**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTOND.C. 20549**

 

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**FORM 10-QSB**

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

 

**Forthe quarterly period ended March 31, 2003**

 
| **o****TRANSITION REPORT UNDER  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|----------------------------------------------------------------------------------------------|

 

**Forthe transition periodfrom         to         **

 

**Commissionfile number: 0-18188**

 

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

 

Number of sharesoutstanding of each of the issuer’s classes of common stock, as of the latestpracticable date:

 

Common stock, nopar value—3,117,811 shares as of May 12, 2003

 

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

 

 

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**PART I — FINANCIAL INFORMATION**

 

ITEM1.  FINANCIAL STATEMENTS

 

PAULSON CAPITAL CORP. AND SUBSIDIARY

CONSOLIDATEDBALANCE SHEETS

 
|                                                                                                                                |   | **3/31/03**     |       | **12/31/02** |       |
|-------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------|------------|--------------|------------|
|                                                                                                                                |   | **(unaudited)** |       |         |       |
| **ASSETS**                                                                                                                          |   |            | ** ** |         | ** ** |
|                                                                                                                                |   |            | ** ** |         | ** ** |
| Cash  and cash equivalents                                                                                                          |   | $               | 102,363    |         | $          | 97,630 |   |
| Receivable  from clearing organization                                                                                              |   | 3,035,236       |       | 3,926,749    |       |
| Notes  and other receivables                                                                                                        |   | 918,203         |       | 681,655      |       |
| Income  taxes receivable                                                                                                            |   | 1,699,355       |       | 1,894,000    |       |
| Trading  securities, at market value                                                                                                |   | 2,091,725       |       | 2,725,081    |       |
| Investment  securities, at market value                                                                                             |   | 11,688,746      |       | 15,656,235   |       |
| Underwriter  warrants, at estimated fair value                                                                                      |   | 1,837,800       |       | 2,714,000    |       |
| Prepaid  and deferred expenses                                                                                                      |   | 1,201,213       |       | 1,158,738    |       |
| Furniture and equipment, net                                                                                                        |   | 248,025         |       | 257,559      |       |
|                                                                                                                                |   |            |       |         |       |
| Total assets                                                                                                                        |   | $               | 22,822,666 |         | $          | 29,111,647 |   |
|                                                                                                                                |   |            |       |         |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                       |   |            |       |         |       |
|                                                                                                                                |   |            |       |         |       |
| **LIABILITIES**                                                                                                                     |   |            |       |         |       |
| Accounts  payable and accrued liabilities                                                                                           |   | $               | 332,900    |         | $          | 524,886 |   |
| Payable  to clearing organization                                                                                                   |   | 1,367,055       |       | 2,087,907    |       |
| Compensation,  employee benefits and  payroll taxes                                                                            |   | 617,536         |       | 595,052      |       |
| Securities  sold, not yet purchased, at market value                                                                                |   | 95,654          |       | 60,843       |       |
|                                                                                                                                |   |            |       |         |       |
| Total  liabilities                                                                                                                  |   | 2,413,145       |       | 3,268,688    |       |
|                                                                                                                                |   |            |       |         |       |
| **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,  3,117,811 at 3/31/03 and 3,125,811 at 12/31/02 |   | 1,084,740       |       | 1,086,740    |       |
| Retained  earnings                                                                                                                  |   | 19,324,781      |       | 24,756,219   |       |
|                                                                                                                                |   |            |       |         |       |
| Total shareholders’ equity                                                                                                     |   | 20,409,521      |       | 25,842,959   |       |
|                                                                                                                                |   |            |       |         |       |
| Total liabilities and shareholders’ equity                                                                                     |   | $               | 22,822,666 |         | $          | 29,111,647 |   |

 

The accompanying notesare an integral part of these statements.

 

2

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PAULSON CAPITAL CORP. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

