**UNITED STATES****SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON D.C. 20549**

 

----

 

**FORM 10-Q**

 

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

 

**For thequarterly period ended June 30, 2005**

 

**o  TRANSITION REPORT UNDER SECTION 13OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For thetransition period from              to**

 

**Commissionfile 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 ParkwayPortland, OR 97204**

(Address of principal executive offices)

 

**(503) 243-6000**

(Issuer’s telephone number)

 

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

 

Indicate by check mark whether the registrant is an accelerated filer

(as defined in Rule 12b-2 of the Exchange Act):Yes  o    No  ý

 

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

 

Common stock, no par value, 3,117,912 as of August 9, 2005

 

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

 

 

----

 

**PAULSONCAPITAL CORP.**

 

**INDEX TOFORM 10-Q**

 
| Part I  - | FINANCIAL INFORMATION                                                                                                                                                  |   |
|---------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                |                                                                                                                                                                   |   |
| Item 1  -      | Financial Statements:                                                                                                                                                  |   |
|                |                                                                                                                                                                   |   |
|                | Consolidated Balance  Sheets:  –    June 30, 2005 and December 31, 2004                                                                  |   |
|                |                                                                                                                                                                   |   |
|                | Consolidated  Statements of Income:   –**    **For the  Three Months and Six Months Ended June 30, 2005 and 2004                              |   |
|                | ** **                                                                                                                                                             |   |
|                | Consolidated  Statement of Shareholders’ Equity   –    For the Year Ended December 31, 2004 and the Six  Months Ended June 30, 2005 |   |
|                |                                                                                                                                                                   |   |
|                | Consolidated  Statements of Cash Flows:   –    For the Six Months Ended June 30, 2005 and 2004                                                |   |
|                |                                                                                                                                                                   |   |
|                | Notes  to Condensed Consolidated Interim Financial Statements                                                                                                          |   |
|                |                                                                                                                                                                   |   |
| Item 2 -            | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                                                            |   |
|                |                                                                                                                                                                   |   |
| Item  3 -           | Quantitative  and Qualitative Disclosures About Market Risk                                                                                                            |   |
|                |                                                                                                                                                                   |   |
| Item 4 -            | Controls and  Procedures                                                                                                                                               |   |
|                |                                                                                                                                                                   |   |
| Part II -      | OTHER INFORMATION                                                                                                                                                      |   |
|                |                                                                                                                                                                   |   |
| Item 1 -            | Legal  Proceedings                                                                                                                                                     |   |
|                |                                                                                                                                                                   |   |
| Item 2 -            | Unregistered Sales of  Equity Securities and Use of Proceeds                                                                                                           |   |
|                |                                                                                                                                                                   |   |
| Item  4 -           | Submission  of Matters to a Vote of Security Holders                                                                                                                   |   |
|                |                                                                                                                                                                   |   |
| Item 6 -            | Exhibits                                                                                                                                                               |   |
|                |                                                                                                                                                                   |   |
| Signatures -        |                                                                                                                                                                   |   |
|                |                                                                                                                                                                   |   |
| Certifications      |                                                                                                                                                                   |   |

 

2

----

 

**PART I****— FINANCIAL INFORMATION**

 

ITEM1. FINANCIAL STATEMENTS

 

PAULSONCAPITAL CORP. AND SUBSIDIARYCONSOLIDATED BALANCE SHEETS

 

 
| ** **                                                                                                                           | ** ** | **06/30/05**    | ** ** | **12/31/04** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|--------------|------------|
| ** **                                                                                                                           | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| **ASSETS**                                                                                                                           |       |            |       |         |       |
|                                                                                                                                 |       |            |       |         |       |
| Cash and cash equivalents                                                                                                            |       | $               | 139,077    |         | $          | 132,845 |   |
| Receivable from clearing organization                                                                                                |       | 7,719,899       |       | 7,856,254    |       |
| Notes and other receivables                                                                                                          |       | 1,461,171       |       | 442,934      |       |
| Income taxes receivable                                                                                                              |       | —          |       | 851,000      |       |
| Trading securities, at market value                                                                                                  |       | 2,770,944       |       | 3,029,326    |       |
| Investment securities, at market value                                                                                               |       | 31,976,098      |       | 20,774,645   |       |
| Underwriter warrants, at estimated fair value                                                                                        |       | 11,530,000      |       | 9,416,000    |       |
| Prepaid and deferred expenses                                                                                                        |       | 1,271,484       |       | 1,583,346    |       |
| Furniture and equipment, net                                                                                                         |       | 265,045         |       | 239,028      |       |
|                                                                                                                                 |       |            |       |         |       |
| Total assets                                                                                                                         |       | $               | 57,133,718 |         | $          | 44,325,378 |   |
|                                                                                                                                 |       |            |       |         |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                        |       |            |       |         |       |
|                                                                                                                                 |       |            |       |         |       |
| **LIABILITIES**                                                                                                                      |       |            |       |         |       |
| Accounts payable and accrued liabilities                                                                                             |       | $               | 807,494    |         | $          | 2,138,856 |   |
| Dividends payable                                                                                                                    |       | 4,457           |       | —       |       |
| Payable to clearing organization                                                                                                     |       | 142,657         |       | 1,021,860    |       |
| Compensation, employee benefits and payroll taxes                                                                                    |       | 3,758,218       |       | 2,108,056    |       |
| Securities sold, not yet purchased, at market value                                                                                  |       | 17,168          |       | 50,144       |       |
| Income taxes payable                                                                                                                 |       | 10,126          |       | —       |       |
| Deferred income taxes                                                                                                                |       | 11,196,502      |       | 5,436,000    |       |
|                                                                                                                                 |       |            |       |         |       |
| Total liabilities                                                                                                                    |       | 15,936,622      |       | 10,754,916   |       |
|                                                                                                                                 |       |            |       |         |       |
| **COMMITMENTS AND CONTINGENCIES**                                                                                                    |       | —          |       | —       |       |
|                                                                                                                                 |       |            |       |         |       |
| **SHAREHOLDERS’ EQUITY**                                                                                                        |       |            |       |         |       |
| Preferred stock, no par value; authorized, 500,000  shares; issued and outstanding, no shares                                        |       | —          |       | —       |       |
| Common stock, no par value; authorized, 10,000,000  shares; issued and outstanding, 3,125,446 at 06/30/05 and 3,190,300 at  12/31/04 |       | 1,780,302       |       | 1,745,824    |       |
| Retained earnings                                                                                                                    |       | 39,416,794      |       | 31,824,638   |       |
|                                                                                                                                 |       |            |       |         |       |
| Total shareholders’ equity                                                                                                      |       | 41,197,096      |       | 33,570,462   |       |
|                                                                                                                                 |       |            |       |         |       |
| Total liabilities and shareholders’ equity                                                                                      |       | $               | 57,133,718 |         | $          | 44,325,378 |   |

 

The accompanying notes are an integral part of these statements.

