results of that portion of Fixed Income National that was closed have been
      recorded as discontinued operations and are not included in the segment
      discussions. The operating results of the portion of the division that was
      not
      discontinued is included in the Institutional Services segment.





*Consolidation*





The
      unaudited condensed consolidated financial statements of the Company include
      the
      accounts of its subsidiaries. All material intercompany transactions and
      balances have been eliminated in consolidation.





In
      management's opinion, the unaudited condensed consolidated financial statements
      include all adjustments necessary for a fair presentation of our consolidated
      financial position at September 30, 2006, our results of operations for the
      three and nine months ended September 30, 2006 and 2005, and our cash flows
      for
      the nine months ended September 30, 2006 and 2005. All adjustments are of a
      normal recurring nature. Interim results are not necessarily indicative of
      results for a full year.





These
      financial statements and notes should be read in conjunction with the Company’s
      Annual Report on Form 10-K for the year ended December 31, 2005.





*Effects
      of Recently Issued Accounting Standards*





In
      December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS
      No. 123R, *Share-Based
      Payment (Revised 2004).* SFAS No.
      123R established standards for the accounting for transactions in which an
      entity (1) exchanges its equity instruments for goods or services, or (2) incurs
      liabilities in exchange for goods or services that are based on the fair value
      of the entity’s equity instruments or that may be settled by the issuance of the
      equity instruments. SFAS No. 123R eliminated the ability to account for
      stock-based compensation using APB 25 and requires that such transactions be
      recognized as compensation cost in the income statement based on their fair
      values on the date of the grant. SFAS No. 123R was effective for the Company
      on
      January 1, 2006. The Company transitioned to fair value based accounting for
      stock-based compensation using a modified version of prospective application
      (“modified prospective application”). Under modified prospective application the
      Company applies SFAS No. 123R to new awards and to awards modified, repurchased,
      or cancelled after January 1, 2006. Additionally, compensation cost for the
      portion of awards for which the requisite service has not been rendered
      (generally


-6-
 **Table
          of Contents**




referring
      to non-vested awards) that were outstanding as of January 1, 2006 must be
      recognized as the remaining requisite service is rendered during the period
      of
      and/or the periods after the adoption of SFAS No. 123R. The attribution of
      compensation cost for those earlier awards is based on the same method and
      on
      the same grant-date fair values previously determined for the pro forma
      disclosures required for companies that did not adopt the fair value accounting
      method for stock-based employee compensation. As a result of the adoption of
      SFAS No. 123R, the Company recognized additional pretax compensation cost of
      $50,000 in the first nine months of 2006 for stock-based compensation awards
      outstanding as of December 31, 2005, for which the requisite service was not
      fully rendered prior to January 1, 2006. Approximately $71,000 remains to be
      recognized over 1.01 weighted average years. Future levels of compensation
      cost
      recognized related to stock-based compensation awards (including the
      aforementioned expected costs during the period of adoption) may be impacted
      by
      new awards and/or modifications, repurchase and cancellations of existing awards
      before and after the adoption of this standard. (See Note 11.)





In
      June
      2005 the Emerging Issues Task Force (EITF) issued EITF No. 04-5, *Investor’s
      Accounting for an Investment in a Limited Partnership When the Investor Is
      the
      Sole General Partner and the Limited Partners Have Certain
      Rights* .
      In
      conjunction with EITF No. 04-5, the FASB staff is planning to amend SOP 78-9, *Accounting
      for Investments in Real Estate Ventures* to be
      consistent with EITF No. 04-5. SOP 78-9-1, *Interaction
      of AICPA Statement of Position 78-9 and EITF No. 04-5,* presumes
      that a general partner controls a limited partnership and therefore should
      consolidate the partnership. This presumption can be overcome if the limited
      partners have kick-out or substantive participating rights. As all of the
      limited partnerships for which we act as general partner have kick-out or
      substantive participating rights, the impact that these new accounting standards
      had on our consolidated financial statements was minimal. The effective date
      of
      SOP 78-9-1 and EITF No. 04-5 was January 1, 2006 for existing limited
      partnerships. EITF 04-5 and SOP 78-9-1 was effective immediately for new and
      modified limited partnerships.





On
      July
      13, 2006, FASB Interpretation (FIN) No. 48, *Accounting
      for Uncertainty in Income Taxes - An Interpretation of FASB Statement No.
      109,* was
      issued. FIN 48 clarifies the accounting for uncertainty in income taxes
      recognized in an enterprise’s financial statements in accordance with FASB
      Statement No. 109, *Accounting
      for Income Taxes.* FIN
      48
      also prescribes a recognition threshold and measurement attribute for the
      financial statement recognition and measurement of a tax position taken or
      expected to be taken in a tax return. The new FASB standard also provides
      guidance on derecognition, classification, interest and penalties, accounting
      in
      interim periods, disclosure, and transition.





The
      evaluation of a tax position in accordance with FIN 48 is a two-step process.
      The first step is a recognition process whereby the enterprise determines
      whether it is more likely than not that a tax position will be sustained upon
      examination, including resolution of any related appeals or litigation
      processes, based on the technical merits of the position. In evaluating whether
      a tax position has met the more-likely-than-not recognition threshold, the
      enterprise should presume that the position will be examined by the appropriate
      taxing authority that has full knowledge of all relevant information. The second
      step is a measurement process whereby a tax position that meets the
      more-likely-than-not recognition threshold is calculated to determine the amount
      of benefit to recognize in the financial statements. The tax position is
      measured at the largest amount of benefit that is greater than 50% likely of
      being realized upon ultimate settlement.





The
      provisions of FIN 48 are effective for fiscal years beginning after December
      15,
      2006. Earlier application is permitted as long as the enterprise has not yet
      issued financial statements, including interim financial statements, in the
      period of adoption. The provisions of FIN 48 are to be applied to all tax
      positions upon initial adoption of this standard. Only tax positions that meet
      the more-likely-than-not recognition threshold at the effective date may be
      recognized or continue to be recognized upon adoption of FIN 48. The Company
      is
      evaluating the impact that the pronouncement will have on its condensed
      consolidated financial statements.





In
      September 2006, the Securities and Exchange Commission (SEC) issued Staff
      Accounting Bulletin No. 108 (“SAB 108”). SAB 108 allows for the adjustment of
      the cumulative effect of prior year immaterial errors in assets and liabilities
      as of the beginning of the fiscal year, with an offsetting adjustment to
      the


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opening
      balance of retained earnings. SAB 108 is effective for the Company for its
      annual financial statement for the year ended December 31, 2006. We are
      currently evaluating the potential impacts of adopting SAB 108.





*Sale
      of Stock*





On
      September 29, 2006, the Company closed a secondary public offering of 5,000,000
      shares of its common stock, resulting in proceeds of $58.4 million, net of
      underwriting discounts and other expenses. The Company received the proceeds
      in
      October 2006 and used $13.2 million to repay the outstanding balance including
      accrued interest on one of its revolving credit facilities. The remaining amount
      was invested in a money market fund. The proceeds are recorded as a receivable
      from broker-dealers at September 30, 2006.





*Reclassifications*





Certain
      reclassifications have been made to the 2005 condensed consolidated financial
      statements to conform them to the 2006 presentation. The reclassifications
      had
      no effect on retained earnings, results of operations or cash flows as
      previously reported.





**2.**
            **ACQUISITIONS
                AND DISPOSITION**





On
      May
      10, 2005, the Company acquired a 51% interest in The Edelman Financial Center,
      LLC, one of the leading financial planning firms in the country. The Company
      will acquire the remaining 49% of Edelman over four years. Edelman, based in
      Fairfax, Virginia, manages over $2.7 billion in assets. At the initial closing,
      SMHG bought 51% of the outstanding membership units of Edelman (“the First
      Tranche Units”). The Company paid $20.0 million, in a combination of cash and
      shares of the Company’s common stock for the First Tranche Units and is required
      to pay additional consideration of approximately $4.8 million in a combination
      of cash and shares of the Company’s common stock based on the profitability of
      Edelman for the year ended September 30, 2006. The additional consideration,
      of
      which approximately $2.4 million will be in cash, and the Company’s common stock
      with a value of approximately $2.4 million, is scheduled to be paid during
      the
      three months ended December 31, 2006.





In
      May
      2008, the Company will purchase an additional 25% membership interest in
      Edelman. The Company will pay an amount equal to 25% of a multiple of between
      8
      and 11 times Edelman’s pretax income for the fiscal year ending December 31,
      2007 (the “Second Tranche Consideration”). The multiple will be determined based
      upon the compound annual growth rate of Edelman’s pretax income for the period
      beginning January 1, 2007 and ending December 31, 2007 over the pretax income
      for the period beginning January 1, 2005 and ending December 31, 2005. The
      Second Tranche Consideration will be paid in a combination of cash and the
      Company’s common stock.





In
      May
      2009, the Company will purchase all of the remaining issued and outstanding
      membership interests of Edelman. The Company will pay an amount equal to 24%
      of
      a multiple of between 8 and 11 times Edelman’s pretax income for the fiscal year
      ending December 31, 2008 (the “Third Tranche Consideration”). The multiple will
      be determined based upon the compound annual growth rate of Edelman’s pretax
      income for the period beginning January 1, 2008 and ending December 31, 2008
      over the pretax income for the period beginning January 1, 2005 and ending
      December 31, 2005. The Third Tranche Consideration will also be paid in a
      combination of cash and the Company’s common stock.





The
      aggregate issuances of common stock may never exceed 20% of the total number
      of
      shares of the Company’s common stock issued and outstanding on the initial
      closing date. The shares of common stock issued were not registered in reliance
      upon the exemption provided in Section 4(2) of the Securities Act of
      1933.





The
      acquisition was accounted for as a purchase, and accordingly, the financial
      information of Edelman has been included in the Company’s consolidated financial
      statements from May 10, 2005. Consideration of


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$24.8
      million exceeded the fair market value of identifiable net tangible assets
      by
      approximately $25.0 million, which has been recorded as goodwill.





On
      April
      15, 2005, the Company acquired a 50% interest in an investment advisory business
      of two financial advisors who are based in Colorado Springs, Colorado. The
      customer accounts were added to those of Sanders Morris Harris and the business
      operates as SMH Colorado. As the Company may exercise control to a degree
      greater than its voting interests, the acquisition was accounted for as a
      purchase, and accordingly, the financial information of SMH Colorado has been
      included in the Company’s consolidated financial statements from April 15, 2005.
      The consideration of $2.5 million, consisting of a combination of cash and
      shares of the Company’s common stock, exceeded the fair market value of
      identifiable net tangible assets by $2.5 million, which has been recorded as
      goodwill.




On
      April
      1, 2005, the Company sold its Douglas, Noyes division to a third party. The
      Company retained cash, receivables, and fixed assets, as well as all accounts
      payable and accrued liabilities associated with Douglas, Noyes. In April 2006
      and continuing thereafter, the Company receives a portion of the investment
      advisory fees earned by Douglas, Noyes. SMHG recorded no gain or loss on the
      sale of Douglas, Noyes. Douglas, Noyes, based in New York City provides
      investment management services.