** **
|                                                    |   | **Three  months ended** |       |
|---------------------------------------------------------|--------|-------------------------|------------|
|                                                    |   | **3/31/03**             |       | **3/31/02** |   |
|                                                    |   |                    |       |   |   |
| **Revenues**                                            |   |                    |       |   |   |
| Commissions                                             |   | $                       | 2,437,785  |   | $ | 1,627,141 |   |
| Corporate  finance                                      |   | 25,363                  |       | 77,323 |   |
| Investment  income (loss)                               |   | (4,228,074              | )          | 966,336 |   |
| Trading  income (loss)                                  |   | (415,591                | )          | (308,019 | ) |
| Interest  and dividends                                 |   | 19,806                  |       | 20,864 |   |
| Other                                                   |   | 805                     |       | 117 |   |
|                                                    |   |                    |       |   |   |
|                                                    |   | (2,159,906              | )          | 2,383,762 |   |
| **Expenses**                                            |   |                    |       |   |   |
| Commissions  and salaries                               |   | 2,450,516               |       | 2,068,424 |   |
| Underwriting  expenses                                  |   | —                  |       | — |   |
| Rent,  telephone and quotation services                 |   | 265,512                 |       | 253,722 |   |
| Interest  expense                                       |   | —                  |       | 7,130 |   |
| Professional  fees                                      |   | 146,039                 |       | 143,299 |   |
| Bad  debt expense                                       |   | 30,000                  |       | 30,000 |   |
| Travel  and entertainment                               |   | 39,481                  |       | 69,478 |   |
| Settlements                                             |   | —                  |       | 85,000 |   |
| Other                                                   |   | 306,989                 |       | 322,504 |   |
|                                                    |   |                    |       |   |   |
|                                                    |   | 3,238,537               |       | 2,979,557 |   |
|                                                    |   |                    |       |   |   |
| Earnings  (loss) before income taxes                    |   | (5,398,443              | )          | (595,795 | ) |
|                                                    |   |                    |       |   |   |
| Income  tax expense (benefit)                           |   |                    |       |   |   |
| Current                                                 |   | —                  |       | (235,000 | ) |
|                                                    |   |                    |       |   |   |
| **Net Earnings (Loss)**                                 |   | $                       | (5,398,443 | ) | $ | (360,795 | ) |
|                                                    |   |                    |       |   |   |
| Earnings  (loss) per share, basic and diluted           |   | $                       | (1.73      | ) | $ | (0.11 | ) |
|                                                    |   |                    |       |   |   |
| Weighted  average number of shares outstanding, basic   |   | 3,121,900               |       | 3,159,845 |   |
|                                                    |   |                    |       |   |   |
| Weighted  average number of shares outstanding, diluted |   | 3,121,900               |       | 3,159,845 |   |

 

The accompanyingnotes are an integral part of these statements

 

3

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PAULSON CAPITAL CORP. AND SUBSIDIARY

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

For the two year period ended December 31, 2001 and 2002

and the three month period ended March 31, 2003

 
|                                          |   | **Common  Stock** |   | **Retained  Earnings** |      |
|-----------------------------------------------|--------|-------------------|--------|------------------------|-----------|
|                                          |   | **Shares**        |   | **Amount**             |      |   |
| 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                   |   | (45,251           | )      | (11,188                | )         | (301,158 | ) |
|                                          |   |              |   |                   |      |   |   |
| Net  loss for year to date                    |   | —            |   | —                 |      | (7,011,154 | ) |
|                                          |   |              |   |                   |      |   |   |
| Balance  at December 31, 2002                 |   | 3,125,811         |   | $                      | 1,086,740 |   | $ | 24,756,219 |   |
|                                          |   |              |   |                   |      |   |   |
| Stock  options exercised (unaudited)          |   | —            |   | —                 |      | — |   |
|                                          |   |              |   |                   |      |   |   |
| Redemption  of common stock  (unaudited) |   | (8,000            | )      | (2,000                 | )         | (32,995 | ) |
|                                          |   |              |   |                   |      |   |   |
| Net  loss for the year to date (unaudited)    |   | —            |   | —                 |      | (5,398,443 | ) |
|                                          |   |              |   |                   |      |   |   |
| Balance  at March 31, 2003 (unaudited)        |   | 3,117,811         |   | $                      | 1,084,740 |   | $ | 19,324,781 |   |

 

The accompanyingnotes are an integral part of these statements

 

4

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PAULSON CAPITALCORP. AND SUBSIDIARY

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

(unaudited)

 
|                                                                                         |   | **Three months ended** |       |
|----------------------------------------------------------------------------------------------|--------|------------------------|------------|
|                                                                                         |   | **3/31/03**            |       | **3/31/02** |   |
| Increase  (Decrease) in Cash and Cash Equivalents                                            |   |                   |       |   |   |
|                                                                                         |   |                   |       |   |   |
| Cash  flows from operating activities                                                        |   |                   |       |   |   |
| Net  earnings (loss)                                                                         |   | $                      | (5,398,443 | ) | $ | (360,795 | ) |
| Adjustments  to reconcile net earnings (loss) to net cash provided by operating  activities: |   |                   |       |   |   |
| Receipt  of underwriter warrants                                                             |   | —                 |       | (68,391 | ) |
| Unrealized  depreciation and expiration of underwriter warrants                              |   | 876,200                |       | 827,391 |   |
| Depreciation  and amortization                                                               |   | 38,680                 |       | 49,189 |   |
| Change  in assets and liabilities                                                            |   |                   |       |   |   |
| Receivables                                                                                  |   | 654,965                |       | 3,827,213 |   |
| Trading  and investment securities                                                           |   | 4,600,845              |       | (3,949,628 | ) |
| Prepaid  and deferred expenses                                                               |   | (42,475                | )          | 182,157 |   |
| Accounts  payable and accrued liabilities                                                    |   | (890,354               | )          | (193,923 | ) |
| Securities  sold, not yet purchased                                                          |   | 34,811                 |       | 12,977 |   |
| Income  taxes payable/receivable                                                             |   | 194,645                |       | (270,095 | ) |
|                                                                                         |   |                   |       |   |   |
| Net  cash provided by operating activities                                                   |   | 68,874                 |       | 56,095 |   |
|                                                                                         |   |                   |       |   |   |
| Cash  flows from investing activities                                                        |   |                   |       |   |   |
| Additions  to furniture and equipment                                                        |   | (29,146                | )          | (28,195 | ) |
|                                                                                         |   |                   |       |   |   |
| Net  cash used in investing activities                                                       |   | (29,146                | )          | (28,195 | ) |
|                                                                                         |   |                   |       |   |   |
| Cash  flows from financing activities                                                        |   |                   |       |   |   |
| Proceeds  from exercise of stock options                                                     |   | —                 |       | 35,500 |   |
| Payments  to retire common stock                                                             |   | (34,995                | )          | (87,750 | ) |
|                                                                                         |   |                   |       |   |   |
| Net  cash used in financing activities                                                       |   | (34,995                | )          | (52,250 | ) |
|                                                                                         |   |                   |       |   |   |
| NET  INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                        |   | 4,733                  |       | (24,350 | ) |
|                                                                                         |   |                   |       |   |   |
| Cash  and cash equivalents at beginning of period                                            |   | 97,630                 |       | 42,938 |   |
|                                                                                         |   |                   |       |   |   |
| Cash  and cash equivalents at end of period                                                  |   | $                      | 102,363    |   | $ | 18,588 |   |
|                                                                                         |   |                   |       |   |   |
| Cash  paid during the three months for                                                       |   |                   |       |   |   |
|                                                                                         |   |                   |       |   |   |
| Interest                                                                                     |   | $                      | —     |   | $ | 7,130 |   |
| Income  taxes                                                                                |   | $                      | 5,225      |   | $ | 35,095 |   |