 

3

----

 

PAULSON CAPITAL CORP. ANDSUBSIDIARYCONSOLIDATED STATEMENTS OFINCOME (unaudited)

 
| ** **                                              | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|---------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                              | ** ** | **6/30/05**            | ** ** | **6/30/04**          | ** ** | **6/30/05** | ** ** | **6/30/04** | ** ** |
| **Revenues**                                            |       |                   |       |                 |       |   |   |   |   |
| Commissions                                             |       | $                      | 3,743,269  |                 | $          | 4,041,276 |   | $ | 7,884,326 |   | $ | 9,278,907 |   |
| Corporate finance                                       |       | 465,970                |       | 2,221,684            |       | 585,955 |   | 6,231,172 |   |
| Investment income (loss)                                |       | 12,361,430             |       | (1,537,707           | )          | 17,513,929 |   | (3,538,982 | ) |
| Trading income                                          |       | 1,410,822              |       | 19,042               |       | 2,112,826 |   | 463,237 |   |
| Interest and dividends                                  |       | 14,454                 |       | 3,357                |       | 22,145 |   | 8,155 |   |
| Other                                                   |       | 165                    |       | 234                  |       | 11,334 |   | 1,149 |   |
|                                                    |       |                   |       |                 |       |   |   |   |   |
|                                                    |       | 17,996,110             |       | 4,747,886            |       | 28,130,515 |   | 12,443,638 |   |
| **Expenses**                                            |       |                   |       |                 |       |   |   |   |   |
| Commissions and salaries                                |       | 6,152,185              |       | 3,624,438            |       | 10,406,189 |   | 9,287,187 |   |
| Underwriting expenses                                   |       | 134,172                |       | 210,845              |       | 134,172 |   | 463,303 |   |
| Rent, telephone and  quotation services                 |       | 285,601                |       | 307,817              |       | 592,099 |   | 611,360 |   |
| Interest expense                                        |       | —                 |       | 500                  |       | — |   | 573 |   |
| Professional fees                                       |       | 346,350                |       | 215,348              |       | 789,116 |   | 479,487 |   |
| Bad debt expense                                        |       | —                 |       | 27,580               |       | — |   | 67,580 |   |
| Travel and entertainment                                |       | 100,923                |       | 241,323              |       | 161,069 |   | 296,389 |   |
| Settlement expense                                      |       | 256,375                |       | 22,500               |       | 518,543 |   | 32,090 |   |
| Depreciation and  amortization                          |       | 22,703                 |       | 22,933               |       | 45,760 |   | 53,798 |   |
| Other                                                   |       | 576,335                |       | 480,974              |       | 1,082,312 |   | 982,378 |   |
|                                                    |       |                   |       |                 |       |   |   |   |   |
|                                                    |       | 7,874,644              |       | 5,154,258            |       | 13,729,260 |   | 12,274,145 |   |
|                                                    |       |                   |       |                 |       |   |   |   |   |
| Income (loss) before  income taxes                      |       | 10,121,466             |       | (406,372             | )          | 14,401,255 |   | 169,493 |   |
|                                                    |       |                   |       |                 |       |   |   |   |   |
| Income tax expense  (benefit)                           |       |                   |       |                 |       |   |   |   |   |
| Current                                                 |       | —                 |       | 144,777              |       | — |   | 419,325 |   |
| Deferred                                                |       | 4,048,572              |       | (298,792             | )          | 5,760,502 |   | (355,087 | ) |
|                                                    |       | 4,048,572              |       | (154,015             | )          | 5,760,502 |   | 64,238 |   |
|                                                    |       |                   |       |                 |       |   |   |   |   |
| **Net Income (Loss)**                                   |       | $                      | 6,072,894  |                 | $          | (252,357 | ) | $ | 8,640,753 |   | $ | 105,255 |   |
|                                                    |       |                   |       |                 |       |   |   |   |   |
| Earnings (loss) per share,  basic                       |       | $                      | 1.94       |                 | $          | (0.08 | ) | $ | 2.74 |   | $ | 0.03 |   |
|                                                    |       |                   |       |                 |       |   |   |   |   |
| Earnings (loss) per share,  diluted                     |       | $                      | 1.93       |                 | $          | (0.08 | ) | $ | 2.73 |   | $ | 0.03 |   |
|                                                    |       |                   |       |                 |       |   |   |   |   |
| Weighted average number of  shares outstanding, basic   |       | 3,131,752              |       | 3,184,068            |       | 3,155,406 |   | 3,172,702 |   |
|                                                    |       |                   |       |                 |       |   |   |   |   |
| Weighted average number of  shares outstanding, diluted |       | 3,139,811              |       | 3,184,068            |       | 3,163,421 |   | 3,190,029 |   |

 

The accompanyingnotes are an integral part of these statements.

 

4

----

 

PAULSON CAPITAL CORP. ANDSUBSIDIARYCONSOLIDATED STATEMENT OFSHAREHOLDERS’ EQUITYFor the year ended December 31, 2004and the six month period ended June 30, 2005

 
| ** **                                                                 | ** ** | **Common Stock** | ** ** | **Retained  Earnings** | ** ** |
|----------------------------------------------------------------------------|------------|------------------|------------|------------------------|------------|
| ** **                                                                 | ** ** | **Shares**       | ** ** | **Amount**             | ** ** | ** ** |
|                                                                       |       |             |       |                   |       |   |   |
| 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 |       | 78,500           |       | 577,518                |       | — |   |
|                                                                       |       |             |       |                   |       |   |   |
| Redemption of common stock                                                 |       | (13,011          | )          | (4,739                 | )          | (86,825 | ) |
|                                                                       |       |             |       |                   |       |   |   |
| Net income for the year                                                    |       | —           |       | —                 |       | 3,489,600 |   |
|                                                                       |       |             |       |                   |       |   |   |
| Balance at December 31, 2004                                          |       | 3,190,300        |       | 1,745,824              |       | 31,824,638 |   |
|                                                                       |       |             |       |                   |       |   |   |
| Redemption of common stock (unaudited)                                     |       | (72,854          | )          | (27,052                | )          | (572,033 | ) |
|                                                                       |       |             |       |                   |       |   |   |
| Dividends to common shareholders (unaudited)                               |       | —           |       | —                 |       | (476,564 | ) |
|                                                                       |       |             |       |                   |       |   |   |
| Stock options exercised (unaudited)                                        |       | 8,000            |       | 61,530                 |       | — |   |
|                                                                       |       |             |       |                   |       |   |   |
| Net income for the year to date (unaudited)                                |       | —           |       | —                 |       | 8,640,753 |   |
|                                                                       |       |             |       |                   |       |   |   |
| Balance at June 30, 2005 (unaudited)                                       |       | 3,125,446        |       | $                      | 1,780,302  |   | $ | 39,416,794 |   |

 

The accompanying notes are an integral part of this statement.

 

5

----

 

PAULSON CAPITAL CORP. AND SUBSIDIARYCONSOLIDATED STATEMENTS OFCASH FLOWS(unaudited)

