**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

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**FORM 10-Q**

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

 

**For the quarterly period ended September 30, 2006**

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

**EXCHANGE ACT OF 1934** |
|-------|----------------------------------------------------------------------------------------------------|

 

**For the transition periodfrom              to              **

**Commission file number: 0-18188**

**PAULSONCAPITAL CORP.**

(Exact name ofregistrant as specified in its charter)

| **Oregon**                      |   | **93-0589534**                       |
|---------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of |   | (I.R.S. Employer Identification No.) |
| incorporation or organization)  |   |                                 |

 

| **811 SW Naito Parkway, Portland, Oregon** |   | **97204**  |
|--------------------------------------------|--------|------------|
| (Address of principal executive offices)   |   | (Zip Code) |

 

Registrant’s telephone number, including areacode:  **503-243-6000**

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Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes  x   No  o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer or a non-accelerated filer. See definition of “acceleratedfiler” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. Largeaccelerated filer o Acceleratedfiler o Non-accelerated filer x

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).  Yes  o   No  x

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

| Common stock, no par value |   | 6,167,132                           |
|----------------------------|--------|-------------------------------------|
| (Class)                    |   | (Outstanding at  November 10, 2006) |

 

 

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**PAULSON CAPITAL CORP. ANDSUBSIDIARY**

**FORM 10-Q**

**INDEX**
| PART I - FINANCIAL  INFORMATION |                                                                                                          |
|---------------------------------|---------------------------------------------------------------------------------------------------------------|
|                            |                                                                                                          |   |
| Item 1.                         | Financial Statements                                                                                          |   |
|                            |                                                                                                          |   |
|                            | Consolidated Balance  Sheets - September 30, 2006 and December 31, 2005 (unaudited)                           |   |
|                            |                                                                                                          |   |
|                            | Consolidated  Statements of Operations - Three and Nine Months Ended September 30, 2006 and  2005 (unaudited) |   |
|                            |                                                                                                          |   |
|                            | Consolidated  Statements of Cash Flows - Nine Months Ended September 30, 2006 and 2005  (unaudited)           |   |
|                            |                                                                                                          |   |
|                            | Notes to  Consolidated Financial Statements (unaudited)                                                       |   |
|                            |                                                                                                          |   |
| 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  1A.                       | Risk  Factors                                                                                                 |   |
|                            |                                                                                                          |   |
| Item 2.                         | Unregistered  Sales of Equity Securities and Use of Proceeds                                                  |   |
|                            |                                                                                                          |   |
| Item  6.                        | Exhibits                                                                                                      |   |
|                            |                                                                                                          |   |
| Signatures                      |                                                                                                          |

 

1

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**PART I - FINANCIAL INFORMATION**

**Item 1.Financial Statements**

**Paulson Capital Corp. andSubsidiary**

**Consolidated Balance Sheets**
| ** **                                                                                                         | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                         | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| ** **                                                                                                         | ** ** | **(Unaudited)**        | ** ** | ** **            | ** ** |
| **Assets**                                                                                                         | ** ** | ** **             | ** ** | ** **            | ** ** |
| Cash and cash  equivalents                                                                                         |       | $                      | 119,041    |                  | $          | 129,549 |   |
| Receivable from  clearing organization                                                                             |       | 4,777,941              |       | 12,608,491            |       |
| Notes and other  receivables                                                                                       |       | 1,958,396              |       | 1,081,528             |       |
| Income taxes  receivable                                                                                           |       | 143,197                |       | —                |       |
| Trading  securities, at market value                                                                               |       | 2,455,157              |       | 1,558,564             |       |
| Investment  securities, at market value                                                                            |       | 21,328,018             |       | 32,401,808            |       |
| Underwriter  warrants, at estimated fair value                                                                     |       | 4,545,000              |       | 6,275,000             |       |
| Prepaid and  deferred expenses                                                                                     |       | 493,115                |       | 674,328               |       |
| Furniture and  equipment, net                                                                                      |       | 295,792                |       | 265,791               |       |
|                                                                                                               |       |                   |       |                  |       |
| Total Assets                                                                                                       |       | $                      | 36,115,657 |                  | $          | 54,995,059 |   |
|                                                                                                               |       |                   |       |                  |       |
| **Liabilities and Shareholders’  Equity**                                                                     | ** ** | ** **             | ** ** | ** **            | ** ** |
| Accounts payable  and accrued liabilities                                                                          |       | $                      | 756,490    |                  | $          | 1,243,866 |   |
| Payable to  clearing organization                                                                                  |       | 166,775                |       | 3,182,347             |       |
| Compensation,  employee benefits and payroll taxes                                                                 |       | 679,705                |       | 2,105,259             |       |
| Securities sold,  not yet purchased, at market value                                                               |       | 2,955                  |       | 23,033                |       |
| Dividends  payable                                                                                                 |       | —                 |       | 929,317               |       |
| Income taxes  payable                                                                                              |       | —                 |       | 2,338,218             |       |
| Deferred revenue                                                                                                   |       | 500,000                |       | —                |       |
| Deferred income  taxes                                                                                             |       | 466,542                |       | 5,408,000             |       |
|                                                                                                               |       |                   |       |                  |       |
| Total  Liabilities                                                                                                 |       | 2,572,467              |       | 15,230,040            |       |
|                                                                                                               |       |                   |       |                  |       |
| **Commitments and Contingencies**                                                                                  |       | —                 |       | —                |       |
|                                                                                                               |       |                   |       |                  |       |
| **Shareholders’ Equity**                                                                                      |       |                   |       |                  |       |
| Preferred stock,  no par value; 500,000 shares authorized; none issued                                             |       | —                 |       | —                |       |
| Common stock, no  par value; 20,000,000 shares authorized; shares issued and outstanding: 6,167,132  and 6,195,448 |       | 1,831,266              |       | 1,817,100             |       |
| Retained  earnings                                                                                                 |       | 31,711,924             |       | 37,947,919            |       |
| Total  Shareholders’ Equity                                                                                   |       | 33,543,190             |       | 39,765,019            |       |
|                                                                                                               |       |                   |       |                  |       |
| Total Liabilities and  Shareholders’ Equity                                                                   |       | $                      | 36,115,657 |                  | $          | 54,995,059 |   |

 

See accompanyingNotes to Consolidated Financial Statements.