 

The accompanyingnotes are an integral part of these statements

 

5

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**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

(unaudited)

1. Basis of Presentation

 

The accompanying unaudited consolidated financialstatements have been prepared in accordance with the instructions for interimfinancial statements in Item 310(b) of Regulation S-B and, therefore, do notinclude all information and footnotes required by generally accepted accountingprinciples for complete financial statements. In the opinion of management, the interim financial statements includeall adjustments (consisting only of normal recurring adjustments) necessary tostate fairly the information shown therein. 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.

 

2. Securities Owned

 

Gains and losses from the disposition of securitiesare reflected as trading revenues in the income statement for the period.

 

3. Commitments andContingencies

 

On November 7, 2001, the Company and its wholly ownedsubsidiary, Paulson Investment Company, Inc., or PIC, were named as defendantsin a lawsuit filed 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’s redemptionwas proper under the terms of the prospectus, which contains the updatedredemption provisions and allowed the issuer to redeem when the closing bidprice 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 claim unspecified monetarydamages and seek $3 million in punitive damages. The lawsuit has been stayed,pending mandatory arbitration before the NASD. The arbitration is in a very early stage and the Company and PIC iscurrently conducting discovery. However, PCC and PIC believe that they have meritorious defenses tothese claims and intend to defend the case vigorously.

 

In January 2002, PIC was served in an arbitrationbrought by one of its former customers, Patricia Weber, against PIC and itsregistered representative Melvin Vukcevich. The arbitration claim alleges unsuitable securities recommendations,misrepresentation, breach of fiduciary duty and negligence.  The claimant is seeking damages of $255,000,interest, an additional return on her portfolio, punitive damages and attorneyfees.  PIC has filed its answer.  PIC believes it has meritorious defenses andintends to defend these matters vigorously.

 

In March 2002, PIC and one of its registeredrepresentatives, Marvin Cox, were named as defendants in lawsuits filed byLouis Barinaga and Stuart Mackenzie, former PIC customers.  The claims of Barinaga and Mackenzie relateto purchases of convertible notes of E.com, which were purchased directly fromE.com.  Barinaga and Mackenzie allegethat PIC and Mr. Cox participated in and materially aided the sale of the notesand, therefore, are liable under state securities law.  Barinaga and Mackenzie allege damages of$717,000 and $165,000, respectively, plus interest and attorney fees. PICasserted that the claims are subject to arbitration. Plaintiffs have abatedtheir lawsuit and refiled their claims before the NASD.  PIC is currently conducting discovery andbelieves it has meritorious defenses and intends to defend this matter vigorously.  The arbitration hearing in this matter isscheduled to begin November 3, 2003 in Portland, Oregon.

 

In March 2002, PIC and one of its registeredrepresentatives, Melvin Vukcevich, were named as respondents in arbitrationclaims filed by former customers Paul and Mary Herold.  The Herolds claim they were misled intopurchasing unsuitable securities and allege damages of $70,000 plus unspecifiedpunitive damages.  This case is in theearly stages of discovery, but PIC believes it has meritorious defenses andintends to defend this matter vigorously. The arbitration hearing in this matter is scheduled to begin June 24,2003 in Los Angeles, California.

 

In October 2002, PIC was named as a defendant in alawsuit filed by Special Situations Fund III, LP and Special Situations CaymanFund, LP.  The lawsuit was filed in U.S.Federal District Court for the State of New Jersey.  It asserts various federal securities law claims and common lawfraud and negligence against numerous defendants, including PIC, arising out oftwo secondary offerings of Suprema Specialties, Inc.  PIC participated in one of the two offerings, the August 25, 2000secondary offering of Suprema Specialities, Inc., as a member of theunderwriting syndicate, underwriting 75,000 shares in total.  The plaintiffs seek damages for the purchaseof 399,151 shares of Suprema Specialities, Inc. stock between August 25, 2000and November 14, 2001.