 
| ** **                                                                                   | ** ** | **Six months ended** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                   | ** ** | **06/30/05**         | ** ** | **06/30/04** | ** ** |
|                                                                                         |       |                 |       |   |   |
| Cash flows from operating activities                                                         |       |                 |       |   |   |
| Net income                                                                                   |       | $                    | 8,640,753  |   | $ | 105,255 |   |
| Adjustments to reconcile net income to net cash  provided by (used in) operating activities: |       |                 |       |   |   |
| Receipt of underwriter warrants                                                              |       | (303,056             | )     | (4,213,583 | ) |
| Unrealized (appreciation) depreciation/expiration of  underwriter warrants                   |       | (1,906,400           | )          | 2,282,072 |   |
| Noncash compensation associated with underwriter warrants                                    |       | 95,456               |       | 1,058,511 |   |
| Depreciation and amortization                                                                |       | 45,760               |       | 53,798 |   |
| Deferred income taxes                                                                        |       | 5,760,502            |       | (355,087 | ) |
| Change in assets and liabilities                                                             |       |                 |       |   |   |
| Receivables                                                                                  |       | (1,018,237           | )          | 102,585 |   |
| Receivables from/payable to clearing organization                                            |       | (742,848             | )          | 171,489 |   |
| Trading and investment securities                                                            |       | (10,943,071          | )          | 1,770,304 |   |
| Prepaid and deferred expenses                                                                |       | 311,862              |       | 208,932 |   |
| Accounts payable and accrued liabilities                                                     |       | 323,257              |       | (1,495,044 | ) |
| Securities sold, not yet purchased                                                           |       | (32,976              | )          | 32,311 |   |
| Income taxes payable/receivable                                                              |       | 861,126              |       | 182,634 |   |
|                                                                                         |       |                 |       |   |   |
| Net cash provided by (used in) operating activities                                          |       | 1,092,128            |       | (95,823 | ) |
|                                                                                         |       |                 |       |   |   |
| Cash flows from investing activities                                                         |       |                 |       |   |   |
| Additions to furniture and equipment                                                         |       | (71,777              | )          | (69,317 | ) |
|                                                                                         |       |                 |       |   |   |
| Cash flows from financing activities                                                         |       |                 |       |   |   |
| Proceeds from exercise of stock options                                                      |       | 61,530               |       | 456,293 |   |
| Dividends paid to common shareholders                                                        |       | (476,564             | )          | (312,481 | ) |
| Payments to retire common stock                                                              |       | (599,085             | )          | (15,600 | ) |
|                                                                                         |       |                 |       |   |   |
| Net cash provided by (used in) financing activities                                          |       | (1,014,119           | )          | 128,212 |   |
|                                                                                         |       |                 |       |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                         |       | 6,232                |       | (36,928 | )  |
|                                                                                         |       |                 |       |   |   |
| Cash and cash equivalents at beginning of period                                             |       | 132,845              |       | 155,314 |   |
|                                                                                         |       |                 |       |   |   |
| Cash and cash equivalents at end of period                                                   |       | $                    | 139,077    |   | $ | 118,386 |   |
|                                                                                         |       |                 |       |   |   |
| Cash paid during the period for:                                                             |       |                 |       |   |   |
|                                                                                         |       |                 |       |   |   |
| Interest                                                                                     |       | $                    | —     |   | $ | 573 |   |
| Income taxes                                                                                 |       | $                    | 19,705     |   | $ | 276,762 |   |

 

The accompanying notes are an integral part of these statements.

 

6

----

 

**PAULSON CAPITAL CORP. AND SUBSIDIARY**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS******(unaudited)

 

1.               Basis of Presentation

 

Thesefinancial statements are those of the Company and its wholly owned subsidiary.In the opinion of management, the accompanying unaudited consolidated financialstatements have been prepared pursuant to the rules and regulations of theSecurities and Exchange Commission and include all adjustments (consisting onlyof normal recurring adjustments) necessary to present fairly the Company’sfinancial position as of June 30, 2005 and its results of operations for thethree and six months ended June 30, 2005 and 2004, and cash flows for the sixmonths ended June 30, 2005 and 2004. The nature of the Company’s business issuch that the results of any interim period are not necessarily indicative ofresults for a full fiscal year. The accompanying unaudited financial statementsand related notes should be read in conjunction with the audited financialstatements and Form 10-KSB of the Company for the fiscal year endedDecember 31, 2004.

 

2.               Dividend

 

OnJanuary 27, 2005, the Company announced the authorization by the Board ofDirectors of a $0.15 special cash dividend to shareholders of record onFebruary 10, 2005. The dividend was paid on March 3, 2005.

 

3.               Securities Owned

 

Gainsand losses from the disposition and appreciation/depreciation of tradingsecurities are reflected as trading revenues in the income statement for theperiod. Gains and losses from the disposition and unrealized gains/losses ofinvestment securities are reflected as investment revenues in the incomestatement for the period. Investment securities may be held for the long termor sold pursuant to the intention of management. 

 

4.               Commitments and Contingencies

 

InMarch 2002, the Company’s wholly owned subsidiary, Paulson InvestmentCompany (“PIC”), and one of its registered representatives, Marvin Cox, werenamed as defendants in a lawsuit filed by Louis Barinaga, a former PICcustomer.  Barinaga’s claims related topurchases of convertible notes of E.com, which were purchased directly fromE.com.  Claimant abated his lawsuit andrefiled his claims before the NASD.  Subsequently,Barinaga amended his arbitration statement of claim to include claims forbreach of fiduciary duty, violations of federal and state securities laws,fraud and negligence relating to transactions in stock of e.Digital.  Barinaga’s amended statement of claim alsonamed UBS PaineWebber, Inc. as a respondent.  Barinaga claimed that Cox, PIC and UBSPaineWebber, Inc.’s actions prevented him from realizing in excess of $12million on sales of e.Digital stock. Barinaga sought over $18 million plus interest and fees on the e.Digitalclaims.  The e.Digital stock in questionwas subject to an agreement entered into between Barinaga and UBSPaineWebber, Inc.  An arbitrationhearing was set to begin on January 24, 2005.  The claim of Barinaga relating to E.com noteswas settled prior to the start of the arbitration.  The remaining claim of Barinaga relating toe.Digital stock also was settled between PIC and Barinaga prior to the start ofthe arbitration.  The settlement has beenconsummated with Barinaga.  However,PIC’s insurance carrier, after previously providing settlement authorization toPIC, has now withdrawn that authorization because of a dispute between Cox andBarinaga.  PIC believes that theinsurance carrier is obligated to provide the settlement authorization to whichit previously agreed.  PIC has filed suitagainst the insurance carrier and intends to pursue the insurance proceedsvigorously. Mediation is scheduled for August 30, 2005.  As of December 31, 2004, the Company hasrecorded the total amount of the settlement expense in its financialstatements.

 

InOctober 2002, PIC was named as a defendant in a lawsuit filed by SpecialSituations Fund III, LP and Special Situations Cayman Fund, LP.  The lawsuit was filed in U.S. District Courtfor the District of New Jersey.  Itasserts various federal securities law claims and common law fraud andnegligence against numerous defendants, including PIC, arising out of twofollow-on offerings of Suprema Specialties, Inc.  PIC participated in one of the two offerings,the August 25, 2000 follow-on offering of Suprema Specialties, Inc.,as a member of the underwriting syndicate, underwriting 75,000 shares intotal.  The stock was sold in theAugust 25, 2000 offering at a price of $8.00 per share.  Plaintiffs seek damages for the purchase of399,151 shares of Suprema Specialties, Inc. stock between August 25,2000 and November 14, 2001.  Thefederal district court has dismissed the claims against PIC.  Plaintiffs have appealed and the case currentlyis pending before the United States Third Circuit Court of Appeals.  Oral argument on the appeal is set forSeptember 16, 2005.  PIC believes it hasmeritorious defenses and intends to defend this matter vigorously.

 

7

----

 

OnApril 12, 2005, the NASD sent a letter to PIC’s outside counsel indicatingthat the NASD Department of Enforcement had made a preliminary determination torecommend that disciplinary action be brought against PIC, and certain otherPIC employees, including its former president, and former employees, forviolations of NASD Rules of Conduct 2110, for mutual fund market-timing,and 3010, for failure to supervise the firm’s mutual fund market-timingbusiness.  The NASD has proposed toresolve the action with PIC in return for a payment by PIC of $218,000 inrestitution and $282,000 in fines.  Theconduct at question relates to activities undertaken in August andSeptember of 2003 by employees in PIC’s New York City office.  Paulson believes that none of the activitiesviolated any state or federal laws or regulations. Accordingly, PIC believes ithas meritorious defenses and its legal counsel is defending this mattervigorously.  PIC filed a response to theNASD’s preliminary determination on May 17, 2005.  If this matter is not settled, it willproceed to a hearing before the NASD, either in 2005 or 2006. 

