**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**WASHINGTON,D.C.  20549

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**FORM 10-Q**

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| **(Mark One)**                                    | ** ** | ** **                                                                                    |
|---------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
| **x**                                             | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|                                              |       |                                                                                          |
| **For the  quarterly period ended June 30, 2006** |
|                                              |       |                                                                                          |
| **OR**                                            |
|                                              |       |                                                                                          |
| **o**                                             | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For thetransition period from             to             **

**Commissionfile number: 0-18188**

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**PAULSON CAPITAL CORP.**

(Exact name of registrantas specified in its charter)

| **Oregon**                                                      | **93-0589534**                        |
|-----------------------------------------------------------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) | (I.R.S. Employer  Identification No.) |
|                                                            |                                  |
| **811 SW Naito Parkway, Portland, Oregon**                      | **97204**                             |
| (Address of principal executive offices)                        | (Zip Code)                            |

 

Registrant’s telephonenumber, including area code:  **503-243-6000**

 

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

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer. Seedefinition of “accelerated filer” and “large accelerated filer” in Rule 12b-2of the Exchange Act. 

Large acceleratedfiler o    Acceleratedfiler o   Non-accelerated filer x

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).    Yes o  No x

Indicate the number of shares outstanding of each ofthe issuer’s classes of common stock, as of the latest practicable date.

| Common stock, no par value | 6,167,132                        |
|----------------------------|----------------------------------|
| (Class)                    | (Outstanding at  August 4, 2006) |

 

 

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**PAULSON CAPITALCORP. AND SUBSIDIARYFORM 10-QINDEX**
|                                 | ** ** | ** **                                                                                              | ** ** | **Page** |
|---------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|----------|
| PART  I - FINANCIAL INFORMATION |       |                                                                                                    |
|                            |       |                                                                                                    |
| Item 1.                         |       | Financial Statements                                                                                    |       |     |
|                            |       |                                                                                                    |       |     |
|                            |       | Consolidated Balance Sheets - June 30, 2006 and  December 31, 2005 (unaudited)                          |       | 2        |
|                            |       |                                                                                                    |       |     |
|                            |       | Consolidated Statements of Operations - Three and Six  Months Ended June 30, 2006  and 2005 (unaudited) |       | 3        |
|                            |       |                                                                                                    |       |     |
|                            |       | Consolidated Statements of Cash Flows - Three and Six  Months Ended June 30, 2006  and 2005 (unaudited) |       | 4        |
|                            |       |                                                                                                    |       |     |
|                            |       | Notes to Consolidated Financial Statements (unaudited)                                                  |       | 5        |
|                            |       |                                                                                                    |       |     |
| Item 2.                         |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations             |       | 9        |
|                            |       |                                                                                                    |       |     |
| Item 3.                         |       | Quantitative  and Qualitative Disclosures About Market Risk                                             |       | 15       |
|                            |       |                                                                                                    |       |     |
| Item 4.                         |       | Controls and  Procedures                                                                                |       | 16       |
|                            |       |                                                                                                    |       |     |
| PART  II - OTHER INFORMATION    |       |                                                                                                    |
|                            |       |                                                                                                    |
| Item 1.                         |       | Legal Proceedings                                                                                       |       | 16       |
|                            |       |                                                                                                    |       |     |
| Item  1A.                       |       | Risk  Factors                                                                                           |       | 16       |
|                            |       |                                                                                                    |       |     |
| Item 2.                         |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                            |       | 16       |
|                            |       |                                                                                                    |       |     |
| Item 4.                         |       | Submission of  Matters to a Vote of Security Holders                                                    |       | 17       |
|                            |       |                                                                                                    |       |     |
| Item  6.                        |       | Exhibits                                                                                                |       | 17       |
|                            |       |                                                                                                    |       |     |
| Signatures                      |       | 18                                                                                                      |

 

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**PART I — FINANCIALINFORMATION**

**ITEM 1. FINANCIAL STATEMENTS**

**Paulson CapitalCorp. and SubsidiaryConsolidated Balance Sheets**
| ** **                                                                                                         | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                         | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| ** **                                                                                                         | ** ** | **(Unaudited)**   | ** ** | ** **            | ** ** |
| **Assets**                                                                                                         | ** ** | ** **        | ** ** | ** **            | ** ** |
| Cash and cash  equivalents                                                                                         |       | $                 | 124,492    |                  | $          | 129,549 |   |
| Receivable from  clearing organization                                                                             |       | 7,018,629         |       | 12,608,491            |       |
| Notes and other  receivables                                                                                       |       | 668,537           |       | 1,081,528             |       |
| Trading  securities, at market value                                                                               |       | 3,580,064         |       | 1,558,564             |       |
| Investment  securities, at market value                                                                            |       | 23,752,654        |       | 32,401,808            |       |
| Underwriter  warrants, at estimated fair value                                                                     |       | 5,860,000         |       | 6,275,000             |       |
| Prepaid and  deferred expenses                                                                                     |       | 392,393           |       | 674,328               |       |
| Furniture and  equipment, net                                                                                      |       | 305,060           |       | 265,791               |       |
|                                                                                                               |       |              |       |                  |       |
| Total Assets                                                                                                       |       | $                 | 41,701,829 |                  | $          | 54,995,059 |   |
|                                                                                                               |       |              |       |                  |       |
| **Liabilities and Shareholders’  Equity**                                                                     | ** ** | ** **        | ** ** | ** **            | ** ** |
| Accounts payable  and accrued liabilities                                                                          |       | $                 | 352,605    |                  | $          | 1,243,866 |   |
| Payable to  clearing organization                                                                                  |       | 1,306,118         |       | 3,182,347             |       |
| Compensation,  employee benefits and payroll taxes                                                                 |       | 811,127           |       | 2,105,259             |       |
| Securities sold,  not yet purchased, at market value                                                               |       | 911               |       | 23,033                |       |
| Dividends  payable                                                                                                 |       | 345               |       | 929,317               |       |
| Income taxes  payable                                                                                              |       | 961,082           |       | 2,338,218             |       |
| Deferred income  taxes                                                                                             |       | 1,492,375         |       | 5,408,000             |       |
|                                                                                                               |       |              |       |                  |       |
| Total  Liabilities                                                                                                 |       | 4,924,563         |       | 15,230,040            |       |
|                                                                                                               |       |              |       |                  |       |
| **Commitments and Contingencies**                                                                                  |       | —            |       | —                |       |
|                                                                                                               |       |              |       |                  |       |
| **Shareholders’ Equity**                                                                                      |       |              |       |                  |       |
| Preferred stock,  no par value; 500,000 shares authorized; none issued                                             |       | —            |       | —                |       |
| Common stock, no  par value; 20,000,000 shares authorized; shares issued and outstanding: 6,170,132  and 6,195,448 |       | 1,831,866         |       | 1,817,100             |       |
| Retained  earnings                                                                                                 |       | 34,945,400        |       | 37,947,919            |       |
| Total Shareholders’  Equity                                                                                   |       | 36,777,266        |       | 39,765,019            |       |
|                                                                                                               |       |              |       |                  |       |
| Total  Liabilities and Shareholders’ Equity                                                                   |       | $                 | 41,701,829 |                  | $          | 54,995,059 |   |
|                                                                                                               |       |              |       |                  |       |

 

See accompanyingNotes to Consolidated Financial Statements.

