**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON D.C. 20549**

** **

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**FORM 10-QSB**

 

 

**ý QUARTERLYREPORT PURSUANT TO  SECTION 13 OR15(d) OF THE**

**SECURITIES EXCHANGE ACT OF 1934**

**For the quarterly period ended March 31, 2002**

 

 

**o TRANSITIONREPORT UNDER SECTION 13 OR 15(d) OF THE**

**SECURITIES EXCHANGE ACT OF 1934**

**For the transition period from          to           **

 

**Commission file number: 0-18188**

 

**PAULSON CAPITAL CORP.**

Exactname of small business issuer as specified in its charter

 

 

**811 S.W. Naito Parkway**

**Portland, OR 97204**

(Addressof principal executive offices)

 

**(503) 243-6000**

(Issuer’stelephone number)

 

 

                Numberof shares outstanding of each of the issuer’s classes of common stock, as ofthe latest practicable date:

 

Commonstock, no par value—3,137,311 shares as of May 9, 2002

 

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

 

 

 

 

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**                PARTI—FINANCIAL INFORMATION**

 

ITEM 1.  FINANCIALSTATEMENTS

 

PAULSON CAPITAL CORP.AND SUBSIDIARYCONSOLIDATED BALANCE SHEETS(unaudited)

 
|                                                                                                                                |   | **3/31/02** |       | **12/31/01** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|--------|-------------|------------|--------------|------------|
|                                                                                                                                |   |        | ** ** |         | ** ** |
| **ASSETS**                                                                                                                          |   |        |       |         |       |
| CURRENT ASSETS                                                                                                                      |   |        |       |         |       |
| Cash and cash equivalents                                                                                                           |   | $           | 18,588     |         | $          | 42,938 |   |
| Receivable from clearing  organization                                                                                              |   | 3,962,340   |       | 8,433,039    |       |
| Notes and other receivables                                                                                                         |   | 1,051,202   |       | 407,716      |       |
| Trading securities, at market  value                                                                                                |   | 2,134,212   |       | 1,559,960    |       |
| Investment securities, at  market value                                                                                             |   | 22,007,956  |       | 18,632,580   |       |
| Underwriter warrants, at  estimated fair value                                                                                      |   | 5,406,000   |       | 6,165,000    |       |
| Prepaid and deferred expenses                                                                                                       |   | 807,593     |       | 989,750      |       |
| Income taxes receivable                                                                                                             |   | 2,116,195   |       | 1,846,100    |       |
|                                                                                                                                |   |        |       |         |       |
| **Total  Current Assets**                                                                                                           |   | 37,504,086  |       | 38,077,083   |       |
|                                                                                                                                |   |        |       |         |       |
| FURNITURE AND EQUIPMENT, net                                                                                                        |   | 323,355     |       | 344,349      |       |
|                                                                                                                                |   |        |       |         |       |
| INVESTMENT IN REAL ESTATE                                                                                                           |   | 169,900     |       | 169,900      |       |
|                                                                                                                                |   |        |       |         |       |
| **Total Assets**                                                                                                                    |   | $           | 37,997,341 |         | $          | 38,591,332 |   |
|                                                                                                                                |   |        |       |         |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                      |   |        |       |         |       |
| CURRENT LIABILITIES                                                                                                                 |   |        |       |         |       |
| Accounts payable and accrued  liabilities                                                                                           |   | $           | 271,951    |         | $          | 369,977 |   |
| Payable to clearing  organization                                                                                                   |   | 2,214,574   |       | 1,418,779    |       |
| Compensation, employee  benefits and payroll taxes                                                                                  |   | 443,779     |       | 1,335,471    |       |
| Securities sold, not yet  purchased, at market value                                                                                |   | 25,823      |       | 12,846       |       |
| Deferred income taxes                                                                                                               |   | 2,305,200   |       | 2,305,200    |       |
|                                                                                                                                |   |        |       |         |       |
| **Total  Current Liabilities**                                                                                                      |   | 5,261,327   |       | 5,442,273    |       |
|                                                                                                                                |   |        |       |         |       |
| Deferred income taxes                                                                                                               |   | 18,100      |       | 18,100       |       |
|                                                                                                                                |   |        |       |         |       |
| 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, 3,158,562 at 3-31-02  and 3,163,062 at 12-31-01 |   | 1,094,928   |       | 1,062,428    |       |
| Retained earnings                                                                                                                   |   | 31,622,986  |       | 32,068,531   |       |
|                                                                                                                                |   |        |       |         |       |
| **Total  Shareholders’  Equity**                                                                                          |   | 32,717,914  |       | 33,130,959   |       |
|                                                                                                                                |   |        |       |         |       |
| **Total  Liabilities and  Shareholders’ Equity**                                                                          |   | $           | 37,997,341 |         | $          | 38,591,332 |   |

 

 

 

Theaccompanying notes are an integral part of these statements.