 

Inaddition to the matters described above, PIC has been named in an NASDarbitration filed in July 2005 by a group of former customers.  The statement of claim indicates it was filedin an attempt to “toll” the running of applicable statutes of limitation.  The statement provides no specific factualallegations or any information regarding what amounts, if any, may be soughtfrom PIC, although PIC believes the amounts may be material.  PIC has not had an opportunity to fully investigatethis claim, but believes it has meritorious defenses and intends to defend thismatter vigorously if the claim is pursued.

 

Anadverse outcome in certain of the matters described above could have a materialadverse effect on PIC or the Company. From time to time, PIC is named incertain other legal proceedings and receives notice that certain customers maycommence legal proceedings against PIC. The Company has no additional legal proceedings other than through PIC.The Company believes, based upon information received to date and, where theCompany believes it appropriate, discussions with legal counsel, thatresolution of any additional pending or threatened litigation will have nomaterial adverse effect on the consolidated financial condition, results ofoperations, or business of the Company.

 

8

----

 

5.               Stock Options

 

TheCompany has a stock-based employee compensation plan. As allowed under SFASNo. 123 “Accounting for Stock-Based Compensation,” the Company continuesto account for stock options for employees under APB No. 25, “Accountingfor Stock Issued to Employees,” and has adopted the disclosure onlyrequirements of SFAS No. 123. There were no stock option grants in the sixmonth periods ended June 30, 2005 or 2004. Accordingly, no pro forma incomeeffect is shown.

 

6.               Earnings Per Share

 

Thefollowing table is a reconciliation of the numerators and denominators of thebasic and diluted per share computations for each of the three months ended June30, 2005 and June 30, 2004.

 
| ** **                                                                | ** ** | **Income**      | ** ** | **Weighted  Average Shares** | ** ** | **Per Share  Amount** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------|------------|------------------------------|------------|-----------------------|------------|
| ** **                                                                | ** ** | **(Numerator)** | ** ** | **(Denominator)**            | ** ** | ** **            | ** ** |
|                                                                      |       |            |       |                         |       |                  |       |
| Three Months Ended June 30, 2005 Income available to  common shareholders |       | $               | 6,072,894  |                         | 3,131,752  |                  | $          | 1.94 |   |
|                                                                      |       |            |       |                         |       |                  |       |
| Effect of dilutive securities – options                              |       |            |       | 8,059                        |       |                  |       |
|                                                                      |       |            |       |                         |       |                  |       |
| Diluted earnings per share                                                |       | $               | 6,072,894  |                         | 3,139,811  |                  | $          | 1.93 |   |
|                                                                      |       |            |       |                         |       |                  |       |
| Three Months Ended June 30, 2004 Loss available to  common shareholders   |       | $               | (252,357   | )                       | 3,184,068  |                  | $          | (.08 | )  |
|                                                                      |       |            |       |                         |       |                  |       |   |   |
| Effect of dilutive securities – options                              |       |            |       | —                       |       |                  |       |   |
|                                                                      |       |            |       |                         |       |                  |       |   |   |
| Diluted earnings per share                                                |       | $               | (252,357   | )                            | 3,184,068  |                  | $          | (.08 | ) |

 

Thefollowing table is a reconciliation of the numerators and denominators of thebasic and diluted per share computations for each of the six months ended June30, 2005 and June 30, 2004.

 
| ** **                                                              | ** ** | **Income**      | ** ** | **Weighted  Average Shares** | ** ** | **Per Share  Amount** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------|------------|------------------------------|------------|-----------------------|------------|
| ** **                                                              | ** ** | **(Numerator)** | ** ** | **(Denominator)**            | ** ** | ** **            | ** ** |
|                                                                    |       |            |       |                         |       |                  |       |
| Six Months Ended June 30, 2005 Income available to  common shareholders |       | $               | 8,640,753  |                         | 3,155,406  |                  | $          | 2.74 |   |
|                                                                    |       |            |       |                         |       |                  |       |
| Effect of dilutive securities – options                            |       |            |       | 8,015                        |       |                  |       |
|                                                                    |       |            |       |                         |       |                  |       |
| Diluted earnings per share                                              |       | $               | 8,640,753  |                         | 3,163,421  |                  | $          | 2.73 |   |
|                                                                    |       |            |       |                         |       |                  |       |
| Six Months Ended June 30, 2004 Income available to  common shareholders |       | $               | 105,255    |                         | 3,172,702  |                  | $          | 0.03 |   |
|                                                                    |       |            |       |                         |       |                  |       |
| Effect of dilutive securities – options                            |       |            |       | 17,327                       |       |                  |       |
|                                                                    |       |            |       |                         |       |                  |       |
| Diluted earnings per share                                              |       | $               | 105,255    |                         | 3,190,029  |                  | $          | 0.03 |   |

 

 

9

----

 

7.               Recently Issued Accounting Pronouncements

 

InDecember 2004, the FASB issued FAS 123R, which requires that compensationcosts relating to share-based payments be recognized in the Company’s financialstatements. The Company currently accounts for those payments under therecognition and measurement principles of Accounting Principles Board(APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” andrelated interpretations. The Company is preparing to implement this standardeffective January 1, 2006.  Althoughwe have not yet determined whether the adoption of 123(R) will result inamounts that are similar to the current pro form data, we expect the adoptionmay have a material impact on future financial statements.  This estimate is based on preliminaryinformation and could materially change based on the actual facts andcircumstances and the terms of future option grants.

 

 

ITEM 2.  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

**General**

 

FORWARD-LOOKINGSTATEMENTS

 

Thisreport, including, without limitation, “Item 2. Management’s Discussion andAnalysis of Financial Condition and Results of Operations,” contains orincorporates both historical and “forward-looking” statements within themeaning of Section 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities Exchange Act of 1934, as amended. Words suchas “anticipates”, “believes”, “expects”, “intends”, “future” and similarexpressions identify forward-looking statements.  Any such forward-looking statements in this reportreflect 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 performance of companies whosesecurities we have underwritten or otherwise sold to our customers may affectour reputation with other potential syndicate and selling group members andinstitutional and other retail accounts and may also affect the amount of moneyin our customers’ portfolios available for the kinds of investments that weoffer.

 

•                    The value of our investment portfolio,including the value of securities without a readily ascertainable market value,that we have estimated for the purpose of reporting on our financial conditionand results of operations, may be significantly and adversely affected bychanges in the value of the companies themselves or of comparable companieswhose stock values we use in estimating the value of our portfolio securities.

 

•                    We are subject to a very high degree ofregulation and are responsible for compliance with applicable regulations byall of our personnel.  A significantregulatory infraction by us or any of our registered representatives couldresult in significant penalties, including the loss of our license to conductsecurities business in one or more jurisdictions.

 

•                    Alternatives available to our customersto transact securities trades could affect our ability to continue to executeour brokerage customers’ transactions.

 

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

 

10

----

 

**Overview**

 

Substantiallyall of our business consists of the securities brokerage and investment bankingactivities of our wholly owned subsidiary, Paulson InvestmentCompany, Inc., or PIC.  PIC hasoperations in four principal categories, all of them in the financial servicesindustry.  These categories are:

 

•                    securities brokerage activities for whichPIC earns commission revenues;

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

•                    securities trading from which PIC recordsprofit or loss, depending on trading results; and

•                    investment income resulting from earningson, and increases or decreases in the value of, PIC’s investment portfolio.