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**Paulson CapitalCorp. and SubsidiaryConsolidated Statements of Operations(Unaudited)**
| ** **                              | ** ** | **For the Three Months Ended June 30,** | ** ** | **For the Six Months Ended June 30,** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                              | ** ** | **2006**                                                              | ** ** | **2005**                                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                    |       |                                                                  |       |                                                                |       |   |   |   |   |
|                                    |       |                                                                  |       |                                                                |       |   |   |   |   |
| **Revenues**                            |       |                                                                  |       |                                                                |       |   |   |   |   |
| Commissions                             |       | $                                                                     | 4,076,360  |                                                                | $          | 3,743,269 |   | $ | 8,179,394 |   | $ | 7,884,326 |   |
| Corporate finance                       |       | 3,178,920                                                             |       | 465,970                                                             |       | 3,232,188 |   | 585,955 |   |
| Investment income (loss)                |       | 75,735                                                                |       | 12,361,430                                                          |       | (5,089,031 | ) | 17,513,929 |   |
| Trading income (loss)                   |       | (254,547                                                              | )          | 1,410,822                                                           |       | (218,710 | ) | 2,112,826 |   |
| Interest and dividends                  |       | 12,996                                                                |       | 14,454                                                              |       | 26,164 |   | 22,145 |   |
| Other                                   |       | 440                                                                   |       | 165                                                                 |       | 1,614 |   | 11,334 |   |
|                                    |       | 7,089,904                                                             |       | 17,996,110                                                          |       | 6,131,619 |   | 28,130,515 |   |
|                                    |       |                                                                  |       |                                                                |       |   |   |   |   |
|                                    |       |                                                                  |       |                                                                |       |   |   |   |   |
| **Expenses**                            |       |                                                                  |       |                                                                |       |   |   |   |   |
| Commissions and  salaries               |       | 4,727,534                                                             |       | 6,152,185                                                           |       | 8,444,543 |   | 10,406,189 |   |
| Underwriting expenses                   |       | 132,446                                                               |       | 134,172                                                             |       | 167,446 |   | 134,172 |   |
| Rent, telephone and quotation services  |       | 289,758                                                               |       | 285,601                                                             |       | 586,266 |   | 592,099 |   |
| Professional fees                       |       | 226,090                                                               |       | 346,350                                                             |       | 450,377 |   | 789,116 |   |
| Travel and entertainment                |       | 211,307                                                               |       | 100,923                                                             |       | 253,339 |   | 161,069 |   |
| Advertising and promotion expense       |       | 49,669                                                                |       | 89,615                                                              |       | 85,703 |   | 145,310 |   |
| Settlement expense                      |       | 4,750                                                                 |       | 256,375                                                             |       | 4,750 |   | 518,543 |   |
| Depreciation and amortization           |       | 22,604                                                                |       | 22,703                                                              |       | 44,477 |   | 45,760 |   |
| Other                                   |       | 362,064                                                               |       | 486,720                                                             |       | 701,033 |   | 937,002 |   |
|                                    |       | 6,026,222                                                             |       | 7,874,644                                                           |       | 10,737,934 |   | 13,729,260 |   |
|                                    |       |                                                                  |       |                                                                |       |   |   |   |   |
| Income (loss)  before income taxes      |       | 1,063,682                                                             |       | 10,121,466                                                          |       | (4,606,315 | ) | 14,401,255 |   |
|                                    |       |                                                                  |       |                                                                |       |   |   |   |   |
| Income tax  expense (benefit):          |       |                                                                  |       |                                                                |       |   |   |   |   |
| Current                                 |       | 14,749                                                                |       | —                                                              |       | 2,114,639 |   | — |   |
| Deferred                                |       | 327,524                                                               |       | 4,048,572                                                           |       | (3,915,625 | ) | 5,760,502 |   |
|                                    |       | 342,273                                                               |       | 4,048,572                                                           |       | (1,800,986 | ) | 5,760,502 |   |
|                                    |       |                                                                  |       |                                                                |       |   |   |   |   |
| Net income  (loss)                      |       | $                                                                     | 721,409    |                                                                | $          | 6,072,894 |   | $ | (2,805,329 | ) | $ | 8,640,753 |   |
|                                    |       |                                                                  |       |                                                                |       |   |   |   |   |
| Basic net income  (loss) per share      |       | $                                                                     | 0.12       |                                                                | $          | 0.97 |   | $ | (0.45 | ) | $ | 1.37 |   |
|                                    |       |                                                                  |       |                                                                |       |   |   |   |   |
| Diluted net  income (loss) per share    |       | $                                                                     | 0.12       |                                                                | $          | 0.97 |   | $ | (0.45 | ) | $ | 1.37 |   |
|                                    |       |                                                                  |       |                                                                |       |   |   |   |   |
| Shares used in  per share calculations: |       |                                                                  |       |                                                                |       |   |   |   |   |
| Basic                                   |       | 6,183,719                                                             |       | 6,263,504                                                           |       | 6,186,441 |   | 6,310,812 |   |
| Diluted                                 |       | 6,231,599                                                             |       | 6,279,622                                                           |       | 6,186,441 |   | 6,326,842 |   |
|                                    |       |                                                                  |       |                                                                |       |   |   |   |   |

 

See accompanyingNotes to Consolidated Financial Statements.

