**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON D.C. 20549**

 

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**FORM 10-QSB**

 

| **ý****  QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**                                                                                           |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                               |
| **For the quarterly period ended June 30, 2004**                                                                                                                                                              |
|                                                                                                                                                                                                               |
| **o****  TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**                                                                                                     |
|                                                                                                                                                                                                               |
| **For the transition period from                  to                ** |
|                                                                                                                                                                                                               |
| **Commission file number: 0-18188**                                                                                                                                                                                |

 

| **PAULSON CAPITAL CORP.**                                         |
|-------------------------------------------------------------------|
| (Exact name of small business issuer as specified in its charter) |
|                                                              |
| **Oregon**                                                        |
| (state or other jurisdiction of incorporation or organization)    |
|                                                              |
| **93-0589534**                                                    |
| (IRS employer identification number)                              |
|                                                              |
| **811 S.W. Naito Parkway  Portland, OR 97204**                    |
| (Address of principal executive offices)                          |
|                                                              |
| **(503) 243-6000**                                                |
| (Issuer’s telephone number)                                  |

 

Indicate by check mark whether the issuer (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theissuer was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes  ý    No  o

 

Number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date:

 

Common stock, no par value 3,185,261 as of August 12, 2004

 

Transitional Small Business Disclosure Format (check one):Yes  o    No  ý

 

 

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**PART I — FINANCIAL INFORMATION**

 

ITEM 1. FINANCIAL STATEMENTS

 

PAULSON CAPITAL CORP. AND SUBSIDIARYCONSOLIDATED BALANCESHEETS

 
| ** **                                                                                                                           | ** ** | **06/30/04**    | ** ** | **12/31/03** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|--------------|------------|
| ** **                                                                                                                           | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| **ASSETS**                                                                                                                           |       |            |       |         |       |
|                                                                                                                                 |       |            |       |         |       |
| Cash and cash equivalents                                                                                                            |       | $               | 118,386    |         | $          | 155,314 |   |
| Receivable from clearing organization                                                                                                |       | 7,940,144       |       | 7,162,477    |       |
| Notes and other receivables                                                                                                          |       | 563,889         |       | 666,474      |       |
| Income taxes receivable                                                                                                              |       | 1,061,187       |       | 1,084,900    |       |
| Trading securities, at market value                                                                                                  |       | 2,541,752       |       | 1,474,649    |       |
| Investment securities, at market value                                                                                               |       | 14,751,047      |       | 17,588,454   |       |
| Underwriter warrants, at estimated fair value                                                                                        |       | 7,184,000       |       | 6,311,000    |       |
| Prepaid and deferred expenses                                                                                                        |       | 1,209,605       |       | 1,418,537    |       |
| Furniture and equipment,  net                                                                                                        |       | 223,846         |       | 208,327      |       |
|                                                                                                                                 |       |            |       |         |       |
| Total assets                                                                                                                         |       | $               | 35,593,856 |         | $          | 36,070,132 |   |
|                                                                                                                                 |       |            |       |         |       |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                       |       |            |       |         |       |
|                                                                                                                                 |       |            |       |         |       |
| **LIABILITIES**                                                                                                                      |       |            |       |         |       |
| Accounts payable and accrued liabilities                                                                                             |       | $               | 186,219    |         | $          | 446,076 |   |
| Dividends payable                                                                                                                    |       | —          |       | 312,481      |       |
| Payable to clearing organization                                                                                                     |       | 1,445,337       |       | 496,181      |       |
| Compensation, employee benefits and payroll taxes                                                                                    |       | 840,548         |       | 2,075,735    |       |
| Securities sold, not yet purchased, at market value                                                                                  |       | 51,362          |       | 19,051       |       |
| Income taxes payable                                                                                                                 |       | 158,921         |       | —       |       |
| Deferred income taxes                                                                                                                |       | 2,770,613       |       | 3,125,700    |       |
|                                                                                                                                 |       |            |       |         |       |
| Total liabilities                                                                                                                    |       | 5,453,000       |       | 6,475,224    |       |
|                                                                                                                                 |       |            |       |         |       |
| **SHAREHOLDERS’ EQUITY**                                                                                                        |       |            |       |         |       |
| Preferred stock, no par value; authorized, 500,000  shares; issued and outstanding, no shares                                        |       | —          |       | —       |       |
| Common stock, no par value; authorized, 10,000,000  shares; issued and outstanding, 3,185,261 at 06/30/04 and 3,124,811 at  12/31/03 |       | 1,628,600       |       | 1,173,045    |       |
| Retained earnings                                                                                                                    |       | 28,512,256      |       | 28,421,863   |       |
|                                                                                                                                 |       |            |       |         |       |
| Total shareholders’  equity                                                                                                     |       | 30,140,856      |       | 29,594,908   |       |
|                                                                                                                                 |       |            |       |         |       |
| Total liabilities and  shareholders’ equity                                                                                     |       | $               | 35,593,856 |         | $          | 36,070,132 |   |

 

The accompanying notes are an integral part of these statements.

 

2

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PAULSON CAPITAL CORP. AND SUBSIDIARYCONSOLIDATED STATEMENTS OF OPERATIONS(unaudited)