2

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**Paulson Capital Corp. andSubsidiary**

**ConsolidatedStatements of Operations**

**(Unaudited)**
| ** **                              | ** ** | **For the Three Months Ended September 30,** | ** ** | **For the Nine Months Ended September 30,** | ** ** |
|-----------------------------------------|------------|----------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                              | ** ** | **2006**                                                                   | ** ** | **2005**                                                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Revenues**                            |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Commissions                             |       | $                                                                          | 3,156,476  |                                                                      | $          | 4,335,517 |   | $ | 11,335,870 |   | $ | 12,219,843 |   |
| Corporate finance                       |       | 1,414,620                                                                  |       | 2,176,018                                                                 |       | 4,646,808 |   | 2,761,973 |   |
| Investment income (loss)                |       | (3,170,780                                                                 | )          | 820,278                                                                   |       | (8,259,811 | ) | 18,334,207 |   |
| Trading income (loss)                   |       | (1,595,605                                                                 | )          | 755,231                                                                   |       | (1,814,315 | ) | 2,868,057 |   |
| Interest and dividends                  |       | 15,203                                                                     |       | 8,661                                                                     |       | 41,367 |   | 30,806 |   |
| Other                                   |       | (680                                                                       | )          | 9,544                                                                     |       | 934 |   | 20,878 |   |
|                                    |       | (180,766                                                                   | )          | 8,105,249                                                                 |       | 5,950,853 |   | 36,235,764 |   |
|                                    |       |                                                                       |       |                                                                      |       |   |   |   |   |
| **Expenses**                            |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Commissions and salaries                |       | 3,314,795                                                                  |       | 5,461,956                                                                 |       | 11,759,338 |   | 15,868,145 |   |
| Underwriting expenses                   |       | 188,579                                                                    |       | 76,078                                                                    |       | 356,025 |   | 210,250 |   |
| Rent, telephone and quotation services  |       | 307,326                                                                    |       | 291,249                                                                   |       | 893,592 |   | 883,348 |   |
| Professional fees                       |       | 155,774                                                                    |       | 425,406                                                                   |       | 606,151 |   | 1,214,522 |   |
| Travel and entertainment                |       | 45,722                                                                     |       | 14,161                                                                    |       | 299,061 |   | 175,230 |   |
| Advertising and promotion               |       | 47,542                                                                     |       | 75,938                                                                    |       | 133,245 |   | 221,248 |   |
| Settlement expense                      |       | 185,461                                                                    |       | (175,000                                                                  | )          | 190,211 |   | 343,543 |   |
| Depreciation and amortization           |       | 29,032                                                                     |       | 22,559                                                                    |       | 73,509 |   | 68,319 |   |
| Other                                   |       | 367,655                                                                    |       | 709,491                                                                   |       | 1,068,688 |   | 1,646,493 |   |
|                                    |       | 4,641,886                                                                  |       | 6,901,838                                                                 |       | 15,379,820 |   | 20,631,098 |   |
|                                    |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Income (loss)  before income taxes      |       | (4,822,652                                                                 | )          | 1,203,411                                                                 |       | (9,428,967 | ) | 15,604,666 |   |
|                                    |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Income tax  expense (benefit):          |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Current                                 |       | (580,503                                                                   | )          | 1,956,954                                                                 |       | 1,534,136 |   | 1,956,954 |   |
| Deferred                                |       | (1,025,833                                                                 | )          | (1,491,288                                                                | )          | (4,941,458 | ) | 4,269,214 |   |
|                                    |       | (1,606,336)                                                                |       | 465,666                                                                   |       | (3,407,322 | ) | 6,226,168 |   |
|                                    |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Net income  (loss)                      |       | $                                                                          | (3,216,316 | )                                                                         | $          | 737,745 |   | $ | (6,021,645 | ) | $ | 9,378,498 |   |
|                                    |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Basic net income  (loss) per share      |       | $                                                                          | (0.52      | )                                                                         | $          | 0.12 |   | $ | (0.97 | ) | $ | 1.49 |   |
|                                    |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Diluted net  income (loss) per share    |       | $                                                                          | (0.52      | )                                                                         | $          | 0.12 |   | $ | (0.97 | ) | $ | 1.49 |   |
|                                    |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Shares used in  per share calculations: |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Basic                                   |       | 6,167,621                                                                  |       | 6,226,442                                                                 |       | 6,180,099 |   | 6,282,470 |   |
| Diluted                                 |       | 6,167,621                                                                  |       | 6,259,444                                                                 |       | 6,180,099 |   | 6,315,350 |   |

 

See accompanyingNotes to Consolidated Financial Statements.

3

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**Paulson Capital Corp. andSubsidiary**

**ConsolidatedStatements of Cash Flows**

**(Unaudited)**
| ** **                                                                                      | ** ** | **For the Nine Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2006**                                                                  | ** ** | **2005** | ** ** |
| ** **                                                                                      | ** ** | ** **                                                                | ** ** | ** ** | ** ** |
| **Cash  flows from operating activities:**                                                      |       |                                                                      |       |   |   |
| Net income (loss)                                                                               |       | $                                                                         | (6,021,645 | ) | $ | 9,378,498 |   |
| Adjustments to reconcile net income (loss) to net  cash flows provided by operating activities: |       |                                                                      |       |   |   |
| Receipt of underwriter warrants                                                                 |       | (2,771,247                                                                | )          | (1,759,264 | ) |
| Unrealized depreciation/expiration of underwriter  warrants                                     |       | 3,609,357                                                                 |       | 3,271,723 |   |
| Noncash compensation associated with underwriter  warrants                                      |       | 891,890                                                                   |       | 408,541 |   |
| Depreciation and amortization                                                                   |       | 73,509                                                                    |       | 68,319 |   |
| Deferred income taxes                                                                           |       | (4,941,458                                                                | )          | 4,305,690 |   |
| Loss on disposal of furniture and equipment                                                     |       | 7,613                                                                     |       | — |   |
| Change in assets and liabilities                                                                |       |                                                                      |       |   |   |
| Receivables from/payable to clearing organization                                               |       | 4,814,978                                                                 |       | (499,157 | ) |
| Notes and other receivables                                                                     |       | (876,868                                                                  | )          | (818,032 | ) |
| Trading and investment securities                                                               |       | 10,177,197                                                                |       | (16,460,162 | ) |
| Prepaid and deferred expenses                                                                   |       | 181,213                                                                   |       | 222,964 |   |
| Accounts payable, accrued liabilities and  compensation payables                                |       | (1,912,930                                                                | )          | 599,886 |   |
| Dividends payable                                                                               |       | (929,317                                                                  | )          | — |   |
| Securities sold, not yet purchased                                                              |       | (20,078                                                                   | )          | 21,721 |   |
| Deferred revenue                                                                                |       | 500,000                                                                   |       | — |   |
| Income taxes payable/receivable                                                                 |       | (2,481,415                                                                | )          | 2,775,340 |   |
| Net cash provided by operating activities                                                       |       | 300,799                                                                   |       | 1,516,067 |   |
|                                                                                            |       |                                                                      |       |   |   |
| **Cash  flows from investing activities:**                                                      |       |                                                                      |       |   |   |
| Additions to furniture and equipment                                                            |       | (111,123                                                                  | )          | (96,387 | ) |
|                                                                                            |       |                                                                      |       |   |   |
| **Cash  flows from financing activities:**                                                      |       |                                                                      |       |   |   |
| Proceeds from stock option exercise                                                             |       | 21,030                                                                    |       | 61,530 |   |
| Dividends paid to common shareholders                                                           |       | —                                                                    |       | (476,564 | ) |
| Payments to retire common stock                                                                 |       | (221,214                                                                  | )          | (871,347 | ) |
| Net cash used in financing activities                                                           |       | (200,184                                                                  | )          | (1,286,381 | ) |
|                                                                                            |       |                                                                      |       |   |   |
| Increase  (decrease) in cash and cash equivalents                                               |       | (10,508                                                                   | )          | 133,299 |   |
|                                                                                            |       |                                                                      |       |   |   |
| **Cash  and cash equivalents:**                                                                 |       |                                                                      |       |   |   |
| Beginning of period                                                                             |       | 129,549                                                                   |       | 132,845 |   |
|                                                                                            |       |                                                                      |       |   |   |
| End of period                                                                                   |       | $                                                                         | 119,041    |   | $ | 266,144 |   |
|                                                                                            |       |                                                                      |       |   |   |
| **Supplemental  cash flow information:**                                                        |       |                                                                      |       |   |   |
| Cash paid during  the period for income taxes                                                   |       | $                                                                         | 4,015,551  |   | $ | 16,416 |   |
| Cash paid during the  period for interest                                                       |       | —                                                                    |       | 421 |   |

 

See accompanyingNotes to Consolidated Financial Statements.

