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

**WASHINGTOND.C. 20549**

 

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**FORM 10-Q**

 

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

 

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

 

**o****  TRANSITION REPORT UNDER SECTION 13 OR15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For thetransition period from              to              **

 

**Commissionfile number: 0-18188**

 

**PAULSON CAPITAL CORP.**

(Exact name of issuer as specified in itscharter)

 

**Oregon**

(State or other jurisdiction of incorporationor organization)

 

**93-0589534**

(IRS employer identification number)

 

**811 S.W.Naito ParkwayPortland, OR 97204**

(Address of principal executive offices)

 

**(503) 243-6000**

(Issuer’s telephone number)

 

Indicate by check mark whether the issuer (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the issuer was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.Yes  ý    No  o

 

Indicate by check mark whether the registrantis an accelerated filer

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

 

Indicate by check mark whether the Registrantis a shell company (as defined in Rule 12b-2 of the Securities ExchangeAct of 1934). Yes  o    No  ý

 

Number of shares outstanding of each of theissuer’s classes of common stock, as of the latest practicable date:

Common stock, no par value, 3,103,370 as of November 11,2005

 

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

 

 

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**PAULSONCAPITAL CORP.**

 

**INDEX TO FORM 10-Q**

 
| Part I   - | FINANCIAL  INFORMATION                                                                                                                                                                       |   |
|----------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                 |                                                                                                                                                                                         |   |
| Item  1  -      | Financial  Statements:                                                                                                                                                                       |   |
|                 |                                                                                                                                                                                         |   |
|                 | Consolidated  Balance Sheets:  –    September 30, 2005 (unaudited) and December 31,  2004                                                                 |   |
|                 |                                                                                                                                                                                         |   |
|                 | Consolidated  Statements of Income:  –**    **For the  Three Months and Nine Months Ended September 30, 2005 and 2004  (unaudited)                             |   |
|                 |                                                                                                                                                                                         |   |
|                 | Consolidated  Statement of Shareholders’ Equity  –    For the Year Ended December 31, 2004 and the  Nine Months Ended September 30, 2005 (unaudited) |   |
|                 |                                                                                                                                                                                         |   |
|                 | Consolidated  Statements of Cash Flows:  –    For the Nine Months Ended September 30, 2005  and 2004 (unaudited)                                               |   |
|                 |                                                                                                                                                                                         |   |
|                 | Notes  to Condensed Consolidated Interim 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  2 -            | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                                                                 |   |
|                 |                                                                                                                                                                                         |   |
| Item 6 -             | Exhibits                                                                                                                                                                                     |   |
|                 |                                                                                                                                                                                         |   |
| Signatures -         |                                                                                                                                                                                         |   |
|                 |                                                                                                                                                                                         |   |
| Certifications       |                                                                                                                                                                                         |   |

 

2

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**PART I— FINANCIAL INFORMATION**

 

ITEM 1. FINANCIAL STATEMENTS

 

PAULSONCAPITAL CORP. AND SUBSIDIARYCONSOLIDATED BALANCE SHEETS

 
| ** **                                                                                                                           | ** ** | **09/30/05**    | ** ** | **12/31/04** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|--------------|------------|
| ** **                                                                                                                           | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| **ASSETS**                                                                                                                           |       |            |       |         |       |
|                                                                                                                                 |       |            |       |         |       |
| Cash and cash equivalents                                                                                                            |       | $               | 266,144    |         | $          | 132,845 |   |
| Receivable from clearing  organization                                                                                               |       | 10,371,528      |       | 7,856,254    |       |
| Notes and other  receivables                                                                                                         |       | 1,260,966       |       | 442,934      |       |
| Income taxes receivable                                                                                                              |       | —          |       | 851,000      |       |
| Trading securities, at  market value                                                                                                 |       | 3,745,601       |       | 3,029,326    |       |
| Investment securities, at  market value                                                                                              |       | 36,518,532      |       | 20,774,645   |       |
| Underwriter warrants, at  estimated fair value                                                                                       |       | 7,495,000       |       | 9,416,000    |       |
| Prepaid and deferred  expenses                                                                                                       |       | 1,360,382       |       | 1,583,346    |       |
| Furniture and equipment,  net                                                                                                        |       | 267,096         |       | 239,028      |       |
|                                                                                                                                 |       |            |       |         |       |
| Total assets                                                                                                                         |       | $               | 61,285,249 |         | $          | 44,325,378 |   |
|                                                                                                                                 |       |            |       |         |       |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                       |       |            |       |         |       |
|                                                                                                                                 |       |            |       |         |       |
| **LIABILITIES**                                                                                                                      |       |            |       |         |       |
| Accounts payable and  accrued liabilities                                                                                            |       | $               | 596,277    |         | $          | 2,138,856 |   |
| Dividends payable                                                                                                                    |       | 4,457           |       | —       |       |
| Payable to clearing  organization                                                                                                    |       | 3,037,977       |       | 1,021,860    |       |
| Compensation, employee  benefits and payroll taxes                                                                                   |       | 4,246,064       |       | 2,108,056    |       |
| Securities sold, not yet  purchased, at market value                                                                                 |       | 71,865          |       | 50,144       |       |
| Income taxes payable                                                                                                                 |       | 1,924,340       |       | —       |       |
| Deferred income taxes                                                                                                                |       | 9,741,690       |       | 5,436,000    |       |
|                                                                                                                                 |       |            |       |         |       |
| Total liabilities                                                                                                                    |       | 19,622,670      |       | 10,754,916   |       |
|                                                                                                                                 |       |            |       |         |       |
| **COMMITMENTS AND CONTINGENCIES**                                                                                                    |       | —          |       | —       |       |
|                                                                                                                                 |       |            |       |         |       |
| **SHAREHOLDERS’ EQUITY**                                                                                                        |       |            |       |         |       |
| Preferred stock, no par  value; authorized, 500,000 shares; issued and outstanding, no shares                                        |       | —          |       | —       |       |
| Common stock, no par value;  authorized, 10,000,000 shares; issued and outstanding, 3,103,370 at 09/30/05  and 3,190,300 at 12/31/04 |       | 1,771,693       |       | 1,745,824    |       |
| Retained earnings                                                                                                                    |       | 39,890,886      |       | 31,824,638   |       |
|                                                                                                                                 |       |            |       |         |       |
| Total shareholders’ equity                                                                                                      |       | 41,662,579      |       | 33,570,462   |       |
|                                                                                                                                 |       |            |       |         |       |
| Total liabilities and  shareholders’ equity                                                                                     |       | $               | 61,285,249 |         | $          | 44,325,378 |   |

 

The accompanying notes are an integral partof these statements.