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**Paulson CapitalCorp. and SubsidiaryConsolidated Statements of Cash Flows(Unaudited)**
| ** **                                                                                      | ** ** | **For the Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2006**                                                            | ** ** | **2005** | ** ** |
|                                                                                            | ** ** | ** **                                                          | ** ** | ** ** | ** ** |
| **Cash  flows from operating activities:**                                                      |       |                                                                |       |   |   |
| Net income (loss)                                                                               |       | $                                                                   | (2,805,329 | ) | $ | 8,640,753 |   |
| Adjustments to reconcile net income (loss) to net  cash flows provided by operating activities: |       |                                                                |       |   |   |
| Receipt of underwriter warrants                                                                 |       | (2,312,907                                                          | )          | (303,056 | ) |
| Unrealized (appreciation) depreciation/expiration of  underwriter warrants                      |       | 1,939,144                                                           |       | (1,906,400 | ) |
| Noncash compensation associated with underwriter  warrants                                      |       | 788,763                                                             |       | 95,456 |   |
| Depreciation and amortization                                                                   |       | 44,477                                                              |       | 45,760 |   |
| Deferred income taxes                                                                           |       | (3,915,625                                                          | )          | 5,760,502 |   |
| Loss on disposal of furniture and equipment                                                     |       | 1,486                                                               |       | — |   |
| Change in assets and liabilities                                                                |       |                                                                |       |   |   |
| Receivables                                                                                     |       | 412,991                                                             |       | (1,018,237 | ) |
| Receivables from/payable to clearing organization                                               |       | 3,713,633                                                           |       | (742,848 | ) |
| Trading and investment securities                                                               |       | 6,627,654                                                           |       | (10,943,071 | ) |
| Prepaid and deferred expenses                                                                   |       | 281,935                                                             |       | 311,862 |   |
| Accounts payable, accrued liabilities and  compensation payables                                |       | (2,185,393                                                          | )          | 323,257 |   |
| Dividends payable                                                                               |       | (928,972                                                            | )          | — |   |
| Securities sold, not yet purchased                                                              |       | (22,122                                                             | )          | (32,976 | ) |
| Income taxes payable                                                                            |       | (1,377,136                                                          | )          | 861,126 |   |
| Net cash provided by operating activities                                                       |       | 262,599                                                             |       | 1,092,128 |   |
|                                                                                            |       |                                                                |       |   |   |
| **Cash  flows from investing activities:**                                                      |       |                                                                |       |   |   |
| Additions to furniture and equipment                                                            |       | (85,232                                                             | )          | (71,777 | ) |
|                                                                                            |       |                                                                |       |   |   |
| **Cash  flows from financing activities:**                                                      |       |                                                                |       |   |   |
| Proceeds from stock option exercise                                                             |       | 21,030                                                              |       | 61,530 |   |
| Dividends paid to common shareholders                                                           |       | —                                                              |       | (476,564 | ) |
| Payments to retire common stock                                                                 |       | (203,454                                                            | )          | (599,085 | ) |
| Net cash used in financing activities                                                           |       | (182,424                                                            | )          | (1,014,119 | ) |
|                                                                                            |       |                                                                |       |   |   |
| Increase  (decrease) in cash and cash equivalents                                               |       | (5,057                                                              | )          | 6,232 |   |
|                                                                                            |       |                                                                |       |   |   |
| **Cash  and cash equivalents:**                                                                 |       |                                                                |       |   |   |
| Beginning of period                                                                             |       | 129,549                                                             |       | 132,845 |   |
|                                                                                            |       |                                                                |       |   |   |
| End of period                                                                                   |       | $                                                                   | 124,492    |   | $ | 139,077 |   |
|                                                                                            |       |                                                                |       |   |   |
| **Supplemental  cash flow information:**                                                        |       |                                                                |       |   |   |
| Cash paid during the  period for income taxes                                                   |       | $                                                                   | 3,491,775  |   | $ | 19,705 |   |

 

See accompanyingNotes to Consolidated Financial Statements.

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**PAULSON CAPITAL CORP. AND SUBSIDIARYNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

**Note1.  Basis of Presentation**

The financial informationfor Paulson Capital Corp. and its wholly-owned subsidiary, Paulson InvestmentCompany, included herein as of June 30, 2006 and December 31, 2005 and for thethree and six-month periods ended June 30, 2006 and 2005 is unaudited; however,such information reflects all adjustments, consisting only of normal recurringadjustments, which, in the opinion of management, are necessary for a fairpresentation of the financial position, results of operations and cash flowsfor the interim periods. The financial information as of December 31, 2005 isderived from our 2005 Annual Report on Form 10-K. The interim consolidatedfinancial statements should be read in conjunction with the consolidatedfinancial statements and the notes thereto included in our 2005 Annual Reporton Form 10-K. The results of operations for the interim periods presented arenot necessarily indicative of the results to be expected for the full year.

**Note2.  Dividend**

Pursuant to a December22, 2005 authorization by our Board of Directors, in February 2006, we paid aspecial cash dividend of $0.30 per share to shareholders of record on January17, 2006.  The dividend paid totaled $0.9million.

**Note3.  Stock Split**

On March 1, 2006,we announced that our Board of Directors approved a two-for-one stock split ofour common stock to be effected in the form of a stock dividend. The stocksplit was effected on March 29, 2006 by issuing one additional share of commonstock for each share of common stock outstanding on March 15, 2006. All priorshare and per share amounts have been adjusted for this stock split. Basic anddiluted net income per share were adjusted as follows for the three andsix-month periods ended June 30, 2005:
| ** **                                                            | ** ** | **Three Months  Ended  June 30, 2005** | ** ** | **Six Months  Ended  June 30, 2005** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Basic net income per  share, as previously reported                   |       | $                                                     | 1.94       |                                                | $          | 2.74 |   |
| Basic net income per  share, as adjusted                              |       | $                                                     | 0.97       |                                                | $          | 1.37 |   |
|                                                                  |       |                                                  |       |                                                |       |
| Diluted net income per  share, as previously reported                 |       | $                                                     | 1.93       |                                                | $          | 2.73 |   |
| Diluted net income per  share, as adjusted                            |       | $                                                     | 0.97       |                                                | $          | 1.37 |   |
|                                                                  |       |                                                  |       |                                                |       |
| Shares used for basic  net income per share, as previously reported   |       | 3,131,752                                             |       | 3,155,406                                           |       |
| Shares used for basic  net income per share, as adjusted              |       | 6,263,504                                             |       | 6,310,812                                           |       |
|                                                                  |       |                                                  |       |                                                |       |
| Shares used for diluted  net income per share, as previously reported |       | 3,139,811                                             |       | 3,163,421                                           |       |
| Shares used for diluted net income per share, as adjusted             |       | 6,279,622                                             |       | 6,326,842                                           |       |

 

**Note4.  Commitments and Contingencies **

In October 2002, wewere named as a defendant in a lawsuit filed by Special Situations Fund III, LPand Special Situations Cayman Fund, LP. The lawsuit was filed in the U.S.District Court for the District of New Jersey. It asserts various federalsecurities law claims and common law fraud and negligent misrepresentationagainst numerous defendants, including us, arising out of two follow-onofferings of Suprema Specialties, Inc. We participated in one of the twoofferings, the August 25, 2000 follow-on offering of SupremaSpecialties, Inc., as a member of the underwriting syndicate, agreeing tounderwrite 75,000 shares in total, although the amount actually retained by usappears to be only 35,000 shares. The

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stock was sold in theAugust 25, 2000 offering at a price of $8.00 per share. Plaintiffs seekdamages for the purchase of 399,151 shares of Suprema Specialties, Inc.stock between August 25, 2000 and November 14, 2001. The federaldistrict court dismissed the claims against us. On appeal, the U. S. ThirdCircuit Court of Appeals affirmed the dismissal of the plaintiffs’ claims forviolation of Rule 10b-5 but reversed as to the dismissal of claims underSection 11 of the Securities Act of 1933. Subsequently, the plaintiffsstipulated that they will not be asserting a claim for common law fraud againstus. The negligent misrepresentation claim remains in the case. We believe ourliability under Section 11 is limited to the amount of shares eitherunderwritten or actually retained by us in the offering. Discovery has begun,but has not yet been completed. We believe we have meritorious defenses andintend to defend this matter vigorously.