 

Becausewe operate in the financial services industry, our revenues and earnings aresubstantially affected by general conditions in financial markets. In oursecurities brokerage and corporate finance business, the amount of our revenuesdepends on levels of market activity requiring the services we provide.  Our investment banking activity, whichconsists primarily of acting as the managing underwriter of initial and follow-onpublic offerings for smaller companies, is similarly affected by the strengthof the market for new equity offerings, which has historically experiencedsubstantial cyclical fluctuation. Although we attempt to match operating costs with activity levels, manyof our expenses are either fixed or difficult to change on short notice.  Accordingly, fluctuations in brokerage andinvestment banking revenues tend to result in sharper fluctuations, on apercentage basis, in net income or loss.

 

Ourinvestment income or loss and, to a lesser extent, our trading income or lossare affected by changes in market valuation of securities generally and, inparticular, by changes in valuation of the equity securities of microcapcompanies in which our investments and trading activities tend to beconcentrated.  Equity markets in general,and microcap equity markets in particular, have always experienced significantvolatility 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. The securities in the investment account areheld for investment, not actively traded, and not deemed part of operations inaccordance with management intentions.

 

Asubstantial portion of our investment banking business consists of acting asmanaging underwriter of initial and follow-on public offerings for microcapcompanies.  As a part of our compensationfor this activity, we typically receive warrants exercisable to purchasesecurities identical to those that we offer and sell to the public.  Generally, the warrants are not exercisablefor the first six months after the offering in which they are earned and arethereafter exercisable for four and one-half 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 atsome time more than six months and less than five years after the offering, thewarrants will remain “under water” and will ultimately expire unexercised.

 

### **CriticalAccounting Policies**

### ** **

Thefollowing discussion and analysis of our financial condition and results ofoperations is based upon our consolidated financial statements, which have beenprepared in accordance with US GAAP.  Inpreparing our consolidated financial statements, we must make estimates andjudgments that affect the reported amounts of assets and liabilities, revenuesand expenses, and related disclosure of contingent assets and liabilities atthe date of our financial statements. Actual results are likely to differ from these estimates under differentassumptions and conditions.

 

Thecritical accounting policies described below include those that reflectsignificant judgments and uncertainties, which potentially could producematerially different results under different assumptions and conditions.  We believe our critical accounting policiesare limited to those described below.

 

11

----

 

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

 

Weestimate the value of our underwriter warrants using the Black-Scholes OptionPricing Model. The Black-Scholes model requires us to use historical price datacombined with certain assumptions and judgments as inputs for the model.  The most influential factor in this model isprice volatility, which we calculate for each issuing company’s warrants basedon the respective company’s own historical stock price movements as well as anindex of historical prices for comparable companies.  When we initially receive a new underwriterwarrant from an initial public offering, its calculated volatility factor isentirely based on the volatility of an index of comparable companies, sincethere is no price history for a new publicly traded company.  As each underwriter warrant approaches itsexpiration date, its volatility factor is derived primarily from the historicalprices of its underlying common stock. We cannot assure you that we will ultimately be able to exercise any ofour warrants in a way that will realize the value that we attribute to them inour financial statements based on this model. As of June 30, 2005, ourunderwriter warrants, based on the Black-Scholes Option Pricing Model, werevalued at approximately $11.5 million, up from the estimated value of $9.4million as of December 31, 2004.

 

Inaddition to our underwriter warrants, we hold other securities, some of whichhave very limited liquidity and some of which do not have a readilyascertainable market value.  We arerequired to carry these securities at estimated fair value.

 

As aresult of the factors described above, our revenues and earnings are subject tosubstantial fluctuation from period to period based on circumstances, many ofwhich are beyond our control.  Anincrease in financial market activity generally, and/or an increase in equityvaluations generally, will normally result in increases in our revenues,earnings and net worth as our activity levels and the value of our investmentportfolio increase.  Conversely, ageneral market retrenchment will typically lead to decreased revenues, earningsand net worth as a result both of decreased activity and the need to adjusthigh investment portfolio values to lower levels.  Accordingly, results for any historicalperiod are not necessarily indicative of similar results for any future period.

 

**Resultsof Operations**

 

PIC’srevenues and operating results are influenced by fluctuations in the equityunderwriting markets as well as general economic and market conditions,particularly conditions in the over-the-counter market, where PIC’s investmentaccount, trading inventory positions and underwriter warrants are heavilyconcentrated.  Significant fluctuationscan occur in PIC’s revenues and operating results from one period to another.  PIC’s results of operations depend upon manyfactors, such as the number of companies that are seeking public financing, thequality and financial condition of those companies, market conditions ingeneral, the performance of previous PIC underwritings and interest in certainindustries by investors.  As a result,revenues and income derived from these activities may vary significantly fromyear to year.  In the tables below,“Corporate Finance” revenues are a function of total proceeds from offeringsdone during the period, compensation per offering, and the fair value of underwriterwarrants received.  “Investment Income”includes realized gains from the exercise of underwriter warrants, gains andlosses from the sales of investment securities, and unrealized gains and lossesfrom underwriter warrants and other investment securities.  “Trading Income” is the net gain or loss fromtrading positions before commissions paid to the representatives in the tradingdepartment.

 

 

12

----

 

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

 

**Three Months Ended June 30, 2005 v. June 30, 2004**

 
| ** **                         | ** ** | ** **              | ** ** | ** **         | ** ** | **Three Months Ended** | ** ** |
|------------------------------------|------------|-------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                         | ** ** | **Increase/(Decrease)** | ** ** | **Percent Change** | ** ** | **June 30, 2005**      | ** ** | **June 30, 2004** | ** ** |
| Revenues:                          |       |                    |       |               |       |                   |       |   |   |
| Sales  Commissions                 |       | $                       | (298,007   | )                  | (7.4       | )                      | $          | 3,743,269 |   | $ | 4,041,276 |   |
| Corporate  Finance                 |       | (1,755,714              | )          | (79.0              | )          | 465,970                |       | 2,221,684 |   |
| Investment  Income                 |       | 13,899,137              |       | N/A                |       | 12,361,430             |       | (1,537,707 | ) |
| Trading Income                     |       | 1,391,780               |       | 7,309.0            |       | 1,410,822              |       | 19,042 |   |
| Other                              |       | 11,028                  |       | 307.1              |       | 14,619                 |       | 3,591 |   |
|                               |       |                    |       |               |       |                   |       |   |   |
| Total                              |       | 13,248,224              |       | 279.0              |       | 17,996,110             |       | 4,747,886 |   |
|                               |       |                    |       |               |       |                   |       |   |   |
| Expenses:                          |       |                    |       |               |       |                   |       |   |   |
| Commissions and  Salaries          |       | 2,527,747               |       | 69.7               |       | 6,152,185              |       | 3,624,438 |   |
| Underwriting  Expenses             |       | (76,673                 | )          | (36.4              | )          | 134,172                |       | 210,845 |   |
| Rent,  Telephone & Quotes |       | (22,216                 | )          | (7.2               | )          | 285,601                |       | 307,817 |   |
| Other                              |       | 291,528                 |       | 28.8               |       | 1,302,686              |       | 1,011,158 |   |
|                               |       |                    |       |               |       |                   |       |   |   |
| Total                              |       | 2,720,386               |       | 52.8               |       | 7,874,644              |       | 5,154,258 |   |
|                               |       |                    |       |               |       |                   |       |   |   |
| Pretax Income  (Loss)              |       | $                       | 10,527,838 |               | N/A        |                   | $          | 10,121,466 |   | $ | (406,372 | )  |

 

 

**ThreeMonths Ended June 30, 2005 vs. Three Months Ended June 30, 2004**

 

**Revenues**

 

Totalrevenues for the second quarter of 2005 increased $13.2 million. As shown inthe table above, sales commissions—which are commissions generated from theretail stock brokerage business—decreased approximately $300,000 as a result oflackluster market performance and lower commissions associated with corporatefinance transactions. Sales commissions are also directly related to the numberof brokers engaged by the Company. The Company had 95 stockbrokers as of June30, 2005, as compared to 104 as of June 30, 2004, a decrease of approximately 9percent.