**3.**
            **SECURITIES
                OWNED AND SECURITIES SOLD, NOT YET
                PURCHASED**





Securities
      owned and securities sold, not yet purchased as of September 30, 2006 and
      December 31, 2005 were as follows:




September
                  30, 2006
              
              December
                  31, 2005Sold,
                  Not Yet
              
              
              
              Sold,
                  Not YetOwned
              
              Purchased
              
              Owned
              
              Purchased(in
                  thousands)
              
              (in
                  thousands)(unaudited)Marketable:U.S.
                  government and agency
              
              $
              1,223
              
              $
              20
              
              $
              4,619
              
              $
              2,019Corporate
                  stocks and options
              
              
              33,152
              
              
              17,730
              
              
              18,096
              
              
              6,149Corporate
                  bonds
              
              
              8,624
              
              
              41
              
              
              7,933
              
              
              —42,999
              
              
              17,791
              
              
              30,648
              
              
              8,168Not
                  readily marketable:Partnerships
              
              
              35,002
              
              
              —
              
              
              34,108
              
              
              —Corporate
                  stocks and warrants
              
              
              7,925
              
              
              —
              
              
              8,901
              
              
              —$
              85,926
              
              $
              17,791
              
              $
              73,657
              
              $
              8,168


Securities
      not readily marketable include investment securities (a) for which there is
      no
      market on a securities exchange or no independent publicly quoted market, (b)
      that cannot be publicly offered or sold unless registration has been effected
      under the Securities Act of 1933, or (c) that cannot be offered or sold because
      of other arrangements, restrictions, or conditions applicable to the securities
      or to the Company. Not readily marketable securities consist of investments
      in
      limited partnerships, equities, options, and warrants. The investments in
      limited partnerships are accounted for using the equity method, which
      approximates fair value, and principally consist of Environmental Opportunities
      Fund, L.P., Environmental Opportunities Fund II, L.P., Environmental
      Opportunities Fund II (Institutional), L.P., Corporate Opportunities Fund,
      L.P.,
      Corporate Opportunities Fund (Institutional), L.P., Sanders Opportunity Fund,
      L.P., Sanders Opportunity Fund (Institutional), L.P., Tactical Opportunities
      High Yield Fund, L.P., Life Sciences Opportunity Fund, L.P., Life Sciences
      Opportunity Fund (Institutional), L.P., Life Sciences Opportunity Fund II,
      L.P.,
      Life Sciences Opportunity Fund (Institutional) II, L.P., 2003 Houston Energy
      Partners, L.P., 2005 Houston Energy Partners, L.P., Concept Capital, LLC, Select
      Sports Group, Ltd., Endowment Advisors, L.P., SMH Private Equity Group I, L.P.,
      SMH Private Equity Group II, L.P., Salient Enhanced Credit Fund, L.P., Salient
      Total Return Fund, L.P., and Global Hedged Equity Fund, L.P.


-9-
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**4.**
            **SECURITIES
                AVAILABLE FOR SALE**





Securities
      available for sale at September 30, 2006 were as follows:


**Amortized**
              
              **Gross
                  Unrealized**
              
              **Estimated****Cost**
              
              **Gains**
              
              **Losses**
              
              **Fair
                  Value**(in
                  thousands)U.S.
                  Government and agency obligations
              
              $
              718
              
              $
              4
              
              $
              (8
              )
              $
              714Corporate
                  bonds
              
              
              250
              
              
              —
              
              
              —
              
              
              250Marketable
                  equity securities
              
              
              459
              
              
              90
              
              
              (19
              )
              
              530Total
              
              $
              1,427
              
              $
              94
              
              $
              (27
              )
              $
              1,494


The
      contractual maturities of debt securities available for sale at September 30,
      2006, were as follows (in thousands):


Due
                before 5 years
            
            $
            742Due
                after 25 years through 30 years
            
            $
            221


Gross
      realized gains on sales of securities available for sale were $12,000 for the
      nine months ended September 30, 2006 and $21,000 for the nine months ended
      September 30, 2005. Gross realized losses on securities available for sale
      were
      $1,000 for the nine months ended September 30, 2006 and $19,000 for the nine
      months ended September 30, 2005.




**5.**
            **INCOME
                TAXES**





The
      differences between the effective tax rate reflected in the income tax provision
      from continuing operations and the statutory federal rate were as
      follows:




**Three
                  Months Ended**
              
              **Nine
                  Months Ended****September
                  30,**
              
              **September
                  30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**(in
                  thousands)Tax
                  computed using the statutory rate
              
              $
              153
              
              $
              2,149
              
              $
              1,301
              
              $
              4,550State
                  income taxes and other
              
              
              47
              
              
              335
              
              
              200
              
              
              735Total
              
              $
              200
              
              $
              2,484
              
              $
              1,501
              
              $
              5,285


**6.**
            **BORROWINGS**





During
      May 2005, the Company entered into a $15.0 million revolving credit facility
      with a bank. The line of credit expires in May 2007, unless extended. Borrowings
      under the line of credit bear interest based on LIBOR. The interest rate on
      the
      Company’s borrowings ranged from 5.85% to 6.97% during 2006. The credit facility
      is secured by a pledge of ownership interests in two of the Company’s
      subsidiaries. Debt covenants require the Company to maintain certain
      debt-to-EDITDA and liquidity to funded debt ratios, as well as minimum assets
      under management. At September 30, 2006, the Company was not in compliance
      with its debt-to-EBITDA covenant. The Company has received a waiver
      from the bank dated effective September 30, 2006, and was in
      full compliance with the credit agreement as of October 4,
      2006. The outstanding balance on the line of credit was $13.0 million at
      September 30, 2006, but was paid in full on October 4, 2006.





During
      December 2005, Salient entered into a $2.5 million revolving credit facility
      with a bank. The line of credit expires in December 2007. Borrowings under
      the
      line of credit bear interest based on LIBOR. The interest rate of Salient’s
      borrowings ranged from 6.03% to 7.05% during 2006. The credit facility
      is


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unsecured
      and not subject to financial covenants; however, SMHG and the principals of
      Salient guarantee payment. The outstanding balance on the line of credit was
      $
      855,000 at September 30, 2006.





During
      December 2005, Edelman entered into a $1.5 million construction loan agreement
      with a bank. Proceeds from the loan were used to build out Edelman’s new office
      facilities. The loan is not subject to financial covenants and is secured by
      Edelman’s property and other assets and guaranteed by Mr. Edelman and SMHG.
      Beginning in January 2006 and ending in December 2006, interest will be paid
      in
      monthly installments at an interest rate, which is based on prime. The interest
      rate on Edelman’s borrowings ranged from 6.75% to 7.75% during 2006. Principal
      and interest payments will be made in equal monthly installments beginning
      in
      January 2007 and ending in December 2013. At September 30, 2006, the outstanding
      balance on the loan was $1.5 million.





**7.**
            **COMMITMENTS
                AND CONTINGENCIES**





In
      April
      2004, the Company acquired a 69% interest in Charlotte Capital from a previous
      investor. Employees of Charlotte Capital retained a 31% ownership interest
      in
      the firm. Employees of Charlotte Capital can earn up to an additional 9%
      ownership interest by achieving specified revenue run rates during the 36-month
      period beginning January 1, 2006 and ending December 31, 2009. No additional
      consideration has been earned as of September 30, 2006.





The
      Company is required to pay approximately $2.4 million in cash and is obligated
      to grant shares of its common stock to the minority shareholder of Edelman
      Financial Center based on the profitability of Edelman for the year ended
      September 30, 2006. The number of shares to be granted will be equal to
      approximately $2.4 million divided by the average of the high and low sales
      prices multiplied by the daily trading volume on each of the ten trading days
      immediately preceding the date of delivery of the shares to the minority
      shareholder of Edelman. Those shares are scheduled to be issued prior to
      December 31, 2006.




The
      Company has issued letters of credit in the amounts of $1.0 million, $199,000,
      $144,000, and $92,000 to the owners of four of the offices that we lease to
      secure payment of our lease obligations for those facilities. The Company has
      issued a letter of credit in the amount of $100,000 to secure the payment of
      the
      deductible portion of the Company’s workers compensation insurance policy.





The
      Company has uncommitted financing arrangements with clearing brokers that
      finance our customer accounts, certain broker-dealer balances, and firm trading
      positions. Although these customer accounts and broker-dealer balances are
      not
      reflected on the consolidated balance sheet for financial accounting reporting
      purposes, the Company has generally agreed to indemnify these clearing brokers
      for losses they may sustain in connection with the accounts, and therefore,
      retains risk on these accounts. The Company is required to maintain certain
      cash
      or securities on deposit with our clearing brokers.





In
      the
      normal course of business, the Company enters into underwriting commitments.
      There were no firm underwriting commitments open at September 30, 2006.





The
      NASD
      initially conducted an inspection of our prime brokerage and private investment
      or hedge fund support operations based in our New York office in November 2004.
      Subsequent to such inspection, the NASD opened an investigation and requested
      the production of additional documents and materials on twelve occasions in
      2005
      and 2006 with respect to our prime brokerage and related hedge fund operations
      and has conducted formal interviews
      of a number of our employees involved in these operations. On August 16, 2006,
      Sanders Morris Harris received a “Wells letter” notification from the NASD,
      which states that the staff of the NASD has made a preliminary determination
      to
      recommend that disciplinary action be brought against Sanders Morris Harris
      and
      four of its employees based on alleged violations of certain conduct rules
      of
      the NASD, including NASD Conduct Rule 2110 relating
      to the alleged improper payment of soft dollar commissions to a fund manager
      and
      relating to the alleged improper sharing of commissions by two employees
      contrary to a written contract with an investment adviser and representations
      to
      the investors in one private investment partnership; NASD Conduct Rule 2210
      relating to the content of hedge fund advertising materials; SEC Rule 17a-4
      and
      NASD Conduct Rules 2210 and 3110 relating to the retention of


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certain
      email, instant messages, and advertising materials; NASD Conduct Rules 1031
      and
      2110 relating to the activities of an unregistered employee; and NASD Conduct
      Rules 2110 and 3010 relating to the written supervisory procedures of Sanders
      Morris Harris for its hedge fund and prime brokerage operations. Under the
      Wells
      procedure, Sanders Morris Harris has an opportunity to respond to the NASD
      before any action is taken against it. Sanders Morris Harris submitted its
      response to the NASD on October 11, 2006. There is no assurance that a prompt
      resolution can be reached or that the ultimate impact on the Company will not
      be
      material. Discussions have commenced between the staff of the NASD and our
      legal
      counsel with respect to the alleged violations.





We
      are
      aware that a company for which Sanders Morris Harris acted as placement agent
      in
      a private placement of convertible preferred shares in June 2005 has experienced
      a significant decline in its net sales, a significant increase in its net loss,
      and currently has negative working capital. While the company has obtained
      financing to meet its short-term working capital requirements, there is no
      assurance that it will be able to sustain its business. We have received written
      and oral communications from a number of the purchasers of securities in the
      offering expressing their dissatisfaction and indicating that they may seek
      legal recourse with respect to the offering. No litigation has been filed at
      this time. While we believe Sanders Morris Harris has valid defenses to any
      claims and is entitled to indemnification and contribution provisions of the
      placement agent agreement, the costs of defending any litigation filed naming
      Sanders Morris Harris could be significant and an adverse determination could
      have a material effect on quarterly or annual operating results in the period
      in
      which it is resolved. Two managing directors of Sanders Morris Harris served
      as
      directors of the company from June 2005 to June 2006.




The
      Company is a party to various legal proceedings that are of an ordinary or
      routine nature incidental to its operations. The Company believes it has
      adequately reserved for such litigation matters and that they will not have
      a
      material adverse effect on consolidated financial position, results of
      operations or cash flows.





The
      Company and its subsidiaries have obligations under operating leases with
      initial noncancelable terms in excess of one year that expire by
      2014.