In December 2005, wereceived notice of possible claims being asserted against us by two brotherswho invested in Wood River Partners LP (“Wood River”). The brothers purchasedtheir interests in Wood River directly from Wood River. One of the individualswas a customer of ours, but the other is not. The brothers have indicated thatthey paid $1,050,000 for their interests in Wood River. The SEC sued Wood Riverin October 2005, and a receiver currently runs Wood River. At this point, it isnot known how much the individuals might recover through the receivership. Theindividuals have indicated that they believe they may have claims against usunder the Oregon Securities Laws for rescission, interest and attorney fees. Webelieve we have meritorious defenses and, if litigation is filed, we intend todefend this matter vigorously.

In January 2006, wereceived notice of a customer complaint against one of our former registeredrepresentatives. The customer has indicated that her accounts declined in valueby just over $500,000. The customer has asserted that our former registeredrepresentative failed to implement strategies and techniques to provide forsafety and preservation of capital in her accounts. She asserts that theregistered representative made misrepresentations regarding the handling of heraccounts. The customer has indicated that she plans to pursue litigationagainst us if the matter is not resolved. At this time, the customer hasrequested that the former registered representative compensate her for thedecline in value of her account and return any fees earned by the former registeredrepresentative. We believe we have meritorious defenses and, if litigation isfiled, we intend to defend this matter vigorously.

On or about March 302006, we were added as an additional respondent in an NASD arbitrationmatter.  The claimants seek approximately$2 million in damages against numerous respondents.  Of that amount, claimants’ attorney hasindicated that the claimants seek approximately $200,000 in damages againstus.  We have filed a motion to dismissthe claims against us, which is currently pending. The arbitration hearing isscheduled for January 2007. We believe we have meritorious defenses and, if ourmotion to dismiss is denied, we intend to defend this matter vigorously.

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

**Note5.  Stock-Based Compensation**

***Adoption of SFAS No. 123R***

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

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relatedinterpretations.  We also followed thedisclosure requirements of SFAS No. 123, “Accounting for Stock-BasedCompensation.”

We elected to adopt themodified prospective transition method as provided by SFAS No. 123R and, accordingly,financial statement amounts for the prior periods presented in this Form 10-Qhave not been restated to reflect the fair value method of expensingstock-based compensation.  Under thismethod, the provisions of SFAS No. 123R apply to all awards granted or modifiedafter the date of adoption. We did not have any unrecognized expense related toawards outstanding at the date of adoption since they were all fully vested.For future awards, expense calculated pursuant to SFAS No. 123R will be recognizedas compensation expense using the Black-Scholes option pricing model over therequisite service period. The cumulative effect of the change in accountingprinciple from APB 25 to SFAS No. 123R was not material.

Therewere no options granted and no pro forma stock-based compensation expense as ifthe method prescribed by SFAS No. 123, “Accounting for Stock-BasedCompensation,” had been appliedin measuring compensation expense in the prior periods presented.

***1999 Stock Option Plan***

Our1999 Stock Option Plan (the “Plan”) reserves 1.0 million shares of our commonstock for issuance upon exercise of options granted under the plan. AtJune 30, 2006, 521,000 options were available for grant and 708,000 shares ofour common stock were reserved for issuance related to the Plan.  The Planprovides for the grant of incentive stock options and nonqualified stockoptions. There were no options granted during the first six months of2006.

Certain information regarding options outstanding andexercisable as of June 30, 2006 was as follows:

|                                              | ** ** | **Options  Outstanding and  Exercisable** | ** ** |
|----------------------------------------------|------------|------------------------------------------------|------------|
| Number                                       |       | 187,000                                        |       |
| Weighted average  per share exercise price   |       | $                                              | 3.93       |   |
| Aggregate  intrinsic value                   |       | $                                              | 406,315    |   |
| Weighted average  remaining contractual term |       | 1.7 years                                      |       |

 

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

***Stock-BasedCompensation***

We estimate thefair value of stock options using the Black-Scholes option pricing model. Thisvaluation model takes into account the exercise price of the award, as well asa variety of significant assumptions. We believe that the valuation techniqueand the approach utilized to develop the underlying assumptions are appropriatein calculating the fair values of our stock options. Estimates of fair value arenot intended to predict actual future events or the value ultimately realizedby persons who receive equity awards. There were no stock options granted during the three and six-monthperiods ended June 30, 2006 or 2005.

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

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Certaininformation regarding our stock-based compensation was as follows:

|                                                                            | ** ** | **Three and Six Months  Ended June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                                          | ** ** | **2005** | ** ** |
| Weighted average  grant-date per share fair value of share options granted |       | $                                                                 | —     |   | $ | — |   |
| Total intrinsic  value of share options exercised                          |       | 25,230                                                            |       | 22,420 |   |
| Stock-based compensation  recognized in results of operations              |       | —                                                            |       | — |   |
| Cash received  from options exercised                                      |       | 21,030                                                            |       | 61,530 |   |
| Tax deduction realized  related to stock options exercised                 |       | 25,230                                                            |       | 22,420 |   |
|                                                                            |            |                                                                   |            |  |  |  |  |

 

**Note6.  Earnings Per Share**

Following is areconciliation of our shares used for our basic net income (loss) per share andour diluted net income (loss) per share:
| ** **                                                                                                            | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Shares used for  basic income (loss) per share                                                                        |       | 6,183,719                                           |       | 6,263,504                                         |       | 6,186,441 |   | 6,310,812 |   |
| Effect of  dilutive stock options                                                                                     |       | 47,880                                              |       | 16,118                                            |       | — |   | 16,030 |   |
| Shares used for  diluted net income (loss) per share                                                                  |       | 6,231,599                                           |       | 6,279,622                                         |       | 6,186,441 |   | 6,326,842 |   |
|                                                                                                                  |       |                                                |       |                                              |       |   |   |   |   |
| Stock options not  included in diluted net income (loss) per share because their effect would  have been antidilutive |       | —                                              |       | —                                            |       | 187,000 |   | — |   |

 

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

In June 2006,we announced that, effective September 2006, RBC Dain Correspondent Services (“DCS”)will become our new clearing firm, replacing National Financial Services, LLC (“NFS”).

**Note 8.Repurchases of Common Stock**

In the firstsix months of 2006, we repurchased a total of 31,316 shares of our common stockfor a weighted average price of $6.50 per share, which totaled $203,000. Theamount paid above the original issue price, which totaled $197,000, was offsetagainst retained earnings.

**Note 9.New Accounting Pronouncements**

***FASB Interpretation No. 48***

In July 2006,the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48,“Accounting for Uncertainty in Income Taxes,” which defines the threshold forrecognizing the benefits of tax return positions in the financial statements as“more-likely-than-not” to be sustained by the taxing authority. InterpretationNo. 48 applies to all tax positions accounted for under SFAS No. 109, “Accountingfor Income Taxes.” Interpretation No. 48 is effective as of the beginning ofthe first fiscal year beginning after December 15, 2006. We are currentlyanalyzing the effects of adopting Interpretation No. 48 and do not expect anymaterial affect on our financial position.