 

6

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On January 15, 2003, PIC filed a motion to dismiss all claims broughtby plaintiffs.  PIC’s motion to dismisswas argued April 14, 2003.  The courthas not yet issued its ruling.  PICbelieves it has meritorious defenses and intends to defend this mattervigorously.

 

In December 2002, PIC and its former registeredrepresentative, Wayde Newman, were named as respondents in arbitration claimsfiled by Eugene V. Doty.  Mr. Dotyasserts claims for fraud, breach of fiduciary duty, and violations of Coloradoconsumer and securities acts and violations of NASD rules.  Mr. Doty seeks $2,300,000, interest,attorney fees and punitive and treble damages. PIC is investigating this claim, but believes it has meritoriousdefenses and intends to defend this matter vigorously.

 

In January 2003, Joanne Thies, a former PIC customer,filed an arbitration claim with the NASD, naming PIC and Peter Jones, a currentPIC registered representative, as respondents. Ms. Thies asserts claims for negligence, failure to supervise, fraud andsecurities law violations relating to her account.  The claimant seeks damages of $457,000, attorney fees, costs andexpenses.  PIC has not had anopportunity to fully investigate this claim, but believes it has meritoriousdefenses and intends to defend this matter vigorously.

 

In February 2003, Brock and Julie Belt, former PICcustomers, filed an arbitration claim with the NASD, naming PIC and KenRowlett, a former PIC registered representative, as respondents.  The complaint alleges unsuitable securitiesrecommendations and seeks $700,000 in damages, plus attorney fees andinterest.  PIC has not had anopportunity to fully investigate this claim, but believes it has meritoriousdefenses and intends to defend this matter vigorously if any claims are filed.

 

In addition to the matters described above, PIC hasinformation that certain former customers may file claims against it; however,no such claims have been asserted at this time.  PIC has no information regarding what amounts, if any, may besought from PIC but believes the amounts may be material.  PIC has not had an opportunity to fully investigatethese claims, but believes it has meritorious defenses and intends to defendthese matters vigorously if any claims are filed.

 

An adverse outcome in certain of the matters describedabove could have a material adverse effect on PIC or the Company. PIC also hasbeen named in certain other legal proceedings and has received notice thatcertain customers may commence legal proceedings against PIC. The Companybelieves, based upon information received to date and, where the Companybelieves it appropriate, discussions with legal counsel, that resolution ofthis additional pending or threatened litigation will have no material adverseeffect on the consolidated financial condition, results of operations, orbusiness of the Company.

 

4. Stock Options

 

At March 31, 2003, the Company had a stock-basedemployee compensation plan. The Company accounts for its stock option planunder SFAS No. 123 "Accounting for Stock-Based Compensation." Asallowed under this statement, the Company continues to account for stockoptions for employees under APB No. 25, "Accounting for Stock Issued toEmployees," and has adopted the disclosure only requirements of SFAS No.123.

 

There were no stock option grants in the 2003 period.In the 2002 period, no stock-based employee compensation cost is reflected innet income, since all options granted under the plan had an exercise priceequal to the market value of the underlying common stock on the date of grant.The following table illustrates the effect on net income and earnings per shareif the Company had applied the fair value recognition provisions of SFAS No.123, *Accounting for Stock-Based Compensation*,to stock-based employee compensation for the quarter ended March 31, 2002.  The fair value of each option grant isestimated on the date of grant using the Black-Scholes option-pricing modelwith the following weighted-average assumption: no dividends; expectedvolatility of 68%; risk-free interest rate of 4.8% and expected life of 5years. There would be no effect on net income and earnings per share for thequarter ended March 31, 2003 because there was no vesting of options during thequarter.

 
| Net loss, as  reported                                                                                                                        |   | $        | (360,795 | ) |
|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|----------|---|
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |   | (130,000 | )        |
| Pro forma net  loss                                                                                                                           |   | $        | (490,795 | ) |
| Loss per share:                                                                                                                               |   |     |     |
| Basic and  diluted - as reported                                                                                                              |   | $        | (.11     | ) |
| Basic and  diluted - pro forma                                                                                                                |   | $        | (.16     | ) |

 

7

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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLANOF OPERATION

 

**General**

 

FORWARD-LOOKINGSTATEMENTS

 

This report, including, without limitation, “Item 2:Management’s Discussion and Analysis or Plan of Operation,” contains orincorporates both historical and “forward-looking” statements within themeaning of Section 27A of the Securities Act of 1933, as amended, and Section21E of the Securities Exchange Act of 1934, as amended.  Words such as “anticipates”, “believes”,“expects”, “intends”, “future” and similar expressions identify forward-lookingstatements.  Any such forward-lookingstatements in this report reflect our current views with respect to futureevents and financial performance and are subject to a variety of factors thatcould cause our actual results to differ materially from historical results orfrom anticipated results expressed or implied by such forward-lookingstatements.  Because of such factors, wecannot assure you that the results anticipated in this report will berealized.  As noted elsewhere in thisreport, various aspects of our business are subject to extreme volatility oftenas a result of factors beyond our ability to anticipate or control.  In particular, factors, such as thecondition of securities markets, which are in turn based on popular perceptionsof the 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:

 

•                  Theperformance of companies whose securities we have underwritten or otherwisesold to our customers may affect our reputation with other potential syndicateand selling group members and institutional and other retail accounts and mayalso affect the amount of money in our customers’ portfolios available for thekinds of investments that we offer.