 

Corporatefinance revenue decreased $1.8 million, from the second quarter of 2004 to thesecond quarter of 2005. The Company completed two corporate financetransactions in the second quarter of 2004 with proceeds totaling $14.5million, as compared to one corporate finance transaction in the second quarterof 2005 with gross proceeds totaling $2.7 million. 

 

Investmentincome increased $13.9 million in the second quarter of 2005 as compared to thesecond quarter of 2004. Investment income can be volatile period-over-periodbased on the fact it is driven by the market value or fair value of thesecurities and underwriter warrants held by the Company. Investment incomeconsists of (1) the unrealized appreciation and depreciation of securitiesheld based on quoted market prices, (2) the unrealized appreciation anddepreciation of securities held that are not readily marketable, based upon theCompany’s estimate of their fair value, (3) the realized gain and loss onthe sale of securities with quoted market prices and securities that are notreadily marketable, and (4) the unrealized appreciation and depreciationof underwriter warrants held by the Company. The appreciation of underwriter warrants totaled approximately $322,000during the second quarter of 2005, as compared to the depreciation andexpiration of underwriter warrants of approximately $611,000 for the secondquarter of 2004. In addition, in the Company’s investment account, the holdingsin Charles & Colvard, Ltd., increased in value over $8.5 million andthe holdings in Daystar Technologies, Inc., increased in value over $1.8million during the second quarter of 2005. The Company has a concentration inCharles and Colvard with holdings approximating $21.3 million as of June 30,2005. The Company may sell Charles & Colvard, Ltd., and/or DaystarTechnologies, Inc., or any other security in its investment account any timedeemed appropriate. The remainder of the total investment income is the resultof the unrealized and realized appreciation of securities with quoted marketprices. There was no change in the estimated fair value of securities notreadily marketable during the second quarter of 2005. 

 

13

----

 

Tradingincome increased $1.4 million in the second quarter of 2005 as compared to thesecond quarter of 2004, as a result of exceptional performance from a couple ofthe Company’s market making securities. PIC’s focus is on very smallcapitalization issues, especially those tied to PIC’s corporate financeclients.

 

**Expenses**

 

Totalexpenses increased $2.7 million in the second quarter of 2005 from the secondquarter of 2004, an increase of 52.8 percent. The largest dollar increase was incommissions and salaries with an increase of $2.5 million in the second quarterof 2005 as compared to the second quarter of 2004. Commission expense increased$1.6 million as a result of higher commissions paid based on performance of theCompany’s investments. Administrative salary expense increased approximately$950,000 primarily as a result of second quarter bonus and profit sharingaccrual as compared to no bonus and profit sharing accrual during the secondquarter of 2004. Underwriting expenses decreased by approximately $77,000 inthe second quarter of 2005 from the second quarter of 2004 as a result of fewerand smaller corporate finance transactions in the second quarter of 2005. Otherexpenses increased approximately $290,000, or 28.8 percent. The increase inother expenses is primarily attributable to an approximate $131,000 increase inprofessional fees primarily associated with legal activity related tosettlements and an estimated $250,000 in settlement expense recorded in thesecond quarter of 2005. The remainder of the net increase in other expensesconsists of increases and decreases in various expense categories.

 

**Income**

 

TheCompany had pretax income of $10.1 million (56.2 percent of revenues) in thesecond quarter of 2005 compared to a pretax loss of approximately $406,000 inthe second quarter of 2004. Profitability, as a percentage of revenues,generally increases when a significant portion of the Company’s revenues isderived from investment income because fewer expenses are associated withinvestment income relative to the other revenue sources. Independent of thechange in the Black-Scholes value of the underwriter warrants and the incomeand expense associated with the receipt of the underwriter warrants, theCompany would have had pretax income totaling $9.6 million for the secondquarter of 2005, compared to pretax loss of approximately $750,000 for thesecond quarter of 2004. Because of the Black-Scholes value of underwriterwarrants and other factors, significant fluctuations often occur in PIC’srevenues and operating results from one period to another.

 

 

14

----

 

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

 

**Six Months Ended June 30, 2005 v. June 30, 2004**

 
| ** **                         | ** ** | ** **              | ** ** | ** **         | ** ** | **Six Months Ended** | ** ** |
|------------------------------------|------------|-------------------------|------------|--------------------|------------|----------------------|------------|
| ** **                         | ** ** | **Increase/(Decrease)** | ** ** | **Percent Change** | ** ** | **June 30, 2005**    | ** ** | **June 30, 2004** | ** ** |
| Revenues:                          |       |                    |       |               |       |                 |       |   |   |
| Sales  Commissions                 |       | $                       | (1,394,581 | )                  | (15.0      | )                    | $          | 7,884,326 |   | $ | 9,278,907 |   |
| Corporate  Finance                 |       | (5,645,217              | )          | (90.6              | )          | 585,955              |       | 6,231,172 |   |
| Investment  Income                 |       | 21,052,911              |       | N/A                |       | 17,513,929           |       | (3,538,982 | ) |
| Trading Income                     |       | 1,649,589               |       | 356.1              |       | 2,112,826            |       | 463,237 |   |
| Other                              |       | 24,175                  |       | 259.8              |       | 33,479               |       | 9,304 |   |
|                               |       |                    |       |               |       |                 |       |   |   |
| Total                              |       | 15,686,877              |       | 126.1              |       | 28,130,515           |       | 12,443,638 |   |
|                               |       |                    |       |               |       |                 |       |   |   |
| Expenses:                          |       |                    |       |               |       |                 |       |   |   |
| Commissions and  Salaries          |       | 1,119,002               |       | 12.0               |       | 10,406,189           |       | 9,287,187 |   |
| Underwriting  Expenses             |       | (329,131                | )          | (71.0              | )          | 134,172              |       | 463,303 |   |
| Rent,  Telephone & Quotes |       | (19,261                 | )          | (3.2               | )          | 592,099              |       | 611,360 |   |
| Other                              |       | 684,505                 |       | 35.8               |       | 2,596,800            |       | 1,912,295 |   |
|                               |       |                    |       |               |       |                 |       |   |   |
| Total                              |       | 1,455,115               |       | 11.9               |       | 13,729,260           |       | 12,274,145 |   |
|                               |       |                    |       |               |       |                 |       |   |   |
| Pretax Income                      |       | $                       | 14,231,762 |               | 8,396.7    |                 | $          | 14,401,255 |   | $ | 169,493 |   |

 

** **

**SixMonths Ended June 30, 2005 vs. Six Months Ended June 30, 2004**

 

**Revenues**

 

Totalrevenues for the first half of 2005 increased $15.7 million. As shown in thetable above, sales commissions decreased $1.4 million as a result of lacklustermarket performance and the lack of commissions associated with corporatefinance transactions. The Russell 2000 Index decreased 1.8 percent during thefirst half of 2005 and the Nasdaq Composite Index decreased 5.4 percent duringthe same period. 