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          of Contents**




**8.**
            **(LOSS)
              EARNINGS PER COMMON SHARE**




Basic
      and
      diluted (loss) earnings per share computations for the periods indicated were
      as
      follows:




**Three
                  Months Ended**
                **September
                  30,****2006**
              
              **2005**(in
                  thousands, except per share amounts)Computation
                  of basic and diluted (loss) earnings per common
                  share:Income
                  from continuing operations
              
              $
              249
              
              $
              3,656Loss
                  from discontinued operations, net of tax
              
              
              (547
              )
              
              —Net
                  (loss) income
              
              $
              (298
              )
              $
              3,656Weighted
                  average common shares outstanding
              
              
              19,370,879
              
              
              18,845,323Weighted
                  average common shares committed
              
              
              190,431
              
              
              —Total
                  basic shares outstanding
              
              
              19,561,310
              
              
              18,845,323Common
                  shares issuable under stock option plan
              
              
              773,335
              
              
              894,771Less
                  shares assumed repurchased with proceeds
              
              
              (340,801
              )
              
              (338,888
              )Weighted
                  average common shares outstanding
              
              
              19,993,844
              
              
              19,401,206Basic
                  (loss) earnings per share:From
                  continuing operations
              
              $
              0.01
              
              $
              0.19From
                  discontinued operations
              
              $
              (0.03
              )
              $
              —Net
                  (loss) earnings per share
              
              $
              (0.02
              )
              $
              0.19Diluted
                  (loss) earnings per share:From
                  continuing operations
              
              $
              0.01
              
              $
              0.19From
                  discontinued operations
              
              $
              (0.03
              )
              $
              —Net
                  (loss) earnings per share
              
              $
              (0.02
              )
              $
              0.19
  **Nine
                  Months Ended**
                **September
                  30,****2006**
              
              **2005**(in
                  thousands, except per share amounts)Computation
                  of basic and diluted earnings per common
                  share:Income
                  from continuing operations
              
              $
              2,325
              
              $
              7,715Loss
                  from discontinued operations, net of tax
              
              
              (1,565
              )
              
              —Net
                  income
              
              $
              760
              
              $
              7,715Weighted
                  average common shares outstanding
              
              
              19,160,863
              
              
              18,587,184Weighted
                  average common shares committed
              
              
              64,175
              
              
              —Total
                  basic shares outstanding
              
              
              19,225,038
              
              
              18,587,184Common
                  shares issuable under stock option plan
              
              
              873,335
              
              
              904,771Less
                  shares assumed repurchased with proceeds
              
              
              (410,356
              )
              
              (299,470
              )Weighted
                  average common shares outstanding
              
              
              19,688,017
              
              
              19,192,485Basic
                  earnings (loss) per share:From
                  continuing operations
              
              $
              0.12
              
              $
              0.42From
                  discontinued operations
              
              $
              (0.08
              )
              $
              —Net
                  earnings (loss) per share
              
              $
              0.04
              
              $
              0.42Diluted
                  earnings (loss) per share:From
                  continuing operations
              
              $
              0.12
              
              $
              0.40From
                  discontinued operations
              
              $
              (0.08
              )
              $
              —Net
                  earnings (loss) per share
              
              $
              0.04
              
              $
              0.40


-13-
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          of Contents**




Outstanding
      stock options (172,500 for the three months ended September 30, 2006, and 22,500
      for the three months ended September 30, 2005; and 72,500 for the nine months
      ended September 30, 2006, and 12,500 for the nine months ended September 30,
      2005) have not been included in diluted earnings per common share because to
      do
      so would have been antidilutive for the periods presented.





**9.**
            **GOODWILL**





During
      the three months ended September 30, 2006, the Company recorded goodwill of
      $4.8
      million representing additional consideration to be paid to the minority
      shareholder of Edelman Financial Center based on the profitability of Edelman
      for the year ended September 30, 2006.





During
      the nine months ended September 30, 2006, the Company recognized goodwill
      impairment charges totaling $4.5 million related to its ownership of Charlotte
      Capital. The principal factor contributing to our decision to record the
      impairment charge related to the continuing decline of assets under management
      and to the fact that Charlotte Capital is not profitable at the current level
      of
      assets under management. Charlotte Capital’s assets under management have
      declined from $429 million at December 31, 2004 to $170 million at September
      30,
      2006, primarily due to portfolio performance that has lagged the benchmark
      returns for the small and small/mid cap value styles that Charlotte Capital
      follows. Charlotte Capital provides investment management services to ten
      institutional investors, the loss of any one of which could have a material
      adverse impact on Charlotte Capital’s assets under management and, consequently,
      Charlotte Capital’s revenues and earnings.





**10.**
            **SUBSEQUENT
                EVENT**





On
      October 30, 2006, Charlotte Capital made the decision to terminate its existing
      advisory agreements and wind up its business. The assets and liabilities of
      the
      business consist primarily of accounts receivable from customers and obligations
      incurred in the normal course of business. We do not anticipate material losses
      associated with the closure of the business. The condensed consolidated
      financials of the Company as of September 30, 2006, do not reflect any expense
      or liability associated with this exit activity.





**11.**
            **BUSINESS
                SEGMENT INFORMATION**





SMHG
      operates through four business segments: Asset and Wealth Management, which
      can
      be further divided into Asset Management and Retail Brokerage; Institutional
      Services, which can be further divided into Institutional Brokerage and Prime
      Brokerage; Investment Banking; and Corporate and Other. The business segments
      are based upon factors such as the services provided and distribution channels
      served. Certain services are provided to customers through more than one of
      our
      business segments.





During
      the third quarter of 2006, the Company made the decision to close and closed
      most of the activities of the division known as Fixed Income National, which
      began operations during the first quarter of 2006. Fixed Income National
      provided fixed income brokerage services to institutional clients. The operating
      results of that portion of Fixed Income National that was closed have been
      recorded as discontinued operations and are not included in the segment
      discussions. The operating results of the portion of the division that was
      not
      discontinued is included in the Institutional Services segment.





***Asset
      and Wealth Management***





The
      Asset
      Management segment provides investment advisory, wealth and investment
      management, financial planning, and trust services to institutional and
      individual clients. The Company earns an advisory fee based on such factors
      as
      the amount of assets under management and the type of services provided. The
      asset management segment may also earn commission revenues from the sale of
      equity, fixed income, mutual fund, and annuity products; and sales credits
      from
      the distribution of investment banking issues. In addition, performance fees
      may
      be earned for exceeding performance benchmarks for the investment portfolios
      in
      the limited partnerships that we manage.


-14-
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          of Contents**




The
      Retail Brokerage segment distributes a range of financial products through
      its
      branch distribution network, including equity and fixed income securities,
      mutual funds, and annuities. Retail revenues consist of commissions and
      principal credits earned on equity and fixed income transactions in customer
      brokerage accounts, distribution fees earned from mutual funds, fees earned
      from
      managed accounts, and net interest on customers’ margin loan and credit account
      balances. Additionally, retail revenues include sales credits from investment
      banking transactions such as the distribution of underwritings that we co-manage
      or in which we participate and private placements of securities in which we
      serve as placement agent. The firm employs registered representatives and also
      licenses independent financial advisors.





***Institutional
      Services***





The
      Institutional Brokerage segment distributes equity and fixed income products
      through its distribution network to its institutional clients. Institutional
      revenues consist of commissions and principal credits earned on transactions
      in
      customer brokerage accounts, net interest on customers’ margin loan and credit
      account balances, and sales credits from the distribution of investment banking
      products.





The
      Prime
      Brokerage segment provides trade execution, clearing, custody and other
      back-office services to hedge funds and other professional traders. Prime broker
      revenues consist of commissions and principal credits earned on equity, and
      fixed income transactions; interest income from securities lending services
      to
      customers; and net interest on customers’ margin loan and credit account
      balances.





***Investment
      Banking***





The
      Investment Banking segment provides corporate securities underwriting, private
      financings, and financial advisory services. The Company participates in
      corporate securities distributions as a manager, co-manager or member of an
      underwriting syndicate or of a selling group in public offerings managed by
      other underwriters. Fees earned for our role as an advisor, manager, or
      underwriter are included in the investment banking segment. Sales credits
      associated with the distribution of investment banking products are reported
      in
      Retail Brokerage, Institutional Brokerage, or Asset Management depending on
      the
      relevant distribution channel.





***Corporate
      and Other***





The
      Corporate and Other segment include realized and unrealized gains and losses
      on
      the Company’s investment portfolios and interest and dividends earned on our
      cash and securities positions. Unallocated corporate revenues and expenses
      are
      included in Corporate and Other. Gains and losses from sports representation
      and
      management services performed by SSG are included in Corporate and
      Other.


-15-
 **Table
          of Contents**


The
      following summarizes certain financial information of each reportable business
      segment for the Three and Nine Months in the period ended September 30, 2006
      and
      2005, respectively. SMHG does not analyze asset information in all business
      segments.




**Three
                  Months Ended**
              
              **Nine
                  Months Ended****September
                  30,**
              
              **September
                  30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**(in
                  thousands)**Revenues:**Asset
                  and Wealth ManagementAsset
                  Management
              
              $
              15,693
              
              $
              12,340
              
              $
              44,912
              
              $
              29,534Retail
                  Brokerage
              
              
              3,965
              
              
              3,765
              
              
              13,868
              
              
              11,794Asset
                  and Wealth Management Total
              
              
              19,658
              
              
              16,105
              
              
              58,780
              
              
              41,328Institutional
                  ServicesInstitutional
                  Brokerage
              
              
              5,196
              
              
              6,547
              
              
              17,922
              
              
              19,404Prime
                  Brokerage
              
              
              9,036
              
              
              4,978
              
              
              25,204
              
              
              13,855Institutional
                  Services Total
              
              
              14,232
              
              
              11,525
              
              
              43,126
              
              
              33,259Investment
                  Banking
              
              
              8,634
              
              
              5,465
              
              
              23,975
              
              
              13,414Corporate
                  and Other
              
              
              (820
              )
              
              1,316
              
              
              1,601
              
              
              3,249Total
              
              $
              41,704
              
              $
              34,411
              
              $
              127,482
              
              $
              91,250**Income
                  (loss) from continuing operations before equity
                  in****(loss)
                  income of limited partnerships, minority interest****and
                  income taxes:**Asset
                  and Wealth ManagementAsset
                  Management
              
              $
              4,801
              
              $
              3,396
              
              $
              12,285
              
              $
              7,747Retail
                  Brokerage
              
              
              (16
              )
              
              136
              
              
              (971
              )
              
              927Asset
                  and Wealth Management Total
              
              
              4,785
              
              
              3,532
              
              
              11,314
              
              
              8,674Institutional
                  ServicesInstitutional
                  Brokerage
              
              
              (102
              )
              
              966
              
              
              147
              
              
              2,605Prime
                  Brokerage
              
              
              269
              
              
              390
              
              
              1,389
              
              
              1,388Institutional
                  Services Total
              
              
              167
              
              
              1,356
              
              
              1,536
              
              
              3,993Investment
                  Banking
              
              
              3,018
              
              
              2,140
              
              
              8,566
              
              
              4,756Corporate
                  and Other
              
              
              (5,292
              )
              
              (2,242
              )
              
              (14,912
              )
              
              (6,554
              )Total
              
              $
              2,678
              
              $
              4,786
              
              $
              6,504
              
              $
              10,869**Equity
                  in (loss) income of limited partnerships:**Asset
                  and Wealth ManagementAsset
                  Management
              
              $
              (1,727
              )
              $
              3,459
              
              $
              395
              
              $
              5,637Retail
                  Brokerage
              
              
              —
              
              
              —
              
              
              —
              
              
              —Asset
                  and Wealth Management Total
              
              
              (1,727
              )
              