 

3

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PAULSONCAPITAL CORP. AND SUBSIDIARYCONSOLIDATED STATEMENTS OFINCOME (unaudited)

 
| ** **                                              | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|---------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                              | ** ** | **09/30/05**           | ** ** | **09/30/04**          | ** ** | **09/30/05** | ** ** | **09/30/04** | ** ** |
| **Revenues**                                            |       |                   |       |                  |       |   |   |   |   |
| Commissions                                             |       | $                      | 4,335,517  |                  | $          | 4,088,558 |   | $ | 12,219,843 |   | $ | 13,367,465 |   |
| Corporate finance                                       |       | 2,176,018              |       | 3,996,238             |       | 2,761,973 |   | 10,227,410 |   |
| Investment income (loss)                                |       | 820,278                |       | 796,771               |       | 18,344,757 |   | (2,742,211 | ) |
| Trading income                                          |       | 755,231                |       | 664,686               |       | 2,868,057 |   | 1,127,923 |   |
| Interest and dividends                                  |       | 8,661                  |       | 16,978                |       | 30,806 |   | 25,133 |   |
| Other                                                   |       | 9,544                  |       | 340                   |       | 10,328 |   | 1,489 |   |
|                                                    |       |                   |       |                  |       |   |   |   |   |
|                                                    |       | 8,105,249              |       | 9,563,571             |       | 36,235,764 |   | 22,007,209 |   |
| **Expenses**                                            |       |                   |       |                  |       |   |   |   |   |
| Commissions and salaries                                |       | 5,461,956              |       | 4,941,263             |       | 15,868,145 |   | 14,228,450 |   |
| Underwriting expenses                                   |       | 76,078                 |       | 303,588               |       | 210,250 |   | 766,891 |   |
| Rent, telephone and quotation services                  |       | 291,249                |       | 308,088               |       | 883,348 |   | 919,448 |   |
| Interest expense                                        |       | 421                    |       | 9,520                 |       | 421 |   | 10,093 |   |
| Professional fees                                       |       | 425,406                |       | 198,436               |       | 1,214,522 |   | 677,923 |   |
| Bad debt expense                                        |       | —                 |       | 4,947                 |       | — |   | 72,527 |   |
| Travel and entertainment                                |       | 14,161                 |       | 31,641                |       | 175,230 |   | 328,030 |   |
| Settlement expense                                      |       | (175,000               | )     | —                |       | 343,535 |   | 32,090 |   |
| Depreciation and amortization                           |       | 22,559                 |       | 20,950                |       | 68,319 |   | 74,748 |   |
| Other                                                   |       | 785,008                |       | 505,000               |       | 1,867,328 |   | 1,487,378 |   |
|                                                    |       |                   |       |                  |       |   |   |   |   |
|                                                    |       | 6,901,838              |       | 6,323,433             |       | 20,631,098 |   | 18,597,578 |   |
|                                                    |       |                   |       |                  |       |   |   |   |   |
| Income before income taxes                              |       | 1,203,411              |       | 3,240,138             |       | 15,604,666 |   | 3,409,631 |   |
|                                                    |       |                   |       |                  |       |   |   |   |   |
| Income tax expense (benefit)                            |       |                   |       |                  |       |   |   |   |   |
| Current                                                 |       | 1,956,954              |       | 239,803               |       | 1,956,954 |   | 659,129 |   |
| Deferred                                                |       | (1,491,288             | )     | 996,169               |       | 4,269,214 |   | 641,081 |   |
|                                                    |       | 465,666                |       | 1,235,972             |       | 6,226,168 |   | 1,300,210 |   |
|                                                    |       |                   |       |                  |       |   |   |   |   |
| **Net Income**                                          |       | $                      | 737,745    |                  | $          | 2,004,166 |   | $ | 9,378,498 |   | $ | 2,109,421 |   |
|                                                    |       |                   |       |                  |       |   |   |   |   |
| Earnings per share, basic                               |       | $                      | 0.24       |                  | $          | 0.63 |   | $ | 2.99 |   | $ | 0.66 |   |
|                                                    |       |                   |       |                  |       |   |   |   |   |
| Earnings per share, diluted                             |       | $                      | 0.24       |                  | $          | 0.62 |   | $ | 2.97 |   | $ | 0.66 |   |
|                                                    |       |                   |       |                  |       |   |   |   |   |
| Weighted average number of shares  outstanding, basic   |       | 3,113,221              |       | 3,192,454             |       | 3,141,235 |   | 3,179,308 |   |
|                                                    |       |                   |       |                  |       |   |   |   |   |
| Weighted average number of shares  outstanding, diluted |       | 3,129,722              |       | 3,209,877             |       | 3,157,675 |   | 3,184,418 |   |

 

The accompanying notes are an integral partof these statements.

 

4

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PAULSONCAPITAL CORP. AND SUBSIDIARYCONSOLIDATED STATEMENTOF SHAREHOLDERS’ EQUITYAs of  December 31, 2004and the nine months ended September 30, 2005

 
| ** **                                      | ** ** | **Common Stock** | ** ** | **Retained** | ** ** |
|-------------------------------------------------|------------|------------------|------------|--------------|------------|
| ** **                                      | ** ** | **Shares**       | ** ** | **Amount**   | ** ** | **Earnings** | ** ** |
|                                            |       |             |       |         |       |   |   |
| Balance at December 31,  2004              |       | 3,190,300        |       | $            | 1,745,824  |   | $ | 31,824,638 |   |
|                                            |       |             |       |         |       |   |   |
| Redemption of common stock  (unaudited)         |       | (94,930          | )          | (35,661      | )          | (835,686 | ) |
|                                            |       |             |       |         |       |   |   |
| Dividends to common  shareholders (unaudited)   |       | —           |       | —       |       | (476,564 | ) |
|                                            |       |             |       |         |       |   |   |
| Stock options exercised  (unaudited)            |       | 8,000            |       | 61,530       |       | — |   |
|                                            |       |             |       |         |       |   |   |
| Net income for the year to  date (unaudited)    |       | —           |       | —       |       | 9,378,498 |   |
|                                            |       |             |       |         |       |   |   |
| Balance at September 30,  2005 (unaudited) |       | 3,103,370        |       | $            | 1,771,693  |   | $ | 39,890,886 |   |
|                                                 |            |                  |            |              |            |  |  |  |  |  |  |

 

The accompanying notes are an integral partof this statement.

 

5

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PAULSON CAPITAL CORP. ANDSUBSIDIARYCONSOLIDATED STATEMENTSOF CASH FLOWS(unaudited)