4

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**PAULSONCAPITAL CORP. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

**Note 1. Basis of Presentation**

Thefinancial information for Paulson Capital Corp. and its wholly-ownedsubsidiary, Paulson Investment Company, included herein as of September 30,2006 and December 31, 2005 and for the three and nine-month periods endedSeptember 30, 2006 and 2005 is unaudited; however, such information reflectsall adjustments, consisting only of normal recurring adjustments, which, in theopinion of management, are necessary for a fair presentation of the financialposition, results of operations and cash flows for the interim periods. Thefinancial information as of December 31, 2005 is derived from our 2005 AnnualReport on Form 10-K. The interim consolidated financial statements should beread in conjunction with the consolidated financial statements and the notesthereto included in our 2005 Annual Report on Form 10-K. The results ofoperations for the interim periods presented are not necessarily indicative ofthe results to be expected for the full year.

**Note 2. Dividend**

Pursuantto a December 22, 2005 authorization by our Board of Directors, in February2006, we paid a special cash dividend of $0.30 per share to shareholders ofrecord on January 17, 2006. The dividend paid totaled $0.9 million.

**Note 3. Stock Split**

OnMarch 1, 2006, we announced that our Board of Directors approved a two-for-onestock split of our common stock to be effected in the form of a stock dividend.The stock split was effected on March 29, 2006 by issuing one additional shareof common stock for each share of common stock outstanding on March 15, 2006.All prior share and per share amounts have been adjusted for this stock split.Basic and diluted net income per share were adjusted as follows for the threeand nine-month periods ended September 30, 2005:
|                                                                       | ** ** | **Three Months  Ended  September 30,  2005** | ** ** | **Nine Months  Ended  September 30,  2005** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Basic net income per share, as previously reported                    |       | $                                                      | 0.24       |                                                  | $          | 2.99 |   |
| Basic net income per share, as adjusted                               |       | $                                                      | 0.12       |                                                  | $          | 1.49 |   |
|                                                                  |       |                                                   |       |                                                  |       |
| Diluted net income per share, as previously reported                  |       | $                                                      | 0.24       |                                                  | $          | 2.97 |   |
| Diluted net income per share, as adjusted                             |       | $                                                      | 0.12       |                                                  | $          | 1.49 |   |
|                                                                  |       |                                                   |       |                                                  |       |
| Shares used for basic net income per share, as previously  reported   |       | 3,113,221                                              |       | 3,141,235                                             |       |
| Shares used for basic net income per share, as  adjusted              |       | 6,226,442                                              |       | 6,282,470                                             |       |
|                                                                  |       |                                                   |       |                                                  |       |
| Shares used for diluted net income per share, as  previously reported |       | 3,129,722                                              |       | 3,157,675                                             |       |
| Shares used for diluted net income per share, as  adjusted            |       | 6,259,444                                              |       | 6,315,350                                             |       |

 

**Note 4. Commitments and Contingencies **

InOctober 2002, we were named as a defendant in a lawsuit filed by SpecialSituations Fund III, LP and Special Situations Cayman Fund, LP. The lawsuit wasfiled in the U.S. District Court for the District of New Jersey. It assertsvarious federal securities law claims and common law fraud and negligentmisrepresentation against numerous defendants, including us, arising out of twofollow-on offerings of Suprema Specialties, Inc. We participated in one ofthe two offerings, the August 25, 2000 follow-on offering of SupremaSpecialties, Inc., as a member of the underwriting syndicate, agreeing tounderwrite

5

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75,000shares in total, although the amount actually retained by us appears to be only35,000 shares. The stock was sold in the August 25, 2000 offering at aprice of $8.00 per share. Plaintiffs seek damages for the purchase of 399,151shares of Suprema Specialties, Inc. stock between August 25, 2000 andNovember 14, 2001. The federal district court dismissed the claims againstus. On appeal, the U. S. Third Circuit Court of Appeals affirmed the dismissalof the plaintiffs’ claims for violation of Rule 10b-5 but reversed as to thedismissal of claims under Section 11 of the Securities Act of 1933.Subsequently, the plaintiffs stipulated that they will not be asserting a claimfor common law fraud against us. The negligent misrepresentation claim remainsin the case. We believe our liability under Section 11 is limited to the amountof shares either underwritten or actually retained by us in the offering.Discovery has begun, but has not yet been completed. We believe we havemeritorious defenses and intend to defend this matter vigorously.

InDecember 2005, we received notice of possible claims being asserted against usby two brothers who invested in Wood River Partners LP (“Wood River”). Thebrothers purchased their interests in Wood River directly from Wood River. Oneof the individuals was a customer of ours, but the other was not. The brothershave indicated that they paid $1,050,000 for their interests in Wood River. TheSEC sued Wood River in October 2005, and a receiver currently runs Wood River.At this point, it is not known how much the individuals might recover throughthe receivership. The individuals have indicated that they believe they mayhave claims against us under the Oregon Securities Laws for rescission,interest and attorney fees. We believe we have meritorious defenses and, iflitigation is filed, we intend to defend this matter vigorously.

InJanuary 2006, we received notice of a customer complaint against one of ourformer registered representatives. The customer has indicated that her accountsdeclined in value by just over $500,000. The customer has asserted that ourformer registered representative failed to implement strategies and techniquesto provide for safety and preservation of capital in her accounts. She assertsthat the registered representative made misrepresentations regarding the handlingof her accounts. The customer has indicated that she plans to pursue litigationagainst us if the matter is not resolved. At this time, the customer hasrequested that the former registered representative compensate her for thedecline in value of her account and return any fees earned by the formerregistered representative. We believe we have meritorious defenses and, iflitigation is filed, we intend to defend this matter vigorously.

Anadverse outcome in certain of the matters described above could have a materialadverse effect on our results of operations, cash flow or financial condition.We have either been named in certain other legal proceedings or are aware ofcertain complaints that may lead to legal proceedings. We believe, based uponinformation received to date and, where we believe it appropriate, based ondiscussions with legal counsel, that resolution of additional pending orthreatened litigation will have not have a material adverse effect on ourresults of operations, cash flow or financial condition.

**Note 5. Stock-Based Compensation**

***Adoptionof SFAS No. 123R***

EffectiveJanuary 1, 2006, we adopted Statement of Financial Accounting Standards (“SFAS”)No. 123R, “Share-Based Payment,” which establishes accounting for equityinstruments exchanged for employee services. Under the provisions of SFAS No.123R, stock-based compensation cost for equity classified awards is measured atthe grant date, based on the fair value of the award, and is recognized as anexpense over the employee’s requisite service period (generally the vestingperiod of the equity award). Prior to January 1, 2006, we accounted forshare-based compensation to employees in accordance with Accounting PrinciplesBoard Option No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) andrelated interpretations. We also followed the disclosure requirements of SFASNo. 123, “Accounting for Stock-Based Compensation.”