***SFAS No. 156***

In March 2006,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 156, “Accountingfor Servicing of Financial Assets — an amendment of FASB Statement No. 140.”SFAS No. 156 amends SFAS No. 140, “Accounting for Transfers and Servicing ofFinancial Assets and Extinguishment of Liabilities,” with respect to accountingfor separately recognized servicing assets and servicing liabilities.   SFAS No. 156 is effective for fiscal yearsthat begin after September 15, 2006, with early adoption permitted as of thebeginning of an entity’s fiscal year. We do not have any servicing assets orservicing liabilities and, accordingly, the adoption of SFAS No. 156 will not haveany effect on our results of operations, financial condition or cash flows.

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***SFAS No. 155***

In February2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid FinancialInstruments — an amendment of FASB Statements No 133 and 140.” SFAS No. 155resolves implementation issues addressed in Statement 133 Implementation IssueNo. D1, “Application of Statement 133 to Beneficial Interests in SecuritizedFinancial Assets.” SFAS No. 155 is effective for fiscal years that begin afterSeptember 15, 2006, with early adoption permitted as of the beginning of anentity’s fiscal year. We do not have any beneficial interests in securitizedfinancial assets and, accordingly, the adoption of SFAS No. 155 will not haveany effect on our results of operations, financial condition or cash flows.

**Note10. Reclassifications**

Certain amountsin the prior period financial statements have been reclassified to conform tothe current period presentation.

**Note11. Subsequent Events**

In July 2006,we completed an initial public offering where we raised approximately $16.5million for Ascent Solar Technologies, Inc.

In August 2006,we settled one of our outstanding legal matters for $180,000, which will berecorded as a component of settlement expense in the third quarter of 2006.

**Item 2.**                          Management’sDiscussion and Analysis of Financial Condition and Results of Operations

**ForwardLooking Statements and Risk Factors**

This report, including, without limitation, “Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” contains or incorporates both historical and “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities Exchange Act of 1934,as amended. Words such as “anticipates,” “believes,” “expects,” “intends,” “future”and similar expressions identify forward-looking statements. Any suchforward-looking statements in this report reflect our current views withrespect to future events and financial performance and are subject to a varietyof factors that could cause our actual results to differ materially fromhistorical results or from anticipated results expressed or implied by suchforward-looking statements. Because of such factors, we cannot assure you thatthe results anticipated in this report will be realized. As noted elsewhere inthis report, various aspects of our business are subject to extreme volatilityoften as a result of factors beyond our ability to anticipate or control. Inparticular, factors, such as the condition of the securities markets, which arein turn based on popular perceptions of the health of the economy generally,can be expected to affect the volume of our business as well as the value ofthe securities maintained in our trading and 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 subject to a very high degree of regulation and are responsible forcompliance with applicable regulations by all of our personnel. A significantregulatory infraction by us or any of our registered representatives couldresult in significant penalties, including the loss of our license to conductsecurities business in one or more jurisdictions.

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·                  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.

**Overview**

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

·                  securities brokerage activities forwhich we earn commission revenues;

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

·                  securities trading from which we recordprofit or loss, depending on trading results; and

·                  investment income resulting fromearnings on, and increases or decreases in the value of, our investmentportfolio.

Because we operatein the financial services industry, our revenues and earnings are substantiallyaffected by general conditions in financial markets. In our securitiesbrokerage business, the amount of our revenues depends on levels of marketactivity requiring the services we provide. Our corporate finance activity,which consists of acting as the managing underwriter of initial and follow-onpublic offerings, private investments in a public equity (“PIPEs”) and privateplacements for smaller companies, is similarly affected by the strength of 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 corporate financerevenues tend to result in sharper fluctuations, on a percentage basis, in netincome or loss.

Our investmentincome or loss and, to a lesser extent, our trading income or loss is affectedby changes in market valuation of securities generally and, in particular, bychanges in valuation of the equity securities of microcap companies in whichour investments and trading activities tend to be concentrated. Equity marketsin general, and microcap equity markets in particular, have always experiencedsignificant volatility and this volatility has, in recent years, been extreme.The result of this volatility on the value of our investment portfolio andsecurities held in connection with our trading and investment activitiesinclude large quarterly fluctuations in income or loss from these operationsand substantial increases or decreases in our net worth as our securitiesholdings are marked to market.

A substantialportion of our corporate finance business consists of acting as managingunderwriter of initial and follow-on public offerings for microcap and smallcapcompanies. As a part of our compensation for these activities, wetypically receive warrants exercisable to purchase securities identical tothose that we offer and sell to the public. The warrants generally have afive-year expiration date and vest immediately. The warrants are generallysubject to a restricted period of six months to one-year in which we cannotexercise the warrants. The exercise price is typically 120% of the price at whichthe securities are initially sold to the public. Accordingly, unless there isat least a 20% increase in the price of these securities at some time more thansix months and less than five years after the offering, the warrants willremain “under water” and will ultimately expire unexercised. We also receivewarrants in connection with our PIPEs, which have varying terms and conditions.

**CriticalAccounting Policies and Use of Estimates**

Except for the addition of the Stock-Based Compensation informationbelow, we reaffirm the critical accounting policies and estimates asreported in our Annual Report on Form 10-K for the year ended December 31,2005, which was filed with the Securities and Exchange Commission on March 29,2006.

10

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***Stock-Based Compensation***

On January 1,2006, we adopted SFAS No. 123R, which requires the measurement and recognitionof compensation expense for all share based payment awards granted to ouremployees and directors. Upon adoption of SFAS No. 123R, we maintained ourmethod of valuation of employee stock options granted using the Black-Scholesoption pricing model which was previously used for the disclosure onlyprovisions allowed under SFAS No. 123. Our determination of fair value of sharebased payment awards on the date of grant using an option pricing model isaffected by our stock price as well as assumptions regarding a number ofvariables, including risk free interest rate, the expected dividend yield, theexpected option life, and expected volatility over the term of the awards. Tothe extent share based payment awards are granted in future periods, we willrecognize the related expense over the requisite service period based on theportion of awards that are ultimately expected to vest during the period.

**Results of Operations**

Our revenues andoperating results are influenced by fluctuations in the equity markets as wellas general economic and market conditions, particularly conditions in theover-the-counter market, where our investment and trading positions and theunderlying stock for the underwriter warrants are heavily concentrated.Significant fluctuations can occur in our revenues and operating results fromone period to another. Our results of operations depend upon many factors, suchas the number of companies that are seeking financing, the quality andfinancial condition of those companies, market conditions in general, theperformance of our previous underwritings and interest in certain industries byinvestors. As a result, revenues and income derived from these activities mayvary significantly from year to year. Our revenues include the following:

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

·                  Corporate finance revenues, which area function of total proceeds from offerings done during the period,compensation per offering and the fair value of underwriter warrants received;

·                  Investment income (loss), whichincludes (i) the unrealized appreciation and depreciation of securitiesheld based on quoted market prices, (ii) the unrealized appreciation anddepreciation of securities held that are not readily marketable, based upon ourestimate of their fair value, (iii) realized gains and losses on the saleof securities with quoted market prices and securities that are not readilymarketable, and (iv) the unrealized appreciation and depreciation ofunderwriter warrants held; and

·                  Trading income (loss), which is thegain or loss from trading positions before commissions paid to therepresentatives in the trading department.