              3,459
              
              
              395
              
              
              5,637Institutional
                  ServicesInstitutional
                  Brokerage
              
              
              —
              
              
              —
              
              
              —
              
              
              —Prime
                  Brokerage
              
              
              —
              
              
              —
              
              
              —
              
              
              —Institutional
                  Services Total
              
              
              —
              
              
              —
              
              
              —
              
              
              —Investment
                  Banking
              
              
              —
              
              
              —
              
              
              —
              
              
              —Corporate
                  and Other
              
              
              56
              
              
              709
              
              
              507
              
              
              932Total
              
              $
              (1,671
              )
              $
              4,168
              
              $
              902
              
              $
              6,569


-16-
 **Table
          of Contents**


**Three
                  Months Ended**
              
              **Nine
                  Months Ended****September
                  30,**
              
              **September
                  30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**(in
                  thousands)**Minority
                  interests in net income of consolidated****companies:**Asset
                  and Wealth ManagementAsset
                  Management
              
              $
              (558
              )
              $
              (2,698
              )
              
              (3,580
              )
              
              (4,251
              )Retail
                  Brokerage
              
              
              —
              
              
              —
              
              
              —
              
              
              —Asset
                  and Wealth Management Total
              
              
              (558
              )
              
              (2,698
              )
              
              (3,580
              )
              
              (4,251
              )Institutional
                  ServicesInstitutional
                  Brokerage
              
              
              —
              
              
              —
              
              
              —
              
              
              —Prime
                  Brokerage
              
              
              —
              
              
              —
              
              
              —
              
              
              —Institutional
                  Services Total
              
              
              —
              
              
              —
              
              
              —
              
              
              —Investment
                  Banking
              
              
              —
              
              
              —
              
              
              —
              
              
              —Corporate
                  and Other
              
              
              —
              
              
              (116
              )
              
              
              
              
              (187
              )Total
              
              $
              (558
              )
              $
              (2,814
              )
              $
              (3,580
              )
              $
              (4,438
              )**Income
                  (loss) from continuing operations before income
                  taxes:**Asset
                  and Wealth ManagementAsset
                  Management
              
              $
              2,516
              
              $
              4,157
              
              $
              9,100
              
              $
              9,134Retail
                  Brokerage
              
              
              (16
              )
              
              136
              
              
              (971
              )
              
              927Asset
                  and Wealth Management Total
              
              
              2,500
              
              
              4,293
              
              
              8,129
              
              
              10,061Institutional
                  ServicesInstitutional
                  Brokerage
              
              
              (102
              )
              
              966
              
              
              147
              
              
              2,605Prime
                  Brokerage
              
              
              269
              
              
              390
              
              
              1,389
              
              
              1,388Institutional
                  Services Total
              
              
              167
              
              
              1,356
              
              
              1,536
              
              
              3,993Investment
                  Banking
              
              
              3,018
              
              
              2,140
              
              
              8,566
              
              
              4,756Corporate
                  and Other
              
              
              (5,236
              )
              
              (1,649
              )
              
              (14,405
              )
              
              (5,810
              )Total
              
              $
              449
              
              $
              6,140
              
              $
              3,826
              
              $
              13,000




**12.**
            **ACCOUNTING
                FOR STOCK BASED COMPENSATION
                PLANS**





Effective
      January 1, 2006, the Company adopted the provisions of SFAS No. 123R, *Share-Based
      Payment (Revised 2004),* which
      requires the Company to recognize the cost of all stock-based compensation
      in
      its consolidated financial statements. The Company’s equity-classified awards
      are measured at grant-date fair value and are not subsequently remeasured.
      The
      valuation of equity instruments underlying stock-based compensation, and the
      period during which the expense is recognized is based on assumptions related
      to
      stock volatility, interest rates, vesting terms, and dividend yields. Changes
      in
      these assumptions, including forfeiture rates, could have significant impacts
      on
      the expense recognized. The Company recognized additional pretax compensation
      expense of $128,000 during the third quarter of 2006, and $213,000 for the
      nine
      months ended September 30, 2006 as a result of the adoption of SFAS No. 123R,
      which includes compensation expense relating to stock-based compensation awards
      outstanding as of December 31, 2005 and grants made subsequent to December
      31,
      2005.


-17-
 **Table
          of Contents**


The
      following table illustrates the pro forma effect on net income and earnings
      per
      share as if the Company had applied the fair value recognition provisions of
      SFAS No. 123 for the three and nine months ended in September 30,
      2005.




**Three
                  Months**
              
              **Nine
                  Months**(in
                  thousands, except per share amounts)Net
                  income as reported
              
              $
              3,656
              
              $
              7,715Deduct:
                  Total stock based employee compensationexpense
                  determined under fair value basedmethod
                  for all awards, net of related tax effects
              
              
              (27
              )
              
              (114
              )Pro
                  forma income
              
              $
              3,629
              
              $
              7,601Earnings
                  per share:Basic-as
                  reported
              
              $
              0.19
              
              $
              0.42Basic-pro
                  forma
              
              $
              0.19
              
              $
              0.41Diluted-as
                  reported
              
              $
              0.19
              
              $
              0.40Diluted-pro
                  forma
              
              $
              0.19
              
              $
              0.40




Under
      its
      1998 Incentive Plan, as amended, (the Incentive Plan), the Company has reserved
      25% of the outstanding common stock of the Company, or 4,000,000 shares of
      common stock, whichever is greater, for the purpose of issuing incentive awards
      under the Incentive Plan. The Company had 2,290,026 shares of common stock
      available for grant under the Incentive Plan at September 30, 2006.





The
      Company has two types of stock-based compensation awards: (1) stock options,
      and
      (2) restricted common stock.





**Stock
      Options**





The
      Incentive Plan provides for the issuance to eligible employees of, among other
      things, incentive and non-qualified stock options that may expire up to 10
      years
      from the date of grant. The outstanding options vest over one to five year
      service periods and have an exercise price equal to the closing price of the
      Company’s stock on the date of the grant. Unvested options on the date of
      termination of employment are forfeited within 90 days of termination.
      Typically, new shares are issued upon the exercise of stock
      options.





During
      the nine months ended September 30, 2006, 119,436 options were exercised for
      which the Company received proceeds of $627,000 .
      During
      the nine months ended September 30, 2005, 141,757 options were exercised for
      which the Company received proceeds of $742,000.





As
      a
      result of the adoption of SFAS No. 123R, the Company recognized additional
      pretax compensation cost of $50,000 in the first nine months of 2006 for
      stock-based compensation awards outstanding as of December 31, 2005, for which
      the requisite service was not fully rendered prior to January 1, 2006.
      Approximately $71,000 remains to be recognized over 1.01 weighted average years.
      During the nine months ended September 30, 2006, 150,000 options were granted
      with a weighted average fair value of $547,000.





The
      intrinsic value of stock options exercised totaled $1.2 million during the
      nine
      months ended September 30, 2006 and $1.6 million for the nine months ended
      September 30, 2005.


-18-
 **Table
          of Contents**


The
      following table sets forth pertinent information regarding stock option
      transactions for the nine months ended September 30, 2006.




WeightedNumber
              
              Averageof
                  Shares
              
              Exercise
                  PriceOutstanding
                  at January 1, 2006
              
              
              915,271
              
              $
              6.42Granted
              
              
              150,000
              
              
              15.19Exercised
              
              
              (119,436
              )
              
              5.20Outstanding
                  at September 30, 2006
              
              
              945,835
              
              $
              5.11Options
                  exercisable at December 31, 2005
              
              
              850,271
              
              $
              5.98Options
                  exercisable at September 30, 2006
              
              
              804,585
              
              $
              6.76Options
                  available for grant at December 31, 2005
              
              
              1,360,889Options
                  available for grant at September 30, 2006
              
              
              2,290,026


The
      following table summarizes information related to stock options outstanding
      and
      exercisable at September 30, 2006:




Options
                  Outstanding
              
              Options
                  ExercisableNumber
              
              Wgtd.
                  Avg.
              
              
              
              Number
              
              Wgtd.
                  Avg.Range
                  of
              
              Outstanding
              
              Remaining
              
              Wgtd.
                  Avg.
              
              Exercisable
              
              Remaining
              
              Wgtd.
                  Avg.Exercise
                  Prices
              
              at
                  9/30/2006
              
              Contr.
                  Life
              
              Exercise
                  Price
              
              at
                  9/30/2006
              
              Contr.
                  Life
              
              Exercise
                  Price$4.44-$6.04
              
              
              615,835
              
              
              3.28
              
              $
              4.83
              
              
              615,835
              
              
              3.28
              
              $
              4.83$7.91-$10.00
              
              
              25,000
              
              
              6.38
              
              
              8.16
              
              
              25,000
              
              
              6.38
              
              
              8.16$12.02-$17.20
              
              
              305,000
              
              
              8.71
              
              
              14.27
              
              
              163,750
              
              
              8.20
              
              
              13.80$4.44-$17.20
              
              
              945,835
              
              
              5.11
              
              
              7.96
              
              
              804,585
              
              
              4.38
              
              
              6.76


The
      aggregate intrinsic value of options outstanding at September 30, 2006, was
      $4.3
      million. The aggregate intrinsic value of options exercisable at September
      30,
      2006, was $4.6 million.





The
      fair
      value of options at date of grant was estimated using the Black-Scholes
      option-pricing model with the following weighted-average
      assumptions:




**Nine
                  Months Ended****September
                  30,****2006**
              
              **2005**Estimated
                  life in years
              
              
              10.00
              
              
              10.00Interest
                  rate
              
              
              4.878%
                  - 5.093
              %
              
              4.049%
                  - 4.210
              %Volatility
              
              
              19.24%
                  - 19.51
              %
              
              22.23%
                  - 26.58
              %Dividend
                  yield
              
              
              1.23%
                  - 1.24
              %
              
              1.05%
                  - 1.17
              %
 **Restricted
      Common Stock**





The
      Incentive Plan permits the Company to grant restricted common stock to its
      employees. Additionally, eligible employees and consultants are allowed to
      purchase in lieu of salary, commission, or bonus, shares of the Company’s
      restricted common stock at a price equal to 66.6% of the 20-day average of
      the
      closing sales prices for a share of the Company’s common stock, ending on the
      day prior to the date the shares were issued. All shares are valued at the
      closing price on the date the shares are issued. The value of


-19-
 **Table
          of Contents**


restricted
      shares granted, less consideration paid, if any, is amortized to compensation
      expense over the one to five-year vesting periods assuming continued employment
      through such date.





Employees
      deferred compensation of $536,000 during the nine months ended September 30,
      2006, and $306,000 during the nine months ended September 30, 2005, that was
      used to purchase restricted common stock. The Company recognized compensation
      expense of $1.8 million during the nine months ended September 30, 2006, and
      $1.5 million during the nine months ended September 30, 2005, related to its
      restricted common stock plan.





The
      following table summarizes certain information related to restricted common
      stock grants at September 30, 2006:




**Weighted****Number
                  of**
              
              **Average****Shares**
              
              **Grant
                  Date Fair Value**Nonvested
                  at January 1, 2006
              
              
              378,059
              
              $
              13.60Nonvested
                  at September 30, 2006
              
              
              525,450
              
              $
              14.55For
                  the nine months ended September 30, 2006:Granted
              
              
              268,840
              
              $
              15.14Vested
              
              
              120,436
              
              $
              12.87Forfeited
              
              
              1,211
              
              
              —


During
      the nine months ended September 30, 2006, the Company granted 268,840 restricted
      common shares with a weighted average grant date fair value of $15.14. During
      the nine months ended September 30, 2005, the Company granted 123,496 restricted
      common shares with a weighted average grant date fair value of $16.59. During
      the nine months ended September 30, 2006, 120,436 restricted common shares
      vested with a weighted average grant date fair value of $12.87. During the
      nine
      months ended September 30, 2005,  189,361
      restricted common shares vested with a weighted average grant date fair value
      of
      $9.01. At September 30, 2006, total unrecognized compensation cost, net of
      estimated forfeitures related to nonvested restricted stock totaled $5.0 million
      and is expected to be recognized over the next 58 months.