Weelected to adopt the modified prospective transition method as provided by SFASNo. 123R and, accordingly, financial statement amounts for the prior periodspresented in this Form 10-Q have not been restated to reflect the fair valuemethod of expensing stock-based compensation. Under this method, the

6

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provisionsof SFAS No. 123R apply to all awards granted or modified after the date ofadoption. We did not have any unrecognized expense related to awardsoutstanding at the date of adoption since they were all fully vested. Forfuture awards, expense calculated pursuant to SFAS No. 123R will be recognizedas compensation expense using the Black-Scholes option pricing model over therequisite service period. The cumulative effect of the change in accountingprinciple from APB 25 to SFAS No. 123R was not material.

There were no optionsgranted and no pro forma stock-based compensation expense as if the methodprescribed by SFAS No. 123, “Accounting for Stock-Based Compensation,” had been applied in measuringcompensation expense in the prior periods presented.

***1999 Stock Option Plan***

Our 1999 Stock Option Plan (the “Plan”) reserves 1.0million shares of our common stock for issuance upon exercise of optionsgranted under the Plan. At September 30, 2006, 521,000 options wereavailable for grant and 708,000 shares of our common stock were reserved forissuance related to the Plan. The Plan provides for the grant of incentivestock options and nonqualified stock options. Activity under the Plan inthe first nine months of 2006 was as follows:
|                                            | ** ** | **Options  Outstanding** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|--------------------------------------------|------------|--------------------------|------------|--------------------------------------------|------------|
| **Outstanding  at December 31, 2005** |       | 193,000                  |       | $                                          | 3.92       |   |
| Granted                                    |       | —                   |       |                                       |       |
| Exercised                                  |       | (6,000                   | )          | 3.51                                       |       |
| Forfeited                                  |       | —                   |       |                                       |       |
| **Outstanding at September 30,  2006**     |       | 187,000                  |       | 3.93                                       |       |
|                                            |            |                          |            |                                            |            |  |

 

Certain information regarding options outstanding andexercisable as of September 30, 2006 was as follows:
|                                              | ** ** | **Options  Outstanding and  Exercisable** | ** ** |
|----------------------------------------------|------------|------------------------------------------------|------------|
| Number                                       |       | 187,000                                        |       |
| Weighted average  per share exercise price   |       | $                                              | 3.93       |   |
| Aggregate  intrinsic value                   |       | $                                              | 344,605    |   |
| Weighted average  remaining contractual term |       | 1.5 years                                      |       |

 

As ofSeptember 30, 2006, there was no unrecognized stock-based compensation.

***Stock-BasedCompensation***

Weestimate the fair value of stock options using the Black-Scholes option pricingmodel. This valuation model takes into account the exercise price of the award,as well as a variety of significant assumptions. We believe that the valuationtechnique and the approach utilized to develop the underlying assumptions areappropriate in calculating the fair values of our stock options. Estimates offair value are not intended to predict actual future events or the valueultimately realized by persons who receive equity awards.  There were no stock options granted duringthe three and nine-month periods ended September 30, 2006 or 2005.

Since our options are fully vested upon the date ofgrant, we recognize the related stock-based compensation expense at that time.Shares to be issued upon the exercise of stock options will come from newlyissued shares.

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Certaininformation regarding our stock-based compensation was as follows:
|                                                                            | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Weighted average  grant-date per share fair value of share options granted |       | $                                                   | —     |   | $ | — |   |
| Total intrinsic  value of share options exercised                          |       | 25,230                                              |       | 22,420 |   |
| Stock-based  compensation recognized in results of operations              |       | —                                              |       | — |   |
| Cash received  from options exercised                                      |       | 21,030                                              |       | 61,530 |   |
| Tax deduction realized  related to stock options exercised                 |       | 25,230                                              |       | 22,420 |   |
|                                                                            |            |                                                     |            |  |  |  |  |

 

Therewas no activity in the three months ended September 30, 2006 or 2005.

**Note 6. Earnings Per Share**

Followingis a reconciliation of our shares used for our basic net income (loss) pershare and our diluted net income (loss) per share: 
| ** **                                                                                                            | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Shares used for  basic income (loss) per share                                                                        |       | 6,167,621                                            |       | 6,226,442                                           |       | 6,180,099 |   | 6,282,470 |   |
| Effect of  dilutive stock options                                                                                     |       | —                                               |       | 33,002                                              |       | — |   | 32,880 |   |
| Shares used for  diluted net income (loss) per share                                                                  |       | 6,167,621                                            |       | 6,259,444                                           |       | 6,180,099 |   | 6,315,350 |   |
|                                                                                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Stock options not  included in diluted net income (loss) per share because their effect would  have been antidilutive |       | 187,000                                              |       | —                                              |       | 187,000 |   | — |   |

 

**Note 7. Selection of New Clearing Firm**

In September 2006, RBC Dain Correspondent Services (“DCS”) became our newclearing firm, replacing National Financial Services, LLC (“NFS”). 

**Note 8. Repurchases of Common Stock**

In the first nine months of 2006, we repurchased a total of 34,316 sharesof our common stock for a weighted average price of $6.45 per share, whichtotaled $221,000. The amount paid above the original issue price, which totaled$214,000, was offset against retained earnings.

**Note 9. New Accounting Pronouncements**

***SFAS No. 157***

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,”which establishes a single authoritative definition of fair value, sets out aframework for measuring fair value and requires additional disclosures aboutfair-value measurements. SFAS No. 157 is effective for fiscal years beginningafter November 15, 2007. We are currently evaluating the provisions of SFAS No.157 and the potential effect on our financial position and results ofoperations.

***Staff AccountingBulletin No. 108***

In September 2006, the Securities and Exchange Commission issued StaffAccounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements,” which addresses how the effects of prior-year uncorrectedmisstatements should be considered when quantifying misstatements incurrent-year financial statements. SAB No. 108 requires companies to quantifymisstatements using both the balance sheet and income statement approaches andto evaluate whether either approach results in quantifying an error that ismaterial in light of relevant quantitative and qualitative factors. SAB No. 108is effective for annual financial statements covering the first fiscal yearending after November 15, 2006. We are not currently aware of any material 

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misstatements and, accordingly, we believe that the implementation of SABNo. 108 will not have any material effect on our financial position or resultsof operations.

***FASBInterpretation No. 48***

In June 2006, the FASB issued Interpretation No. 48, “Accounting forUncertainty in Income Taxes,” which defines the threshold for recognizing thebenefits of tax return positions in the financial statements as “more-likely-than-not”to be sustained by the taxing authority. Interpretation No. 48 applies to alltax positions accounted for under SFAS No. 109, “Accounting for Income Taxes.”Interpretation No. 48 is effective as of the beginning of the first fiscal yearbeginning after December 15, 2006. We are currently analyzing the effects ofadopting Interpretation No. 48 and have not yet determined if the adoption willhave a material effect on our financial position.

**Note10.  Reclassifications**

Certain amounts in the prior period financial statements have beenreclassified to conform to the current period presentation.