The following tables set forth the changes in our operating results inthe three and six-month periods ended June 30, 2006 compared to the three andsix-month periods ended June 30, 2005:
| ** **                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Increase** | ** ** | **%  Increase** | ** ** |
|----------------------------------------|------------|-------------------------------------------------|------------|--------------|------------|-----------------|------------|
| ** **                             | ** ** | **2006**                                        | ** ** | **2005**     | ** ** | **(Decrease)**  | ** ** | **(Decrease)** | ** ** |
| Revenues:                              | ** ** | ** **                                      | ** ** | ** **   | ** ** | ** **      | ** ** | ** ** | ** ** |
| Commissions                            |       | $                                               | 4,076,360  |         | $          | 3,743,269       |       | $ | 333,091 |   | 8.9 | % |
| Corporate finance                      |       | 3,178,920                                       |       | 465,970      |       | 2,712,950       |       | 582.2 |   |
| Investment income                      |       | 75,735                                          |       | 12,361,430   |       | (12,285,695     | )          | (99.1 | ) |
| Trading income (loss)                  |       | (254,547                                        | )          | 1,410,822    |       | (1,665,369      | )          | (118.0 | ) |
| Interest and dividends                 |       | 12,996                                          |       | 14,454       |       | (1,458          | )          | (10.1 | ) |
| Other                                  |       | 440                                             |       | 165          |       | 275             |       | 166.7 |   |
| Total revenues                         |       | 7,089,904                                       |       | 17,996,110   |       | (10,906,206     | )          | (60.6 | ) |
| Expenses:                              |       |                                            |       |         |       |            |       |   |   |
| Commissions and salaries               |       | 4,727,534                                       |       | 6,152,185    |       | (1,424,651      | )          | (23.2 | ) |
| Underwriting expenses                  |       | 132,446                                         |       | 134,172      |       | (1,726          | )          | (1.3 | ) |
| Rent, telephone and quotation services |       | 289,758                                         |       | 285,601      |       | 4,157           |       | 1.5 |   |
| Professional fees                      |       | 226,090                                         |       | 346,350      |       | (120,260        | )          | (34.7 | ) |
| Travel and entertainment               |       | 211,307                                         |       | 100,923      |       | 110,384         |       | 109.4 |   |
| Settlement expense                     |       | 4,750                                           |       | 256,375      |       | (251,625        | )          | (98.1 | ) |
| All other                              |       | 434,337                                         |       | 599,038      |       | (164,701        | )          | (27.5 | ) |
| Total expenses                         |       | 6,026,222                                       |       | 7,874,644    |       | (1,848,422      | )          | (23.5 | ) |
| Income before income  taxes            |       | $                                               | 1,063,682  |         | $          | 10,121,466      |       | $ | (9,057,784 | ) | (89.5 | ) |

 

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| ** **                             | ** ** | **Six Months Ended  June 30,** | ** ** | **Increase** | ** ** | **%  Increase** | ** ** |
|----------------------------------------|------------|-----------------------------------------------|------------|--------------|------------|-----------------|------------|
| ** **                             | ** ** | **2006**                                      | ** ** | **2005**     | ** ** | **(Decrease)**  | ** ** | **(Decrease)** | ** ** |
| Revenues:                              | ** ** | ** **                                    | ** ** | ** **   | ** ** | ** **      | ** ** | ** ** | ** ** |
| Commissions                            |       | $                                             | 8,179,394  |         | $          | 7,884,326       |       | $ | 295,068 |   | 3.7 | % |
| Corporate finance                      |       | 3,232,188                                     |       | 585,955      |       | 2,646,233       |       | 451.6 |   |
| Investment income (loss)               |       | (5,089,031                                    | )          | 17,513,929   |       | (22,602,960     | )          | (129.1 | ) |
| Trading income (loss)                  |       | (218,710                                      | )          | 2,112,826    |       | (2,331,536      | )          | (110.4 | ) |
| Interest and dividends                 |       | 26,164                                        |       | 22,145       |       | 4,019           |       | 18.1 |   |
| Other                                  |       | 1,614                                         |       | 11,334       |       | (9,720          | )          | (85.8 | ) |
| Total revenues                         |       | 6,131,619                                     |       | 28,130,515   |       | (21,998,896     | )          | (78.2 | ) |
| Expenses:                              |       |                                          |       |         |       |            |       |   |   |
| Commissions and salaries               |       | 8,444,543                                     |       | 10,406,189   |       | (1,961,646      | )          | (18.9 | ) |
| Underwriting expenses                  |       | 167,446                                       |       | 134,172      |       | 33,274          |       | 24.8 |   |
| Rent, telephone and quotation services |       | 586,266                                       |       | 592,099      |       | (5,833          | )          | (1.0 | ) |
| Professional fees                      |       | 450,377                                       |       | 789,116      |       | (338,739        | )          | (42.9 | ) |
| Travel and entertainment               |       | 253,339                                       |       | 161,069      |       | 92,270          |       | 57.3 |   |
| Settlement expense                     |       | 4,750                                         |       | 518,543      |       | (513,793        | )          | (99.1 | ) |
| All other                              |       | 831,213                                       |       | 1,128,072    |       | (296,859        | )          | (26.3 | ) |
| Total expenses                         |       | 10,737,934                                    |       | 13,729,260   |       | (2,991,326      | )          | (21.8 | ) |
| Income (loss) before  income taxes     |       | $                                             | (4,606,315 | )            | $          | 14,401,255      |       | $ | (19,007,570 | ) | (132.0 | ) |

 

***Revenues***

Commissionsincreased 8.9% and 3.7%, respectively, in the three and six-month periods endedJune 30, 2006 compared to the same periods of 2005. The total number of trades,including mutual fund trades, executed by our brokers were 27,215 and 53,683 inthe three and six-month periods ended June 30, 2006, respectively, compared to24,380 and 54,064, respectively, in the comparable periods of 2005. We had 96brokers at June 30, 2006 compared to 95 brokers at June 30, 2005.

Corporate financeincome of $3.2 million in both the three and six-month periods ended June 30,2006 primarily represented commissions earned from one initial public offeringin which we raised $19.5 million for American Mold Guard, Inc., as well as theBlack-Scholes value of the underwriter warrants received inconnection with that offering. In addition we completed several privatetransactions, including two PIPEs.

Corporate finance incomeof $0.5 million and $0.6 million, respectively, in the three and six-monthperiods ended June 30, 2005 primarily included commissions related to a smallinitial public offering in which we raised $3.0 million for Nuvim, Inc., aswell as the Black-Scholes value of the underwriter warrants received inconnection with that offering. In addition we completed other small privatetransactions.