 

•                  Thevalue of our investment portfolio, including the value of securities without areadily ascertainable market value, that we have estimated for the purpose ofreporting on our financial condition and results of operations, may besignificantly and adversely affected by changes in the value of the companiesthemselves or of comparable companies whose stock values we use in estimatingthe value of our portfolio securities.

 

•                  Weare subjectto a very high degree of regulation and are responsible for compliance withapplicable regulations by all of our personnel.  A significant regulatory infraction by us or any of ourregistered representatives could result in significant penalties, including theloss of our license to conduct securities business in one or morejurisdictions.

 

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

 

•                  Theloss of our Chairman, Chester Paulson, could have a material adverse impact onour business.

 

8

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**Overview**

 

Substantially all of ourbusiness consists of the securities brokerage and investment banking activitiesof our wholly owned subsidiary, Paulson Investment Company, Inc., or PIC.PIC has operations in four principal categories, all of them in the financial servicesindustry. These categories are:

 

•                                          securitiesbrokerage activities for which PIC earns commission revenues;

 

•                                          corporatefinance revenues consisting principally of underwriting discounts, underwriterwarrants received, and other compensation from investment banking activities;

 

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

 

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

 

Because we operate in the financial services industry,our revenues and earnings are substantially affected by conditions in financialmarkets generally. In our securities brokerage and corporate financebusinesses, the amount of our revenues depends substantially on levels ofmarket activity requiring the services we provide. For example, our investmentbanking activity, which consists primarily of acting as managing orparticipating underwriter of initial and follow-on public offerings for smallercompanies, depends on the market for new equity offerings, which hashistorically experienced substantial cyclical fluctuation. Although we attemptto match operating costs with activity levels, many of our expenses are eitherfixed or difficult to change on short notice. Accordingly, fluctuations inbrokerage and corporate finance revenues tend to result in sharperfluctuations, on a percentage basis, in net income or loss.

 

Our investment income or loss and, to a lesser extent,our trading income or loss are affected by changes in market valuation ofsecurities generally and, in particular, by changes in valuation of the equitysecurities of microcap companies in which our investments and tradingactivities tend to be concentrated. Equity markets in general, and microcap equitymarkets in particular, have always experienced significant volatility and thisvolatility has in recent years been extreme. The results of this volatility onthe value of our investment portfolio and securities held in connection withour trading and investment activities include large quarterly fluctuations inincome or loss from these operations and substantial increases or decreases inour net worth as our securities holdings are marked to market.

 

A substantial portion of our investment banking businessconsists of acting as managing underwriter of initial and follow-on publicofferings for microcap companies. As a part of our underwriter compensation forthis activity, we typically receive warrants exercisable to purchase securitiesidentical to those that we offer and sell to the public. The underwriterwarrants are not exercisable for the first year after the offering in whichthey are earned and are thereafter generally exercisable for four years, afterwhich they expire. The exercise price is typically 120% of the price at whichwe initially sold the securities to the public. Accordingly, unless there is atleast a 20% increase in the price of these securities at some time more thanone and less 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 our financialcondition and results of operations is based upon our consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States. In preparing our consolidated financial statements, we must makeestimates and judgments that affect the reported amounts of assets andliabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities at the date of our financial statements.  Actual results are likely to differ fromthese 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.

 

*Use ofEstimates*. We are required to estimate the value of allderivative securities that we hold at the date of any financial statements andto include that value, and changes in such value, in those financialstatements.  Accordingly, the aggregateestimated value of our underwriter warrants as of the date of any balance sheetis recorded as an asset on that balance sheet. When a new warrant is earned asa result of our investment banking activity, its estimated value is included inCorporate Finance revenue for the period in which it is earned. In subsequentperiods, any change in estimated value is recorded as Investment Income for theperiod. If, and when, an underwriter warrant is exercised, the book value isadjusted to reflect the value of the securities purchased, net of the exerciseprice, and the adjustment amount is recorded as investment income or loss forthe relevant period. If the warrant expires unexercised, the book value isadjusted to zero and the decrease is recorded as a loss in the relevant period.