-20-
 **Table
          of Contents**




**13.**
            **SUPPLEMENTAL
                CASH FLOW INFORMATION**




**Nine
                  Months Ended****September
                  30,****2006**
              
              **2005**(in
                  thousands)(unaudited)Cash
                  paid for income taxes, net
              
              $
              606
              
              $
              5,807Cash
                  paid for interest
              
              
              631
              
              
              193Noncash
                  activities:Acquisitions
                  and consolidation:Fixed
                  assets
              
              
              —
              
              
              338Other
                  assets
              
              
              —
              
              
              250Goodwill
              
              
              4,831
              
              
              22,676Accounts
                  payable and accrued liabilties
              
              
              (67
              )
              
              (811
              )Minority
                  interest
              
              
              —
              
              
              (97
              )Commitment
                  to issue common stock
              
              
              (2,382
              )
              
              —Sale
                  of stock:Receivable
                  from broker-dealers
              
              
              58,544
              
              
              —Common
                  stock
              
              
              (50
              )
              
              —Additional
                  paid in capital
              
              
              (57,897
              )
              
              —Other
                  assets
              
              
              (500
              )
              
              —Accounts
                  payable
              
              
              (97
              )
              
              —Consideration
                  payable
              
              
              (2,382
              )
              
              —




**14.**
            **RELATED
                PARTIES**





The
      Company had receivables from related parties totaling $5.1 million at September
      30, 2006, primarily consisting of $3.6 million of notes receivable from
      employees and consultants representing, primarily loans made to induce the
      employees and consultants to affiliate with the Company.





**15.**
            **DISCONTINUED
                OPERATIONS**





During
      the third quarter of 2006, the Company made the decision to close and closed
      most of the activities in the division known as Fixed Income National. The
      Company exited the mortgage-backed, agency, and high-grade corporate bond
      businesses in New York City, but will continue the high-yield and syndicate
      activities. In conjunction with the discontinuance of certain activities of
      the
      Fixed Income National division, during the nine months ended September 30,
      2006
      the Company recorded a loss of $1.6 million, net of tax, for operating losses,
      and for costs related to the exit of the business including compensation
      commitments, abandoned leases, and other expenses.


-21-
 **Table
          of Contents**


A
      summary
      of selected financial information of discontinued operations for the three
      and
      nine months ended September 30, 2006 is as follows (in thousands):




**Three**
              
              **Nine****Months**
              
              **Months**Operating
                  activities:Revenues
              
              $
              1
              
              $
              837Expenses
              
              
              685
              
              
              3,147Loss
                  from discontinued operations before income taxes
              
              
              684
              
              
              2,310Benefit
                  for income taxes
              
              
              257
              
              
              865Net
                  loss from operations, net of tax
              
              
              (427
              )
              
              (1,445
              )Costs
                  related to exit of business, net of tax
              
              
              (120
              )
              
              (120
              )Loss
                  from discontinued operations, net of tax
              
              $
              (547
              )
              $
              (1,565
              )


-22-
 **Table
          of Contents**




**Item
      2.*****Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations***





The
      following discussion should be read in conjunction with the Condensed
      Consolidated Financial Statements and their related notes.





**Overview**





Sanders
      Morris Harris Group (the “Company” or “SMHG”) is a holding company that, through
      its subsidiaries and affiliates, provides asset and wealth management,
      investment banking, and institutional services to a large and diversified group
      of clients and customers, including individuals, corporations, and financial
      institutions. A summary of these services follows:





*Asset
      and Wealth Management* provides
      investment advisory, wealth and investment management, financial planning,
      and
      trust services, to high net worth and mass affluent individuals and
      institutions, including investment strategies and alternatives, tax efficient
      estate and financial planning, trusts, and agent/fiduciary investment management
      services, throughout their financial life cycle, as well as private client
      brokerage services. In addition, we provide specialized asset management
      products and services in specific investment styles to corporations and
      institutions both through internal marketing efforts and externally through
      formal sub-advisory relationships and other distribution arrangements with
      third
      parties.




*Investment
      Banking* includes
      capital raising, public offerings and private placements of equity and debt
      securities, financial advisory services, including advice on mergers,
      acquisitions and restructurings, and merchant banking services.




*Institutional
      Services* provides
      institutional equity and fixed income brokerage, institutional research, prime
      brokerage, and proprietary trading to a broad array of institutions throughout
      North America, Europe, and Asia, including banks, retirement funds, mutual
      funds, endowments, investment advisors, and insurance companies.





We
      have
      expanded both the range and depth of services offered to our clients through
      a
      combination of acquisitions and internal expansion. This growth has necessitated
      that we add additional personnel, as well as production-related incentive
      compensation plans. We have also improved and expanded our infrastructure
      including facilities, technology, and information services, to enable us to
      better compete with other firms that offer services similar to
      ours.





Our
      financial services business is affected by general economic conditions. Our
      revenues relating to asset-based advisory services and managed accounts are
      typically from fees based on the market value of assets under management or
      administration. The growth in assets under our management resulted in higher
      management fees for us. While growth in assets under management has resulted
      in
      higher management fees for us, the instability in the overall stock market,
      lower trading volume, and reduced commission rates have had a negative impact
      on
      our commission revenue.





We
      closely monitor our operating environment to enable us to respond promptly
      to
      market cycles. In addition, we seek to lessen earnings volatility by controlling
      expenses, increasing fee-based business, and developing new revenue sources.
      Nonetheless, operating results of any specific period should not be considered
      representative of future performance.




The
      discussion of the Company’s results of operations below may contain
      forward-looking statements. These statements, which reflect management’s beliefs
      and expectations, are subject to risks and uncertainties that may cause actual
      results to differ materially. For a discussion of the risks and uncertainties
      that may affect the Company’s future results, please see “Competition” and
“Government Regulation” in Part I, Item 1, “Risk Factors” in Part I, Item 1A,
      and “Factors Affecting Forward-Looking Statements” in Part II, Item 7, and other
      items throughout the Company’s Annual Report on Form 10-K for the year ended
      December 31, 2005.


-23-
 **Table
          of Contents**




Beginning
      in the first quarter of 2006, the Company’s retail brokerage business is
      included in Asset and Wealth Management and the Company’s prime brokerage
      business is included in institutional services.




**Components
      of Revenue and Expenses**





*Revenue* .
      Our
      revenues are comprised primarily of (1) commission revenue from retail, prime
      and institutional brokerage transactions, (2) fees from asset-based advisory
      services, asset management, financial planning, and fiduciary services (3)
      principal transactions, and (4) investment banking revenue from corporate
      finance fees, merger and acquisition fees, and merchant banking fees. We also
      earn interest on cash held and dividends received from the equity and fixed
      income securities held in our corporate capital accounts and have realized
      and
      unrealized gains (or losses) on securities in our inventory account.





*Expenses.* Our
      expenses consist of (1) compensation and benefits, (2) floor brokerage and
      clearing costs, and (3) other expenses. Compensation and benefits have both
      a
      variable component based on revenue production, and a fixed component. The
      variable component includes institutional and retail sales commissions, bonuses,
      overrides, and other incentives. Retail and institutional commissions are based
      on competitive commission schedules. Employees of the investment banking group
      and the research group receive a salary and discretionary bonuses as
      compensation. The fixed component includes administrative and executive
      salaries, payroll taxes, employee benefits, and temporary employee costs.
      Compensation and benefits is our largest expense item and includes wages,
      salaries, and benefits. During the third quarter of 2006, compensation and
      benefits represented 68% of total expenses and 63% of total revenue, compared
      to
      67% of total expenses and 58% of total revenue during the third quarter of
      2005.
      During the first nine months of 2006, compensation and benefits represented
      65%
      of total expenses and 62% of total revenues compared to 67% of total expenses
      and 59% of total revenues for the same period in 2005. Compensation and benefits
      expense, total expenses, and total revenues included in the above calculations
      do not include discontinued operations.





Floor
      brokerage, exchange, and clearance expenses include clearing and trade execution
      costs associated with the retail, prime, and institutional brokerage business
      at
      SMH. SMH clears its transactions through several clearing firms, including
      Pershing LLC, a member of BNY Securities Group and a subsidiary of The Bank
      of
      New York, Goldman Sachs Execution & Clearing, L.P., ADP Clearing &
Outsourcing, Inc., and First Clearing Corporation.





Other
      expenses include (1) occupancy and equipment expenses, such as rent and utility
      charges for facilities, and (2) communications and data processing expenses,
      such as third-party systems, data, and software providers.





**Results
      of Operations**





*Three
      Months Ended September 30, 2006 Compared to Three Months Ended September 30,
      2005*





The
      Company expanded its institutional fixed income brokerage operations during
      the
      first quarter of 2006 when a team formerly employed by Advest Group joined
      the
      Company. The new division is known as Fixed Income National. During the third
      quarter of 2006 most of the division was closed and the Company recorded a
      loss
      from discontinued operations.





Total
      revenues were $41.7 million in the third quarter of 2006 compared to $34.4
      million for the same quarter in 2005, an increase of $7.3 million, or 21%
      reflecting the conversion of customer accounts to fee-based from
      commission-based at Edelman, and growth in investment banking and proprietary
      trading operations. Total expenses for the third quarter of 2006 increased
      $9.4
      million, or 32% to $39.0 million from $29.6 million in the same quarter of
      the
      previous year as the result of increased employee compensation and benefits
      tied
      to the increase in revenue and changes in connection with the closure of the
      Fixed Income National division. Equity in income of limited partnerships
      declined to a loss of $1.7 million in 2006 from income of $4.2 million in 2005,
      reflecting the negative impact that the decline in values of energy related
      securities had on the value of the investment portfolios of the limited
      partnerships that we manage. Net


-24-
 **Table
          of Contents**


income
      attributable to minority interest declined to $558,000 during the third quarter
      of 2006 from $2.8 million during the same period in 2005, primarily due to
      the
      decline in value of the investment portfolios of the limited partnerships that
      we account for using the equity method. The income from continuing operations
      for the three-month period ended September 30, 2006, totaled $249,000, compared
      to $3.7 million in the same period in 2005 resulting from the decline in the
      values of the investment portfolios, and increased compensation costs. Basic
      and
      diluted loss per share was $0.02 for the three months ended September 30,
      2006, compared to income of $0.19 for the same period in 2005.





Commissions
      revenue increased to $12.9 million in the third quarter of 2006 from
      $11.8  million
      for the same period in 2005, primarily as a result of growth in our proprietary
      trading operations. Investment banking revenue increased to $11.6 million during
      the third quarter of 2006 from $8.3 million in the same period of 2005,
      principally due to an increase in advisory fees. Revenues from investment
      advisory and related services fees increased to $11.1 million in the third
      quarter of 2006 from $9.2 million in the same quarter of 2005 primarily due
      to
      the conversion of customer accounts to fee-based from commission-based at
      Edelman. Principal transactions revenue totaled $3.3 million for the third
      quarter of 2006 versus $3.1 million in the third quarter of 2005 reflecting
      growth in our proprietary trading operations. Interest and dividend income
      increased to $1.5 million in the third quarter of 2006 from $1.1 million in
      the
      same period last year, due to higher margin interest reflecting an increase
      in
      margin balances and due to higher earnings from the financing of proprietary
      trading accounts. Other income increased from $820,000 during the third quarter
      of 2005 to $1.4 million during the same period in 2006 due to an increase in
      fees earned on the Company’s cash balance and customer credit balances at its
      clearing firms resulting from higher deposit balances.