 

 

2

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

 
|                                                              |   | **Three months ended March 31,** |       |
|-------------------------------------------------------------------|--------|----------------------------------|------------|
|                                                              |   | **2002**                         |       | **2001** |   |
|                                                              |   |                             | ** ** |   | ** ** |
| **Revenues**                                                      |   |                             |       |   |   |
| Commissions                                                       |   | $                                | 1,627,141  |   | $ | 1,931,901 |   |
| Corporate finance                                                 |   | 77,323                           |       | 1,588,482 |   |
| Investment income                                                 |   | 966,336                          |       | (1,787,666 | ) |
| Trading income                                                    |   | (308,019                         | )          | 215,977 |   |
| Interest and dividends                                            |   | 20,864                           |       | 10,864 |   |
| Other                                                             |   | 117                              |       | 673 |   |
|                                                              |   |                             |       |   |   |
| **Total  Revenues**                                               |   | 2,383,762                        |       | 1,960,231 |   |
|                                                              |   |                             |       |   |   |
| **Expenses**                                                      |   |                             |       |   |   |
| Commissions and salaries                                          |   | 2,068,424                        |       | 2,016,889 |   |
| Underwriting expenses                                             |   | —                           |       | 217,397 |   |
| Rent, telephone and quotation  services                           |   | 253,722                          |       | 255,104 |   |
| Interest expense                                                  |   | 7,130                            |       | 3 |   |
| Professional fees                                                 |   | 143,299                          |       | 71,599 |   |
| Bad debt expense                                                  |   | 30,000                           |       | 30,000 |   |
| Travel and entertainment                                          |   | 69,478                           |       | 62,201 |   |
| Settlements                                                       |   | 85,000                           |       | 1,050 |   |
| Other                                                             |   | 322,504                          |       | 338,816 |   |
|                                                              |   |                             |       |   |   |
| **Total  Expenses**                                               |   | 2,979,557                        |       | 2,993,059 |   |
|                                                              |   |                             |       |   |   |
| Earnings (loss) before income  taxes                              |   | (595,795                         | )          | (1,032,828 | ) |
| Provision for income taxes                                        |   |                             |       |   |   |
| Current                                                           |   | (235,000                         | )          | (526,730 | ) |
| Deferred                                                          |   | —                           |       | 109,000 |   |
|                                                              |   |                             |       |   |   |
| **Net Earnings  (Loss)**                                          |   | $                                | (360,795   | ) | $ | (615,098 | ) |
|                                                              |   |                             |       |   |   |
| Earnings (loss) per share,  basic and diluted                     |   | $                                | (0.11      | ) | $ | (0.18 | ) |
|                                                              |   |                             |       |   |   |
| Weighted average number of  shares outstanding, basic and diluted |   | 3,159,845                        |       | 3,325,833 |   |

 

 

 

Theaccompanying notes are an integral part of these statements

 

3

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PAULSON CAPITAL CORP. AND SUBSIDIARYCONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITYFor the two year period ended December 31, 2000 and 2001 and the threemonths ended March 31, 2002 (unaudited)

 
|                         |   | **Common Stock** |   | **Retained********Earnings** |      |
|------------------------------|--------|------------------|--------|------------------------------|-----------|
|                         |   | **Shares**       |   | **Amount**                   |      |   |
| Balance at December 31, 1999 |   | 3,541,235        |   | $                            | 732,343   |   | $ | 30,388,263 |   |
|                         |   |             |   |                         |      |   |   |
| Stock option grants          |   | —           |   | 317,750                      |      | — |   |
|                         |   |             |   |                         |      |   |   |
| Stock options exercised      |   | 16,000           |   | 71,000                       |      | — |   |
|                         |   |             |   |                         |      |   |   |
| Redemption of common stock   |   | (189,869         | )      | (41,082                      | )         | (1,235,230 | ) |
|                         |   |             |   |                         |      |   |   |
| Net loss for the year        |   | —           |   | —                       |      | (3,048,214 | ) |
|                         |   |             |   |                         |      |   |   |
| Balance at December 31, 2000 |   | 3,367,366        |   | 1,080,011                    |      | 26,104,819 |   |
|                         |   |             |   |                         |      |   |   |
| Stock options exercised      |   | 7,000            |   | 31,063                       |      | — |   |
|                         |   |             |   |                         |      |   |   |
| Redemption of common stock   |   | (211,304         | )      | (48,646                      | )         | (1,073,350 | ) |
|                         |   |             |   |                         |      |   |   |
| Net earnings for the year    |   | —           |   | —                       |      | 7,037,062 |   |
|                         |   |             |   |                         |      |   |   |
| Balance at December 31, 2001 |   | 3,163,062        |   | 1,062,428                    |      | 32,068,531 |   |
|                         |   |             |   |                         |      |   |   |
| Stock options exercised      |   | 8,000            |   | 35,500                       |      | — |   |
|                         |   |             |   |                         |      |   |   |
| Redemption of common stock   |   | (12,500          | )      | (3,000                       | )         | (84,750 | ) |
|                         |   |             |   |                         |      |   |   |
| Net loss for year to date    |   | —           |   | —                       |      | (360,795 | ) |
|                         |   |             |   |                         |      |   |   |
| Balance at March 31, 2002    |   | 3,158,562        |   | $                            | 1,094,928 |   | $ | 31,622,986 |   |