 
| ** **                                              | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|---------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                              | ** ** | **6/30/04**            | ** ** | **6/30/03**          | ** ** | **6/30/04** | ** ** | **6/30/03** | ** ** |
|                                                    |       |                   |       |                 |       |   |   |   |   |
| **Revenues**                                            |       |                   |       |                 |       |   |   |   |   |
| Commissions                                             |       | $                      | 4,041,276  |                 | $          | 4,288,954 |   | $ | 9,278,907 |   | $ | 6,726,739 |   |
| Corporate finance                                       |       | 2,221,684              |       | 2,337,428            |       | 6,231,172 |   | 2,362,791 |   |
| Investment income (loss)                                |       | (1,537,707             | )          | 4,776,792            |       | (3,538,982 | ) | 548,718 |   |
| Trading income                                          |       | 19,042                 |       | 850,054              |       | 463,237 |   | 434,463 |   |
| Interest and dividends                                  |       | 3,357                  |       | 10,747               |       | 8,155 |   | 30,553 |   |
| Other                                                   |       | 234                    |       | 840                  |       | 1,149 |   | 1,645 |   |
|                                                    |       |                   |       |                 |       |   |   |   |   |
|                                                    |       | 4,747,886              |       | 12,264,815           |       | 12,443,638 |   | 10,104,909 |   |
| **Expenses**                                            |       |                   |       |                 |       |   |   |   |   |
| Commissions and salaries                                |       | 3,624,438              |       | 4,782,936            |       | 9,287,187 |   | 7,233,452 |   |
| Underwriting expenses                                   |       | 210,845                |       | 111,298              |       | 463,303 |   | 111,298 |   |
| Rent, telephone and quotation services                  |       | 307,817                |       | 286,795              |       | 611,360 |   | 552,307 |   |
| Interest expense                                        |       | 500                    |       | —               |       | 573 |   | — |   |
| Professional fees                                       |       | 215,348                |       | 173,446              |       | 479,487 |   | 319,485 |   |
| Bad debt expense                                        |       | 27,580                 |       | 130,000              |       | 67,580 |   | 160,000 |   |
| Travel and entertainment                                |       | 241,323                |       | 78,953               |       | 296,389 |   | 118,434 |   |
| Depreciation and amortization                           |       | 22,933                 |       | 11,850               |       | 53,798 |   | 76,654 |   |
| Other                                                   |       | 503,474                |       | 372,503              |       | 1,014,468 |   | 614,687 |   |
|                                                    |       |                   |       |                 |       |   |   |   |   |
|                                                    |       | 5,154,258              |       | 5,947,781            |       | 12,274,145 |   | 9,186,317 |   |
|                                                    |       |                   |       |                 |       |   |   |   |   |
| Earnings (loss) before income taxes                     |       | (406,372               | )          | 6,317,034            |       | 169,493 |   | 918,592 |   |
|                                                    |       |                   |       |                 |       |   |   |   |   |
| Income tax expense (benefit)                            |       |                   |       |                 |       |   |   |   |   |
| Current                                                 |       | 144,777                |       | —               |       | 419,325 |   | — |   |
| Deferred                                                |       | (298,792               | )          | 350,000              |       | (355,087 | ) | 350,000 |   |
|                                                    |       | (154,015               | )          | 350,000              |       | 64,238 |   | 350,000 |   |
|                                                    |       |                   |       |                 |       |   |   |   |   |
| **Net Earnings (Loss)**                                 |       | $                      | (252,357   | )                    | $          | 5,967,034 |   | $ | 105,255 |   | $ | 568,592 |   |
|                                                    |       |                   |       |                 |       |   |   |   |   |
| Earnings (loss) per share, basic and diluted            |       | $                      | (0.08      | )                    | $          | 1.91 |   | $ | 0.03 |   | $ | 0.18 |   |
|                                                    |       |                   |       |                 |       |   |   |   |   |
| Weighted average number of shares outstanding,  basic   |       | 3,184,068              |       | 3,117,811            |       | 3,172,702 |   | 3,119,844 |   |
|                                                    |       |                   |       |                 |       |   |   |   |   |
| Weighted average number of shares outstanding,  diluted |       | 3,184,068              |       | 3,118,488            |       | 3,190,029 |   | 3,120,517 |   |

 

The accompanying notes are an integral part of these statements.

 

3

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PAULSON CAPITAL CORP. AND SUBSIDIARYCONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITYFor the year ended December 31, 2003and the six month period ended June 30, 2004

 
| ** **                                                                              | ** ** | **Common Stock** | ** ** | **Retained** | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------|------------|--------------|------------|
| ** **                                                                              | ** ** | **Shares**       | ** ** | **Amount**   | ** ** | **Earnings** | ** ** |
|                                                                                    |       |             |       |         |       |   |   |
| Balance at December 31, 2002                                                       |       | 3,125,811        |       | $            | 1,086,740  |   | $ | 24,756,219 |   |
|                                                                                    |       |             |       |         |       |   |   |
| Stock options exercised and income tax benefit from  stock option exercise              |       | 14,000           |       | 90,055       |       | — |   |
|                                                                                    |       |             |       |         |       |   |   |
| Redemption of common stock                                                              |       | (15,000          | )          | (3,750       | )          | (62,152 | ) |
|                                                                                    |       |             |       |         |       |   |   |
| Dividends to common shareholders                                                        |       | —           |       | —       |       | (312,481 | ) |
|                                                                                    |       |             |       |         |       |   |   |
| Net income for the year                                                                 |       | —           |       | —       |       | 4,040,277 |   |
|                                                                                    |       |             |       |         |       |   |   |
| Balance at December 31, 2003                                                       |       | 3,124,811        |       | $            | 1,173,045  |   | $ | 28,421,863 |   |
|                                                                                    |       |             |       |         |       |   |   |
| Stock options exercised and income tax benefit from  stock option exercise  (unaudited) |       | 62,500           |       | 456,293      |       | — |   |
|                                                                                    |       |             |       |         |       |   |   |
| Redemption of common stock (unaudited)                                                  |       | (2,050           | )          | (738         | )          | (14,862 | ) |
|                                                                                    |       |             |       |         |       |   |   |
| Net earnings for the year to date (unaudited)                                           |       | —           |       | —       |       | 105,255 |   |
|                                                                                    |       |             |       |         |       |   |   |
| Balance at June 30, 2004 (unaudited)                                               |       | 3,185,261        |       | $            | 1,628,600  |   | $ | 28,512,256 |   |

 

The accompanying notes are an integral part of these statements.