**Note11.  Subsequent Events**

InOctober 2006, we entered into a settlement with our former insurance company,AIG, in relation to a prior settlement related to certain investmenttransactions. We will receive approximately $280,000 after payments to ourattorneys related to this matter. We do not expect any future activity inregard to this matter.

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

**ForwardLooking Statements and Risk Factors**

This report, including, without limitation, “Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” contains or incorporates both historical and “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities Exchange Act of 1934,as amended. Words such as “anticipates,” “believes,” “expects,” “intends,” “future”and similar expressions identify forward-looking statements. Any suchforward-looking statements in this report reflect our current views withrespect to future events and financial performance and are subject to a varietyof factors that could cause our actual results to differ materially fromhistorical results or from anticipated results expressed or implied by such forward-lookingstatements. Because of such factors, we cannot assure you that the resultsanticipated in this report will be realized. As noted elsewhere in this report,various aspects of our business are subject to extreme volatility often as aresult of factors beyond our ability to anticipate or control. In particular,factors, such as the condition of the securities markets, which are in turnbased on popular perceptions of the health of the economy generally, can beexpected to affect the volume of our business as well as the value of thesecurities maintained in our trading and investment accounts. Other factorsthat may affect our future financial condition or results of operations includethe following:

·                  The performance of companies whose securities we haveunderwritten or otherwise sold to our customers may affect our reputation withother potential syndicate and selling group members and institutional and otherretail accounts and may also affect the amount of money in our customers’portfolios available for the kinds of investments that we offer.

·                  The value of our investment portfolio, including thevalue of securities without a readily ascertainable market value, that we haveestimated for the purpose of reporting on our financial condition and resultsof operations, may be significantly and adversely affected by changes in thevalue of the companies themselves or of comparable companies whose stock valueswe use in estimating the value of our portfolio securities.

·                  We are subject to a very high degree of regulation andare responsible for compliance with applicable regulations by all of ourpersonnel. A significant regulatory infraction by us or any of our

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registeredrepresentatives could result in significant penalties, including the loss ofour license to conduct securities business in one or more jurisdictions.

·                  Alternatives available to our customers to transactsecurities’ trades could affect our ability to continue to execute ourbrokerage customers’ transactions.

·                  The loss of our Chairman, Chester Paulson, could havea material adverse impact on our business.

**Overview**

Substantiallyall of our business consists of the securities brokerage and corporate financeactivities of our wholly-owned subsidiary, Paulson InvestmentCompany, Inc., which has operations in four principal categories, all ofthem in the financial services industry. These categories are:

·                  securitiesbrokerage activities for which we earn commission revenues;

·                  corporatefinance revenues consisting principally of underwriting discounts andunderwriter warrants;

·                  securitiestrading from which we record profit or loss, depending on trading results; and

·                  investmentincome resulting from earnings on, and increases or decreases in the value of,our investment portfolio.

Becausewe operate in the financial services industry, our revenues and earnings aresubstantially affected by general conditions in financial markets. In oursecurities brokerage business, the amount of our revenues depends on levels ofmarket activity requiring the services we provide. Our corporate financeactivity, which consists of acting as the managing underwriter of initial andfollow-on public offerings, private investments in a public equity (“PIPEs”)and private placements for smaller companies, is similarly affected by thestrength of the market for new equity offerings, which has historicallyexperienced substantial cyclical fluctuation. Although we attempt to matchoperating costs with activity levels, many of our expenses are either fixed ordifficult to change on short notice. Accordingly, fluctuations in brokerage andcorporate finance 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 lossis 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 inparticular, have always experienced significant volatility and this volatilityhas, in recent years, been extreme. The result of this volatility on the valueof our investment portfolio and securities held in connection with our tradingand investment activities include large quarterly fluctuations in income orloss from these operations and substantial increases or decreases in our networth as our securities holdings are marked to market.

Asubstantial portion of our corporate finance business consists of acting asmanaging underwriter of initial and follow-on public offerings for microcap andsmallcap companies. As a part of our compensation for these activities, wetypically receive warrants exercisable to purchase securities identical tothose that we offer and sell to the public. The warrants generally have afive-year expiration date and vest immediately. The warrants are generallysubject to a restricted period of six months to one year in which we cannot exercisethe warrants. The exercise price is typically 120% of the price at which thesecurities are initially sold to the public. Accordingly, unless there is atleast a 20% increase in the price of these securities at some time more thansix months and less than five years after the offering, the warrants willremain “under water” and will ultimately expire unexercised. We also receivewarrants in connection with our PIPEs, which have varying terms and conditions.

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**CriticalAccounting Policies and Use of Estimates**

Except for the addition of the Stock-BasedCompensation information below, we reaffirm the critical accountingpolicies and estimates as reported in our Quarterly Report on Form 10-Q for thequarter ended March 31, 2006, which was filed with the Securities and ExchangeCommission on May 15, 2006.

***Stock-Based Compensation***

OnJanuary 1, 2006, we adopted SFAS No. 123R, which requires the measurement andrecognition of compensation expense for all share based payment awards grantedto our employees and directors. Upon adoption of SFAS No. 123R, we maintainedour method of valuation of employee stock options granted using theBlack-Scholes option pricing model which was previously used for the disclosureonly provisions allowed under SFAS No. 123. Our determination of fair value ofshare based payment awards on the date of grant using an option pricing modelis affected by our stock price as well as assumptions regarding a number ofvariables, including risk free interest rate, the expected dividend yield, theexpected option life, and expected volatility over the term of the awards. Tothe extent share based payment awards are granted in future periods, we willrecognize the related expense over the requisite service period based on theportion of awards that are ultimately expected to vest during the period.

**Results of Operations**

Ourrevenues and operating results are influenced by fluctuations in the equitymarkets as well as general economic and market conditions, particularlyconditions in the over-the-counter market, where our investment and tradingpositions and the underlying stock for the underwriter warrants are heavilyconcentrated. Significant fluctuations can occur in our revenues and operatingresults from one period to another. Our results of operations depend upon manyfactors, such as the number of companies that are seeking financing, thequality and financial condition of those companies, market conditions ingeneral, the performance of our previous underwritings and interest in certainindustries by investors. As a result, revenues and income derived from theseactivities may vary significantly from year to year. Our revenues include thefollowing:

·                  Commissions,which represent amounts earned from our retail securities brokerage activities;

·                  Corporatefinance revenues, which are a function of total proceeds from offerings doneduring the period, compensation per offering and the fair value of underwriterwarrants received;

·                  Investmentincome (loss), which includes (i) the unrealized appreciation anddepreciation of securities held based on quoted market prices, (ii) theunrealized appreciation and depreciation of securities held that are notreadily marketable, based upon our estimate of their fair value,(iii) realized gains and losses on the sale of securities with quotedmarket prices and securities that are not readily marketable, and (iv) theunrealized appreciation and depreciation of underwriter warrants held; and

·                  Trading income(loss), which is the gain or loss from trading positions before commissionspaid to the representatives in the trading department.