 

Corporatefinance revenue decreased $5.6 million for the first half of 2005, from thesame comparable period in the prior year. The Company completed four corporatefinance transactions in the first six months of 2004 with gross proceedstotaling $34.5 million, compared with one corporate finance transaction duringthe first six months of 2005 with gross proceeds totaling $2.7 million. Inaddition, during the first half of 2005 the Company had a small privateplacement and participated in a few small transactions in which anotherinvestment banking firm was the lead underwriter. Market conditions haveresulted in a more challenging IPO market during the first half of 2005 ascompared to the prior year. 

 

Investmentincome increased $21.1 million in the first half of 2005 as compared to thefirst half of 2004. Investment income can be volatile period-over-period basedon the fact it is driven by the market value or fair value of the securitiesand underwriter warrants held by the Company. Investment income consists of(1) the unrealized appreciation and depreciation of securities held basedon quoted market prices, (2) the unrealized appreciation and depreciationof securities held that are not readily marketable, based upon the Company’sestimate of their fair value, , (3) the realized gain and loss on the saleof securities with quoted market prices and securities that are not readilymarketable, and (4) the unrealized appreciation and depreciation ofunderwriter warrants held by the Company. The appreciation of underwriter warrants totaled $1.9 million during thefirst half of 2005, as compared to the depreciation and expiration ofunderwriter warrants of $2.3 million for the first half of 2004. In theCompany’s investment account, the holdings of Charles & Colvard, Ltd.,increased in value $10.0 million during the first half of 2005, in addition tosignificant increases in several other holdings of the Company. The Company maysell Charles & Colvard, Ltd., or any other security in its investmentaccount any time deemed appropriate. The remainder of the total investmentincome is the result of the unrealized and realized appreciation of securitieswith quoted market prices. There was no change in the estimated fair value ofsecurities not readily marketable during the first half of 2005.

 

15

----

 

Tradingincome increased $1.6 million in the first half of 2005 as compared to thefirst half of 2004, as a result of exceptional performance from a couple of theCompany’s market making securities. PIC’s focus is on very small capitalizationissues, especially those tied to PIC’s corporate finance clients.

 

**Expenses**

 

Totalexpenses increased $1.5 million in the first six months of 2005 as compared tothe same time period in 2004, an increase of 11.9 percent. The largest dollarincrease was in commissions and salaries with an increase of $1.1 million inthe first half of 2005. Commission expense increased approximately $800,000 asa result of higher commissions paid based on performance of the Company’sinvestments. Administrative salary expense increased approximately $315,000 asa result of (1) accrued profit sharing and bonus amount of $1.3 million for thefirst half of 2005 with no comparable expense for the first half of 2004, (2) adecrease of approximately $960,000 in compensation expense associated with thereceipt of underwriter warrants during the first half of 2005 as compared tothe same period in the prior year, and (3) additional salary expense.Underwriting expenses decreased by approximately $330,000 from the first halfof 2004 as a result of fewer corporate finance transactions in the 2005 period.Other expenses increased approximately $685,000 or 35.8 percent. The increasein other expenses is primarily attributable to an approximate $310,000 increasein professional fees primarily associated with legal activity related tosettlements and an increase of $485,000 in estimated settlement expense. Theremainder of the net increase in other expenses consists of increases anddecreases in various expense categories.

 

**Income**

 

TheCompany had pretax income of $14.4 million (51.2 percent of revenues) in thefirst half of 2005 compared to pretax income of approximately $170,000 in thefirst half of 2004. Profitability, as a percentage of revenues, generallyincreases when a significant portion of the Company’s revenues is derived frominvestment income because fewer expenses are associated with investment incomerelative to the other revenue sources. Independent of the change in theBlack-Scholes value of the underwriter warrants and the income and expenseassociated with the receipt of the underwriter warrants, the Company would havehad pretax income totaling $12.3 million for the first half of 2005, comparedto pretax loss of approximately $700,000 for the first half of 2004. Because ofthe Black-Scholes value of underwriter warrants and other factors, significantfluctuations often occur in PIC’s revenues and operating results from oneperiod to another.

 

**Liquidityand Capital Resources**

 

The majority of PIC’s assets are cash and assetsreadily convertible to cash.  PIC’ssecurities inventory is stated at market value for the securities that arereadily marketable and estimated fair value for the securities that are notreadily marketable. The liquidity of the market for many of PIC’s securitiesholdings, 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.

 

 

16

----

 

PICborrows money from National Financial Services, its clearing firm, in theordinary course of its business, pursuant to an understanding under which theclearing firm agrees to finance PIC’s trading accounts.  As of June 30, 2005, no net loans wereoutstanding pursuant to this arrangement. PIC and the Company are generally able to meet their compensation andother 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, 2005, PIC owned 16 underwriter warrants, all but two of which werethen exercisable; five had an exercise price below the June 30, 2005 marketprice of the securities receivable upon exercise. In the six months ended June30, 2005, the Company exercised a total of six underwriter warrants. Theintrinsic value of these five warrants is $4.2 million. There is little or nodirect relationship between the intrinsic value of PIC’s underwriter warrantsat the end of any given period and the fair value calculated using theBlack-Scholes pricing model, as described more fully in Critical AccountingPolicies above. The prices of these securities are influenced by generalmovements in the prices of OTC securities as well as the success of the issuersof the underwriter warrants.  The pricesof the securities underlying the underwriter warrants are very volatile, andsubstantial fluctuations in the Company’s estimate of their value can beexpected in the future.

 

In thesix months ended June 30, 2005, approximately $1.1 million of net cash wasprovided by operating activities.  Themajor adjustments to reconcile this result to the Company’s net income includethe following items that are positive adjustments to or provided cash tooperating activities: an increase in deferred income taxes of $5.8 million; anincrease in accounts payable and accrued liabilities of approximately $323,000;and an increase of income taxes receivable/payable of approximately $861,000.The following items are negative adjustments to or a use of cash for operatingactivities: appreciation of underwriter warrants totaling $1.9 million; anincrease in trading and investment securities of approximately $11.0 million;and an increase in receivables of $1.0 million. Net cash used in investingactivities in the first six months of 2005 was for additions to furniture andequipment of approximately $72,000. Net cash used in financing activities in thefirst six months of 2005 approximated $1.0 million, primarily resulting fromapproximately $477,000 in dividends paid to common shareholders andapproximately $600,000 in payments to retire common stock.

 

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

 

AtJune 30, 2005, the Company had no material commitments for capitalexpenditures.

 

Ingeneral, the primary sources of PIC’s, and therefore the Company’s, liquidityinclude PIC’s trading positions, borrowings on those positions and profitsrealized upon the exercise of underwriter warrants. All of these sources dependin large part on the trend in the general markets for OTC securities.  Rising OTC price levels will tend to increasethe value and liquidity of PIC’s trading positions, the amount that can beborrowed from National Financial Services based upon those positions, and thevalue of PIC’s underwriter warrants.  TheCompany believes its liquidity is sufficient to meet its needs for both theshort and long term horizon. The Company’s liquidity could be affected byprotracted unfavorable market conditions.

 

**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 investmentaccount, it may adversely affect the Company’s financial position and resultsof operations.