 
| ** **                                                                                   | ** ** | **Nine months ended** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                   | ** ** | **09/30/05**          | ** ** | **09/30/04** | ** ** |
|                                                                                         |       |                  |       |   |   |
| Cash flows from operating  activities                                                        |       |                  |       |   |   |
| Net income                                                                                   |       | $                     | 9,378,498  |   | $ | 2,109,421 |   |
| Adjustments to reconcile  net income to net cash provided by (used in) operating activities: |       |                  |       |   |   |
| Receipt of underwriter  warrants                                                             |       | (1,759,264            | )          | (6,761,240 | ) |
| Unrealized depreciation/expiration/exercise  of underwriter warrants                         |       | 3,271,723             |       | 3,093,668 |   |
| Noncash compensation  associated with underwriter warrants                                   |       | 408,541               |       | 1,942,572 |   |
| Depreciation                                                                                 |       | 68,319                |       | 74,748 |   |
| Deferred income taxes                                                                        |       | 4,305,690             |       | 641,081 |   |
| Change in assets and  liabilities                                                            |       |                  |       |   |   |
| Receivables                                                                                  |       | (818,032              | )          | 209,418 |   |
| Receivables from/payable  to clearing organization                                           |       | (499,157              | )          | 658,526 |   |
| Trading and investment  securities                                                           |       | (16,460,162           | )          | (2,091,468 | ) |
| Prepaid and deferred  expenses                                                               |       | 222,964               |       | 125,544 |   |
| Accounts payable and  accrued liabilities                                                    |       | 599,886               |       | (1,342,388 | ) |
| Securities sold, not yet  purchased                                                          |       | 21,721                |       | 36,032 |   |
| Income taxes  payable/receivable                                                             |       | 2,775,340             |       | 1,183,983 |   |
|                                                                                         |       |                  |       |   |   |
| Net cash provided by (used  in) operating activities                                         |       | 1,516,067             |       | (120,103 | ) |
|                                                                                         |       |                  |       |   |   |
| Cash flows from investing  activities                                                        |       |                  |       |   |   |
| Additions to furniture and  equipment                                                        |       | (96,387               | )          | (98,540 | ) |
|                                                                                         |       |                  |       |   |   |
| Cash flows from financing  activities                                                        |       |                  |       |   |   |
| Proceeds from exercise of  stock options                                                     |       | 61,530                |       | 539,997 |   |
| Dividends paid to common  shareholders                                                       |       | (476,564              | )          | (312,481 | ) |
| Payments to retire common  stock                                                             |       | (871,347              | )          | (46,443 | ) |
|                                                                                         |       |                  |       |   |   |
| Net cash provided by (used  in) financing activities                                         |       | (1,286,381            | )          | 181,073 |   |
|                                                                                         |       |                  |       |   |   |
| NET INCREASE (DECREASE) IN  CASH AND CASH EQUIVALENTS                                        |       | 133,299               |       | (37,570 | ) |
|                                                                                         |       |                  |       |   |   |
| Cash and cash equivalents  at beginning of period                                            |       | 132,845               |       | 155,314 |   |
|                                                                                         |       |                  |       |   |   |
| Cash and cash equivalents  at end of period                                                  |       | $                     | 266,144    |   | $ | 117,744 |   |
|                                                                                         |       |                  |       |   |   |
| Cash paid during the  period for:                                                            |       |                  |       |   |   |
|                                                                                         |       |                  |       |   |   |
| Interest                                                                                     |       | $                     | 421        |   | $ | 10,093 |   |
| Income taxes                                                                                 |       | $                     | 16,416     |   | $ | 314,330 |   |

 

The accompanying notes are an integral partof these statements.

 

6

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**PAULSON CAPITAL CORP. ANDSUBSIDIARY**

**NOTESTO CONDENSED CONSOLIDATED INTERIM FINANCIAL STATEMENTS**(unaudited)

 

1.               Basis of Presentation

 

These financial statements are those of the Companyand its wholly owned subsidiary. In the opinion of management, the accompanyingunaudited consolidated financial statements have been prepared pursuant to the rules andregulations of the Securities and Exchange Commission and include alladjustments (consisting only of normal recurring adjustments) necessary topresent fairly the Company’s financial position as of September 30, 2005and its results of operations for the three and nine months ended September 30,2005 and 2004, and cash flows for the nine months ended September 30, 2005and 2004. The nature of the Company’s business is such that the results of anyinterim period are not necessarily indicative of results for a full fiscalyear. The accompanying unaudited financial statements and related notes shouldbe read in conjunction with the audited financial statements and Form 10-KSBof the Company for the fiscal year ended December 31, 2004.

 

2.               Dividend

 

On January 27, 2005, the Company announced theauthorization by the Board of Directors of a $0.15 special cash dividend toshareholders of record on February 10, 2005. The dividend was paid on March 3,2005.

 

3.               Securities Owned

 

Gains and losses from the disposition and appreciation/depreciationof trading securities are reflected as trading revenues in the income statementfor the period. Gains and losses from the disposition and unrealizedgains/losses of investment securities are reflected as investment revenues inthe income statement for the period. Investment securities may be held for thelong term or sold pursuant to the intention of management.

 

4.               Commitments and Contingencies

 

In December 2004 and January 2005, theCompany’s wholly owned subsidiary, Paulson Investment Company (“PIC”), settledarbitration proceedings filed by Louis Barinaga, a former PIC customer.  The December 2004 settlement related toBarinaga’s claims involving the purchases of convertible notes of E.com, whichwere purchased directly from E.com.  The January 2005settlement related to Barinaga’s claims involving transactions in the stock ofe.Digital.  The settlement has beenconsummated with Barinaga.  However, PIC’sinsurance carrier, after previously providing settlement authorization to PICregarding the e.Digital settlement, has now withdrawn that authorization.  PIC believes that the insurance carrier isobligated to provide the settlement authorization to which it previouslyagreed.  PIC has filed suit against theinsurance carrier and intends to pursue the insurance proceeds vigorously.  As of December 31, 2004, the Company hasrecorded the total amount of the settlement expense in its financialstatements.

 

In October 2002, PIC was named as a defendantin a lawsuit filed by Special Situations Fund III, LP and Special SituationsCayman Fund, LP.  The lawsuit was filedin U.S. District Court for the District of New Jersey.  It asserts various federal securities lawclaims and common law fraud and negligence against numerous defendants, includingPIC, arising out of two follow-on offerings of Suprema Specialties, Inc.  PIC participated in one of the two offerings,the August 25, 2000 follow-on offering of Suprema Specialties, Inc.,as a member of the underwriting syndicate, underwriting 75,000 shares intotal.  The stock was sold in the August 25,2000 offering at a price of $8.00 per share. Plaintiffs seek damages for the purchase of 399,151 shares of SupremaSpecialties, Inc. stock between August 25, 2000 and November 14,2001.  The federal district court hasdismissed the claims against PIC. Plaintiffs have appealed and the case currently is pending before theUnited States Third Circuit Court of Appeals. Oral argument on the appeal occurred September 16, 2005.  PIC believes it has meritorious defenses andintends to defend this matter vigorously.

 

7

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On April 12, 2005, the NASD sent a letter toPIC’s outside counsel indicating that the NASD Department of Enforcement hadmade a preliminary determination to recommend that disciplinary action bebrought against PIC, and certain other PIC employees, including its formerpresident, and former employees, for violations of NASD Rules of Conduct2110, for mutual fund market-timing, and 3010, for failure to supervise thefirm’s mutual fund market-timing business. The NASD and Paulson have agreed to resolve the action with PIC inreturn for a payment by PIC of $150,000 in restitution and $175,000 infines.  The NASD and Paulson currentlyare negotiating the language of the settlement, and there is no assurance thatan agreement will be finalized.  If thismatter is not settled, it likely will proceed to a hearing before the NASD bythe end of 2006.

 

In addition to the matters described above, PIC hasbeen named in an NASD arbitration filed in July 2005 by a group of formercustomers.  The statement of claimindicates it was filed in an attempt to “toll” the running of applicablestatutes of limitation.  The statementprovides no specific factual allegations or any information regarding whatamounts, if any, may be sought from PIC. PIC has not had an opportunity tofully investigate this claim, but believes it has meritorious defenses andintends to defend this matter vigorously if the claim is pursued.

 

An adverse outcome in certain of the mattersdescribed above could have a material adverse effect on PIC or the Company.From time to time, PIC is named in certain other legal proceedings and receivesnotice that certain customers may commence legal proceedings against PIC.  The Company has no additional legalproceedings other than through PIC. The Company believes, based uponinformation received to date and, where the Company believes it appropriate,discussions with legal counsel, that resolution of any additional pending orthreatened litigation will have no material adverse effect on the consolidatedfinancial condition, results of operations, or business of the Company.