 

 

 

Theaccompanying notes are an integral part of these statements

 

 

 

4

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PAULSON CAPITAL CORP. AND SUBSIDIARYCONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited)

 

 
|                                                                                                 |   | **Three months ended March 31,** |     |
|------------------------------------------------------------------------------------------------------|--------|----------------------------------|----------|
|                                                                                                 |   | **2002**                         |     | **2001** |   |
| Increase  (Decrease) in Cash and Cash Equivalents                                                    |   |                             |     |   |   |
|                                                                                                 |   |                             |     |   |   |
| Cash flows from operating  activities                                                                |   |                             |     |   |   |
| Net earnings (loss)                                                                                  |   | $                                | (360,795 | ) | $ | (615,098 | ) |
| Adjustments to reconcile net  earnings (loss) to net cash provided by (used in) operating activities |   |                             |     |   |   |
| Receipt of underwriter  warrants                                                                     |   | (68,391                          | )        | — |   |
| Unrealized (appreciation)  depreciation on investment securities                                     |   | 1,145                            |     | 1,423,537 |   |
| Realized gain on investment  securities                                                              |   | (967,482                         | )        | (852,971 | ) |
| Depreciation and amortization                                                                        |   | 49,189                           |     | 50,602 |   |
| Deferred income taxes                                                                                |   | —                           |     | 109,000 |   |
| Change in assets and  liabilities                                                                    |   |                             |     |   |   |
| Receivables                                                                                          |   | 3,827,213                        |     | 5,134,311 |   |
| Trading securities                                                                                   |   | (574,252                         | )        | 202,035 |   |
| Prepaid and deferred expenses                                                                        |   | 182,157                          |     | 592,694 |   |
| Income taxes receivable                                                                              |   | (270,095                         | )        | — |   |
| Accounts payable and accrued  liabilities                                                            |   | (193,923                         | )        | (791,115 | ) |
| Securities sold, not yet  purchased                                                                  |   | 12,977                           |     | 62,253 |   |
|                                                                                                 |   |                             |     |   |   |
| Income taxes payable                                                                                 |   | —                           |     | (3,176,749 | ) |
|                                                                                                 |   |                             |     |   |   |
| Net cash provided by  operating activities                                                           |   | 1,637,743                        |     | 2,138,499 |   |
|                                                                                                 |   |                             |     |   |   |
| Cash flows from investing  activities                                                                |   |                             |     |   |   |
| Purchases of investment  securities                                                                  |   | (8,622,285                       | )        | (10,890,701 | ) |
| Proceeds from sale of  investment securities                                                         |   | 7,040,637                        |     | 9,270,619 |   |
| Additions to furniture and  equipment                                                                |   | (28,195                          | )        | (8,538 | ) |
|                                                                                                 |   |                             |     |   |   |
| Net cash provided by (used  in) investing activities                                                 |   | (1,609,843                       | )        | (1,628,620 | ) |
|                                                                                                 |   |                             |     |   |   |
| Cash flows from financing  activities                                                                |   |                             |     |   |   |
| Proceeds from exercise of  stock options                                                             |   | 35,500                           |     | — |   |
| Payments to retire common  stock                                                                     |   | (87,750                          | )        | (486,248 | ) |
|                                                                                                 |   |                             |     |   |   |
| Net cash provided by (used  in) financing activities                                                 |   | (52,250                          | )        | (486,248 | ) |
|                                                                                                 |   |                             |     |   |   |
| Net increase (decrease) in  cash and cash equivalents                                                |   | (24,350                          | )        | 23,631 |   |
|                                                                                                 |   |                             |     |   |   |
| Cash and cash equivalents at  beginning of period                                                    |   | 42,938                           |     | 104,309 |   |
|                                                                                                 |   |                             |     |   |   |
| Cash and cash equivalents at  end of period                                                          |   | $                                | 18,588   |   | $ | 127,940 |   |
|                                                                                                 |   |                             |     |   |   |
| Cash paid during the three  months for                                                               |   |                             |     |   |   |
| Interest                                                                                             |   | $                                | 7,130    |   | $ | 3 |   |
|                                                                                                 |   |                             |     |   |   |
| Income taxes                                                                                         |   | $                                | 35,095   |   | $ | 2,650,019 |   |

 

Theaccompanying notes are an integral part of these statements

 

 

 

5

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**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**(Unaudited)**

 

 

 

**1. Basis of Presentation**

 

                Theaccompanying unaudited consolidated financial statements have been prepared inaccordance with the instructions for interim financial statements in Item310(b) of Regulation S-B and, therefore, do not include all informationand footnotes required by generally accepted accounting principles for completefinancial statements. In the opinion of management, the interim financialstatements include all adjustments (consisting only of normal recurringadjustments) necessary to state fairly the information shown therein. Thenature of the Company’s business is such that the results of any interim periodare not necessarily indicative of results for a full fiscal year.