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The following tables set forth the changes in ouroperating results in the three and nine-month periods ended September 30, 2006compared to the three and nine-month periods ended September 30, 2005:
| ** **                              | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | **%**          | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                              | ** ** | **September 30,**           | ** ** | **Increase** | ** ** | **Increase**   | ** ** |
| ** **                              | ** ** | **2006**                         | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Revenues:                               | ** ** | ** **                       | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| Commissions                             |       | $                                | 3,156,476  |         | $          | 4,335,517      |       | $ | (1,179,041 | ) | (27.2 | )% |
| Corporate  finance                      |       | 1,414,620                        |       | 2,176,018    |       | (761,398       | )          | (35.0 | ) |
| Investment  income (loss)               |       | (3,170,780                       | )          | 820,278      |       | (3,991,058     | )          | (486.5 | ) |
| Trading  income (loss)                  |       | (1,595,605                       | )          | 755,231      |       | (2,350,836     | )          | (311.3 | ) |
| Interest  and dividends                 |       | 15,203                           |       | 8,661        |       | 6,542          |       | 75.5 |   |
| Other                                   |       | (680                             | )          | 9,544        |       | (10,224        | )          | (107.1 | ) |
| Total  revenues (loss)                  |       | (180,766                         | )          | 8,105,249    |       | (8,286,015     | )          | (102.2 | ) |
| Expenses:                               |       |                             |       |         |       |           |       |   |   |
| Commissions  and salaries               |       | 3,314,795                        |       | 5,461,956    |       | (2,147,161     | )          | (39.3 | ) |
| Underwriting  expenses                  |       | 188,579                          |       | 76,078       |       | 112,501        |       | 147.9 |   |
| Rent,  telephone and quotation services |       | 307,326                          |       | 291,249      |       | 16,077         |       | 5.5 |   |
| Professional  fees                      |       | 155,774                          |       | 425,406      |       | (269,632       | )          | (63.4 | ) |
| Travel  and entertainment               |       | 45,722                           |       | 14,161       |       | 31,561         |       | 222.9 |   |
| Advertising  and promotion              |       | 47,542                           |       | 75,938       |       | (28,396        | )          | (37.4 | ) |
| Settlement  expense                     |       | 185,461                          |       | (175,000     | )          | 360,461        |       | 206.0 |   |
| Depreciation  and amortization          |       | 29,032                           |       | 22,559       |       | 6,473          |       | 28.7 |   |
| All  other                              |       | 367,655                          |       | 709,491      |       | (341,836       | )          | (48.2 | ) |
| Total  expenses                         |       | 4,641,886                        |       | 6,901,838    |       | (2,259,952     | )          | (32.7 | ) |
| Income (loss) before  income taxes      |       | $                                | (4,822,652 | )            | $          | 1,203,411      |       | $ | (6,026,063 | ) | (500.7 | )% |

 
| ** **                              | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | **%**          | ** ** |
|-----------------------------------------|------------|---------------------------------|------------|--------------|------------|----------------|------------|
| ** **                              | ** ** | **September 30,**          | ** ** | **Increase** | ** ** | **Increase**   | ** ** |
| ** **                              | ** ** | **2006**                        | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Revenues:                               | ** ** | ** **                      | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| Commissions                             |       | $                               | 11,335,870 |         | $          | 12,219,843     |       | $ | (883,973 | ) | (7.2 | )% |
| Corporate  finance                      |       | 4,646,808                       |       | 2,761,973    |       | 1,884,835      |       | 68.2 |   |
| Investment  income (loss)               |       | (8,259,811                      | )          | 18,334,207   |       | (26,594,018    | )          | (145.1 | ) |
| Trading  income (loss)                  |       | (1,814,315                      | )          | 2,868,057    |       | (4,682,372     | )          | (163.3 | ) |
| Interest  and dividends                 |       | 41,367                          |       | 30,806       |       | 10,561         |       | 34.3 |   |
| Other                                   |       | 934                             |       | 20,878       |       | (19,944        | )          | (95.5 | ) |
| Total  revenues                         |       | 5,950,853                       |       | 36,235,764   |       | (30,284,911    | )          | (83.6 | ) |
| Expenses:                               |       |                            |       |         |       |           |       |   |   |
| Commissions  and salaries               |       | 11,759,338                      |       | 15,868,145   |       | (4,108,807     | )          | (25.9 | ) |
| Underwriting  expenses                  |       | 356,025                         |       | 210,250      |       | 145,775        |       | 69.3 |   |
| Rent,  telephone and quotation services |       | 893,592                         |       | 883,348      |       | 10,244         |       | 1.2 |   |
| Professional  fees                      |       | 606,151                         |       | 1,214,522    |       | (608,371       | )          | (50.1 | ) |
| Travel  and entertainment               |       | 299,061                         |       | 175,230      |       | 123,831        |       | 70.7 |   |
| Advertising  and promotion              |       | 133,245                         |       | 221,248      |       | (88,003        | )          | (39.8 | ) |
| Settlement  expense                     |       | 190,211                         |       | 343,543      |       | (153,332       | )          | (44.6 | ) |
| Depreciation  and amortization          |       | 73,509                          |       | 68,319       |       | 5,190          |       | 7.6 |   |
| All  other                              |       | 1,068,688                       |       | 1,646,493    |       | (577,805       | )          | (35.1 | ) |
| Total  expenses                         |       | 15,379,820                      |       | 20,631,098   |       | (5,251,278     | )          | (25.5 | ) |
| Income (loss) before  income taxes      |       | $                               | (9,428,967 | )            | $          | 15,604,666     |       | $ | (25,033,633 | ) | (160.4 | )% |

 

***Revenues***

Commissionsdecreased $1.2 million and $0.9 million, respectively, in the three andnine-month periods ended September 30, 2006 compared to the same periods of2005. The total number of trades, including mutual fund trades, executed by ourbrokers were 22,918 and 76,601 in the three and nine-month periods endedSeptember 30, 2006, respectively, compared to 26,554 and 79,657, respectively,in the comparable periods of 2005. We had 91 brokers at September 30, 2006compared to 94 brokers at September 30, 2005.

Corporate finance incomeof $1.4 million in the three-month period ended September 30, 2006 primarilyrepresented commissions earned from one initial public offering in which weraised $16.5 million for Ascent SolarTechnologies, Inc., as well as the Black-Scholes value of theunderwriter warrants received

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in connection withthat offering. The corporate financeincome of $4.6 million in the nine-month period ended September 30, 2006 alsoincluded commissions earned from a public offering in which we raised$19.5 million for American Mold Guard, Inc., as well as the Black-Scholes valueof the underwriter warrants received in connection with that offering. Inaddition we completed several private transactions, including PIPEs, during thethree and nine-month periods ended September 30, 2006.

Corporatefinance income of $2.2 million in the three-month period ended September 30,2005 primarily included commissions earned from one initial public offering inwhich we raised $10.7 million for ICOPDigital, Inc., as well as the Black-Scholes value of the underwriterwarrants received in connection with that offering. Corporate financeincome of $2.8 million in the nine-month period ended September 30, 2005 alsoincluded commissions related to a small initial public offering in which weraised $3.0 million for Nuvim, Inc., as well as the Black-Scholes value of theunderwriter warrants received in connection with that offering. In addition wecompleted other small private transactions during these periods.