 

4

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 PAULSON CAPITAL CORP. ANDSUBSIDIARYCONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited)

 
| ** **                                                                                     | ** ** | **Six months ended** | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                     | ** ** | **06/30/04**         | ** ** | **06/30/03** | ** ** |
|                                                                                           |       |                 |       |   |   |
| Cash flows from operating activities                                                           |       |                 |       |   |   |
| Net earnings                                                                                   |       | $                    | 105,255    |   | $ | 568,592 |   |
| Adjustments to reconcile net earnings to net cash  provided by (used in) operating activities: |       |                 |       |   |   |
| Receipt of underwriter warrants                                                                |       | (4,213,583           | )          | (1,413,378 | ) |
| Unrealized (appreciation)/depreciation and  expiration of underwriter warrants                 |       | 2,282,072            |       | (795,287 | ) |
| Noncash compensation associated with underwriter  warrants                                     |       | 1,058,511            |       | 479,665 |   |
| Depreciation and amortization                                                                  |       | 53,798               |       | 76,654 |   |
| Deferred income taxes                                                                          |       | (355,087             | )          | 350,000 |   |
| Change in assets and liabilities                                                               |       |                 |       |   |   |
| Receivables                                                                                    |       | 102,585              |       | (99,852 | ) |
| Receivables from/payable to clearing organization                                              |       | 171,489              |       | (5,898,078 | ) |
| Trading and investment securities                                                              |       | 1,770,304            |       | 1,723,259 |   |
| Prepaid and deferred expenses                                                                  |       | 208,932              |       | 76,536 |   |
| Accounts payable and accrued liabilities                                                       |       | (1,495,044           | )          | 1,251,766 |   |
| Securities sold, not yet purchased                                                             |       | 32,311               |       | 1,907,563 |   |
| Income taxes payable/receivable                                                                |       | 182,634              |       | 1,794,483 |   |
|                                                                                           |       |                 |       |   |   |
| Net cash provided by (used in) operating activities                                            |       | (95,823              | )          | 21,923 |   |
|                                                                                           |       |                 |       |   |   |
| Cash flows from investing activities                                                           |       |                 |       |   |   |
| Additions to furniture and equipment                                                           |       | (69,317              | )          | (42,142 | ) |
|                                                                                           |       |                 |       |   |   |
| Net cash used in investing activities                                                          |       | (69,317              | )          | (42,142 | ) |
|                                                                                           |       |                 |       |   |   |
| Cash flows from financing activities                                                           |       |                 |       |   |   |
| Proceeds from exercise of stock options and tax  benefit from stock option exercise            |       | 456,293              |       | — |   |
| Dividends paid to common shareholders                                                          |       | (312,481             | )          | — |   |
| Payments to retire common stock                                                                |       | (15,600              | )          | (34,995 | ) |
|                                                                                           |       |                 |       |   |   |
| Net cash provided by (used in) financing activities                                            |       | 128,212              |       | (34,995 | ) |
|                                                                                           |       |                 |       |   |   |
| NET DECREASE IN CASH AND CASH EQUIVALENTS                                                      |       | (36,928              | )          | (55,214 | ) |
|                                                                                           |       |                 |       |   |   |
| Cash and cash equivalents at beginning of period                                               |       | 155,314              |       | 97,630 |   |
|                                                                                           |       |                 |       |   |   |
| Cash and cash equivalents at end of period                                                     |       | $                    | 118,386    |   | $ | 42,416 |   |
|                                                                                           |       |                 |       |   |   |
| Cash paid during the period for:                                                               |       |                 |       |   |   |
|                                                                                           |       |                 |       |   |   |
| Interest                                                                                       |       | $                    | 573        |   | $ | — |   |
| Income taxes                                                                                   |       | $                    | 276,762    |   | $ | 5,225 |   |

 

The accompanying notes are an integral part of these statements.

 

5

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**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**(unaudited)

 

1.Basis of Presentation

 

Theaccompanying unaudited consolidated financial statements have been prepared inaccordance with the instructions for interim financial statements in Item310(b) of Regulation S-B, and therefore do not include all information andfootnotes required by accounting principles generally accepted in the UnitedStates of America (US GAAP) for complete financial statements.  In the opinion of management, the interimfinancial statements include all adjustments (consisting only of normalrecurring adjustments) necessary to state fairly the information shown therein.  The nature of the Company’s business is suchthat the results of any interim period are not necessarily indicative ofresults for a full fiscal year.

 

2.Securities Owned

 

Gainsand losses from the disposition of trading securities are reflected as tradingrevenues in the income statement for the period. Gains and losses from thedisposition of investment securities are reflected as investment revenues inthe income statement for the period.

 

3.Commitments and Contingencies

 

In March 2002, theCompany’s wholly owned subsidiary, Paulson Investment Company (“PIC”), and oneof its registered representatives, Marvin Cox, were named as defendants inlawsuits filed by Louis Barinaga and Stuart Mackenzie, former PICcustomers.  The claims of Barinaga andMackenzie relate to purchases of convertible notes of E.com, which werepurchased directly from E.com.  Barinagaand Mackenzie allege that PIC and Mr. Cox participated in and materially aidedthe sale of the notes and, therefore, are liable under state securitieslaw.  Barinaga and Mackenzie allege damagesof $717,000 and $165,000, respectively, plus interest and attorney fees. PICasserted that the claims are subject to arbitration. Plaintiffs have abatedtheir lawsuit and refiled their claims before the NASD.  Claimant Barinaga amended his arbitrationstatement of claim to include claims for breach of fiduciary duty, violationsof federal and state securities laws, fraud and negligence relating totransactions in stock of e.Digital. Barinaga’s amended statement of claim also names UBS PaineWebber, Inc.as a respondent.  Barinaga claims thatCox, PIC and UBS PaineWebber, Inc.’s actions prevented him from realizing inexcess of $12 million on sales of e.Digital stock.  Barinaga seeks $12,165,103 plus interest andfees on the e.Digital claims.  The e.Digitalstock in question was subject to an agreement entered into between Barinaga andUBS PaineWebber, Inc.  Discovery intothese new claims is in a very early stage. An arbitration hearing has been set to begin on January 24,2005.  PIC believes it has meritoriousdefenses and intends to defend this matter vigorously.

 

In October 2002, PIC wasnamed as a defendant in a lawsuit filed by Special Situations Fund III, LP andSpecial Situations Cayman Fund, LP.  Thelawsuit was filed in U.S. District Court for the District of New Jersey.  It asserts various federal securities lawclaims and common law fraud and negligence against numerous defendants,including PIC, arising out of two follow-on offerings of Suprema Specialties,Inc.  PIC participated in one of the twoofferings, the August 25, 2000 follow-on offering of Suprema Specialties,Inc., as a member of the underwriting syndicate, underwriting 75,000 shares intotal.  The plaintiffs seek damages forthe purchase of 399,151 shares of Suprema Specialties, Inc. stock betweenAugust 25, 2000 and November 14, 2001.  The second round of motions to dismiss iscurrently pending.  Discovery has not yetstarted.  PIC believes it has meritoriousdefenses and intends to defend this matter vigorously.