 

**2. Securities Owned**

 

                Gainsand losses from the disposition of securities owned are reflected in tradingrevenues on the income statement for the period.

 

**3. Commitments and Contingencies**

 

                InJanuary 2001, V.J.E. Enterprises, Inc. and Vincent and Diana Nartker,former PIC customers, filed a customer complaint with PIC regarding thehandling of their account by PIC and one of its registered representatives.They have asserted that their account was mismanaged and that PIC failed tosupervise its registered representative. They have requested that PIC pay them$275,100. PIC is investigating this claim, but believes it has meritoriousdefenses and intends to defend this matter vigorously if an arbitration isfiled.

 

                InMay 2001, PIC received notice that Eugene V. Doty, a former PIC customer, hadmade a customer complaint about the handling of his account at PIC. Mr. Dotyalleges that his account was traded excessively but has not identified whatamount, if any, he seeks from PIC or its former brokers.  PIC is investigating this claim, butbelieves it has meritorious defenses and intends to defend this mattervigorously if an arbitration is filed.

 

                OnNovember 7, 2001, the Company and PIC were named as defendants in a lawsuitfiled by Spirit Partners, L.P. and Tech-Trade Capital LLC.  The lawsuit was filed in the Supreme Courtof the State of New York for the County of New York.  The lawsuit alleges that PIC committed fraud and was unjustlyenriched in connection with the redemption of warrants issued in the initialpublic offering of audiohighway.com, for which PIC served as underwriter.  According to plaintiffs, the warrantagreement and prospectus contain different provisions governing the redemptionof the warrants.  This allegedlyoccurred because the redemption provisions were changed during the registrationprocess, and the warrant agreement was not amended to reflect the change inprovisions.  audiohighway.com’sredemption was proper under the terms of the prospectus, which contains theupdated redemption provisions and allowed the issuer to redeem when the closingbid price of the common stock was at least $13.50 for 10 calendar days.  Plaintiffs allege that the redemption wasimproper under the terms of the warrant agreement, which they allege containsthe original redemption provisions and allows the issuer to redeem when theclosing bid price of the common stock exceeded $13.50 for 20 consecutivetrading days.  Plaintiffs also allegethat counsel for audiohighway.com and PIC fraudulently concealed the allegeddiscrepancy between the prospectus and warrant agreement by amending thewarrant agreement to be consistent with the prospectus. Plaintiffs claimunspecified monetary damages and seek $3 million in punitive damages.  The lawsuit is in a very early stage and PCCand PIC have not yet responded to the claims or conducted discovery.  However, PCC and PIC believe that they havemeritorious defenses to these claims and intend to defend the case vigorously.

 

                InJanuary 2002, PIC was served in an arbitration brought by one of its formercustomers, Patricia Weber, against PIC and its registered representative MelvinVuckevich.  The arbitration claimalleges unsuitable securities recommendations, misrepresentation, breach offiduciary duty and negligence.  Theclaimant is seeking damages of $255,000, interest, an additional return on herportfolio, punitive damages and attorney fees. PIC has not had an opportunity to fully investigate this claim, butbelieves it has meritorious defenses and intends to defend these mattersvigorously.

 

 

6

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                InMarch 2002, PIC and one of its registered representatives, Marvin Cox, werenamed as defendants in lawsuits filed by Louis Barinaga and Stuart Mackenzie,former PIC customers.  The claims ofBarinaga and Mackenzie relate to purchases of convertible notes of E.com, whichwere purchased directly from E.com. Barinaga and Mackenzie allege that PIC and Mr. Cox participated in andmaterially aided the sale of the notes and, therefore, are liable under statesecurities law.  Barinaga and Mackenzieallege damages of $717,000 and $165,000, respectively, plus interest andattorney fees. PIC has asserted that the claims are subject to arbitration andboth plaintiffs have agreed to pursue their claims in arbitration.  PIC has not had an opportunity to fullyinvestigate these claims, but believes it has meritorious defenses and intendsto defend this matter vigorously.

 

                Inaddition to the matters described above, PIC has information that certainformer customers may file claims against it; however, no such claims have beenasserted at this time.  PIC has noinformation regarding what amounts, if any, may be sought from PIC but believesthe amounts may be material.  PIC hasnot had an opportunity to fully investigate these claims, but believes it hasmeritorious defenses and intends to defend these matters vigorously if anyclaims are filed.