During
      the three months ended September 30, 2006, employee compensation and benefits
      increased to $26.4 million from $19.8 million in the same period last year
      due
      to more employees and higher revenues during 2006. Floor brokerage, exchange
      and
      clearance fees increased to $1.7 million in the third quarter of 2006 from
      $1.3
      million in the same quarter of 2005 reflecting higher clearing and execution
      costs resulting from the increased trading volume in our proprietary trading
      operations. Occupancy costs totaled $2.9 million during the third quarter of
      2006, compared to $2.2 million in the prior year quarter due to expansion of
      our
      New York City offices and the addition of two new retail offices. Other general
      and administrative expenses increased to $5.8 million during the third quarter
      of 2006 from $4.3 million in the third quarter of last year mainly due to our
      growth.





Our
      effective tax rate from continuing operations was 44.5% for the three months
      ended September 30, 2006 and 40.5% for the three months ended September 30,
      2005. The impact of the nondeductibility of permanent tax differences on a
      reduced level of taxable income caused the effective tax rate in 2006 to exceed
      that of 2005.





During
      the three months ended September 30, 2006, the Company recorded a loss from
      discontinued operations in the amount of $547,000, net of tax, or $0.03 per
      basic and diluted share related to its decision to close most of the activities
      in the division known as Fixed Income National. The loss includes operating
      losses during the third quarter, as well as accruals for compensation
      commitments, abandoned leases, and other expenses that will be paid in
      subsequent periods.





RESULTS
      BY SEGMENT




During
      the third quarter of 2006, the Company made the decision to close and closed
      most of the activities of the division known as Fixed Income National, which
      began operations during the first quarter of 2006. Fixed Income National
      provided fixed income brokerage services to institutional clients. The operating
      results of that portion of Fixed Income National that was closed have been
      recorded as discontinued operations and are not included in the segment
      discussions. The operating results of the portion of the division that was
      not
      discontinued is included in the Institutional Services segment.


-25-
 **Table
          of Contents**




**Asset
      and Wealth Management**





*Asset
      Management*




**Three
                  Months Ended**
                **September
                  30,****2006**
              
              **2005**(in
                  thousands)Revenues
              
              $
              15,693
              
              $
              12,340Income
                  before income taxes
              
              $
              2,516
              
              $
              4,157


Revenues
      from asset management increased to $15.7 million from $12.3 million, and income
      before income taxes decreased to $2.5 million from $4.2 million. Commission
      revenues increased to $3.2 million from $1.7 million, while investment
      management and related service fees increased to $10.6 million from $9.0
      million. The revenue growth is primarily due to the conversion of customer
      accounts to fee-based from commission-based in our Edelman division. After
      deducting the costs of mutual fund expenses, Edelman retains a larger portion
      of
      the client service fee under a fee-based arrangement than a commission-based
      arrangement. Total expenses rose to $10.9 million from $9.0 million due to
      the
      higher revenues. Equity in income of limited partnerships declined to a loss
      of
      $1.7 million in 2006 from income of $3.5 million in 2005, reflecting the
      negative impact that the decline in values of energy related securities had
      on
      the value of the investment portfolios of the limited partnerships that we
      manage. Minority interests in net income of consolidated companies reflect
      the
      portion of net income attributable to minority interest ownership of entities
      included in this segment’s consolidated financial statements. Income
      attributable to minority interests, which reduces SMHG’s pretax income, declined
      to $558,000 million in 2006 from $2.7 million in 2005, principally due to the
      decline in value of the investment portfolios of the limited partnerships that
      we account for using the equity method.





*Retail
      Brokerage*




**Three
                  Months Ended**
                **September
                  30,****2006**
              
              **2005**(in
                  thousands)Revenues
              
              $
              3,965
              
              $
              3,765(Loss)
                  income before income taxes
              
              $
              (16
              )
              $
              136


Revenues
      from retail brokerage increased to $4.0 million from $3.8 million, and income
      before income taxes declined to a loss of $16,000 from a profit of $136,000.
      While revenues increased modestly, expenses increased slightly more resulting
      in
      a small loss in the 2006 period.


-26-
 **Table
          of Contents**




**Institutional
      Services**





*Institutional
      Brokerage*




**Three
                  Months Ended**
                **September
                  30,****2006**
              
              **2005**(in
                  thousands)Revenues
              
              $
              5,196
              
              $
              6,547(Loss)
                  income before income taxes
              
              $
              (102
              )
              $
              966


Revenues
      from institutional brokerage declined to $5.2 million from $6.5 million, and
      income before income taxes declined to a loss of $102,000 from income of
      $966,000. Commission revenue declined from $4.2 million to $2.7 million
      reflecting a decline in both the number of shares traded in our institutional
      equity division and the commission revenue per share traded. These declines
      are
      largely the result of the growth in electronic trading strategy execution
      software that replaces, in some cases, the role of traditional traders.
      Principal revenue declined from $1.2 million to $634,000 due to a reduction
      in
      the volume of fixed income trading activity. These declines were partially
      offset by an increase of approximately $900,000 in sales credits from syndicate
      and investment banking activities, reflecting a higher volume of shares
      allocated to the institutional division. Total expenses declined to $5.3
      million from $5.6 million in 2005 primarily due to the startup of the Fixed
      Income National division during the first quarter of 2006.





*Prime
      Brokerage*




**Three
                  Months Ended**
                **September
                  30,****2006**
              
              **2005**(in
                  thousands)Revenues
              
              $
              9,036
              
              $
              4,978Income
                  before income taxes
              
              $
              269
              
              $
              390


Revenues
      from prime brokerage increased to $9.0 million from $5.0 million, while income
      before income taxes declined to $269,000 from $390,000. Commission revenue
      increased to $4.8 million from $3.6  million,
      while principal transaction revenue increased to $3.6 million from $1.2 million,
      reflecting growth in proprietary trading activities. Total expenses increased
      to
      $8.8 million during 2006 from $4.6 million during the third quarter of 2005
      reflecting increased compensation and other costs related to proprietary trading
      activities. Compensation and other costs when measured as a percentage of
      proprietary trading revenues are higher than similar costs associated with
      other
      revenue sources.





**Investment** **** **Banking**




**Three
                  Months Ended**
                **September
                  30,****2006**
              
              **2005**(in
                  thousands)Revenues
              
              $
              8,634
              
              $
              5,465Income
                  before income taxes
              
              $
              3,018
              
              $
              2,140




-27-






Revenues
      from investment banking increased to $8.6 million from $5.5 million, and income
      before income taxes increased to $3.0 million from $2.1 million. The revenue
      increase is primarily due to increased revenues from advisory fees during 2006.
      Total expenses increased to $5.6 million from $3.3 million in 2005 due to higher
      compensation costs related to the higher revenues and to higher occupancy costs
      caused by the division’s relocation to larger offices in the New York area.





**Corporate
      and Other**




**Three
                  Months Ended**
                **September
                  30,****2006**
              
              **2005**(in
                  thousands)Revenues
              
              $
              (820
              )
              $
              1,316Loss
                  before income taxes
              
              $
              (5,236
              )
              $
              (1,649
              )


Revenues
      from corporate and other declined to a negative $820,000 from $1.3 million,
      and
      the loss before income taxes increased to $5.2 million from $1.6 million. The
      revenue decline is due primarily to losses in our investment portfolios. During
      2006, our investment portfolios declined by $1.4 million, compared to a gain
      of
      $1.3 million in the prior year. Small energy stocks, which comprise a
      significant portion of our investment portfolios, declined sharply late in
      the
      third quarter of 2006. Total expenses increased to $4.5 million from $3.5
      million. Included in the 2006 expenses was $383,000 of legal costs related
      to
      the NASD inspection of our prime brokerage operations.





*Nine
      Months Ended September 30, 2006 Compared to Nine Months Ended September 30,
      2005*





Total
      revenues were $127.5 million in the nine months of 2006 compared to $91.3
      million for the same period in 2005, an increase of $36.2 million, or 40%
      reflecting the acquisition of Edelman in May 2005, and growth in the investment
      banking and proprietary trading operations. Total expenses for the nine months
      of 2006 increased $40.6 million, or 51% to $121.0 million from $80.4 million
      in
      the same period of the previous year. The Company recorded a goodwill impairment
      charge in the amount of $4.5 million during 2006 associated with its Charlotte
      Capital division. Income attributable to minority interests decreased to $3.6
      million from $4.4 million during the nine months of 2005, primarily due to
      decline in equity in income from limited partnerships. Income from continuing
      operations for the nine-month period ended September 30, 2006, declined $5.4
      million, or 70% to $2.3 million from $7.7 million in the same period in 2005.
      Basic income per share from continuing operations was $0.12 for the nine months
      ended September 30, 2006 compared to $0.42 for the same period in 2005. Diluted
      income per share from continuing operations was $0.12 for the nine months ended
      September 30, 2006, compared to $0.40 for the same period in 2005.





Commissions
      revenue increased to $42.9 million in the nine months of 2006 from $33.3 million
      for the same period in 2005, primarily as a result of the Edelman acquisition
      and growth in proprietary trading operations. Investment banking revenue
      increased to $33.6 million during the nine months of 2006 from $22.5 million
      in
      the same period of 2005, principally due to an increase in private placement
      and
      advisory fees. Revenues from investment advisory and related services fees
      increased to $28.4 million in the nine months of 2006 from $22.3 million in
      the
      same period of 2005 primarily due to the acquisition of Edelman during 2005.
      Principal transactions revenue totaled $13.7 million for the nine months of
      2006
      versus $7.2 million in the nine months of 2005 reflecting growth in our
      proprietary trading operations. Interest and dividend income increased to $4.5
      million in the nine months of 2006 from $3.4 million in the same period last
      year, due to higher margin interest reflecting an increase in margin balances
      and to higher revenues from the financing of proprietary trading accounts.
      Other
      income increased from $2.5 million during the nine months of 2005 to $4.4
      million during the same period in 2006 due to an increase in fees earned on
      the
      Company’s cash balance and customer credit balances at its clearing firms
      resulting from higher deposit balances.


-28-
 **Table
          of Contents**




During
      the nine months ended September 30, 2006, employee compensation and benefits
      increased to $78.4 million from $54.0 million in the same period last year
      due
      to more employees and higher revenues during 2006. Floor brokerage, exchange
      and
      clearance fees increased to $5.5 million in the nine months of 2006 from $3.5
      million in the same period of 2005 reflecting higher clearing and execution
      costs resulting from the increased trading volume in proprietary trading
      accounts. Communication and data processing costs increased to $6.3 million
      in
      2006 from $5.8 million in the same period last year resulting primarily from
      increased personnel and additional offices. Occupancy costs totaled $8.4 million
      during the nine months of 2006, compared to $6.2 million in the prior year
      period due to expansion of our New York City offices, and the addition of
      Edelman. Interest expense totaled $804,000 during the nine months of 2006
      compared to $265,000 during the same period in 2005, due to the addition of
      three credit facilities during 2005. The Company recorded a goodwill impairment
      charge in the amount of $4.5 million during 2006 associated with its Charlotte
      Capital division. Other general and administrative expenses increased to $17.1
      million during the nine months of 2006 from $10.6 million in the nine months
      of
      last year mainly due to our growth.