 

5.               Stock Options

 

The Company has a stock-based employee compensationplan. As allowed under SFAS No. 123 “Accounting for Stock-BasedCompensation,” the Company continues to account for stock options for employeesunder APB No. 25, “Accounting for Stock Issued to Employees,” and hasadopted the disclosure only requirements of SFAS No. 123. There were nostock option grants in the nine month periods ended September 30, 2005 or2004. Accordingly, no pro forma income effect is shown.

 

8

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6.               Earnings Per Share

 

The following table is a reconciliation of thenumerators and denominators of the basic and diluted per share computations foreach of the three months ended September 30, 2005 and September 30,2004.

 
| ** **                                                                          | ** ** | **Income**      | ** ** | **Weighted  Average Shares** | ** ** | **Per Share  Amount** | ** ** |
|-------------------------------------------------------------------------------------|------------|-----------------|------------|------------------------------|------------|-----------------------|------------|
| ** **                                                                          | ** ** | **(Numerator)** | ** ** | **(Denominator)**            | ** ** | ** **            | ** ** |
|                                                                                |       |            |       |                         |       |                  |       |
| Three Months Ended September 30,  2005 Income available to common shareholders |       | $               | 737,745    |                         | 3,113,221  |                  | $          | 0.24 |   |
|                                                                                |       |            |       |                         |       |                  |       |
| Effect of dilutive  securities – options                                       |       |            |       | 16,501                       |       |                  |       |
|                                                                                |       |            |       |                         |       |                  |       |
| Diluted earnings per share                                                          |       | $               | 737,745    |                         | 3,129,722  |                  | $          | 0.24 |   |
|                                                                                |       |            |       |                         |       |                  |       |
| Three Months Ended September 30,  2004 Income available to common shareholders |       | $               | 2,004,166  |                         | 3,192,454  |                  | $          | 0.63 |   |
|                                                                                |       |            |       |                         |       |                  |       |   |   |
| Effect of dilutive  securities – options                                       |       |            |       | 17,423                       |       |                  |       |   |
|                                                                                |       |            |       |                         |       |                  |       |   |   |
| Diluted earnings per share                                                          |       | $               | 2,004,166  |                         | 3,209,877  |                  | $          | 0.62 |   |

 

The following table is a reconciliation of thenumerators and denominators of the basic and diluted per share computations foreach of the nine months ended September 30, 2005 and September 30,2004.

 
| ** **                                                                         | ** ** | **Income**      | ** ** | **Weighted  Average Shares** | ** ** | **Per Share  Amount** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------|------------|------------------------------|------------|-----------------------|------------|
| ** **                                                                         | ** ** | **(Numerator)** | ** ** | **(Denominator)**            | ** ** | ** **            | ** ** |
|                                                                               |       |            |       |                         |       |                  |       |
| Nine Months Ended September 30,  2005 Income available to common shareholders |       | $               | 9,378,498  |                         | 3,141,235  |                  | $          | 2.99 |   |
|                                                                               |       |            |       |                         |       |                  |       |
| Effect of dilutive  securities – options                                      |       |            |       | 16,440                       |       |                  |       |
|                                                                               |       |            |       |                         |       |                  |       |
| Diluted earnings per share                                                         |       | $               | 9,378,498  |                         | 3,157,675  |                  | $          | 2.97 |   |
|                                                                               |       |            |       |                         |       |                  |       |
| Nine Months Ended September 30,  2004 Income available to common shareholders |       | $               | 2,109,421  |                         | 3,179,308  |                  | $          | 0.66 |   |
|                                                                               |       |            |       |                         |       |                  |       |
| Effect of dilutive  securities – options                                      |       |            |       | 5,110                        |       |                  |       |
|                                                                               |       |            |       |                         |       |                  |       |
| Diluted earnings per share                                                         |       | $               | 2,109,421  |                         | 3,184,418  |                  | $          | 0.66 |   |

 

9

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7.               Recently Issued Accounting Pronouncements

 

In December 2004, the FASB issued FAS 123R,which requires that compensation costs relating to share-based payments berecognized in the Company’s financial statements. The Company currentlyaccounts for those payments under the recognition and measurement principles ofAccounting Principles Board (APB) Opinion No. 25, “Accounting forStock Issued to Employees,” and related interpretations. The Company ispreparing to implement this standard effective January 1, 2006.  Although we have not yet determined whetherthe adoption of 123(R) will result in amounts that are similar to the currentpro form data, we expect the adoption may have a material impact on futurefinancial statements.  This estimate isbased on preliminary information and could materially change based on theactual facts and circumstances and the terms of future option grants.

 

In June 2005, the FASB issued Statement No. 154,“Accounting Changes and Error Corrections,” (SFAS 154) a replacement of APBOpinion No. 20, “Accounting Changes,” and Statement No. 3, “ReportingAccounting Changes in Interim Financial Statements.” SFAS 154 changes therequirements for the accounting for and the reporting of a change in accountingprinciple. Previously, most voluntary changes in accounting principles requiredrecognition by recording a cumulative effect adjustment within net income inthe period of change. SFAS 154 requires retrospective application to priorperiods’ financial statements, unless it is impracticable to determine eitherthe specific period effects or the cumulative effect of the change. SFAS 154 iseffective for accounting changes made in fiscal years beginning after December 15,2005. The Company does not believe SFAS 154 will have a material effect on itsconsolidated financial position, results of operations or cash flows.

 

8.               Reclassifications

 

Certain 2004 amounts havebeen reclassified to conform to the 2005 presentation.

 

ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

**General**

 

FORWARD-LOOKINGSTATEMENTS

 

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 such forward-looking statements in thisreport reflect our current views with respect to future events and financialperformance and are subject to a variety of factors that could cause our actualresults to differ materially from historical results or from anticipatedresults expressed or implied by such forward-looking statements.  Because of such factors, we cannot assure youthat the results anticipated in this report will be realized.  As noted elsewhere in this report, variousaspects of our business are subject to extreme volatility often as a result offactors beyond our ability to anticipate or control.  In particular, factors, such as the conditionof the securities markets, which are in turn based on popular perceptions ofthe health of the economy generally, can be expected to affect the volume ofour business as well as the value of the securities maintained in our tradingand investment accounts.  Other factorsthat may affect our future financial condition or results of operations includethe following:

 

•                  The performance of companies whose securitieswe have underwritten or otherwise sold to our customers may affect ourreputation with other potential syndicate and selling group members andinstitutional and other retail accounts and may also affect the amount of moneyin our customers’ portfolios available for the kinds of investments that weoffer.

 

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

 

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

 

•                  Alternatives available to our customers totransact securities’ trades could affect our ability to continue to execute ourbrokerage customers’ transactions.

 

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

 

10

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**Overview**

 

Substantially all of our business consists of thesecurities brokerage and investment banking activities of our wholly ownedsubsidiary, Paulson Investment Company, Inc., or PIC.  PIC has operations in four principalcategories, all of them in the financial services industry.  These categories are:

 

•                  securities brokerage activities for which PICearns commission revenues;

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

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

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

 

Because we operate in the financial servicesindustry, our revenues and earnings are substantially affected by generalconditions in financial markets. In our securities brokerage and corporatefinance business, the amount of our revenues depends on levels of marketactivity requiring the services we provide. Our investment banking activity, which consists primarily of acting asthe managing underwriter of initial and follow-on public offerings for smallercompanies, is similarly affected by the strength of the market for new equityofferings, which has historically experienced substantial cyclicalfluctuation.  Although we attempt tomatch operating costs with activity levels, many of our expenses are eitherfixed or difficult to change on short notice. Accordingly, fluctuations in brokerage and investment banking revenuestend to result in sharper fluctuations, on a percentage basis, in net income orloss.