 

                Anadverse outcome in certain of the matters described above could have a materialadverse effect on PIC or the Company. PIC also has been named in certain otherlegal proceedings and has received notice that certain customers may commencelegal proceedings against PIC. The Company believes, based upon informationreceived to date and, where the Company believes it appropriate, discussionswith legal counsel, that resolution of this additional pending or threatenedlitigation will have no material adverse effect on the consolidated financialcondition, results of operations, or business of the Company.

 

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS

 

**General**

 

                FORWARDLOOKING STATEMENTS

 

                Thisreport, including, without limitation, “Item 2: Management’s Discussion andAnalysis or Plan of Operations,” contains or incorporates both historical and“forward-looking” statements within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the Securities ExchangeAct of 1934, as amended.  Words such as“anticipates”, “believes”, “expects”, “intends”, “future” and similarexpressions identify forward-looking statements.  Any such forward-looking statements in this report reflect ourcurrent views with respect to future events and financial performance and aresubject to a variety of factors that could cause our actual results to differmaterially from historical results or from anticipated results expressed orimplied by such forward-looking statements. Because of such factors, we cannot assure you that the resultsanticipated in this report will be realized. As noted elsewhere in this report, various aspects of our business aresubject to extreme volatility often as a result of factors beyond our abilityto anticipate or control.  Inparticular, factors, such as the condition of securities markets, which are inturn based on popular perceptions of the health of the economy generally, canbe expected to affect the volume of our business as well as the value of thesecurities maintained in our trading and investment accounts.  Other factors that may affect our futurefinancial condition or results of operations include the following:

 
| • |   | The performance of companies whose securities we have  underwritten or otherwise sold to our customers may affect our reputation  with other potential syndicate and selling group members and institutional  and other retail accounts and may also affect the amount of money in our  customers’ portfolios available for the kinds of investments that we offer.                                                                        |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| • |   | The value of our investment portfolio, including the  value of securities without a readily ascertainable market value, that we  have estimated for the purpose of reporting on our financial condition and  results of operations, may be significantly and adversely affected by changes  in the value of the companies themselves or of comparable companies whose  stock values we use in estimating the value of our portfolio securities. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| • |   | We are subject to a very high degree of regulation and  are responsible for compliance with applicable                                                                                                                                                                                                                                                                                                                                          |

 

 

 

7

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|   |   | regulations by all of our personnel.  A significant regulatory infraction by us  or any of our registered representatives could result in significant  penalties, including the loss of our license to conduct securities business  in one or more jurisdictions. |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                   |
| • |   | Alternatives available to our customers to transact  securities trades could affect our ability to continue to execute our  brokerage customers’ transactions.                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                   |
| • |   | The loss of our Chairman, Chester Paulson, could have a  material adverse impact on our business.                                                                                                                                                                      |

 

 

**Overview**

 

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

 
| • |   | securities brokerage activities for which PIC earns  commission revenues;                                                                                                    |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                         |
| • |   | securities trading from which PIC records profit or  loss, depending on trading results;                                                                                     |
|   |   |                                                                                                                                                                         |
| • |   | corporate finance revenues consisting principally of  underwriting discounts, underwriter warrants received, and other compensation  from investment banking activities; and |
|   |   |                                                                                                                                                                         |
| • |   | investment income resulting from earnings on, and  increases or decreases in the value of, PIC’s investment portfolio.                                                  |

 

                Becausewe operate in the financial services industry, our revenues and earnings aresubstantially affected by conditions in financial markets generally. In oursecurities brokerage and corporate finance businesses, the amount of ourrevenues depends substantially on levels of market activity requiring theservices we provide. For example, our investment banking activity, whichconsists primarily of acting as managing or participating underwriter ofinitial and follow-on public offerings for smaller companies, depends on themarket for new equity offerings, which has historically experienced substantialcyclical fluctuation. Although we attempt to match operating costs withactivity levels, many of our expenses are either fixed or difficult to changeon short notice. Accordingly, fluctuations in brokerage and investment bankingrevenues tend to result in sharper fluctuations, on a percentage basis, in netincome or loss.

 

                Ourinvestment income or loss and, to a lesser extent, our trading income or lossare affected by changes in market valuation of securities generally and, inparticular, by changes in valuation of the equity securities of microcapcompanies in which our investments and trading activities tend to beconcentrated. Equity markets in general, and microcap equity markets inparticular, have always experienced significant volatility and this volatilityhas in recent years been extreme. The results of this volatility on the valueof our investment portfolio and securities held in connection with our tradingand investment activities include large quarterly fluctuations in income orloss from these operations and substantial increases or decreases in our networth as our securities holdings are marked to market.

 

                Asubstantial portion of our investment banking business consists of acting asmanaging underwriter of initial and follow-on public offerings for microcapcompanies. As a part of our underwriter compensation for this activity, wetypically receive warrants exercisable to purchase securities identical tothose that we offer and sell to the public. The warrants are not exercisablefor the first year after the offering in which they are earned and arethereafter exercisable for four years, after which they expire. The exerciseprice is typically 120% of the price at which we initially sold the securitiesto the public. Accordingly, unless there is at least a 20% increase in theprice of these securities at some time more than one and less than five yearsafter the offering, the warrants will remain “under water” and will ultimatelyexpire unexercised.