Investmentincome (loss) decreased $12.3 million and $22.6 million, respectively, in thethree and six-month periods ended June 30, 2006 compared to the same periods of2005, primarily due to net losses related to underwriter warrants andunrealized depreciation of securities held in the 2006 periods compared to netgains related to the underwriter warrants and appreciation of securities heldin the 2005 periods as detailed in the following table:
| ** **                                                                                                                                                                                 | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                                                                                                 | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net unrealized  gain (loss) related to underwriter warrants                                                                                                                                |       | $                                                   | (314,144   | )                                                 | $          | 322,400 |   | (1,939,144 | ) | $ | 1,906,400 |   |
| Net unrealized  appreciation (depreciation) of securities held based on quoted market prices  or, for securities that are not readily marketable, our estimate of their  fair market value |       | 925                                                 |       | 9,046,842                                         |       | (9,599,337 | ) | 11,351,839 |   |
| Net realized  gains on the sale of securities with quoted market prices and securities that  are not readily marketable                                                                    |       | 388,954                                             |       | 2,992,188                                         |       | 6,449,450 |   | 4,255,690 |   |
|                                                                                                                                                                                       |       | $                                                   | 75,735     |                                              | $          | 12,361,430 |   | (5,089,031 | ) | $ | 17,513,929 |   |

 

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Investment income(loss) is volatile from period to period due to the fact that it is driven bythe market value or fair value of the securities and underwriter warrants held.

Trading incomedecreased $1.7 million and $2.3 million, respectively, in the three andsix-month periods ended June 30, 2006 compared to the same periods of 2005,primarily due to lower prices for several of the securities we hold in ourtrading inventories. Our focus is on very small capitalization issues,especially those tied to our corporate finance clients. Trading income can bevolatile from period to period based on the fact that it is driven by themarket value of the securities in which we make a market.

***Expenses***

Total expensesdecreased $1.8 million and $3.0 million, respectively, in the three andsix-month periods ended June 30, 2006 compared to the same periods of 2005,primarily due to decreases in commissions and salaries, professional fees,settlement expense and other, partially offset by increases in travel andentertainment.

Commissions andsalaries decreased $1.4 million and $2.0 million, respectively, in the threeand six-month periods ended June 30, 2006 compared to the same periods of 2005,primarily due to the fact that we do not pay trading and investment commissionson trading and investment losses. There were no significant changes in salaryexpense for the periods presented.

Professional feesdecreased $0.1 million and $0.3 million, respectively, in the three andsix-month periods ended June 30, 2006 compared to the same periods of 2005,primarily due to significant decreases in legal activity as a result of thesettlement of certain cases during the 2005 periods.

The $0.1 millionincrease in travel and entertainment expense in both the three and six-monthperiods ended June 30, 2006 compared to the same periods of 2005 was primarilydue to a corporate finance/incentive conference held in June 2006 with nocomparable conference in 2005.

Settlement expensein the 2005 periods related to amounts required to settle certain legalmatters.

Other expenseincludes items such as depreciation and amortization, advertising andpromotion, dues and subscriptions and other office expenses. Other expensedecreased $0.2 million and $0.3 million, respectively, in the three andsix-month periods ended June 30, 2006 compared to the same periods of 2005,primarily due to a $40,000 and $60,000 decrease, respectively, in advertisingand promotion due to a greater focus in our advertising campaigns, as well asnet decreases in various other expense categories.

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

Areconciliation of income (loss) before income taxes without the effect ofunderwriter warrants to income (loss) before income taxes as reported was asfollows:
| ** **                                                                                   | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Income (loss)  before income taxes, without effect of underwriter warrants                   |       | $                                                   | (146,318   | )                                                 | $          | 9,591,466 |   | $ | (4,191,315 | ) | $ | 12,287,255 |   |
| Increase  (decrease) in Black-Scholes value of underwriter warrants                          |       | (314,144                                            | )          | 322,400                                           |       | (1,939,144 | ) | 1,906,400 |   |
| Black-Scholes  value of underwriter warrants received during the period, net of compensation |       | 1,524,144                                           |       | 207,600                                           |       | 1,524,144 |   | 207,600 |   |
| Income (loss) before  income taxes, as reported                                              |       | $                                                   | 1,063,682  |                                              | $          | 10,121,466 |   | $ | (4,606,315 | ) | $ | 14,401,255 |   |

 

Because of changes in the underlying securities andother factors, significant fluctuations in the value of underwriter warrantsoften occur from period to period, affecting the comparability of our revenuesand operating results.

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**Liquidity andCapital Resources**

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

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

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

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

We borrow money from our clearing firm, NationalFinancial Services (“NFS”), in the ordinary course of business, pursuant to anunderstanding under which NFS agrees to finance our trading accounts. As ofJune 30, 2006, we had $9.3 million available to borrow from NFS and no netloans were outstanding pursuant to this arrangement. We are generally able tomeet our compensation and other obligations out of current liquid assets.

Following the lapse of restrictions upon issuance,capital available from the sale of the underlying securities of underwriterwarrants exercised can fluctuate significantly from period to period as thevalue of the underlying securities fluctuates with overall market andindividual company financial condition or performance. There is no publicmarket for the underwriter warrants. The securities receivable upon exercise ofthe underwriter warrants cannot be resold unless the issuer has registeredthese securities with the SEC and with the states in which the securities willbe sold unless exemptions are available. Any delay or other problem in theregistration of these securities would have an adverse impact upon our abilityto obtain funds from the exercise of the underwriter warrants and the resale ofthe underlying securities. At June 30, 2006, we owned 13 underwriter warrants,all but two of which were exercisable. Three of the warrants had an exerciseprice below the June 30, 2006 market price of the securities receivable uponexercise. The intrinsic value of these warrants was $1.3 million at June 30,2006. There is little or no direct relationship between the intrinsic value ofour underwriter warrants at the end of any given period and the fair valuecalculated using the Black-Scholes option pricing model. The prices of thesecurities underlying the underwriter warrants are very volatile, andsubstantial fluctuations in our estimate of their value can be expected in thefuture. In the six months ended June 30, 2006, we exercised one underwriterwarrant, which resulted in net proceeds of $0.7 million upon the sale of therelated securities.

Cash provided by operating activities in the first sixmonths of 2006 totaled $0.3 million, primarily due to our net loss of $2.8million and net non-cash income items of $3.5 million being offset by changesin our operating assets and liabilities as discussed in more detail below.

Our net receivable from our clearing organizationdecreased $3.7 million to $5.7 million at June 30, 2006 from $9.4 million atDecember 31, 2005, primarily due to the results of the activity in our tradingand investment accounts, as well as the timing of general corporateexpenditures.

Notes and other receivables, which primarily representemployee and independent broker advances and expenses in excess of commissionearnings, commissions receivable and amounts receivable from corporate financeclients, decreased $0.4 million to $0.7 million at June 30, 2006 from $1.1million at December 31, 2005, primarily due to payments received from corporatefinance clients.