 

Our investment income or loss and, to a lesserextent, our trading income or loss are affected by changes in market valuationof securities generally and, in particular, by changes in valuation of theequity securities of microcap companies in which our investments and tradingactivities tend to be concentrated.  Equitymarkets in general, and microcap equity markets in particular, have alwaysexperienced significant volatility and this volatility has, in recent years,been extreme.  The results of thisvolatility on the value of our investment portfolio and securities held inconnection with our trading and investment activities include large quarterlyfluctuations in income or loss and substantial increases or decreases in ournet worth as our securities holdings are marked to market. The securities inthe investment account are held for investment, not actively traded, and notdeemed part of operations in accordance with management intentions.

 

A substantial portion of our investment bankingbusiness consists of acting as managing underwriter of initial and follow-onpublic offerings for microcap companies. As a part of our compensation for this activity, we typically receivewarrants exercisable to purchase securities identical to those that we offerand sell to the public.  Generally, thewarrants are not exercisable for the first six months after the offering inwhich they are earned and are thereafter exercisable for four and one-halfyears, after which they expire.  Theexercise price is typically 120% of the price at which the securities areinitially sold to the public. Accordingly, unless there is at least a 20%increase in the price of these securities at some time more than six months andless than five years after the offering, the warrants will remain “under water”and will ultimately expire unexercised.

 

### **CriticalAccounting Policies**

###  

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

 

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

 

11

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

 

We estimate the value of our underwriter warrantsusing the Black-Scholes Option Pricing Model. The Black-Scholes model requiresus to use historical price data combined with certain assumptions and judgmentsas inputs for the model.  The mostinfluential factor in this model is price volatility, which we calculate foreach issuing company’s warrants based on the respective company’s ownhistorical stock price movements as well as an index of historical prices forcomparable companies.  When we initiallyreceive a new underwriter warrant from an initial public offering, itscalculated volatility factor is entirely based on the volatility of an index ofcomparable companies, since there is no price history for a new publicly tradedcompany.  As each underwriter warrantapproaches its expiration date, its volatility factor is derived primarily fromthe historical prices of its underlying common stock.  We cannot assure you that we will ultimatelybe able to exercise any of our warrants in a way that will realize the valuethat we attribute to them in our financial statements based on this model. Asof September 30, 2005, our underwriter warrants, based on theBlack-Scholes Option Pricing Model, were valued at approximately $7.5 million, downfrom the estimated value of $9.4 million as of December 31, 2004. Duringthe nine months ended September 30, 2005, the Company exercised eight ofits underwriter warrants.

 

In addition to our underwriter warrants, we holdother securities, some of which have very limited liquidity and some of whichdo not have a readily ascertainable market value.  We are required to carry these securities atestimated fair value.

 

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

 

**Results of Operations**

 

PIC’s revenues and operating results are influencedby fluctuations in the equity underwriting markets as well as general economicand market conditions, particularly conditions in the over-the-counter market,where PIC’s investment account, trading inventory positions and underwriterwarrants are heavily concentrated. Significant fluctuations can occur in PIC’s revenues and operatingresults from one period to another.  PIC’sresults of operations depend upon many factors, such as the number of companiesthat are seeking public financing, the quality and financial condition of thosecompanies, market conditions in general, the performance of previous PICunderwritings and interest in certain industries by investors.  As a result, revenues and income derived fromthese activities may vary significantly from year to year.  In the tables below, “Corporate Finance”revenues are a function of total proceeds from offerings done during theperiod, compensation per offering, and the fair value of underwriter warrantsreceived.  “Investment Income” includesrealized gains from the exercise of underwriter warrants, gains and losses fromthe sales of investment securities, and unrealized gains and losses fromunderwriter warrants and other investment securities.  “Trading Income” is the net gain or loss fromtrading positions before commissions paid to the representatives in the tradingdepartment.

 

12

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**Summary of Changes in MajorCategoriesof Revenues and Expense**

 

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

 
| ** **                         | ** ** | ** **              | ** ** | ** **         | ** ** | **Three Months Ended**      | ** ** |
|------------------------------------|------------|-------------------------|------------|--------------------|------------|-----------------------------|------------|
| ** **                         | ** ** | **Increase/(Decrease)** | ** ** | **Percent Change** | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** |
| Revenues:                          |       |                    |       |               |       |                        |       |   |   |
| Sales Commissions                  |       | $                       | 246,959    |               | 6.0        |                        | $          | 4,335,517 |   | $ | 4,088,558 |   |
| Corporate Finance                  |       | (1,820,220              | )          | (45.5              | )          | 2,176,018                   |       | 3,996,238 |   |
| Investment Income                  |       | 23,507                  |       | 3.0                |       | 820,278                     |       | 796,771 |   |
| Trading Income                     |       | 90,545                  |       | 13.6               |       | 755,231                     |       | 664,686 |   |
| Other                              |       | 887                     |       | 5.1                |       | 18,205                      |       | 17,318 |   |
|                               |       |                    |       |               |       |                        |       |   |   |
| Total                              |       | (1,458,322              | )          | (15.2              | )          | 8,105,249                   |       | 9,563,571 |   |
|                               |       |                    |       |               |       |                        |       |   |   |
| Expenses:                          |       |                    |       |               |       |                        |       |   |   |
| Commissions and Salaries           |       | 520,693                 |       | 10.5               |       | 5,461,956                   |       | 4,941,263 |   |
| Underwriting Expenses              |       | (227,510                | )          | (74.9              | )          | 76,078                      |       | 303,588 |   |
| Rent, Telephone &  Quotes |       | (16,839                 | )          | (5.5               | )          | 291,249                     |       | 308,088 |   |
| Other                              |       | 302,061                 |       | 39.2               |       | 1,072,555                   |       | 770,494 |   |
|                               |       |                    |       |               |       |                        |       |   |   |
| Total                              |       | 578,405                 |       | 9.1                |       | 6,901,838                   |       | 6,323,433 |   |
|                               |       |                    |       |               |       |                        |       |   |   |
| Pretax Income (Loss)               |       | $                       | (2,036,727 | )                  | (62.9      | )                           | $          | 1,203,411 |   | $ | 3,240,138 |   |

 

**Three Months Ended September 30, 2005 vs. Three Months Ended September 30,2004**

 

**Revenues**

 

Total revenues for the third quarter of 2005 decreased$1.5 million from the same quarter of the prior year primarily as a result of adecrease in corporate finance revenue. Corporate finance revenue decreased $1.8million from the third quarter of 2004 to the third quarter of 2005. TheCompany completed one corporate finance transaction in each of the tworespective quarters; however, the corporate finance transaction in the thirdquarter of 2004 had gross proceeds totaling $41.7 million as compared to thecorporate finance transaction in the third quarter of 2005 with gross proceedstotaling $10.7 million.

 

As shown in the table above, sales commissions—whichare commissions generated from the retail stock brokerage business—increased approximately$247,000 as a result of a slightly more favorable market during the thirdquarter of 2005 and a modest increase in trading activity. Total number oftrades executed by the Company’s stock brokers for the third quarter of 2005approximated 27,000 as compared to 23,000 trades during the comparable quarter ofthe prior year.