 

 

8

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                Weare required to estimate the value of all derivative securities that we hold atthe date of any financial statements and to include that value, and changes insuch value, in those financial statements. Accordingly, the aggregate estimated value of our warrants as of the date of any balance sheet is recorded asan asset on that balance sheet. When a new warrant is earned as a result of ourinvestment banking activity, its estimated value is included in corporatefinance revenue for the period in which it is earned. In subsequent periods,any change in estimated value is recorded as investment income or loss for theperiod. If, and when, a warrant is exercised the book value is adjusted toreflect the value of the securities purchased, net of the exercise price, andthe adjustment amount is recorded as income or loss for the relevant period. Ifthe warrant expires unexercised, the book value is adjusted to zero and thedecrease is recorded as a loss in the relevant period.

 

                We are estimating the value ofour underwriter warrants using the Black–Scholes Option PricingModel.  The Black-Scholes model requiresus to use historical price data combined with various assumptions and judgmentsto develop the inputs for the model. In particular, we have calculated avolatility factor for each company’s warrants that is based on its own stockprice movements as well as an index: as our warrants getcloser to their expiration date their volatility factor is almost entirelybased on each company's own historical prices. We cannot assure you that wewill ultimately be able to exercise any of our warrants in a way that willrealize the value that we attribute to them in our financial statements based on this model.

 

                As aresult of the factors described above, our revenues and earnings are subject tosubstantial fluctuation from period to period based on circumstances many ofwhich are beyond our control. An increase in financial market activitygenerally, and/or an increase in equity valuations generally, will normallyresult in increases in revenue, earnings and net worth as our activity levelsand the value of our investment portfolio increase. Conversely, a generalmarket retrenchment will typically lead to decreased revenue, earnings and networth as a result both of decreased activity and the need to adjust highinvestment portfolio values to lower levels. Accordingly, results for anyhistorical period are not necessarily indicative of similar results for anyfuture period.

 

**Results of Operations**

 

***Three MonthsEnded March 31, 2002 vs. Three Months Ended March 31, 2001***

 

                 The revenues and operating results of theCompany’s operating subsidiary, Paulson Investment Company, Inc. (“PIC”),are influenced by fluctuations in the equity underwriting markets as well asgeneral economic and market conditions, particularly conditions in theover-the-counter market, where PIC’s investment account, trading inventorypositions and underwriter warrants are heavily concentrated. Significantfluctuations can occur in PIC’s revenues and operating results from one periodto another. PIC’s financial results depend upon many factors, such as thenumber of companies that are seeking public financing, the quality and financialcondition of those companies, market conditions in general, the performance ofprevious PIC underwritings and interest in certain industries by investors. Asa result, revenues and income derived from these activities may varysignificantly from period to period. In the table below, “Trading Income” isthe net gain or loss from trading positions before commissions paid to therepresentatives in the trading department.

 

 

9

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**Summary of Changes in Major Categories**

**of Revenues and Expenses**

 

 

 
|                       |   |                                    |       |   |   |
|----------------------------|--------|-----------------------------------------|------------|--------|--------|
|                       |   | **Quarters Ended  3/31/02 vs. 3/31/01** | ** ** |
|                       |   |                                    |
|                       |   | **increase /(decrease)**                |       |
| **Revenues:**              |   |                                    |       |
| Sales Commissions          |   | $                                       | (304,760   | )      | (15.8  | )% |
| Corporate Finance          |   | (1,511,159                              | )          | (95.1  | )%     |
| Investment Income          |   | 2,754,002                               |       | N/A    |   |
| Trading Income             |   | (523,996                                | )          | N/A    |   |
| Other                      |   | 9,444                                   |       | 81.8   | %      |
|                       |   |                                    |       |   |   |
| Total                      |   | $                                       | 423,531    |   | 21.6   | % |
|                       |   |                                    |       |   |   |   |
| **Expenses:**              |   |                                    |       |   |   |
| Commissions and Salaries   |   | $                                       | 51,535     |   | 2.5    | % |
| Underwriting Expenses      |   | (217,397                                | )          | (100.0 | )%     |
| Rent, Telephone and Quotes |   | (1,382                                  | )          | (0.5   | )%     |
| Other                      |   | 153,742                                 |       | 30.5   | %      |
|                       |   |                                    |       |   |   |
| Total                      |   | $                                       | (13,502    | )      | (.5    | )% |
|                       |   |                                    |       |   |   |
| Pretax Income              |   | $                                       | 437,033    |   | 42.3   | % |

 

 