 

In January 2004, PIC andone of its registered representatives, David Harris, were named as respondentsin an NASD complaint filed by a former customer of PIC, PatriciaMendelsohn.  Claimant Mendelsohn allegesthat Harris recommended unsuitable investments and caused her losses ofapproximately $90,000.  ClaimantMendelsohn also alleges that PIC failed to adequately supervise Harris while hewas handling her account.  Discovery hasnot yet started.  PIC believes it hasmeritorious defenses and intends to defend this matter vigorously.

 

In April 2004, PIC andone of its registered representatives, Keith McGrath, were named as defendantsin a complaint filed in U.S. District Court for the District of New Jersey by aformer customer of PIC, Michael Tursi. Plaintiff Tursi alleges that PIC and McGrath, along with several otherdefendants, mishandled his investment accounts over a period of roughly twoyears.  Plaintiff Tursi alleges commonlaw and statutory claims for securities fraud. The total damages sought are $1.3 million.  Discovery has not yet started.  PIC believes it has meritorious defenses andintends to defend this matter vigorously.

 

6

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

 

4.Stock Options

 

TheCompany has a stock-based employee compensation plan. As allowed under SFAS No.123 “Accounting for Stock-Based Compensation,” the Company continues to accountfor stock options for employees under APB No. 25, “Accounting for Stock Issuedto Employees,” and has adopted the disclosure only requirements of SFAS No.123. There were no stock option grants in the six month periods endedJune 30, 2004 and June 30, 2003, accordingly no pro forma incomeeffect is shown.

 

5. Earnings Per Share

 

The following table is a reconciliation of the numerators anddenominators of the basic and diluted per share computations for each of thethree months ended June 30, 2004 and June 30, 2003.

 
| ** **                                                                          | ** ** | **Income**      | ** ** | **Weighted  Average  Shares** | ** ** | **Per  Share  Amount** | ** ** |
|-------------------------------------------------------------------------------------|------------|-----------------|------------|-------------------------------|------------|------------------------|------------|
| ** **                                                                          | ** ** | **(Numerator)** | ** ** | **(Denominator)**             | ** ** | ** **             | ** ** |
|                                                                                |       |            |       |                          |       |                   |       |
| Three Months Ended June 30, 2004 Loss  available to common stockholders        |       | $               | (252,357   | )                             | 3,184,068  |                   | $          | (.08 | ) |
|                                                                                |       |            |       |                          |       |                   |       |
| Effect of dilutive securities Stock options                                         |       | —          |       | —                        |       |                   |       |
|                                                                                |       |            |       |                          |       |                   |       |
| Diluted earnings per share Earnings  available to common stockholders               |       | $               | (252,357   | )                             | 3,184,068  |                   | $          | (.08 | ) |
|                                                                                |       |            |       |                          |       |                   |       |
| Three Months Ended June 30, 2003  Income available to common stockholders |       | $               | 5,967,034  |                          | 3,117,811  |                   | $          | 1.91 |   |

 

The following table is a reconciliation of the numerators anddenominators of the basic and diluted per share computations for each of theperiods ended June 30, 2004 and June 30, 2003.

 
| ** **                                                                        | ** ** | **Income**      | ** ** | **Weighted  Average  Shares** | ** ** | **Per  Share  Amount** | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------|------------|-------------------------------|------------|------------------------|------------|
| ** **                                                                        | ** ** | **(Numerator)** | ** ** | **(Denominator)**             | ** ** | ** **             | ** ** |
|                                                                              |       |            |       |                          |       |                   |       |
| Six Months Ended June 30, 2004 Income  available to common stockholders      |       | $               | 105,255    |                          | 3,172,702  |                   | $          | 0.03 |   |
|                                                                              |       |            |       |                          |       |                   |       |
| Effect of dilutive securities Stock options                                       |       | —          |       | 17,327                        |       |                   |       |
|                                                                              |       |            |       |                          |       |                   |       |
| Diluted earnings per share Earnings  available to common stockholders             |       | $               | 105,255    |                          | 3,190,029  |                   | $          | 0.03 |   |
|                                                                              |       |            |       |                          |       |                   |       |
| Six Months Ended June 30, 2003  Income available to common stockholders |       | $               | 568,592    |                          | 3,119,844  |                   | $          | 0.18 |   |

 

7

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6. Reclassifications

 

Certain 2003 amounts have been reclassified to conform to the 2004presentation.

 

ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOR PLAN OF OPERATION

 

**General**

 

FORWARD-LOOKINGSTATEMENTS

 

This report, including, without limitation, “Item 2. Management’sDiscussion and Analysis of Financial Condition and Results of Operations,”contains or incorporates both historical and “forward-looking” statementswithin the meaning of Section 27A of the Securities Act of 1933, as amended,and Section 21E of the Securities Exchange Act of 1934, as amended. Wordssuch as “anticipates”, “believes”, “expects”, “intends”, “future” and similarexpressions identify forward-looking statements.  Any such forward-looking statements in thisreport reflect our current views with respect to future events and financialperformance and are subject to a variety of factors that could cause our actualresults to differ materially from historical results or from anticipatedresults expressed or implied by such forward-looking statements.  Because of such factors, we cannot assure youthat the results anticipated in this report will be realized.  As noted elsewhere in this report, variousaspects of our business are subject to extreme volatility often as a result offactors beyond our ability to anticipate or control.  In particular, factors, such as the conditionof the securities markets, which are in turn based on popular perceptions ofthe health of the economy generally, can be expected to affect the volume ofour business as well as the value of the securities maintained in our tradingand investment accounts.  Other factorsthat may affect our future financial condition or results of operations includethe following:

 

•                  The performanceof companies whose securities we have underwritten or otherwise sold to ourcustomers may affect our reputation with other potential syndicate and sellinggroup members and institutional and other retail accounts and may also affectthe amount of money in our customers’ portfolios available for the kinds ofinvestments that we offer.

 

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

 

•                  We are subject toa very high degree of regulation and are responsible for compliance withapplicable regulations by all of our personnel. A significant regulatory infraction by us or any of our registeredrepresentatives could result in significant penalties, including the loss ofour license to conduct securities business in one or more jurisdictions.

 

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

 

•                  The loss of ourChairman, Chester Paulson, could have a material adverse impact on ourbusiness.