 

17

----

 

ITEM 3. QUANTITATIVE ANDQUALITATIVE DISCLOSURE OF MARKET RISK

 

Market risk is the riskof loss to the Company resulting primarily from changes in equity prices and toa significantly lesser extent, interest rates and foreign currency rates.  The Company has exposure to market riskthrough the market-making and trading operations of PIC, its broker-dealersubsidiary.  In connection with theseactivities, PIC maintains inventories in order to ensure availability ofsecurities and to facilitate client transactions as well as trading for its ownproprietary equity investment account. PIC was a market-maker for 43 equity securities from 39 differentissuers and no tax exempt or taxable debt obligations at June 30, 2005.

 
| ** **                                                        | ** ** | **June 30, 2005**                       | ** ** | **December 31, 2004**                 | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                        | ** ** | **Trading and  investment  securities** | ** ** | **Securities sold but  not yet purchased** | ** ** | **Trading and  investment  securities** | ** ** | **Securities sold but  not yet purchased** | ** ** |
| Marketable  equity and other securities at fair value             |       | $                                       | 34,643,598 |                                       | $          | 17,168 |   | $ | 23,583,728 |   | $ | 50,144 |   |
|                                                              |       |                                    |       |                                       |       |   |   |   |   |
| Marketable debt  securities                                       |       | 103,444                                 |       | —                                     |       | 220,243 |   | — |   |
|                                                              |       |                                    |       |                                       |       |   |   |   |   |
| Total marketable  equity, debt and other securities at fair value |       | $                                       | 34,747,042 |                                       | $          | 17,168 |   | $ | 23,803,971 |   | $ | 50,144 |   |

 

Changes in the value ofPIC’s trading inventories and its proprietary investment accounts resultprimarily from fluctuations in equity prices as well as changes in interestrates and general market and economic conditions.  PIC’s primary method of controlling risk inits trading inventories and investment accounts is through daily monitoring anduse of position limits.  PIC’s tradinginventories consist primarily of Nasdaq equity securities: as of June 30, 2005,the equity trading inventory limit was $2 million and the fixed income limitwas $500,000.  PIC’s trading activitieswere within these limits at June 30, 2005. Position limits in trading inventory accounts are monitored on a dailybasis as are limit exceptions.  Debtobligation trading inventories are relatively small, since, for the most part,these securities are purchased only upon orders from customers.   Consolidated positions and exposure reportsare prepared and reviewed monthly by the Senior Vice President of Trading.  Trading also monitors inventory levels andtrading results on a monthly basis, with particular focus on positionconcentration, liquidity and volatility. Trading prepares summary results every month to record each position atfair market value, which can require adjustments for lack of liquidity, highconcentration or other reasons.

 

Equity Price Risk

 

PIC is exposed tosignificant equity price risk as a result of its customer transactions andmarket-making activity in equity securities and its concentrations in a limitednumber of equities, many of which are related to its investment bankingprojects.  PIC’s broker-dealer activitiesare client-driven, with the objective of meeting its clients’ needs whileearning a trading profit to compensate for the risk associated with carryinginventories in equities, many of which are volatile, and some of which areilliquid, micro and small cap securities. PIC attempts to reduce the risk of loss inherent in this activity bymonitoring these securities positions continuously throughout each day. Theaverage aggregate inventory held in PIC’s proprietary investment accountsduring the quarter ended June 30, 2005 was approximately $29.7 million. Pricesof the marketable equities held in these accounts are readily available andmonitored on a continuous basis.

 

18

----

 

Interest Rate Risk

 

 PIC has very little direct exposure tointerest rate risk.  A relatively minoramount of PIC’s trading inventory consists of debt obligations, and any ofthese positions PIC might have occasionally are in its trading inventory foronly a very short time.  However, to theextent that interest rate fluctuations affect general market conditions andcause investors to shift away from or more heavily into equity investing,interest rates can have an effect on the value of PIC’s equity positions.

 

Foreign Currency Risk

 

PIC does not deal insecurities denominated in foreign currencies and only trades foreign equitiesupon receipt of an order from customers, so it does not have any significantexposure to foreign currency risk in its trading inventory or investmentaccounts.

 

ITEM 4.  CONTROLS AND PROCEDURES

 

(a)           Our management, with theparticipation of our President and Chief Financial Officer, conducted anevaluation of our disclosure controls and procedures, as such terms are definedunder Rules 13a-15(e) and 15d-15(e) promulgatedunder the Securities Exchange Act of 1934, as amended, as of the end of theperiod covered by this report. Based on their evaluation, our President and ChiefFinancial Officer concluded that our disclosure controls and procedures wereeffective.

 

(b)           For the quarter ended June 30, 2005,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.

 

 

19

----

 

**PART II****OTHER INFORMATION**

 

Item 1. LegalProceedings.

 

SeeNote 4 to Condensed Consolidated Financial Statements in Part I.

 

Item 2. Unregistered Sales of Equity Securities and Use ofProceeds.

 

**Issuer Purchases of Equity Securities**

 
| **Period**           | ** ** | **(a)**

**Paulson Capital  Corp. Total  Number of Shares  Purchased** | ** ** | **(b)**

**Paulson Capital Corp.  Average Price Paid  per Share** | ** ** | **(c)**

**Total Number of  Shares  Purchased as Part of  Publicly Announced  Plans  or Programs** | ** ** | **(d)**

**Maximum Number of  Shares that May Yet  Be Purchased Under  The Plans or  Programs** | ** ** |
|----------------------|------------|------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|
| 04/01/05 to 04/30/05 |       | 52,644                                                                 |       | $                                                                 | 8.03       |                                                                                                    | 2,249      |                                                                                                 | 204,275    |   |
| 05/01/05 to 05/31/05 |       | None                                                                   |       | N/A                                                               |       | N/A                                                                                                     |       | 204,275                                                                                              |       |
| 06/01/05 to 06/30/05 |       | 4,500                                                                  |       | $                                                                 | 10.66      |                                                                                                    | 2,000      |                                                                                                 | 202,275    |   |
| Total                |       | 57,144  (1)                                                            |       | $                                                                 | 8.22       |                                                                                                    | 4,249      |                                                                                                 | 202,275    |   |

 

All of the shares reflected in column (c) wereopen-market transactions as part of a corporate plan for stock repurchase. Thestock repurchase plan, approved by the board of directors on September 17,2001, authorizes the repurchase of up to 300,000 shares. There is no expirationdate on the stock repurchase plan.

 

(1) Of these 57,144 shares, 52,895 were purchasedfrom executive officers and employees of the Company (and their affiliates),not as open-market purchases, at an average price of $8.21 per share.

 

Item3. Defaults upon Senior Securities.

 

None

 

20

----

 

Item 4. Submission ofMatters to a Vote of Security Holders.

 

On June 9, 2005, the Company held its annual meeting of stockholders toelect five directors. The directors elected at the meeting were Chester L.F.Paulson, Jacqueline M. Paulson, Steve Kleeman, Shannon P. Pratt, and Paul F.Shoen. The number of votes cast for or withheld for each candidate is asfollows:

 
| ** **             | ** ** | **For**   | ** ** | **Withheld** | ** ** |
|------------------------|------------|-----------|------------|--------------|------------|
| Chester  L. F. Paulson |       | 3,016,019 |       | 46,390       |       |
| Jacqueline  M. Paulson |       | 3,019,119 |       | 43,290       |       |
| Steve  Kleemann        |       | 3,061,309 |       | 1,100        |       |
| Shannon  Pratt         |       | 3,058,209 |       | 4,200        |       |
| Paul  Schoen           |       | 3,058,209 |       | 4,200        |       |

 

 

Item 5. OtherInformation.

 

None

 

Item 6. 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.     |

 

 

21

----

 

**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,  2005 | By:                    | /s/ CHESTER L.F.  PAULSON |
|                   |                   | Chester L.F.  Paulson |
|                   |                   | President  Principal Executive Officer |
|                   |                   |   |
| Date: August 12,  2005 | By:                    | /s/ CAROL RICE |
|                   |                   | Carol Rice |
|                   |                   | Chief Financial  Officer  Principal Financial Officer |

 

 

 

22

----