                Totalrevenues for the first quarter of 2002 rose 21.6 percent from the firstquarter of 2001, from $1,960,231 to $2,383,762. As shown in the table above, salescommissions fell $304,760, from $1,931,901 in the first quarter of 2001 to$1,627,141 in the comparable 2002 period. This decrease resulted primarily fromthe less favorable price movements and trading levels in the stock market,especially the market for the very small capitalization issues (the primaryfocus of PIC’s investment banking and trading businesses) in the 2002 quartercompared to 2001. The Nasdaq Composite fell 5.39 percent in the firstquarter of 2002 and fell 25.5 percent in the first quarter of 2001. Corporatefinance revenue fell to $77,323 in the first quarter of 2002, down95.1 percent from $1,588,482 for the first quarter of 2001. One corporatefinance transaction for $10 million was completed in the first quarter of2001; no transactions were closed in the first quarter of 2002. Corporatefinance revenue is directly related to the amount of money raised in completedinvestment banking transactions. Investment income rose from a loss of$1,787,666 in the first quarter of 2001 to a gain of $966,336 in the firstquarter of 2002. There were no underwriter warrant exercises in 2001 or 2002for the quarter ending March 31. There was a small loss in underwriter warrantvalue, but this loss was more than offset by net gains in other investmentsecurities in the first quarter of 2002. Trading income decreased $523,996, toa loss of $308,019 in the first quarter of 2002 from a gain of $215,977 in thecomparable 2001 period. This decrease was also due to decreased prices andtrading in the market for very small capitalization companies described above.Other income increased $9,444, from $11,537 in the first quarter of 2001 to$20,981 in the 2002 quarter, due primarily to an increase in interest anddividend income.

 

                Totalexpenses fell $13,502 in the first quarter of 2002 from the comparable 2001period, a decrease of .5 percent, from $2,993,059 to $2,979,557.Commissions and salaries rose $51,535, or 2.5 percent, from $2,016,889 inthe 2001 period to $2,068,424 in 2002. This increase was primarily due tohigher bonus and compensation arrangements related to increased investmentincome.  Underwriting expenses fell$217,397, from $217,397 in the 2001 quarter to $0 in the first quarter of 2002.No transactions were completed in the 2002 period, while one transaction wascompleted in 2001. Rent, telephone and quote expenses decreased from $255,104in the 2001 period to $253,722 in 2002, a decrease of .5 percent. Theaggregate of all other expenses rose 30.5 percent, from $503,669 in thefirst quarter of 2001 to $657,411 in the first quarter of 2002, primarily dueto an increase in professional services expenses and a lawsuit settlement.

 

                TheCompany had a pretax loss of $1,032,828 in the first quarter of 2001 comparedto a pretax loss of $595,795 in the comparable 2002 period, primarily due to anincrease in investment income that more than offset decreases in corporatefinance revenues and trading income. Significant fluctuations can occur inPIC’s revenues and operating results from one period to another.

 

                TheCompany also had an estimated tax benefit of $417,730 for the first quarter of2001, compared to an estimated tax benefit in the first quarter of 2002 of$235,000. Independent of investment income, the Company would have had apre-tax loss of $1,562,131 for the first quarter of 2002 and a pre-tax profitof $754,838 for the first quarter of 2001.

 

 

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**Liquidity and Capital Resources**

 

                Themajority of PIC’s assets are cash and assets readily convertible to cash. PIC’ssecurities inventory is stated at market value. The liquidity of the market formany of PIC’s securities holdings, however, varies with trends in the stockmarket. Since many of the securities held by PIC are thinly traded, and PIC isin many cases a primary market maker in the issues held, any significant salesof PIC’s positions could adversely affect the liquidity of the issues held. Ingeneral, falling prices in OTC securities (which make up most of PIC’s tradingpositions) lead to decreased liquidity in the market for these issues, whilerising prices in OTC issues tend to increase the liquidity of the market forthese securities. The decline in prices for the OTC securities traded by PIC todate in 2002 and late 2001 was combined with a general decrease in theliquidity of the markets for these securities. PIC’s investment account andtrading inventory accounts are stated at fair market value, which is at orbelow quoted market price.

 

                PICborrows money from its clearing firm in the ordinary course of its business,pursuant to an understanding under which the clearing firm agrees to financePIC’s trading accounts. As of March 31, 2002, no net loans wereoutstanding pursuant to this arrangement. PIC and the Company are generally ableto meet their compensation and other obligations out of current liquid assets.