 

9

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We estimate the value of our underwriter warrantsusing the Black-Scholes Option Pricing Model. The Black-Scholes model requires us to use historical price datacombined with various other assumptions and judgments as inputs for themodel.  The most influential factor inthis model is price volatility, which we calculate for each company’s warrants,based on each company’s own historical stock price movements as well as anindex of comparable companies.  When weinitially receive a new underwriter warrant, from an initial public offering,its calculated volatility factor is entirely based on the volatility of anindex of comparable companies, since there is no price history for a new publiclytraded company. As each underwriter warrant approaches its expiration date, itsvolatility factor is derived primarily from the historical prices of itsunderlying common stock. We cannot assure you that we will ultimately be ableto exercise any of our warrants in a way that will realize the value that weattribute to them in our financial statements based on this model.  As of March 31, 2003, our underwriterwarrants, based on the Black-Scholes Option Pricing Model, were valued atapproximately $1.8 million, down from $2.7 million estimated value at December31, 2002.

 

In addition to our underwriter warrants, we hold othersecurities, some of which have very limited liquidity and some of which do nothave a readily ascertainable market value. According to Generally Accepted Accounting Principles, we are requiredto carry these securities at estimated fair value, with no discount forrestricted or illiquid securities.

 

As a result of the factors described above, ourrevenues and earnings are subject to substantial fluctuation from period toperiod based on circumstances that often are beyond our control. An increase infinancial market activity generally, and/or an increase in equity valuationsgenerally, will normally result in increases in revenue, earnings and net worthas our activity levels and the value of our investment portfolio increase.Conversely, a general market retrenchment will typically lead to decreasedrevenue, earnings and net worth as a result of both decreased activity and theneed to adjust high investment portfolio values to lower levels. Accordingly,results for any historical period are not necessarily indicative of similarresults for any future period.

 

**Results of Operations**

 

PIC’s revenues and operating results are influenced byfluctuations in the equity underwriting markets as well as general economic andmarket 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’s financial results depend upon many factors, such as the number ofcompanies 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 byinvestors.  As a result, revenues andincome derived from these activities may vary significantly from period toperiod.  In the table below,  “Corporate Finance” revenues are a functionof total proceeds from offerings done during the period, compensation peroffering, and the fair value of underwriter warrants received.  “Investment Income” includes realized gainsfrom exercise of underwriter warrants, gains and losses from the sales ofinvestment securities, and unrealized gains and losses from underwriterwarrants and other investment securities. “Trading Income” is the net gain or loss from trading positions beforecommissions paid to the representatives in the trading department.

 

**Summary of Changes in MajorCategories**

**of Revenues and Expenses**

increase/(decrease)

 
|                                    |   | **Quarters  Ended March 31  2003 vs. 2002** |       |
|-----------------------------------------|--------|---------------------------------------------|------------|
| **Revenues:**                           |   |                                        | ** ** |   | ** ** |
| Commissions                             |   | $                                           | 810,644    |   | 49.8 | % |
| Corporate  finance                      |   | (51,960                                     | )          | (67.2 | )% |
| Investment  income                      |   | (5,194,410                                  | )          | N/A |   |
| Trading  income                         |   | (107,572                                    | )          | (34.9 | )% |
| Other                                   |   | (370                                        | )          | (1.8 | )% |
|                                    |   |                                        |       |   |   |
| Total                                   |   | $                                           | (4,543,668 | ) | N/A |   |
|                                    |   |                                        |       |   |   |
| **Expenses:**                           |   |                                        |       |   |   |
| Commissions  and salaries               |   | $                                           | 382,092    |   | 18.5 | % |
| Underwriting  expenses                  |   | —                                      |       | — |   |
| Rent,  telephone and quotation services |   | 11,790                                      |       | 4.6 | % |
| Other                                   |   | (134,902                                    | )          | (20.5 | )% |
|                                    |   |                                        |       |   |   |
| Total                                   |   | $                                           | 258,980    |   | 8.7 | % |
|                                    |   |                                        |       |   |   |
| Earnings  before income taxes           |   | $                                           | (4,802,648 | ) | (806.1 | )% |

 

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**ThreeMonths Ended March 31, 2003 vs. Three Months Ended March 31, 2002**

 

Revenues for the first quarter of 2003 decreased$4,543,668, to negative revenues of $2,159,906, from revenues of $2,383,762 for the first quarter of2002.  As shown in the table above,commissions increased $810,644, or 49.8 percent, from $1,627,141 in the firstquarter of 2002 to $2,437,785 in the comparable 2003 period. This increaseresulted from an increase in the number of retail brokers in the 2003 quartercompared to the same period in 2002. Corporate finance revenues fell $51,960 inthe first quarter of 2003, to $25,363, from $77,323 for the first quarter of2002.  No corporate finance transactionswere completed in the first quarter of 2003 or 2002.  Investment income decreased from a profit of $966,336 in thefirst quarter of 2002 to a loss of $4,228,074 in the first quarter of2003.  Investment income in the 2003period consisted of significant, realized and unrealized net losses ininvestment securities unrelated to underwriter warrants, and a decrease in theestimated fair value of underwriter warrants. No underwriter warrants wereexercised in either the 2002 or 2003 quarters. Trading losses increased by$107,572, to a loss of $415,591 in the first quarter of 2003, from a tradingloss of $308,019 in the comparable 2002 period.  This increased trading loss was primarily due to sustained weaksecurities pricing and investor focus on the war in Iraq.  Other income, including interest anddividends, increased $370, from $20,981 in the first quarter of 2002 to $20,611in the 2003 quarter.