 

**Overview**

 

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

 

•                  securitiesbrokerage activities for which PIC earns commission revenues;

•                  corporatefinance revenues consisting principally of underwriting discounts andunderwriter warrants;

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

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

 

8

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

 

Our investment income or loss and, to a lesser extent, our tradingincome or loss are affected by changes in market valuation of securitiesgenerally and, in particular, by changes in valuation of the equity securitiesof microcap companies in which our investments and trading activities tend tobe concentrated.  Equity markets ingeneral, and microcap equity markets in particular, have always experiencedsignificant volatility and this volatility has, in recent years, been extreme.  The results of this volatility on the valueof our investment portfolio and securities held in connection with our tradingand investment activities include large quarterly fluctuations in income orloss and substantial increases or decreases in our net worth as our securitiesholdings are marked to market.

 

A substantial portion of our investment banking business consists ofacting as managing underwriter of initial and follow-on public offerings formicrocap companies.  As a part of ourcompensation for this activity, we typically receive warrants exercisable topurchase securities identical to those that we offer and sell to thepublic.  Generally, the warrants are notexercisable for the first year after the offering in which they are earned andare thereafter exercisable for four years, after which they expire.  The exercise price is typically 120% of theprice at which the securities are initially sold to the public. Accordingly,unless there is at least a 20% increase in the price of these securities at sometime more than one and less than five years after the offering, the warrantswill remain “under water” and will ultimately expire unexercised.

 

### **Critical Accounting Policies**

 

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

 

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

 

*Use of Estimates.* Weare required to estimate the value of securities that we hold at the date ofany financial statements and to include that value, and changes in such value,in those financial statements. Accordingly, the aggregate estimated value of securities, includingwarrants, as of the date of any balance sheet is recorded as an asset on thatbalance sheet.  When a new warrant isreceived as a result of our investment banking activity, its estimated value isincluded in corporate finance revenue on the date on which it is earned.  Subsequently, any change in estimated valueis recorded as investment income or loss. When a warrant is exercised, the book value is adjusted to reflect thevalue of the securities purchased, net of the exercise price, and theadjustment amount is recorded as income or loss for the relevant period. If thewarrant expires unexercised, the book value is adjusted to zero and thedecrease is recorded as a loss in the relevant period.

 

We estimate the value of our underwriter warrants using theBlack-Scholes Option Pricing Model. The Black-Scholes model requires us to usehistorical price data combined with various assumptions and judgments as inputsfor the model.  The most influentialfactor in this model is price volatility, which we calculate for each company’swarrants based on each company’s own historical stock price movements as wellas an index of historical prices for comparable companies.  When we initially receive a new underwriter warrantfrom an initial public offering, its calculated volatility factor is entirelybased on the volatility of an index of comparable companies, since there is noprice history for a new publicly traded company.  As each underwriter warrant approaches itsexpiration date, its volatility factor is derived primarily from the historicalprices of its underlying common stock. We cannot assure you that we will ultimately be able to exercise any ofour warrants in a way that will realize the value that we attribute to them inour financial statements based on this model. As of June 30, 2004, ourunderwriter warrants, based on the Black-Scholes Option Pricing Model, werevalued at approximately $7.2 million, up from the estimated value of $6.3million as of December 31, 2003.

 

9

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In addition to our underwriter warrants, we hold other securities, someof which have very limited liquidity and some of which do not have a readilyascertainable market value.  According toUS GAAP, we are required to carry these securities at estimated fair value.

 

As a result of the factors described above, our revenues and earningsare subject to substantial fluctuation from period to period based oncircumstances, many of which are beyond our control.  An increase in financial market activitygenerally, and/or an increase in equity valuations generally, will normallyresult in increases in our revenues, earnings and net worth as our activitylevels and the value of our investment portfolio increase.  Conversely, a general market retrenchmentwill typically lead to decreased revenues, earnings and net worth as a resultboth of decreased activity and the need to adjust high investment portfoliovalues to lower levels.  Accordingly,results for any historical period are not necessarily indicative of similarresults for any future period.

 

**Results of Operations**

 

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

 

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

 

**Three Months Ended June 30, 2004 v.June 30, 2003**

 
| ** **                   | ** ** | **Increase/(Decrease)** | ** ** | **Percent Change** | ** ** | **Three Months Ended  June 30, 2004 v. June 30, 2003** | ** ** |
|------------------------------|------------|-------------------------|------------|--------------------|------------|------------------------------------------------------------------|------------|
| Revenues:                    |       |                    |       |               |       |                                                             |       |   |   |
| Sales Commissions            |       | $                       | (247,678   | )                  | (5.8       | )                                                                | $          | 4,041,276 |   | $ | 4,288,954 |   |
| Corporate Finance            |       | (115,744                | )          | (5.0               | )          | 2,221,684                                                        |       | 2,337,428 |   |
| Investment Income            |       | (6,314,499              | )          | N/A                |       | (1,537,707                                                       | )          | 4,776,792 |   |
| Trading Income               |       | (831,012                | )          | (97.8              | )          | 19,042                                                           |       | 850,054 |   |
| Other                        |       | (7,996                  | )          | (69.0              | )          | 3,591                                                            |       | 11,587 |   |
|                         |       |                    |       |               |       |                                                             |       |   |   |
| Total                        |       | $                       | (7,516,929 | )                  | (61.3      | )                                                                | $          | 4,747,886 |   | $ | 12,264,815 |   |
|                         |       |                    |       |               |       |                                                             |       |   |   |
| Expenses:                    |       |                    |       |               |       |                                                             |       |   |   |
| Commissions and Salaries     |       | (1,158,498              | )          | (24.2              | )          | 3,624,438                                                        |       | 4,782,936 |   |
| Underwriting Expenses        |       | 99,547                  |       | 89.4               |       | 210,845                                                          |       | 111,298 |   |
| Rent, Telephone & Quotes |       | 21,022                  |       | 7.3                |       | 307,817                                                          |       | 286,795 |   |
| Other                        |       | 244,406                 |       | 31.9               |       | 1,011,158                                                        |       | 766,752 |   |
|                         |       |                    |       |               |       |                                                             |       |   |   |
| Total                        |       | $                       | (793,523   | )                  | (13.3      | )                                                                | $          | 5,154,258 |   | $ | 5,947,781 |   |
|                         |       |                    |       |               |       |                                                             |       |   |   |
| Pretax Income (Loss)         |       | $                       | (6,723,406 | )                  | N/A        |                                                             | $          | (406,372 | ) | $ | 6,317,034 |   |

 

**Three Months Ended June 30, 2004 vs. Three Months EndedJune 30, 2003**

 

**Revenues**

 

Total revenues for the second quarter of 2004 decreased a total of$7,516,929, to $4,747,886 from $12,264,815 for the second quarter of 2003. Asshown in the table above, sales commissions decreased $247,678, or 5.8 percent,to $4,041,276 in the second quarter of 2004 from $4,288,954 in the secondquarter of 2003. This decrease is primarily the result of a reduced number ofretail brokers, from 146 as of June 30, 2003, to 138 as of June 30, 2004.