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Changes in our trading and investment securities aredependent on the purchase and sale of securities during the period, as well aschanges in their fair market values during the period.

Prepaid and deferred expenses decreased $0.3 millionto $0.4 million at June 30, 2006 from $0.7 million at December 31, 2005,primarily due to the amortization of registration fees for our registeredrepresentatives and of insurance premiums.

Accounts payable decreased $0.8 million to $0.4million at June 30, 2006 from $1.2 million at December 31, 2005, primarily dueto the payment of $0.5 million of settlements during the first half of 2006,which were related to the fiscal 2005 settlements.

Compensation, employee benefits and payroll taxesdecreased $1.3 million to $0.8 million at June 30, 2006 from $2.1 million atDecember 31, 2005, primarily due to the payment of commissions that wereaccrued at December 31, 2005. Accruals for commissions were lower in 2006 dueto weaker results of operations.

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

Income taxes payable decreased $1.3 million to $1.0million at June 30, 2006 from $2.3 million at December 31, 2005, primarily dueto $3.5 million of income tax payments made during the first six months of2006, partially offset by the accrual for fiscal 2006 taxes payable related torealized gains on investments.

Deferred income taxes decreased $3.9 million to $1.5million at June 30, 2006 from $5.4 million at December 31, 2005, primarily dueto a $9.6 million unrealized loss on securities.

Capital expenditures of $85,000 in the first sixmonths of 2006 were primarily for leasehold improvements at our Salem, Oregonoffice. At June 30, 2006, we did not have any material commitments for capitalexpenditures.

In September 2001,our Board of Directors approved a stock repurchase program pursuant to which weare authorized to repurchase up to 600,000 shares of our common stock. ThroughJune 30, 2006, we had repurchased a total of 278,142 shares and 321,858 sharesremained available for repurchase. This repurchase program does not have anexpiration date.

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

There have been no material changes inour reported market risks or risk management policies since the filing of ourForm 10-Q for the quarter ended March 31, 2006, which was filed with theSecurities and Exchange Commission on May 15, 2006.

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**Item 4.  Controls and Procedures**

***DisclosureControls and Procedures***

Our management hasevaluated, under the supervision and with the participation of our Presidentand our Chief Financial Officer, the effectiveness of our disclosure controlsand procedures as of the end of the period covered by this report as defined inRule 13a-15(b) or Rule 15d-15(e) under the Securities Exchange Act of 1934 (the“Exchange Act”). Based on that evaluation, our President and our ChiefFinancial Officer have concluded that, as of the end of the period covered bythis report, our disclosure controls and procedures are effective in ensuringthat information required to be disclosed in our Exchange Act reports is (1)recorded, processed, summarized and reported in a timely manner, and (2)accumulated and communicated to our management, including our President and ourChief Financial Officer, as appropriate, to allow timely decisions regardingrequired disclosure.

***Changesin Internal Controls***

There has been nochange in our internal control over financial reporting that occurred duringour last fiscal quarter that has materially affected, or is reasonably likelyto materially affect, our internal control over financial reporting.

**PART II -OTHER INFORMATION**

**Item 1.  Legal Proceedings**

See Note 4 ofNotes to Consolidated Financial Statements in Part I, Item 1.

**Item 1A.  Risk Factors**

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

**Item 2.  Unregistered Sales of Equity Securities andUse of Proceeds**

We repurchased thefollowing shares of our common stock during the second quarter of 2006:
| ** **           | ** ** | **Total number  of shares  purchased** | ** ** | **Average  price paid  per share** | ** ** | **Total number of  shares purchased  as part of publicly  announced plan** | ** ** | **Maximum number  of shares that may  yet be purchased  under the plan** | ** ** |
|----------------------|------------|--------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|
| April 1 to April  30 |       | 600                                              |       | $                                            | 7.25       |                                                                                                          | 254,934    |                                                                                                             | 345,066    |   |
| May 1 to May 31      |       | 14,400                                           |       | 6.91                                         |       | 269,334                                                                                                       |       | 330,666                                                                                                          |       |
| June 1 to June  30   |       | 8,808                                            |       | 6.35                                         |       | 278,142                                                                                                       |       | 321,858                                                                                                          |       |
| Total                |       | 23,808                                           | (1)        | 6.71                                         |       | 278,142                                                                                                       |       | 321,858                                                                                                          |       |
|                      |            |                                                  |            |                                              |            |                                                                                                               |            |                                                                                                                  |            |  |

 

(1)                Ofthe 23,808 shares, 6,000 were purchased from our executive officers andemployees (and their affiliates), not as open-market purchases, at an averageprice of $7.00 per share.

The plan torepurchase up to a total of 600,000 shares of our common stock was approved byour Board of Directors in September 2001 and does not have an expirationdate.  

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**Item 4.  Submission of Matters to a Vote of SecurityHolders**

Our annual meeting ofthe shareholders was held on June 8, 2006. The following action was approved:

1.                 To elect thefollowing persons to serve as directors of Paulson Capital Corp. until the nextannual meeting of shareholders and until their successors are duly elected andqualified:

| Name                   | ** ** | **Number of Shares  Voting For** | ** ** | **Number of Shares  Withheld Voting** | ** ** |
|------------------------|------------|-------------------------------------------------|------------|------------------------------------------------------|------------|
| Chester L. F.  Paulson |       | 5,965,927                                       |       | 92,068                                               |       |
| Jacqueline M.  Paulson |       | 5,972,327                                       |       | 85,668                                               |       |
| Steve Kleemann         |       | 6,053,995                                       |       | 4,000                                                |       |
| Shannon P. Pratt       |       | 6,053,995                                       |       | 4,000                                                |       |
| Paul Shoen             |       | 6,053,995                                       |       | 4,000                                                |       |

 

**Item 6.  Exhibits**

Thefollowing exhibits are filed herewith and this list is intended to constitutethe exhibit index:

| 10.1 |   | Fully Disclosed Clearing Agreement between RBC Dain  Correspondent Services and Paulson Investment Company, Inc.                                               |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1 |   | Certification of Principal Executive Officer  pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act  of 1934.                            |
| 31.2 |   | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934.                                 |
| 32.1 |   | Certification of Principal Executive Officer  pursuant to Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act  of 1934 and 18 U.S.C. Section 1350. |
| 32.2 |   | Certification of Chief Financial Officer pursuant to  Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 and  18 U.S.C. Section 1350.     |

 

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**SIGNATURES**

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.
| Date:  August 11, 2006 | PAULSON CAPITAL CORP.                                                                     |
|-----------------------------|-------------------------------------------------------------------------------------------|
|                        |                                                                                      |
|                        | By                                                                                        | /s/ CHESTER L. F. PAULSON |
|                        | Chester L. F. Paulson  President and Chief Executive Officer  Principal Executive Officer |
|                        |                                                                                      |   |
|                        | By                                                                                        | /s/ KAREN L. JOHANNES |
|                        | Karen L. Johannes  Chief Financial Officer  Principal Financial Officer                   |

 

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