Investmentincome decreased $4.0 million and $26.6 million, respectively, in the three andnine-month periods ended September 30, 2006 compared to the same periods of2005 as detailed in the following table:

 
| ** **                                                                                                                                                                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                                                                                                | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net unrealized gain (loss) related to underwriter  warrants                                                                                                                               |       | $                                                    | (1,670,213 | )                                                   | $          | (5,178,123 | ) | $ | (3,609,357 | ) | $ | (3,271,723 | ) |
| Net unrealized appreciation (depreciation) of  securities held based on quoted market prices or, for securities that are not  readily marketable, our estimate of their fair market value |       | (1,743,253                                           | )          | (2,925,541                                          | )          | (11,342,590 | ) | 8,426,298 |   |
| Net realized gains on the sale of securities with  quoted market prices and securities that are not readily marketable                                                                    |       | 242,686                                              |       | 8,923,942                                           |       | 6,692,136 |   | 13,179,632 |   |
|                                                                                                                                                                                      |       | $                                                    | (3,170,780 | )                                                   | $          | 820,278 |   | $ | (8,259,811 | ) | $ | 18,334,207 |   |

 

Investmentincome (loss) is volatile from period to period due to the fact that it isdriven by the market value or fair value of the securities and underwriterwarrants held.

Tradingincome decreased $2.4 million and $4.7 million, respectively, in the three andnine-month periods ended September 30, 2006 compared to the same periods of2005 to a loss of $1.6 million and a loss of $1.8 million, respectively, in the2006 periods. These losses are primarily due to lower volume and lower pricesfor several of the securities we hold in our trading inventories. Our focus ison very small capitalization issues, especially those tied to our corporatefinance clients. Trading income (loss) can be volatile from period to period basedon the fact that it is driven by the market value of the securities in which wemake a market.

***Expenses***

Totalexpenses decreased $2.3 million and $5.3 million, respectively, in the threeand nine-month periods ended September 30, 2006 compared to the same periods of2005, primarily due to decreases in commissions and salaries, professional feesand other expenses. These decreases were partially offset in the three-monthperiod ended September 30, 2006 compared to the same period of 2005 by anincrease in settlement expense.

Commissionsand salaries decreased $2.1 million and $4.1 million, respectively, in thethree and nine-month periods ended September 30, 2006 compared to the sameperiods of 2005. Retail commissions as a percentage of retail sales iscomparable year over year. However, we do not pay trading and investmentcommissions on trading and investment losses, accordingly, we have had asignificant decrease in trading and investment commissions in the 2006 periodscompared to the 2005 periods. In addition, there was a $35,000 increase insalaries in the third quarter of 2006 compared to the third quarter of 2005 aswe hired a Sarbanes-Oxley manager and made a few management pay adjustments.

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Professionalfees decreased $0.3 million and $0.6 million, respectively, in the three andnine-month periods ended September 30, 2006 compared to the same periods of2005, primarily due to significant decreases in legal activity as a result ofthe settlement of certain cases during the 2005 periods.

Settlementexpense in the 2006 periods related to the settlement of one matter in thethird quarter of 2006. The credit to settlement expense in the three-monthperiod ended September 30, 2005 related to a change in estimate of settlementexpense. Settlement expense in the nine-month period ended September 30, 2005also included amounts required to settle certain legal matters.

Otherexpense includes items such as dues and subscriptions, charitablecontributions, bad debt expense and other office expenses. Other expensedecreased $0.3 million and $0.6 million, respectively, in the three andnine-month periods ended September 30, 2006 compared to the same periods of2005, primarily due to a $270,000 and $250,000 decrease, respectively, incharitable contributions as well as net decreases in various other expensecategories.

***Income (Loss) Before Income Taxes***

Wegenerated losses before income taxes in the three and nine-month periods endedSeptember 30, 2006 compared to income before income taxes in the comparableperiods of 2005 due to the decreases in revenues, partially offset by decreasesin expenses in the 2006 periods compared to the 2005 periods as discussedabove.

Inaddition, because of changes in the underlying securities and other factors,significant fluctuations in the value of underwriter warrants often occur fromperiod to period, affecting the comparability of our revenues and operatingresults.

***Liquidity and Capital Resources***

Our primary sources of liquidity include our cash andcash equivalents and receivables from our clearing organization, offset bypayables to our clearing organization.

In addition, our sources of liquidity include ourtrading positions, investment positions, borrowings on those positions andprofits realized upon the sale of the securities underlying underwriterwarrants exercised. The liquidity of the market for many of our securitiesholdings, however, varies with trends in the stock market. Since many of thesecurities we hold are thinly traded, and we are, in many cases, a primary marketmaker in the issues held, any significant sales of our positions couldadversely affect the liquidity of the issues held. In general, falling pricesin OTC securities (which make up most of our trading positions) lead todecreased liquidity in the market for these issues, while rising prices in OTCissues tend to increase the liquidity of the market for these securities.

We believe our liquidity is sufficient to meet ourneeds for both the short and long-term horizon. Our liquidity could benegatively affected by protracted unfavorable market conditions.

As a securities broker-dealer, we are required by SECregulations to meet certain liquidity and capital standards. We believe we werein compliance with these standards at September 30, 2006.

Following the lapse of restrictions upon issuance,capital available from the sale of the underlying securities of underwriterwarrants exercised can fluctuate significantly from period to period as thevalue of the underlying securities fluctuates with overall market andindividual company financial condition or performance. There is no publicmarket for the underwriter warrants. The securities receivable upon exercise ofthe underwriter warrants cannot be resold unless the issuer has registeredthese securities with the SEC and with the states in which the securities willbe sold unless exemptions are available. Any delay or other problem in theregistration of these securities would have an adverse impact upon our abilityto obtain funds from the exercise of the underwriter warrants and the resale ofthe underlying securities. At September 30, 2006, we owned 14 underwriterwarrants from 13 issuers, all but two of which

14

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were exercisable. One of the warrants had an exerciseprice below the September 30, 2006 market price of the securities receivableupon exercise. The intrinsic value of this warrant was $0.7 million atSeptember 30, 2006. There is little or no direct relationship between theintrinsic value of our underwriter warrants at the end of any given period andthe fair value calculated using the Black-Scholes option pricing model. Theprices of the securities underlying the underwriter warrants are very volatile,and substantial fluctuations in our estimate of their value can be expected inthe future. In the nine-month period ended September 30, 2006, we exercised oneunderwriter warrant, which resulted in net proceeds of $0.7 million upon thesale of the related securities.

Cash provided by operating activities in the firstnine months of 2006 totaled $0.3 million, primarily due to our net loss of $6.0million and net non-cash income items of $3.1 million being offset by changesin our operating assets and liabilities as discussed in more detail below.

Our net receivable from our clearing organizationdecreased $4.8 million to $4.6 million at September 30, 2006 from $9.4 millionat December 31, 2005, primarily due to the results of the activity in ourtrading and investment accounts, as well as the timing of general corporateexpenditures.

Notes and other receivables, which primarily representemployee and independent broker advances and expenses in excess of commissionearnings, commissions receivable and amounts receivable from corporate financeclients, increased $0.9 million to $2.0 million at September 30, 2006 from $1.1million at December 31, 2005, primarily due to additional advances to corporatefinance clients, offset by payments received.

Trading and investment securities combined decreased$10.2 million to $23.8 million at September 30, 2006 compared to $34.0 millionat December 31, 2005. Changes in our trading and investment securities aredependent on the purchase and sale of securities during the period, as well aschanges in their fair market values during the period.