 

10

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Corporate finance revenues decreased slightly to $2,221,684, for thesecond quarter of 2004 compared to $2,337,428 for the second quarter of 2003.The Company completed two corporate finance transactions during the secondquarter of 2004 raising a total of $15.3 million for two corporate financeclients. In comparison, for the second quarter of 2003, the Company completedone corporate finance transaction raising a total of $16.4 million. Corporatefinance revenues also include the receipt of underwriter warrants ascompensation for the Company’s underwriting efforts. During the second quarterof 2004, the Company received underwriter warrants valued using theBlack-Scholes option-pricing model, resulting in unrealized revenue of $956,036(net of $398,581 compensation expense), as compared to underwriter warrantsreceived during the second quarter of 2003 valued at $933,713 (net of $479,665compensation expense).

 

Investment income decreased $6,314,499, from a gain of $4,776,792 inthe second quarter of 2003 to a loss of $1,537,707 in the second quarter of2004. Investment income consists of (1) the unrealized and realizedappreciation and depreciation of securities held based on quoted market prices,(2) the unrealized and realized appreciation and depreciation of securitiesheld that are not readily marketable, based upon the Company’s estimate oftheir fair value, and (3) the unrealized appreciation and depreciation ofunderwriter warrants held by the Company.  The depreciation of underwriter warrants,including warrant expiration, totaled $611,436 during the second quarter of2004, as compared to the appreciation of underwriter warrants of $1,671,487 forthe second quarter of 2003. There was no change in the estimated fair value ofsecurities not readily marketable during the second quarter of 2004. Theremainder of the total investment income is the result of the unrealized andrealized depreciation of securities with quoted market prices. The Company hassignificant investment holdings in several small cap securities whose marketprice decreased during the second quarter of 2004 as compared to the prioryear.  

 

Trading income decreased $831,012 to $19,042 in the second quarter of2004 from $850,054 in the second quarter of 2003, as a result of adverse marketconditions for several of the securities in which the Company makes a market.The Russell 2000 index, which is one indicator of market trends in small capsecurities, posted a 22.9 percent gain in the second quarter of 2003, ascompared to a 0.2 percent gain in the second quarter of 2004. PIC’s focus is onvery small capitalization issues, especially those tied to PIC’s corporatefinance clients. Generally, favorable market conditions result in increased revenuesfor PIC.

 

**Expenses**

 

Total expenses decreased by $793,523 in the second quarter of 2004 fromthe second quarter of 2003, a decrease of 13.3 percent to $5,154,258 from$5,947,781. The largest dollar and percentage decrease was in commissions andsalaries.  Commissions and salariesdecreased $1,158,498, or 24.2 percent, to $3,624,438 in the second quarter of2004 from $4,782,936 in the second quarter of 2003. This decrease is primarilyrelated to the decrease in trading income and investment income commissions.Also, the Company had no profit sharing or bonus accrual for the second quarterof 2004, as compared to a bonus/profit sharing accrual of $213,331 for thesecond quarter of 2003. Underwriting expenses increased by $99,547 from thesecond quarter of 2003 because of two corporate finance transactions completedduring the second quarter of 2004, as compared to one corporate financetransaction completed during the second quarter of 2003. Other expensesincreased 31.9 percent, to $1,011,158 in the second quarter of 2004, up from$766,752 in the second quarter of 2003. The increase in other expenses ispartially the result of an increase in travel and entertainment expense of$162,370 from an investment banking conference held during the second quarter of2004. The Company did not hold an investment banking conference during thesecond quarter of 2003. Also, professional fees (primarily legal) increased$41,902 from the second quarter of 2004, as compared to the second quarter of2003. The remainder of the net increase in other expenses consists of increasesand decreases in various expense categories.

 

**Income**

 

The Company had a pretax loss of $406,372 in the second quarter of 2004compared to pretax income of $6,317,034 in the second quarter of 2003. Independentof the change in the Black-Scholes value of the underwriter warrants and theincome and expense associated with the receipt of the underwriter warrants, theCompany would have had a pretax loss totaling $750,972 for the second quarterof 2004, as compared to pretax income of $3,711,834 for the second quarter of2003. Because of the Black-Scholes value of underwriter warrants and otherfactors, significant fluctuations do occur in PIC’s revenues and operatingresults from one period to another.

 

11

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

 

**Six Months Ended June 30, 2004 v.June 30, 2003**

 
| ** **                   | ** ** | **Increase/(Decrease)** | ** ** | **Percent Change** | ** ** | **Six Months Ended  June 30, 2004 v. June 30, 2003** | ** ** |
|------------------------------|------------|-------------------------|------------|--------------------|------------|----------------------------------------------------------------|------------|
| Revenues:                    |       |                    |       |               |       |                                                           |       |   |   |
| Sales Commissions            |       | $                       | 2,552,168  |               | 37.9       |                                                           | $          | 9,278,907 |   | $ | 6,726,739 |   |
| Corporate Finance            |       | 3,868,381               |       | 163.7              |       | 6,231,172                                                      |       | 2,362,791 |   |
| Investment Income            |       | (4,087,700              | )          | N/A                |       | (3,538,982                                                     | )          | 548,718 |   |
| Trading Income               |       | 28,774                  |       | 6.6                |       | 463,237                                                        |       | 434,463 |   |
| Other                        |       | (22,894                 | )          | (71.1              | )          | 9,304                                                          |       | 32,198 |   |
|                         |       |                    |       |               |       |                                                           |       |   |   |
| Total                        |       | $                       | 2,338,729  |               | 23.1       |                                                           | $          | 12,443,638 |   | $ | 10,104,909 |   |
|                         |       |                    |       |               |       |                                                           |       |   |   |
| Expenses:                    |       |                    |       |               |       |                                                           |       |   |   |
| Commissions and Salaries     |       | 2,053,735               |       | 28.4               |       | 9,287,187                                                      |       | 7,233,452 |   |
| Underwriting Expenses        |       | 352,005                 |       | 316.3              |       | 463,303                                                        |       | 111,298 |   |
| Rent, Telephone & Quotes |       | 59,053                  |       | 10.7               |       | 611,360                                                        |       | 552,307 |   |
| Other                        |       | 623,035                 |       | 48.3               |       | 1,912,295                                                      |       | 1,289,260 |   |
|                         |       |                    |       |               |       |                                                           |       |   |   |
| Total                        |       | $                       | 3,087,828  |               | 33.6       |                                                           | $          | 12,274,145 |   | $ | 9,186,317 |   |
|                         |       |                    |       |               |       |                                                           |       |   |   |
| Pretax Income (Loss)         |       | $                       | (749,099   | )                  | (81.5      | )                                                              | $          | 169,493 |   | $ | 918,592 |   |