Our
      effective tax rate from continuing operations was 39.2% for the nine months
      ended September 30, 2006 compared to 40.7% for the nine months ended September
      30, 2005.





During
      the nine months ended September 30, 2006, the Company recorded a loss from
      discontinued operations in the amount of $1.6 million, net of tax, or $0.08
      per
      basic and diluted share, related to its decision to close most of the activities
      in the division known as Fixed Income National. The loss includes operating
      losses during the third quarter, as well as accruals for compensation
      commitments, abandoned leases, and other expenses that will be paid in
      subsequent periods.





Results
      by Segment





During
      the third quarter of 2006, the Company made the decision to close and closed
      most of the activities of the division known as Fixed Income National, which
      began operations during the first quarter of 2006. Fixed Income National
      provided fixed income brokerage services to institutional clients. The operating
      results of that portion of Fixed Income National that was closed have been
      recorded as discontinued operations and are not included in the segment
      discussions. The operating result of the portion of the division that was not
      discontinued is included in the Institutional Services segment.





**Asset
      and Wealth Management**





*Asset
      Management*




**Nine
                  Months Ended**
                **September
                  30,****2006**
              
              **2005**(in
                  thousands)Revenues
              
              $
              44,912
              
              $
              29,534Income
                  before income taxes
              
              $
              9,100
              
              $
              9,134


Revenues
      from asset management increased to $44.9 million from $29.5 million, and income
      before income taxes remained constant at $9.1 million. Commission revenues
      increased to $11.0 million from $4.0 million, while investment management and
      related service fees increased to $27.4 million from $21.5 million. Other income
      increased from $917,000 during 2005 to $2.9 million in 2006, primarily due
      to an
      increase in insurance commissions. The revenue growth is primarily due to the
      acquisition of Edelman in May 2005. Total expenses rose to $32.6 million from
      $21.8 million due to the higher revenues. Equity in income of limited
      partnerships declined to $395,000 in 2006 from $5.6 million in 2005, reflecting
      the negative impact that the decline in values of energy related securities
      had
      on the value of the investment portfolios of the limited partnerships that
      we
      manage. Minority interests in net income of consolidated companies reflect
      the
      portion of net income attributable to minority interest ownership of entities
      included in this segment’s


-29-
 **Table
          of Contents**




consolidated
      financial statements. Income attributable to minority interests, which reduces
      SMHG’s pretax income, declined to $3.6 million in 2006 from $4.3 million in
      2005, principally due to the decline in value of the investment portfolios
      of
      the limited partnerships that we account for using the equity
      method.





*Retail
      Brokerage*




**Nine
                  Months Ended**
                **September
                  30,****2006**
              
              **2005**(in
                  thousands)Revenues
              
              $
              13,868
              
              $
              11,794(Loss)
                  income before income taxes
              
              $
              (971
              )
              $
              927


Revenues
      from retail brokerage increased to $13.9 million from $11.8 million, and income
      before income taxes declined to a loss of $971,000 from income of $927,000.
      Commission revenues increased to $7.6  million
      from $6.6 million due primarily to two new offices. Sales credits from
      investment banking transactions increased to $3.0 million from $2.4 million
      due
      to an increase in fees earned from the Company’s participation in syndicate
      transactions. Revenues from insurance commissions increased $289,000 due to
      higher sales of insurance annuity products. Total expenses increased to $14.8
      million from $10.9 million in 2005 primarily due to costs associated with the
      opening of two new retail offices, and to an increase in legal expenses related
      to arbitration claims against the Company.





**Institutional
      Services**





*Institutional
      Brokerage*




**Nine
                  Months Ended**
                **September
                  30,****2006**
              
              **2005**(in
                  thousands)Revenues
              
              $
              17,922
              
              $
              19,404Income
                  before income taxes
              
              $
              147
              
              $
              2,605


Revenues
      from institutional brokerage declined to $17.9 million from $19.4 million,
      and
      income before taxes declined to $147,000 from income of $2.6 million. Commission
      revenue decreased to $11.0 million from $12.2 million, due to decline in both
      the number of shares traded in our institutional equity division and the
      commission revenue per share traded. Sales credits from investment banking
      transactions declined $160,000 representing a reduction in investment banking
      transactions. These declines are largely the result of the growth in electronic
      trading strategy execution software that replaces, in some cases, the role
      of
      traditional traders. Total expenses increased to $17.8 million from $16.8
      million in 2005 primarily due to the startup of the Fixed Income National
      division during the first quarter of 2006.


-30-
 **Table
          of Contents**




*Prime
      Brokerage*




**Nine
                  Months Ended**
                **September
                  30,****2006**
              
              **2005**(in
                  thousands)Revenues
              
              $
              25,204
              
              $
              13,855Income
                  before income taxes
              
              $
              1,389
              
              $
              1,388


Revenues
      from prime brokerage increased to $25.2 million from $13.9 million, and income
      before taxes remained constant at $1.4 million. Commission revenue increased
      to
      $13.2 million from $10.3 million, while principal transaction revenue increased
      to $10.2 million from $2.7 million, reflecting growth in proprietary trading
      activities. Interest and dividend income increased from $636,000 to $1.6
      million reflecting higher earnings from the financing of the proprietary trading
      accounts. Total expenses increased to $23.8 million during 2006 from $12.5
      million during 2005 reflecting increased compensation and other costs related
      to
      proprietary trading activities. Compensation and other costs when measured
      as a
      percentage of proprietary trading revenues are higher than similar costs
      associated with other revenue sources.





**Investment** **** **Banking**




**Nine
                  Months Ended**
                **September
                  30,****2006**
              
              **2005**(in
                  thousands)Revenues
              
              $
              23,975
              
              $
              13,414Income
                  before income taxes
              
              $
              8,566
              
              $
              4,756


Revenues
      from investment banking increased to $24.0 million from $13.4 million, and
      income before taxes increased to $8.6 million from $4.8 million. The revenue
      increase is primarily due to increased revenues from private placement
      transactions and advisory fees during 2006. Total expenses increased to $15.4
      million from $8.7 million in 2005 due to higher compensation costs related
      to
      the higher revenues and to higher occupancy costs caused by the division’s
      relocation to larger offices in the New York area.





**Corporate
      and Other**




**Nine
                  Months Ended**
                **September
                  30,****2005**
              
              **2005**(in
                  thousands)Revenues
              
              $
              1,601
              
              $
              3,249Loss
                  before income taxes
              
              $
              (14,405
              )
              $
              (5,810
              )


Revenues
      from corporate and other decreased to $1.6 million from $3.2 million, and the
      loss before income taxes increased to $14.4 million from $5.8 million. The
      Company recorded a goodwill impairment charge in the amount of $4.5 million
      during 2006 related to its Charlotte Capital division.


-31-
 **Table
          of Contents**




**Liquidity
      and Capital Resources**





We
      intend
      to satisfy a large portion of our funding needs with our own capital resources,
      consisting mainly of internally generated earnings and liquid assets we
      currently hold.





On
      September 29, 2006, the Company closed a secondary public offering of 5,000,000
      shares of its common stock, resulting in proceeds of $58.4 million, net of
      underwriting discounts and other expenses. The Company received the proceeds
      in
      October 2006 and used $13.2 million to repay the outstanding balance including
      accrued interest on one of its revolving credit facilities. The remaining amount
      was invested in a money market fund. The proceeds are recorded as a receivable
      from broker-dealers at September 30, 2006.




At
      September 30, 2006, we had approximately $19.5 million in cash and cash
      equivalents, which together with receivables from broker-dealers, deposits
      with
      clearing brokers, marketable securities owned, and securities available for
      sale
      represented approximately 44% of our total assets at the end of the third
      quarter.





For
      the
      nine months ended September 30, 2006, net cash provided by operations totaled
      $4.1 million versus $2.9 during the first nine months of 2005.





Securities
      owned increased by $11.4 million, net of equity in income of limited
      partnerships of $902,000, during the nine months of 2006, while securities
      sold,
      not yet purchased increased by $9.6 million and payables to clearing brokers
      increased by $1.8 million. The increases in securities owned, securities sold,
      not yet purchased and payables to clearing brokers is primarily due to the
      trading portfolios of our proprietary trading operations. The Company’s
      proprietary trading operations carry both long and short fixed income and equity
      securities. These trading operations generally seek to generate profits based
      on
      trading spreads, rather than through speculation on the direction of the market.
      We employ hedging strategies designed to insulate the net value of our trading
      inventories from fluctuations in the general level of interest rates and equity
      price variances. We finance a portion of our trading positions through our
      clearing broker-dealers.





Capital
      expenditures for the third quarter of 2006 were $4.0 million, mainly for the
      purchase of furniture, computer equipment and software, as well as for leasehold
      improvements, necessary for our growth.





At
      September 30, 2006, SMH, our registered broker-dealer subsidiary, was in
      compliance with the net capital requirements of the Securities and Exchange
      Commission's Uniform Net Capital Rules and had capital in excess of the required
      minimum. Salient Trust Co., LTA was in compliance with the Texas Department
      of
      Banking net capital requirement and had capital in excess of the required
      minimum.





In
      view
      of the inherent difficulty of predicting the outcome of legal proceedings,
      particularly where the plaintiffs seek substantial or indeterminate damages
      or
      where novel legal theories or a large number of parties are involved, we cannot
      state with confidence what the eventual outcome of currently pending matters
      will be, what the timing of the ultimate resolution of these matters will be,
      or
      what the eventual result in each pending matter will be. Based on currently
      available information, we have established reserves for certain litigation
      matters and our management does not believe that resolution of any matter will
      have a material adverse effect on our liquidity or financial position although,
      depending on our results for a particular period, an adverse determination
      could
      have a material effect on quarterly or annual operating results in the period
      in
      which it is resolved.





**Factors
      Affecting Forward-Looking Statements**





This
      quarterly report on Form 10-Q includes "forward-looking statements" within
      the
      meaning of Section 27A of the Securities Act of 1933, as amended, and Section
      21E of the Securities and Exchange Act of 1934, as amended (the "Acts"). These
      forward-looking statements may relate to such matters as anticipated financial
      performance, future revenues or earnings, business prospects, projected
      ventures, new products, anticipated market performance and similar matters.
      The
      Private Securities Litigation Reform Act of 1995


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provides
      a safe harbor for forward-looking statements. To comply with the safe harbor,
      the Company cautions readers that a variety of factors could cause the Company's
      actual results to differ materially from the anticipated results or other
      expectations expressed in the Company's forward-looking statements. These risks
      and uncertainties, many of which are beyond the Company's control, include,
      but
      are not limited to (1) trading volume in the securities markets; (2) volatility
      of the securities markets and interest rates; (3) changes in regulatory
      requirements, which could affect the demand for the Company's services or the
      cost of doing business; (4) general economic conditions, both domestic and
      foreign, especially in the regions where the Company does business; (5) changes
      in the rate of inflation and related impact on securities markets; (6)
      competition from existing financial institutions and other new participants
      in
      the securities markets; (7) legal developments affecting the litigation
      experience of the securities industry; (8) successful implementation of
      technology solutions; (9) changes in valuations of the Company’s trading and
      warrant portfolios resulting from mark-to-market adjustments; (10) dependence
      on
      key personnel; and (11) demand for the Company's services. The Company does
      not
      undertake to publicly update or revise any forward-looking
      statements.