 

                Anothersource of capital to PIC and the Company has been the underwriter warrantsissued to PIC in connection with its corporate finance activities and the saleof the underlying securities. These underwriter warrants are not exercisablefor the first year after the offerings in which they are earned and arethereafter exercisable for four years, after which they expire. The exerciseprice is typically 120% of the price at which we initially sold the securitiesto the public. Accordingly, unless there is at least a 20% increase in theprice of these securities at some time more than one and less than five yearsafter the offering, the warrants will remain “under water” and will ultimatelyexpire unexercised. There is no public market for the underwriter warrants. Thesecurities receivable upon exercise of the underwriter warrants cannot beresold unless the issuer has registered these securities with the SEC and thestates in which the securities will be sold or exemptions are available. Anydelay or other problem in the registration of these securities would have anadverse impact upon PIC’s ability to obtain funds from the exercise of theunderwriter warrants and the resale of the underlying securities. AtMarch 31, 2002, PIC owned 27 underwriter warrants (from 22 issuers), ofwhich 24 were currently exercisable; three had an exercise price below thecurrent market price of the securities receivable upon exercise. These pricesare influenced by general movements in the prices of OTC securities as well asthe success of the issuers of the underwriter warrants. The prices of thesecurities underlying the underwriter warrants are very volatile, andsubstantial fluctuations in the Company’s estimate of their value can beexpected in the future.

 

                Inthe three months ended March 31, 2002, $1,637,743 of net cash was providedby operating activities of the Company. The major adjustments to reconcile thisresult to the Company’s net loss of $360,795 include a decrease in receivablesof $3,827,213 and pre-paid expenses of $182,157 partially offset by a realizedgain in investment securities of $967,482, an increase in trading securities of$574,252, an increase in income taxes receivable of $270,095, and a decrease inaccounts payable/accrued liabilities of $193,923. In the 2002 first quarter,$1,609,843 of net cash was used by the Company in investing activities, theresult of $7,040,637 from the sale of investment securities being more thanoffset by the purchase of $8,622,285 of investment securities and $28,195 ofadditions to furniture and equipment. $52,250 in cash was used in financingactivities by the Company in the quarter, the result of payments to retirecommon stock of $87,750, partially offset by option exercises of $35,500.

 

                As asecurities broker-dealer, PIC is required by SEC regulations to meet certainliquidity and capital standards. At March 31, 2002, the Company had nomaterial commitments for capital expenditures.

 

                Ingeneral, the primary ongoing sources of PIC’s, and therefore the Company’s,liquidity, including PIC’s trading positions, borrowings on those positions andprofits recognized from underwriter warrants, all depend in large part on thetrend in the general markets for OTC securities. Rising OTC price levels willtend to increase the value and liquidity of PIC’s trading positions, the amountthat can be borrowed from its clearing firm based upon those positions, and thevalue of PIC’s underwriter warrants. The Company believes its liquidity issufficient to meet its needs for the foreseeable future.

 

**Inflation**

 

                Because PIC’s assets are primarily liquid, they arenot significantly affected by inflation. The rate of inflation affects PIC’sexpenses, such as employee compensation, office leasing and communicationscosts. These costs may not be readily recoverable in the price of servicesoffered by the Company. To the extent inflation results in rising interestrates and has other adverse effects in the securities markets and the value ofsecurities held in inventory or PIC’s investment account, it may adverselyaffect the Company’s financial position and results of operations.

 

 

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**PART II**

**OTHER INFORMATION**

 
| Item 1.  |   | Legal Proceedings.                                                                            |
|---------------|--------|-----------------------------------------------------------------------------------------------|
|          |   |                                                                                          |
|          |   | See Note 3 of Notes to Condensed Consolidated  Financial Statements in Item 1 of Part I. |
|          |   |                                                                                          |
| Item 2.       |   | Changes in Securities.                                                                        |
|          |   |                                                                                          |
|          |   | None                                                                                          |
|          |   |                                                                                          |
| Item 3.  |   | Defaults upon Senior Securities.                                                              |
|          |   |                                                                                          |
|          |   | None                                                                                          |
|          |   |                                                                                          |
| Item 4.  |   | Submission of Matters to a Vote of Security Holders.                                          |
|          |   |                                                                                          |
|          |   | None                                                                                          |
|          |   |                                                                                          |
| Item 5.  |   | Other Information.                                                                            |
|          |   |                                                                                          |
|          |   | None                                                                                          |
|          |   |                                                                                          |
| Item 6.  |   | Exhibits and Reports on Form 8-K                                                         |
|          |   |                                                                                          |
|          |   | Exhibits—None                                                                            |
|          |   |                                                                                          |
|          |   | No Reports on Form 8-K were filed during the  quarter ended March 31, 2002.         |

 

 

 

 

 

 

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**SIGNATURES**

 

                Inaccordance with the requirements of the Exchange Act , the registrant hascaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
|        |        | PAULSON CAPITAL CORP. |
|-------------|-------------|-----------------------|
|  Date: | May 9, 2002 |                  |   |
|        |        | By:                   | /s/ CHESTER L.F. PAULSON |
|        |        |                  |   |
|        |        |                  |   |
|        |        |                  | Chester L.F. Paulson*President* |
|        |        |                  |   |
|        |        | By:                   | /s/ CAROL A. RICE |
|  Date: | May 9, 2002 |                  |   |
|        |        |                  |   |
|        |        |                  | Carol  A. Rice*Principal Accounting  Officer* |

 

 

 

 

 

 

 

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