 

Investment income increased approximately $24,000 inthe third quarter of 2005 as compared to the third quarter of 2004. Investmentincome can be volatile period-over-period based on the fact it is driven by themarket value or fair value of the securities and underwriter warrants held bythe Company. Investment income consists of (1) the unrealized appreciationand depreciation of securities held based on quoted market prices, (2) theunrealized appreciation and depreciation of securities held that are notreadily marketable, based upon the Company’s estimate of their fair value, (3) therealized gain and loss on the sale of securities with quoted market prices andsecurities that are not readily marketable, and (4) the unrealizedappreciation and depreciation of underwriter warrants held by the Company.  The depreciation/expiration/exercise ofunderwriter warrants of approximately $5.1 million during the third quarter of2005, was significantly greater than the depreciation/expiration/exercise ofunderwriter warrants of approximately $812,000 for the third quarter of 2004. Thedepreciation/expiration/exercise of the underwriter warrants was offset by a$2.0 million increase in the holdings of Charles and Colvard in addition toincreases in several other holdings of the Company during the third quarter of2005. There was a decrease of $25,000 in the estimated fair value of securitiesnot readily marketable during the third quarter of 2005. The remainder of thetotal investment income is the result of the unrealized and realized appreciationof securities with quoted market prices.

 

13

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Trading income increased approximately $91,000 inthe third quarter of 2005 as compared to the third quarter of 2004, as a resultof stronger performance from a couple of the securities in which the Companymakes a market. PIC’s focus is on very small capitalization issues, especiallythose tied to PIC’s corporate finance clients.

 

**Expenses**

 

Total expenses increased approximately $578,000 inthe third quarter of 2005 from the third quarter of 2004, an increase of 9.1percent. The largest dollar increase was in commissions and salaries with anincrease of approximately $521,000 in the third quarter of 2005 as compared tothe same period of the prior year. Commission expense increased approximately$540,000 primarily as a result of higher commissions paid on higher commissionrevenues and an increase in commissions paid based on the performance of theCompany’s investments. Administrative salary expense decreased approximately $20,000as a result of an internal reorganization resulting in the elimination of acouple of operational positions. Underwriting expenses decreased byapproximately $228,000 in the third quarter of 2005 from the third quarter of2004 as a result of the smaller corporate finance transaction completed in the thirdquarter of 2005 as compared to the same period of the prior year. Otherexpenses increased approximately $302,000, or 39.2 percent. The increase inother expenses is attributable to an approximate $254,000 increase inprofessional fees primarily associated with legal activity related to settlements.In addition, the Company’s contribution expense increased approximately$268,000 during the third quarter of 2005 as a result of a significant donationmade to the University of Oregon. As an offset, the Company reduced itsestimated settlement expense in the third quarter of 2005 by approximately$175,000 as ongoing legal negotiations resulted in a change in the estimatedamount. The remainder of the net increase in other expenses consists ofincreases and decreases in various expense categories.

 

**Income**

 

The Company had pretax income of $1.2 million (14.8percent of revenues) in the third quarter of 2005 compared to pretax income ofapproximately $3.2 million (33.9 percent of revenues) in the third quarter of2004. Pretax income as a percentage of revenues was less in the third quarterof 2005 as compared to the same period the prior year due to the decrease incorporate finance revenues. Independent of the change in the Black-Scholesvalue of the underwriter warrants and the income and expense associated withthe receipt of the underwriter warrants during the third quarter of eachrespective year, the Company would have had pretax income totaling $5.2 millionfor the third quarter of 2005, compared with pretax income of approximately $2.4million for the third quarter of 2004. Because of the Black-Scholes value ofunderwriter warrants and other factors, significant fluctuations often occur inPIC’s revenues and operating results from one period to another.

 

14

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**Summary of Changes in MajorCategoriesof Revenues and Expense**

 

**Nine months Ended September 30,2005 v. September 30, 2004**

 
| ** **                         | ** ** | ** **              | ** ** | ** **         | ** ** | **Nine months Ended**       | ** ** |
|------------------------------------|------------|-------------------------|------------|--------------------|------------|-----------------------------|------------|
| ** **                         | ** ** | **Increase/(Decrease)** | ** ** | **Percent Change** | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** |
| Revenues:                          |       |                    |       |               |       |                        |       |   |   |
| Sales Commissions                  |       | $                       | (1,147,622 | )                  | (8.6       | )                           | $          | 12,219,843 |   | $ | 13,367,465 |   |
| Corporate Finance                  |       | (7,465,437              | )          | (73.0              | )          | 2,761,973                   |       | 10,227,410 |   |
| Investment Income                  |       | 21,086,968              |       | N/A                |       | 18,344,757                  |       | (2,742,211 | ) |
| Trading Income                     |       | 1,740,134               |       | 154.3              |       | 2,868,057                   |       | 1,127,923 |   |
| Other                              |       | 14,512                  |       | 54.5               |       | 41,134                      |       | 26,622 |   |
|                               |       |                    |       |               |       |                        |       |   |   |
| Total                              |       | 14,228,555              |       | 64.7               |       | 36,235,764                  |       | 22,007,209 |   |
|                               |       |                    |       |               |       |                        |       |   |   |
| Expenses:                          |       |                    |       |               |       |                        |       |   |   |
| Commissions and Salaries           |       | 1,639,695               |       | 11.5               |       | 15,868,145                  |       | 14,228,450 |   |
| Underwriting Expenses              |       | (556,641                | )          | (72.6              | )          | 210,250                     |       | 766,891 |   |
| Rent, Telephone &  Quotes |       | (36,100                 | )          | (3.9               | )          | 883,348                     |       | 919,448 |   |
| Other                              |       | 986,566                 |       | 36.8               |       | 3,669,355                   |       | 2,682,789 |   |
|                               |       |                    |       |               |       |                        |       |   |   |
| Total                              |       | 2,033,520               |       | 10.9               |       | 20,631,098                  |       | 18,597,578 |   |
|                               |       |                    |       |               |       |                        |       |   |   |
| Pretax Income                      |       | $                       | 12,195,035 |               | 357.7      |                        | $          | 15,604,666 |   | $ | 3,409,631 |   |

 

**Nine months Ended September 30, 2005 vs. Nine months Ended September 30,2004**

 

**Revenues**

 

Total revenues for the first nine months of 2005increased $14.2 million. As shown in the table above, sales commissionsdecreased $1.1 million as a result of lackluster market performance generally andthe lack of commissions associated with corporate finance transactions. TheRussell 2000 Index increased a modest 2.5 percent during the first nine months of2005 and the Nasdaq Composite Index decreased 1.1 percent during the sameperiod. Sales commissions are also directly related to the number of brokersengaged by the Company. The Company had 94 stock brokers as of September 30,2005, as compared to 99 as of September 30, 2004.

 

Corporate finance revenue decreased $7.5 million forthe first nine months of 2005, from the comparable period in the prior year.The Company completed five corporate finance transactions in the first ninemonths of 2004 with gross proceeds totaling $76.2 million, compared with two corporatefinance transactions during the first nine months of 2005 with gross proceedstotaling $13.4 million. In addition, during the first nine months of 2005 theCompany had a small private placement and participated in a few smalltransactions in which another investment banking firm was the lead underwriter.Market conditions have resulted in a more challenging IPO market during the firstnine months of 2005 as compared to the prior year.