**Item
      3*****.
      Quantitative and Qualitative Disclosures About Market
      Risk***





**Market
      Risks**





During
      the nine months ended September 30, 2006, there has been no material changes
      to
      the information contained in Part II, Item 7A of the Company’s Annual Report on
      Form 10-K for the year ended December 31, 2005.





At
      September 30, 2006, securities owned by the Company were recorded at a fair
      value of $85.9 million, including $43.0 million in marketable securities, $35.0
      million representing the Company’s investments in limited partnerships and $7.9
      million representing other not readily marketable securities.





At
      September 30, 2006, Salient had securities available for sale with a fair value
      of $1.5 million. These securities have an original cost of $1.4 million, and
      are
      subject to equity price risk. At September 30, 2006, the unrealized increase
      in
      market value totaling $67,000 less tax of $26,000 has been included as a
      separate component of shareholders’ equity.




**Item
      4.*****Controls
      and Procedures***





** Our
      management, including our Chief Executive Officer and Chief Financial Officer,
      have conducted an evaluation of the effectiveness of our disclosure controls
      and
      procedures (as defined in Rule 13a-15(e) promulgated under the Exchange Act),
      as
      of the end of the fiscal period covered by this report. Based upon that
      evaluation, our Chief Executive Officer and Chief Financial Officer have
      concluded that our disclosure controls and procedures are effective in ensuring
      that the information required to be disclosed in the reports we file or submit
      under the Exchange Act is recorded, processed, summarized and reported within
      the time periods specified in the rules and forms of the Securities and Exchange
      Commission and that such information is accumulated and communicated to our
      management, including our Chief Executive Officer and Chief Financial Officer,
      as appropriate to allow timely decisions regarding required disclosure. There
      have been no changes made in our internal controls over financials reporting
      during the period covered by this report that have materially affected, or
      are
      reasonably likely to materially affect, our internal control over financial
      reporting.


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          of Contents**




**PART
      II. OTHER INFORMATION**





**Item
      1.*****Legal
      Proceedings***





Many
      aspects of our business involve substantial risks of liability. In the normal
      course of business, we have been and in the future may be named as defendant
      or
      co-defendant in lawsuits and arbitration proceedings involving primarily claims
      for damages. We are also involved in a number of regulatory matters arising
      out
      of the conduct of our business. There can be no assurance that these matters
      will not have a material adverse effect on our results of operation in any
      future period and a significant judgment could have a material adverse impact
      on
      our consolidated financial position, results of operations, and cash flows.
      In
      addition to claims for damages and monetary sanctions that may be made against
      us, we incur substantial costs in investigating and defending claims and
      regulatory matters.





The
      NASD
      initially conducted an inspection of our prime brokerage and private investment
      or hedge fund support operations based in our New York office in November 2004.
      Subsequent to such inspection, the NASD opened an investigation and requested
      the production of additional documents and materials on twelve occasions in
      2005
      and 2006 with respect to our prime brokerage and related hedge fund operations
      and has conducted formal interviews of a number of our employees involved in
      these operations. On August 16, 2006, Sanders Morris Harris received a “Wells
      letter” notification from the NASD, which states that the staff of the NASD has
      made a preliminary determination to recommend that disciplinary action be
      brought against Sanders Morris Harris and four of its employees based on alleged
      violations of certain conduct rules of the NASD, including NASD Conduct Rule
      2110 relating to the alleged improper payment of soft dollar commissions to
      a
      fund manager and relating to the alleged improper sharing of commissions by
      two
      employees contrary to a written contract with an investment adviser and
      representations to the investors in one private investment partnership; NASD
      Conduct Rule 2210 relating to the content of hedge fund advertising materials;
      SEC Rule 17a-4 and NASD Conduct Rules 2210 and 3110 relating to the retention
      of
      certain email, instant messages, and advertising materials; NASD Conduct Rules
      1031 and 2110 relating to the activities of an unregistered employee; and NASD
      Conduct Rules 2110 and 3010 relating to the written supervisory procedures
      of
      Sanders Morris Harris for its hedge fund and prime brokerage operations. Under
      the Wells procedure, Sanders Morris Harris has an opportunity to respond to
      the
      NASD before any action is taken against it. Sanders Morris Harris submitted
      its
      response to the NASD on October 11, 2006. There is no assurance that a prompt
      resolution can be reached or that the ultimate impact on the Company will not
      be
      material. Discussions have commenced between the staff of the NASD and our
      legal
      counsel with respect to the alleged violations.





We
      are
      aware that a company for which Sanders Morris Harris acted as placement agent
      in
      a private placement of convertible preferred shares in June 2005 has experienced
      a significant decline in its net sales, a significant increase in its net loss,
      and currently has negative working capital. While the company has obtained
      financing to meet its short-term working capital requirements, there is no
      assurance that it will be able to sustain its business. We have received written
      and oral communications from a number of the purchasers of securities in the
      offering expressing their dissatisfaction and indicating that they may seek
      legal recourse with respect to the offering. No litigation has been filed at
      this time. While we believe Sanders Morris Harris has valid defenses to any
      claims and is entitled to indemnification and contribution provisions of the
      placement agent agreement, the costs of defending any litigation filed naming
      Sanders Morris Harris could be significant and an adverse determination could
      have a material effect on quarterly or annual operating results in the period
      in
      which it is resolved. Two managing directors of Sanders Morris Harris served
      as
      directors of the company from June 2005 to June 2006.




In
      view
      of the inherent difficulty of predicting the outcome of legal proceedings,
      particularly where the plaintiffs seek substantial or indeterminate damages
      or
      where novel legal theories or a large number of parties are involved, we cannot
      state with confidence what the eventual outcome of currently pending matters
      will be, what the timing of the ultimate resolution of these matters will be,
      or
      what the eventual result in each pending matter will be. Based on currently
      available information, we have established reserves for certain litigation
      matters and our management does not believe that resolution of any matter will
      have a material adverse effect on our liquidity or financial position although,
      depending on our results for a particular period, an adverse determination
      could
      have a material effect on quarterly or annual operating results in the period
      in
      which it is resolved.


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          of Contents**




**Item
      6**.***Exhibits***




**Exhibit** **Number**
            **Description** 3.1
            Articles
                of Incorporation of the Company, as amended (Filed as Exhibit 3.1
                to the
                Company’s Annual Report on Form 10-K for the year ended December 31, 2001
                (File No. 000-30066), and incorporated herein by
                reference).


3.2
            Amended
                and Restated Bylaws of the Company (Filed as Exhibit 3.2 to the Company’s
                Quarterly report on Form 10-Q for the quarter ended June 30, 2004
                (File
                No. 000-30066), and incorporated herein by
                reference).


†10.01
            Sanders
                Morris Harris Group Inc. 1998 Incentive Plan as amended (Filed as
                Appendix
                A to the Definitive Proxy Statement on Schedule 14A of the Company
                dated
                May 3, 2002 (File No. 000-30066), and incorporated herein by
                reference).


†10.02
            Sanders
                Morris Harris Group Inc. Capital Incentive Program (Filed as Exhibit
                10.1
                to the Company’s Form 10-Q for the quarter ended September 30, 2001 (File
                No. 000-30066), and incorporated herein by reference).


†10.03
            Form
                of Option Agreement pursuant to 1998 Incentive Plan (Filed as Exhibit
                10.03 to the Company’s Annual Report on Form 10-K for the year ended
                December 31, 2005 (File No. 000-30066), and incorporated herein by
                reference).


†10.04
            Form
                of Restricted Stock Agreement pursuant to 1998 Incentive Plan (Filed
                as
                Exhibit 10.04 to the Company’s Annual Report on Form 10-K for the year
                ended December 31, 2005 (File No. 000-30066), and incorporated herein
                by
                reference).


10.05
            Sublease
                Agreement dated January 19, 1994, between Texas Commerce Bank National
                Association and Harris Webb & Garrison, Inc., as amended by that
                certain First Amendment to Sublease Agreement dated February 23,
                1994, the
                Second Amendment to Sublease Agreement dated April 26, 1994, and
                the Third
                Amendment to Sublease Agreement dated January 19, 1995 (Filed as
                Exhibit
                10.16 to the Proxy Statement/Prospectus of the Company dated December
                31,
                1998 (File No. 333-65417), and incorporated herein by
                reference).


10.06
                On-Line
                    Services Agreement dated as of June 1, 2005, between Innovest
                    Systems, LLC
                    and Pinnacle Trust Co., LTA. (Filed as Exhibit 10.05 to the Company’s
                    Quarterly Report on Form 10-Q for the quarter ended September
                    30, 2005
                    (File No. 000-30066), and incorporated herein by
                    reference).


10.07
            Office
                Lease Agreement and related amendments dated September 25, 1996,
                between
                Texas Tower limited and Sanders Morris Mundy Inc. (Filed as Exhibit
                10.3
                to the Company’s Quarterly Report on Form 10-Q for the quarter ended March
                31, 2000 (File No. 000-30066), and incorporated herein by
                reference).


10.08
            Credit
                Agreement dated as of May 9, 2005, between Sanders Morris Harris
                Group
                Inc. and JPMorgan Chase Bank, National Association (Filed as Exhibit
                10.7
                to the Company’s Quarterly Report on Form 10-Q for the quarter ended June
                30, 2005 (File No. 000-30066), and incorporated herein by
                reference).


10.09
            Reorganization
                and Purchase Agreement dated as of May 10, 2005, among Sanders Morris
                Harris Group Inc., The Edelman Financial Center, Inc., The Edelman
                Financial Center, LLC, and Fredric M. Edelman (Filed as Exhibit 2.1
                to the
                Company’s Current Report on Form 8-K dated May 10, 2005 (File No.
                000-30066), and incorporated herein by
                reference).


10.10
            Agreement
                and Amendment to Credit Agreement dated as of May 8, 2006, between
                Sanders
                Morris Harris Group Inc. and JPMorgan Chase Bank, National Association
                (Filed as Exhibit 10.10 to the Company’s Quarterly Report on Form 10-Q for
                the quarter ended June 30, 2006 (File No. 000-30066), and incorporated
                herein by reference).


10.11
            Agreement
                and Amendment to Credit Agreement dated as of February 27, 2006,
                between
                Sanders Morris Harris Group, Inc. and JPMorgan Chase Bank, National
                Association (Filed as Exhibit 10.11 to the Company’s Quarterly Report on
                Form 10-Q for the quarter ended June 30, 2006 (File No. 000-30066),
                and
                incorporated herein by reference).


*31.1
            Rule
                13a-14(a)/15d - 14(a) Certification of Chief Executive
                Officer.


*31.2
            Rule
                13a-14(a)/15d - 14(a) Certification of Chief Financial
                Officer.


*32.1
            Certification
                Pursuant to18 U.S.C. 1350, as Adopted Pursuant to Section 906 of
                the
                Sarbanes-Oxley Act of 2002.


*32.2
            Certification
                Pursuant to 18 U.S.C. 1350, as Adopted Pursuant to Section 906 of
                the
                Sarbanes-Oxley Act of 2002.





*
            Filed
                herewith.


†
            Management
                contract or compensation plan or
                arrangement.




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          of Contents**




**SIGNATURES**





Pursuant
      to the requirements of the Securities Exchange Act of 1934, the registrant
      has
      duly caused this report to be signed on its behalf by the undersigned, thereunto
      duly authorized.




**SANDERS
      MORRIS HARRIS GROUP INC.**






By:  / s/
      BEN T.
      MORRIS


**Ben
      T. Morris**


**Chief
      Executive Officer**






By: /s/
      RICK
      BERRY


**Rick
      Berry**


**Chief
      Financial Officer**








Date:  November
      8, 2006


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