Underwriter warrants decreased $1.8 million to $4.5million at September 30, 2006 compared to $6.3 million at December 31,2005.  A roll-forward of the value of thewarrants was as follows:
| **Balance, December 31, 2005**                                 |   | $          | 6,275,000 |   |
|----------------------------------------------------------------|--------|------------|-----------|--------|
| Fair value of  warrants received, net of employee compensation |   | 1,879,357  |      |
| Net unrealized  loss on value of warrants                      |   | (2,988,719 | )         |
| Value of  warrants exercised and expired                       |   | (620,638   | )         |
| **Balance, September 30, 2006**                                |   | $          | 4,545,000 |   |

 

Prepaid and deferred expenses decreased $0.2 millionto $0.5 million at September 30, 2006 from $0.7 million at December 31, 2005,primarily due to the amortization of registration fees for our registeredrepresentatives and of insurance premiums.

Accounts payable decreased $0.4 million to $0.8million at September 30, 2006 from $1.2 million at December 31, 2005, primarilydue to the payment of $0.5 million of settlements during the first nine monthsof 2006, which were related to the fiscal 2005 settlements.

Compensation, employee benefits and payroll taxes decreased$1.4 million to $0.7 million at September 30, 2006 from $2.1 million atDecember 31, 2005, primarily due to the payment of commissions that wereaccrued at December 31, 2005. Accruals for commissions were lower in 2006 dueto weaker results from operations.

Dividends payable of $0.9million at December 31, 2005 represented a special dividend, which wasauthorized by the Board of Directors, of $0.30 per share to shareholders ofrecord on January 17, 2006. The dividend payment was made on February 10, 2006.

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Income taxes payable decreased $2.5 million to areceivable of $143,000 at September 30, 2006 from a payable of $2.3 million atDecember 31, 2005, primarily due to $4.0 million of income tax payments madeduring the first nine months of 2006, partially offset by the accrual forfiscal 2006 taxes payable related to realized gains on investments.

Deferred revenue of $0.5 million at September 30, 2006relates to amounts received from DCS based on the execution of a five-yearagreement, which is being amortized at the rate of $8,333 per month throughSeptember 2011.

Deferred income taxes payable decreased $4.9 millionto $0.5 million at September 30, 2006 from $5.4 million at December 31, 2005,primarily due to a $13 million unrealized loss on securities.

Capital expenditures of $111,000 in the first ninemonths of 2006 were primarily for leasehold improvements at our Salem, Oregonoffice. At September 30, 2006, we did not have any material commitments forcapital expenditures.

InSeptember 2001, our Board of Directors approved a stock repurchase programpursuant to which we are authorized to repurchase up to 600,000 shares of ourcommon stock. Through September 30, 2006, we had repurchased a total of 281,142shares and 318,858 shares remained available for repurchase. This repurchaseprogram does not have an expiration date.

**Item 3.  Quantitative and Qualitative DisclosuresAbout Market Risk**

There have been nomaterial changes in our reported market risks or risk management policies sincethe filing of our Form 10-Q for the quarter ended March 31, 2006, which wasfiled with the Securities and Exchange Commission on May 15, 2006.

**Item 4.  Controls and Procedures**

***Disclosure Controls andProcedures***

Ourmanagement has evaluated, under the supervision and with the participation ofour President and our Chief Financial Officer, the effectiveness of ourdisclosure controls and procedures as of the end of the period covered by thisreport as defined in Rule 13a-15(b) or Rule 15d-15(e) under the SecuritiesExchange Act of 1934 (the “Exchange Act”). Based on that evaluation, ourPresident and our Chief Financial Officer have concluded that, as of the end ofthe period covered by this report, our disclosure controls and procedures areeffective in ensuring that information required to be disclosed in our ExchangeAct reports is (1) recorded, processed, summarized and reported in a timelymanner, and (2) accumulated and communicated to our management, including ourPresident and our Chief Financial Officer, as appropriate, to allow timelydecisions regarding required disclosure.

***Changes in Internal Controls***

Therehas been no change in our internal control over financial reporting thatoccurred during our last fiscal quarter that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

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**PART II - OTHER INFORMATION**

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

SeeNote 4 of Notes to Consolidated Financial Statements in Part I, Item 1.

**Item 1A.  Risk Factors**

OurAnnual Report on Form 10-K for the year ended December 31, 2005 includes adetailed discussion of our risk factors. There have been no material changesfrom the risk factors previously disclosed in our Annual Report on Form 10-K.Accordingly, the information in this Form 10-Q should be read in conjunctionwith the risk factors and information disclosed in our Annual Report on Form10-K for the year ended December 31, 2005, which was filed with the Securitiesand Exchange Commission on March 29, 2006. See also Part I, Item 2 “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” in this report under the heading“Forward Looking Statements and RiskFactors.”

**Item 2.  Unregistered Sales of Equity Securitiesand Use of Proceeds**

Werepurchased the following shares of our common stock during the third quarterof 2006:
|                              | ** ** | **Total number  of shares  purchased** | ** ** | **Average  price paid  per share** | ** ** | **Total number of  shares purchased  as part of publicly  announced plan** | ** ** | **Maximum number  of shares that may  yet be purchased  under the plan** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|
| July 1 to July  31           |       | 3,000                                            |       | $                                            | 5.92       |                                                                                                          | 281,142    |                                                                                                             | 318,858    |   |
| August 1 to  August 31       |       | —                                           |       | —                                       |       | —                                                                                                        |       | —                                                                                                           |       |
| September 1 to  September 30 |       | —                                           |       | —                                       |       | —                                                                                                        |       | —                                                                                                           |       |
| Total                        |       | 3,000                                            | (1)        | $                                            | 5.92       |                                                                                                          | 281,142    |                                                                                                             | 318,858    |   |

 

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(1)          Noneof the 3,000 shares were purchased from our executive officers or employees (ortheir affiliates).

Theplan to repurchase up to a total of 600,000 shares of our common stock wasapproved by our Board of Directors in September 2001 and does not have anexpiration date.  

**Item 6.  Exhibits**

Thefollowing exhibits are filed herewith and this list is intended to constitutethe exhibit index:
| 31.1 |   | Certification of Principal Executive Officer  pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of  1934.                            |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934.                                 |
| 32.1 |   | Certification of Principal Executive Officer  pursuant to Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act  of 1934 and 18 U.S.C. Section 1350. |
| 32.2 |   | Certification of Chief Financial Officer pursuant to  Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 and  18 U.S.C. Section 1350.     |

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
| Date:    November  20, 2006 |   | PAULSON CAPITAL CORP.                 |
|-------------------------------------------------|--------|---------------------------------------|
|                                            |   |                                  |
|                                            |   |                                  |
|                                            |   | By                                    | /s/ CHESTER L. F. PAULSON |   |
|                                            |   | Chester L. F. Paulson                 |
|                                            |   | President and Chief Executive Officer |
|                                            |   | Principal Executive Officer           |
|                                            |   |                                  |
|                                            |   |                                  |
|                                            |   | By                                    | /s/ KAREN L. JOHANNES |   |
|                                            |   | Karen L. Johannes                     |
|                                            |   | Chief Financial Officer               |
|                                            |   | Principal Financial Officer           |
|                                                 |        |                                       |  |  |  |  |

 

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