 

Investment income increased $21.1 million in the firstnine months of 2005 as compared to the first nine months of 2004. Investmentincome can be volatile period-over-period because it is driven by the marketvalue or fair value of the securities and underwriter warrants held by theCompany. Investment income consists of (1) the unrealized appreciation anddepreciation of securities held based on quoted market prices, (2) theunrealized appreciation and depreciation of securities held that are notreadily marketable, based upon the Company’s estimate of their fair value, (3) therealized gain and loss on the sale of securities with quoted market prices andsecurities that are not readily marketable, and (4) the unrealizedappreciation and depreciation of underwriter warrants held by the Company.  The depreciation/expiration/exercise of underwriterwarrants totaling $3.3 million during the first nine months of 2005, closelycompares to the depreciation/expiration/exercise of underwriter warrants of $3.1million for the first nine months of 2004. In the Company’s investment account,the holdings of Charles & Colvard, Ltd., increased in value $10.9million during the first nine months of 2005, in addition to significantincreases in several other holdings of the Company. The Company may sellCharles & Colvard, Ltd., or any other security in its investmentaccount at any time deemed appropriate. There was a decrease of $25,000 in theestimated fair value of securities not readily marketable during the first ninemonths of 2005.  The remainder of thetotal investment income is the result of the unrealized and realizedappreciation of securities with quoted market prices.

 

15

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Trading income increased $1.7 million in the firstnine months of 2005 as compared to the first nine months of 2004, as a resultof exceptional performance from a couple of the securities in which the Companymakes a market. PIC’s focus is on very small capitalization issues, especiallythose tied to PIC’s corporate finance clients.

 

**Expenses**

 

Total expenses increased $2.0 million in the first ninemonths of 2005 as compared to the same time period in 2004, an increase of 10.9percent. The largest dollar increase was in commissions and salaries with anincrease of $1.6 million in the first nine months of 2005. Commission expenseincreased approximately $1.6 million primarily as a result of highercommissions paid based on the performance of the Company’s investments.Administrative salary expense increased approximately $297,000 as a result of (1) anincrease in accrued profit sharing and bonus amount of $1.6 million for the firstnine months of 2005 as compared to the same period in the prior year, (2) adecrease of approximately $1.5 million in compensation expense associated withthe receipt of underwriter warrants during the first nine months of 2005 ascompared to the same period in the prior year, and (3) additional salaryexpense. Underwriting expenses decreased by approximately $557,000 from the firstnine months of 2004 as a result of fewer corporate finance transactions in the2005 period. Other expenses increased approximately $987,000, or 36.8 percent.The increase in other expenses is primarily attributable to an approximate $445,000increase in professional fees primarily associated with legal activity relatedto settlements, an increase of approximately $311,000 in estimated settlementexpense, and an increase of approximately $277,000 in charitable contributions.The remainder of the net increase in other expenses consists of increases anddecreases in various expense categories.

 

**Income**

 

The Company had pretax income of $15.6 million (43.1percent of revenues) in the first nine months of 2005 compared to pretax incomeof approximately $3.4 million (15.5 percent of revenues) in the first ninemonths of 2004. In the Company’s investment account, the holdings of Charles &Colvard, Ltd., increased $10.9 million during the first three quarters of 2005.Profitability, as a percentage of revenues, generally increases when asignificant portion of the Company’s revenues is derived from investment incomebecause fewer expenses are associated with investment income relative to theother revenue sources. Independent of the change in the Black-Scholes value ofthe underwriter warrants and the income and expense associated with the receiptof the underwriter warrants, the Company would have had pretax income totaling$17.5 million for the first nine months of 2005, compared with pretax income ofapproximately $1.7 million for the first nine months of 2004. Because of theBlack-Scholes value of underwriter warrants and other factors, significantfluctuations often occur in PIC’s revenues and operating results from oneperiod to another.

 

**Liquidity and Capital Resources**

 

The majority of PIC’sassets are cash and assets readily convertible to cash.  PIC’s securities inventory is stated atmarket value for the securities that are readily marketable and estimated fairvalue for the securities that are not readily marketable. The liquidity of themarket for many of PIC’s securities holdings, however, varies with trends inthe stock market.  Since many of thesecurities held by PIC are thinly traded, and PIC is in many cases a primarymarket maker in the issues held, any significant sales of PIC’s positions couldadversely affect the liquidity of the issues held.  In general, falling prices in OTC securities(which make up most of PIC’s trading positions) lead to decreased liquidity inthe market for these issues, while rising prices in OTC issues tend to increasethe liquidity of the market for these securities.

 

16

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PIC borrows money from National Financial Services,its clearing firm, in the ordinary course of its business, pursuant to anunderstanding under which the clearing firm agrees to finance PIC’s tradingaccounts.  As of September 30, 2005,no net loans were outstanding pursuant to this arrangement.  PIC and the Company are generally able tomeet their compensation and other obligations out of current liquid assets.

 

Another source of capital to PIC and the Company hasbeen the underwriter warrants issued to PIC in connection with its corporatefinance activities and the sale of the underlying securities. There is nopublic market for the underwriter warrants. The securities receivable uponexercise of the underwriter warrants cannot be resold unless the issuer hasregistered these securities with the SEC and with the states in which thesecurities will be sold unless exemptions are available.  Any delay or other problem in theregistration of these securities would have an adverse impact upon PIC’sability to obtain funds from the exercise of the underwriter warrants and theresale of the underlying securities.  At September 30,2005, PIC owned 14 underwriter warrants, all but two of which were thenexercisable; three had an exercise price below the September 30, 2005market price of the securities receivable upon exercise. The intrinsic value ofthese three warrants is $1.8 million. There is little or no direct relationshipbetween the intrinsic value of PIC’s underwriter warrants at the end of anygiven period and the fair value calculated using the Black-Scholes pricingmodel, as described more fully in Critical Accounting Policies above. Theprices of these securities are influenced by general movements in the prices ofOTC securities as well as the success of the issuers of the underwriterwarrants.  The prices of the securitiesunderlying the underwriter warrants are very volatile, and substantialfluctuations in the Company’s estimate of their value can be expected in thefuture. In the nine months ended September 30, 2005, the Company exerciseda total of eight underwriter warrants.

 

In the nine months ended September 30, 2005,approximately $1.5 million of net cash was provided by operatingactivities.  The major adjustments toreconcile this result to the Company’s net income include the following itemsthat are positive adjustments to or provided cash to operating activities: depreciation/expiration/exerciseof underwriter warrants of approximately $3.3 million; an increase in deferredincome taxes of approximately $4.3 million; an increase of income taxespayable/receivable of approximately $2.8 million; and an increase in accountspayable and accrued liabilities of approximately $600,000. The following itemsare negative adjustments to or a use of cash for operating activities: receiptof underwriter warrants totaling approximately $1.8 million; an increase intrading and investment securities of approximately $16.5 million; an increasein receivables of approximately $818,000; and an increase in receivablefrom/payable to clearing organization of approximately $499,000. Net cash usedin investing activities in the first nine months of 2005 was for additions tofurniture and equipment of approximately $96,000. Net cash used in financingactivities in the first nine months of 2005 approximated $1.3 million,primarily resulting from approximately $477,000 in dividends paid to commonshareholders and approximately $871,000 in payments to retire common stock.

 

As a securities broker-dealer, PIC is required bySEC regulations to meet certain liquidity and capital standards.  We believe we are in compliance with thesestandards.

 

At September 30, 2005, the Company had no materialcommitments for capital expenditures.