 

Persistent weak market conditions related to thelingering effects of the recession and investor attention on the war in Iraq,plus the continuing lack of investor confidence in the securities market ingeneral (related to the additional reports of accounting irregularities bymajor, public U.S. corporations), have resulted in decreased equity securitiesprices across many sectors.  The Nasdaqcomposite showed a very slight increase of 0.4 percent in the first quarter of2003 compared to a decrease of 5.41 percent for the first quarter of 2002.

 

Total expenses increased $258,980 in the first quarterof 2003 from the comparable 2002 period, an increase of 8.7 percent, from$2,979,557 to $3,238,537.  Commissionsand salaries increased $382,092, or 18.5 percent, from $2,068,424 in the 2002period to $2,450,516 in 2003.  Thisincrease was primarily due to higher commissions paid on increased commissionrevenues.  There were no underwrit­ingexpenses during the first quarter of 2003 or 2002 and no corporate financetransactions were completed in first quarter of 2002 or 2003.  Rent, telephone and quote expenses increasedfrom $253,722 the first quarter of 2002 compared to $265,512 in the same quarterof 2003, an increase of 4.6 percent, primarily due to the addition of a newemployee branch in Manhattan.  Theaggregate of all other expenses fell 20.5 percent, from $657,411 in the firstquarter of 2002 to $522,509 in the first quarter of 2003, primarily due to theabsence of expenses related to settlements and lower travel expenses.

 

The Company had a pretax loss of $5,398,443 in thefirst quarter of 2003 compared to a pretax loss of $595,795 in the comparable2002 period.  The larger pre-tax loss wasprimarily due to an increase in the loss in investment and trading incomepartially offset by increased commissions in the 2003 period.  Exclusive of investment income (loss), theCompany would have had a pretax loss of $1,170,369 for the first quarter of2003 compared to a pretax loss of $1,562,131 in first quarter of 2002.Significant fluctuations can occur in PIC’s revenues and operating results fromone period to another, particularly in very volatile market environments suchas the market to date in 2003.

 

The Company had no estimated tax benefits for thefirst quarter of 2003, compared to estimated tax benefits in the first quarterof 2002 of $235,000.

 

**Liquidityand Capital Resources**

 

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

 

PIC borrows money from its clearing firm in theordinary course of its business, pursuant to an understanding under which theclearing firm agrees to finance PIC’s trading accounts.  As of March 31, 2003, no net loans wereoutstanding pursuant to this arrangement. PIC and the Company are generally able to meet their compensation andother obligations out of current liquid assets.

 

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. These underwriterwarrants are not exercisable for the first year after the offerings in whichthey are earned and are thereafter generally exercisable for four years, afterwhich they expire.  The exercise priceis typically 120% of the price at which we initially sold the securities to thepublic.  Accordingly, unless there is atleast a 20% increase in the price of these securities at some time more thanone and less than five years after the offering, the warrants will remain“under water” and will ultimately expire 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.  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.  AtMarch 31,

 

11

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2003, PIC owned 22 underwriter warrants (from 17 issuers),  all of which were currently exercisable; onehad an exercise price below the current market price of the securitiesreceivable upon exercise.  If we hadexercised that warrant and sold the securities on March 31, 2003, we would havereceived approximately $1,100.  There islittle or no direct relationship between the intrinsic value of PIC’sunderwriter warrants at the end of any given period and the fair valuecalculated using the Black-Scholes pricing model, as described more fully inOverview above. The prices of these securities are influenced by generalmovements in the prices of OTC securities as well as the success of the issuersof the underwriter warrants.  The pricesof the securities underlying the underwriter warrants are very volatile, andsubstantial fluctuations in the Company’s estimate of their value can beexpected in the future.

 

In the three months ended March 31, 2003, $68,874 ofnet cash was provided by operating activities of the Company.  The major adjustments to reconcile thisresult to the Company’s net loss of $5,398,443 include a decrease in the valueof trading and investment securities of $4,600,845, unrealized depreciation inunderwriter warrants of $876,200, and a decrease in receivables of $654,965partially offset by a decrease in accounts payable and accrued liabilities of$890,534.  In the most recent period,$29,146 of net cash was used by the Company’s investing activities, consistingof additions to furniture and equipment. The Company used cash of $34,995 in financing activities during thefirst quarter of 2003 for payments to retire common stock.

 

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

 

At March 31, 2003, the Company had no materialcommitments for capital expenditures.

 

In general, the primary ongoing sources of PIC’s, andtherefore the Company’s, liquidity, including PIC’s trading positions,borrowings on those positions and profits recognized from underwriter warrants,all depend in large part on the trend in the general markets for OTCsecurities.  Rising OTC price levels willtend to increase the value and liquidity of PIC’s trading positions, the amountthat can be borrowed from its clearing firm based upon those positions, and thevalue of PIC’s underwriter warrants. The Company believes its liquidity is sufficient to meet its needs forthe foreseeable future.