 

**SixMonths Ended June 30, 2004 vs. Six Months Ended June 30, 2003**

 

**Revenues**

 

Total revenues for the first six months of 2004 increased $2,338,729,to $12,443,638, from $10,104,909 for the first six months of 2003. As shown inthe table above, sales commissions increased $2,552,168, or 37.9 percent, to$9,278,907 for the first six months of 2004 from $6,726,739 for the first sixmonths of 2003. This increase was primarily the result of increased trading activityin the first quarter of 2004 relative to the first quarter of 2003. 

 

Corporate finance revenues increased $3,868,381, or163.7 percent, for the first two quarters of 2004, to $6,231,172, from$2,362,791 for the first two quarters of 2003. Four corporate financetransactions with gross proceeds totaling approximately $35.3 million werecompleted during the first six months of 2004, compared to one corporatefinance transaction with proceeds totaling $16.4 million completed during thesame period in 2003. Corporate finance revenues are directly related to theamount of money raised in completed transactions.  

 

Investment income decreased by $4,087,700, to a lossof $3,538,982 for the first six months of 2004 compared to income of $548,718for the first six months of 2003. During the first six months of 2004, the fairvalue of the underwriter warrants depreciated a total of $2.3 million, ascompared to underwriter warrant appreciation of $1.7 million during the firstsix months of 2003. Realized gain in the first six months of 2004 totaled$563,546, as compared to a realized loss of $2.4 million during the first sixmonths of 2003. The remainder of the total investment income account isunrealized gain and losses in securities with quoted market prices.

 

Trading income increased $28,774, to $463,237 for the first six monthsof 2004, from $434,463 during the first six months of 2003. The modest increasewas a result of slightly higher trading volume during the 2004 period. TheRussell 2000 Index was up 6.22 percent from December 31, 2003, to June 30,2004, as compared to an increase of 17 percent for the comparable period of theprior year. With the concerns surrounding energy prices during the first sixmonths of 2004, market performance was less robust.

 

12

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**Expenses**

 

Total expenses for the first six months of 2004increased $3,087,828, or 33.6 percent, to $12,274,145 from $9,186,317 for thefirst six months of 2003. Commission and salary expenses increased 28.4percent, or $2,053,735, from $7,233,452 for the first six months of 2003 to$9,287,187 for the first two quarters of 2004. This increase was primarily dueto larger retail and corporate finance commissions paid on higher commissionrevenues during the 2004 period. Underwriting expenses totaled $463,303 for the first two quarters of2004 as a result of the closing of four corporate finance transactions ascompared to $111,298 in the comparable prior year when one corporate financetransaction was completed. The aggregate of all other expenses increased$623,035, or 48.3 percent, for the first six months of 2004, to $1,912,295 from$1,289,260 for the first six months of 2003. The increases in other expense include: travel and entertainmentincrease of $177,955 as a result of the investor conference held inJune 2004; legal fee increase of $136,610 as a result of increased legalactivity related to settlements; and advertising expense increase of $54,013 asa result of PIC’s retention of a public relations firm during the first half of2004. Decreases in other expenses include: bonus and profit sharing expensedecrease of $213,331 as a result of no accrual during the 2004 period andestimated bad debt expense decrease of $92,420 as a result of effective collectionon amounts due the Company.

 

**Income**

 

The Company had pretax earnings of $169,493 for the first six months of2004 compared to pretax income of $918,592 for the first six months of 2003.Independent of the change in the Black- Scholes value of the underwriterwarrants and the income and expense associated with the receipt of theunderwriter warrants, the Company would have had a pretax loss totaling$703,507 for the first six months of 2004, as compared to a pretax loss of$810,408 for the comparable period of 2003. Because of the Black-Scholes valueof underwriter warrants and other factors, significant fluctuations do occur inPIC’s revenues and operating results from one period to another. 

** **

**Liquidity and Capital Resources**

 

The majority of PIC’s assets are cash and assetsreadily convertible to cash.  PIC’ssecurities inventory is stated at market value. The liquidity of the market for many of PIC’s securities holdings,however, varies with trends in the stock market.  Since many of the securities held by PIC arethinly traded, and PIC is in many cases a primary market maker in the issuesheld, any significant sales of PIC’s positions could adversely affect theliquidity of the issues held.  Ingeneral, falling prices in OTC securities (which make up most of PIC’s tradingpositions) lead to decreased liquidity in the market for these issues, whilerising prices in OTC issues tend to increase the liquidity of the market forthese securities.

 

PICborrows money from its clearing firm in the ordinary course of its business,pursuant to an understanding under which the clearing firm agrees to financePIC’s trading accounts.  As ofJune 30, 2004, no net loans were outstanding pursuant to this arrangement.  PIC and the Company are generally able tomeet their compensation and other obligations out of current liquid assets.