 

In general, the primary sources of PIC’s, andtherefore the Company’s, liquidity include PIC’s trading positions, borrowingson those positions and profits realized upon the exercise of underwriterwarrants. All of these sources depend in large part on the trend in the generalmarkets for OTC securities.  Rising OTCprice levels will tend to increase the value and liquidity of PIC’s tradingpositions, the amount that can be borrowed from National Financial Servicesbased upon those positions, and the value of PIC’s underwriter warrants.  The Company believes its liquidity issufficient to meet its needs for both the short and long term horizon. TheCompany’s liquidity could be affected by protracted unfavorable marketconditions.

 

**Inflation**

 

Because PIC’s assets are primarily liquid, they arenot significantly affected by inflation. The rate of inflation affects PIC’s expenses, such as employeecompensation, office leasing and communications costs.  These costs may not readily be recoverable inthe price of services offered by the Company. To the extent inflation results in rising interest rates and has otheradverse effects in the securities markets and the value of securities held ininventory or PIC’s investment account, it may adversely affect the Company’sfinancial position and results of operations.

 

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ITEM3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK

 

Market risk is the risk of loss to the Companyresulting primarily from changes in equity prices and to a significantly lesserextent, interest rates and foreign currency rates.  The Company has exposure to market riskthrough the market-making and trading operations of PIC, its broker-dealersubsidiary.  In connection with theseactivities, PIC maintains inventories in order to ensure availability ofsecurities and to facilitate client transactions as well as trading for its ownproprietary equity investment account. PIC was a market-maker for 46 equity securities from 41 differentissuers and no tax exempt or taxable debt obligations at September 30,2005.

 
| ** **                                                        | ** ** | **September 30, 2005**             | ** ** | **December 31, 2004**                 | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                        | ** ** | **Trading and  investment  securities** | ** ** | **Securities sold but  not yet purchased** | ** ** | **Trading and  investment  securities** | ** ** | **Securities sold but  not yet purchased** | ** ** |
| Marketable equity and  other securities at fair value             |       | $                                       | 40,222,651 |                                       | $          | 71,865 |   | $ | 23,583,728 |   | $ | 50,144 |   |
|                                                              |       |                                    |       |                                       |       |   |   |   |   |
| Marketable debt securities                                        |       | 41,482                                  |       | —                                     |       | 220,243 |   | — |   |
|                                                              |       |                                    |       |                                       |       |   |   |   |   |
| Total marketable equity,  debt and other securities at fair value |       | $                                       | 40,264,133 |                                       | $          | 71,865 |   | $ | 23,803,971 |   | $ | 50,144 |   |

 

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

 

EquityPrice Risk

 

PIC is exposed to significant equity price risk as aresult of its customer transactions and market-making activity in equitysecurities and its concentrations in a limited number of equities, many ofwhich are related to its investment banking projects.  PIC’s broker-dealer activities areclient-driven, with the objective of meeting its clients’ needs while earning atrading profit to compensate for the risk associated with carrying inventoriesin equities, many of which are volatile, and some of which are illiquid, microand small cap securities.  PIC attemptsto reduce the risk of loss inherent in this activity by monitoring thesesecurities positions continuously throughout each day. The average aggregateinventory held in PIC’s proprietary investment accounts during the quarterended September 30, 2005 was approximately $37.4 million. Prices of themarketable equities held in these accounts are readily available and monitoredon a continuous basis.

 

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InterestRate Risk

 

 PIC has verylittle direct exposure to interest rate risk. A relatively minor amount of PIC’s trading inventory consists of debtobligations, and any of these positions PIC might have occasionally are in itstrading inventory for only a very short time. However, to the extent that interest rate fluctuations affect generalmarket conditions and cause investors to shift away from or more heavily intoequity investing, interest rates can have an effect on the value of PIC’sequity positions.

 

ForeignCurrency Risk

 

PIC does not deal in securities denominated inforeign currencies and only trades foreign equities upon receipt of an orderfrom customers, so it does not have any significant exposure to foreigncurrency risk in its trading inventory or investment accounts.

 

ITEM4.  CONTROLS AND PROCEDURES

 

(a)                                  Our management, with the participation of ourPresident and Chief Financial Officer, conducted an evaluation of ourdisclosure controls and procedures, as such terms are defined under Rules 13a-15(e) and15d-15(e) promulgated under the Securities Exchange Act of 1934, asamended, as of the end of the period covered by this report. Based on theirevaluation, our President and Chief Financial Officer concluded that ourdisclosure controls and procedures were effective.

 

(b)                                 For the quarter ended September 30, 2005,there have been no changes in our internal control over financial reportingthat have materially affected or are reasonably likely to materially affect ourinternal control over financial reporting.

 

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**PART IIOTHER INFORMATION**

 

Item1. Legal Proceedings.

 

See Note 4 to Condensed Consolidated FinancialStatements in Part I.

 

Item2. Unregistered Sales of Equity Securities and Use of Proceeds.

 

**Issuer Purchases of EquitySecurities**

 
| **Period**            | ** ** | **(a)  Paulson Capital  Corp. Total  Number of Shares  Purchased** | ** ** | **(b)  Paulson Capital Corp.  Average Price Paid  per Share** | ** ** | **(c)  Total Number of  Shares  Purchased as Part of  Publicly Announced  Plans  or Programs** | ** ** | **(d)  Maximum Number of  Shares that May Yet  Be Purchased Under  The Plans or  Programs** | ** ** |
|-----------------------|------------|--------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| 07/01/05 to  07/31/05 |       | 7,534                                                              |       | $                                                             | 13.38      |                                                                                                | —     |                                                                                             | 202,275    |   |
| 08/01/05 to  08/31/05 |       | 10,135                                                             |       | $                                                             | 11.89      |                                                                                                | 10,135     |                                                                                             | 192,140    |   |
| 09/01/05 to  09/30/05 |       | 4,407                                                              |       | $                                                             | 11.56      |                                                                                                | 4,407      |                                                                                             | 187,733    |   |
| Total                 |       | 22,076                                                             | (1)        | $                                                             | 12.33      |                                                                                                | 14,542     |                                                                                             | 187,733    |   |
|                       |            |                                                                    |            |                                                               |            |                                                                                                     |            |                                                                                                  |            |  |  |

 

All of the shares reflected in column (c) wereopen-market transactions as part of a corporate plan for stock repurchase. Thestock repurchase plan, approved by the board of directors on September 17,2001, authorizes the repurchase of up to 300,000 shares; a total of 112,267shares have been repurchased through September 30, 2005. There is noexpiration date on the stock repurchase plan.

 

(1) Of these 22,076 shares, 7,534 werepurchased from executive officers and employees of the Company (and theiraffiliates), not as open-market purchases, at an average price of $13.38 pershare.

 

Item3. Defaults upon Senior Securities.

 

None

 

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

 

None

 

Item5. Other Information.

 

None

 

Item 6. Exhibits

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

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 
|                         | PAULSON CAPITAL CORP. |
|------------------------------|-----------------------|
|                         |                  |   |
|                         |                  |   |
| Date: November 11, 2005 | By:                   | /s/ CHESTER L.F. PAULSON |
|                         |                  | Chester L.F. Paulson |
|                         |                  | President  Principal Executive Officer |
|                         |                  |   |
| Date: November 11, 2005 | By:                   | /s/ CAROL RICE |
|                         |                  | Carol Rice |
|                         |                  | Chief Financial Officer  Principal Financial Officer |

 

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