 

**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 recoverablein the price of services offered by the Company.  To the extent inflation results in rising interest rates and hasother adverse effects in the securities markets and the value of securitiesheld in inventory or PIC’s investment account, it may adversely affect theCompany’s financial position and results of operations.

 

ITEM 3.  CONTROLS AND PROCEDURES

 

(a)                                  Underthe supervision and with the participation of our management, our President andChief Financial Officer conducted an evaluation of our disclosure controls andprocedures, as such term is defined under Rules 13a-14(c) and 15d-14(c)promulgated under the Securities Exchange Act of 1934, as amended, within 90days of the filing date of this report. Based on their evaluation, our President and Chief Financial Officerconcluded that our disclosure controls and procedures are effective.

 

(b)                                 Therehave been no significant changes (including corrective actions with regard tosignificant deficiencies or material weaknesses) in our internal controls or inother factors that could significantly affect these controls subsequent to thedate of the evaluation referenced in paragraph (a) above.

 

12

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**PART II**

**OTHER INFORMATION**

 

Item 1. LegalProceedings.

 

See Note 3 to CondensedConsolidated Financial Statements in Part 1.

 

Item 2. Changes inSecurities.

None

 

Item 3. Defaults uponSenior Securities.

None

 

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

None

 

Item 5. OtherInformation.

None

 

Item 6. Exhibits andReports on Form 8-K

 

                (a) Exhibits

 
|   |   |                                                                                                                                                          |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 99.1   |   | 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 |
| 99.2   |   | Certification of  Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 |

 

                (b) No Reports on Form 8-K were filed during thequarter ended March 31, 2003.

 

13

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                     | PAULSON CAPITAL CORP. |
|--------------------------|-----------------------|
|                     |                  |   |
|                     |                  |   |
| Date:  May 12, 2003 | By:                   | /s/ CHESTER L.F.  PAULSON |   |
|                     |                  | Chester L.F. Paulson |
|                     |                  | President |
|                     |                  | Principal Executive  Officer |
|                     |                  |   |
| Date: May 12, 2003       | By:                   | /s/ CAROL RICE |   |
|                     |                  | Carol Rice |
|                     |                  | Chief Financial Officer |
|                     |                  | Principal Financial  Officer |

 

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**CERTIFICATION  OF PRINICIPAL EXECUTIVE OFFICER**

 

I, Chester L.F. Paulson,certify that:

 

1. I have reviewed thisquarterly report on Form 10-QSB of Paulson Capital Corp.

 

2. Based on my knowledge,this quarterly report does not contain any untrue statement of a material factor omit to state a material fact necessary to make the statements made, inlight of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3. Based on my knowledge,the financial statements, and other financial information included in thisquarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4. The registrant’s othercertifying officers and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and we have:

 

a) designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisquarterly report is being prepared:

 

b) evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”);

 

c) presented in thisquarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluations as of the Evaluation Date:

 

5. The registrant’s othercertifying officers and I have disclosed, based on our most recent evaluation,to the registrant’s auditors and the audit committee of registrant’s board ofdirectors (or persons performing the equivalent function):

 

a) all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b) any fraud, whether ornot material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6. The registrant’s othercertifying officers and I have indicated in this quarterly report whether ornot there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 

Date: May 12, 2003

 
|                         | /s/ Chester L.  F. Paulson |   |
|------------------------------|----------------------------|--------|
| Chester L. F.  Paulson       |
| President                    |
| Principal  Executive Officer |

 

15

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**CERTIFICATIONOF PRINCIPAL FINANCIAL OFFICER**

 

I, Carol Rice, certifythat:

 

1. I have reviewed thisquarterly report on Form 10-QSB of Paulson Capital Corp.;

 

2. Based on my knowledge,this quarterly report does not contain any untrue statement of a material factor omit to state a material fact necessary to make the statements made, inlight of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3. Based on my knowledge,the financial statements, and other financial information included in thisquarterly report, fairly present in all material respects the financialcondition, results or operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4. The registrant’s othercertifying officers and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and we have:

 

a) designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisquarterly report is being prepared;

 

b) evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of a datewithin 90 days prior to the filing date of this quarterly report (the“Evaluation Date”);

 

c) presented in thisquarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5. The registrant’s othercertifying officers and I have disclosed, based on our most recent evaluation,to the registrant’s auditors and the audit committee of registrant’s board ofdirectors (or persons performing the equivalent function):

 

a) all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors and theaudit committee of registrant’s board of directors (or persons performing theequivalent function):

 

b) any fraud, whether ornot material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6. The registrant’s othercertifying officers and I have indicated in this quarterly report whether ornot there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 

Date: May 12, 2003

 
|                         | /s/ Carol Rice |   |
|------------------------------|----------------|--------|
| Carol Rice                   |
| Chief Financial  Officer     |
| Principal  Financial Officer |

 

16

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**EXHIBIT INDEX**

 
| 99.1   |   | Certification of  Principal Executive Officer Pursuant to U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                 |
| 99.2   |   | Certification of  Principal Financial Officer Pursuant to U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |

 

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