 

Anothersource of capital to PIC and the Company has been the underwriter warrantsissued to PIC in connection with its corporate finance activities and the saleof the underlying securities. There is no public market for the underwriterwarrants. The securities receivable upon exercise of the underwriter warrantscannot be resold unless the issuer has registered these securities with the SECand with the states in which the securities will be sold unless exemptions areavailable.  Any delay or other problem inthe registration of these securities would have an adverse impact upon PIC’sability to obtain funds from the exercise of the underwriter warrants and theresale of the underlying securities.  AtJune 30, 2004, PIC owned 22 underwriter warrants (from 16 issuers), allbut four of which were currently exercisable; five had an exercise price belowthe current market price of the securities receivable upon exercise.  The intrinsic value of these five warrants is$491,015. There is little or no direct relationship between the intrinsic valueof PIC’s underwriter warrants at the end of any given period and the fair valuecalculated using the Black-Scholes pricing model, as described more fully inCritical Accounting Policies above. The prices of these securities areinfluenced by general movements in the prices of OTC securities as well as thesuccess of the issuers of the underwriter warrants.  The prices of the securities underlying the underwriterwarrants are very volatile, and substantial fluctuations in the Company’sestimate of their value can be expected in the future.

 

13

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In the six months ended June 30, 2004, $95,824 of net cash wasused in operating activities.  The majoradjustments to reconcile this result to the Company’s net income include thefollowing items that are positive adjustments to or provided cash to operatingactivities: noncash compensation associated with underwriter warrants of$1,058,511; unrealized depreciation and expiration of underwriter warrantstotaling $2,282,072, and net change in trading and investment securities of$1,770,304. The following items are negative adjustments to or a use of cashfor operating activities: a decrease in accounts payable and accruedliabilities of $1,495,042, and the receipt of underwriter warrants of$4,213,583. Net cash used in investing activities in the first six months of2004 was for additions to furniture and equipment of $69,316. Net cash providedby financing activities in the first quarter of 2004 totaled $128,212,resulting from proceeds from the exercise of employee stock options and incometax benefit from stock option exercise, dividends paid to common shareholders, andpayments to retire common stock.

 

Asa securities broker-dealer, PIC is required by SEC regulations to meet certainliquidity and capital standards.  Webelieve we are in compliance with these standards.

 

AtJune 30, 2004, the Company had no material commitments for capitalexpenditures.

 

In general, the primary sources of PIC’s, and therefore the Company’s,liquidity, include PIC’s trading positions, borrowings on those positions andprofits realized upon the exercise of underwriter warrants. All of thesesources depend in large part on the trend in the general markets for OTCsecurities.  Rising OTC price levels willtend to increase the value and liquidity of PIC’s trading positions, the amountthat can be borrowed from National Financial Services based upon thosepositions, and the value of PIC’s underwriter warrants.  The Company believes its liquidity issufficient to meet its needs for both the short and long term horizon. TheCompany’s liquidity could be affected by protracted unfavorable market conditions.

 

**Inflation**

 

BecausePIC’s assets are primarily liquid, they are not significantly affected byinflation.  The rate of inflation affectsPIC’s expenses, such as employee compensation, office leasing andcommunications costs.  These costs maynot readily be recoverable in the price of services offered by theCompany.  To the extent inflation resultsin rising interest rates and has other adverse effects in the securitiesmarkets and the value of securities held in inventory or PIC’s investment account,it may adversely affect the Company’s financial position and results ofoperations.

 

ITEM3.  CONTROLS AND PROCEDURES

 

(a)                                  Our management, with the participation of ourPresident and Chief Financial Officer, conducted an evaluation of ourdisclosure controls and procedures, as such terms are defined under Rules13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934,as amended, as of the end of the period covered by this report. Based on theirevaluation, our President and Chief Financial Officer concluded that ourdisclosure controls and procedures were effective.

 

(b)                                 For the quarter ended June 30, 2004,there have been no changes in our internal control over financial reportingthat have materially affected or are reasonably likely to materially affect ourinternal control over financial reporting. 

 

14

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**PART IIOTHER INFORMATION**

 

Item1. Legal Proceedings.

 

SeeNote 3 to Condensed Consolidated Financial Statements in Part 1.

 

Item2. Changes in Securities.

 

None

 

Item3. Defaults upon Senior Securities.

 

None

 

Item4. Submission of Matters to a Vote of Security Holders.

 

(a)The Company held its annual meeting on June 3, 2004.

 

(b) The six Company directors (Chester L.F. Paulson, JacquelineM. Paulson, Glen Davis, Steve Kleemann, Shannon P. Pratt, and Paul Shoen) wereeach elected for an additional one year term.

 

(c)The results of the voting for election of each director were as follows:

 
| **Nominee**           | ** ** | **For**   | ** ** | **Abstain** | ** ** |
|-----------------------|------------|-----------|------------|-------------|------------|
|                  |       |      |       |        |       |
| Chester L. F. Paulson |       | 3,104,821 |       | 6,300       |       |
| Jacqueline M. Paulson |       | 3,104,821 |       | 6,300       |       |
| Glen Davis            |       | 3,104,821 |       | 6,300       |       |
| Steve Kleemann        |       | 3,104,821 |       | 6,300       |       |
| Shannon Pratt         |       | 3,104,821 |       | 6,300       |       |
| Paul Schoen           |       | 3,104,821 |       | 6,300       |       |

 

Item5. Other Information.

 

None

 

Item6. Exhibits and Reports on Form 8-K

 

(a)Exhibits

 
| 31.1   |   | Certification  of Principal Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. Filed herewith electronically.                                                     |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                              |
| 31.2   |   | Certification  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002. Filed herewith electronically.                                                         |
|   |   |                                                                                                                                                                                              |
| 32.1   |   | Certification of Principal  Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002. Filed herewith  electronically. |
|   |   |                                                                                                                                                                                              |
| 32.2   |   | Certification of Chief  Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002. Filed herewith  electronically.     |

 

(b)No Reports on Form 8-K were filed during the quarter ended June 30, 2004.

 

15

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
|                        |   | PAULSON  CAPITAL CORP. |
|-----------------------------|--------|------------------------|
|                        |   |                   |
|                        |   |                   |
| Date:  August 12, 2004 |   | By:                    | /s/  CHESTER L.F. PAULSON |   |
|                        |   |                   | Chester  L.F. Paulson |
|                        |   |                   | President  Principal Executive Officer |
|                        |   |                   |   |
| Date:  August 12, 2004 |   | By:                    | /s/  CAROL RICE |   |
|                        |   |                   | Carol  Rice |
|                        |   |                   | Chief  Financial Officer  Principal Financial Officer |

 

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