##### Table of Contents





UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549





FORM 10-Q





(Mark One)



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

For the quarterly period ended September 30, 2008

OR



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

For the transition period from                          to

Commission file number: 000-18188

PAULSON CAPITAL CORP.

(Exact name of registrant as 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 telephone number, including area code: 503-243-6000





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 for such shorter
period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No   ̈

Indicate by check mark whether the registrant is
a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of accelerated filer, large accelerated filer and smaller reporting company in Rule 12b-2 of
the Exchange Act. Large accelerated filer   ̈    Accelerated filer   ̈    Non-accelerated filer   ̈    (Do not check if a smaller reporting company)    Smaller reporting company  x

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

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



|                           |  |                                   
|-------------------------- |  | ----------------------------------
|Common stock, no par value |  | 5,942,150                         
|(Class)                    |  | (Outstanding at November 14, 2008)









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##### Table of Contents

PAULSON CAPITAL CORP. AND SUBSIDIARY

FORM 10-Q

INDEX



|                               |  |                                                                                                             |  |   
|------------------------------ |  | ----------------------------------------------------------------------------------------------------------- |  | --
|PART I - FINANCIAL INFORMATION |  | Page                                                                                                       
|                               |  |                                                                                                            
|Item 1.                        |  | Financial Statements                                                                                        |  |   
|                               |  |                                                                                                            
|                               |  | Consolidated Balance Sheets - September 30, 2008 and December 31, 2007 (unaudited)                          |  | 2 
|                               |  |                                                                                                            
|                               |  | Consolidated Statements of Operations - Three and Nine Months Ended September 30, 2008 and 2007 (unaudited) |  | 3 
|                               |  |                                                                                                            
|                               |  | Consolidated Statements of Cash Flows - Nine Months Ended September 30, 2008 and 2007 (unaudited)           |  | 4 
|                               |  |                                                                                                            
|                               |  | Notes to Consolidated Financial Statements (unaudited)                                                      |  | 5 
|                               |  |                                                                                                            
|Item 2.                        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                       |  | 8 
|                               |  |                                                                                                            
|Item 3.                        |  | Quantitative and Qualitative Disclosures About Market Risk                                                  |  | 14
|                               |  |                                                                                                            
|Item 4T.                       |  | Controls and Procedures                                                                                     |  | 14
|                               | 
|PART II - OTHER INFORMATION    |  |                                                                                                            
|                               |  |                                                                                                            
|Item 6.                        |  | Exhibits                                                                                                    |  | 15
|                               | 
|Signatures                     |  | 16                                                                                                         



1



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##### Table of Contents

PART IFINANCIAL INFORMATION



|Item 1. | Financial Statements
|------- | --------------------

Paulson Capital Corp. and
Subsidiary

Consolidated Balance Sheets



|                                                                                                                 |  |                   |            |                  |   |           
|---------------------------------------------------------------------------------------------------------------- |  | ----------------- | ---------- | ---------------- | - | ----------
|                                                                                                                 |  | September 30,2008 |            | December 31,2007
|                                                                                                                 |  | (Unaudited)       |            |                 
|Assets                                                                                                           |  |                   |            |                  |   |           
|Cash and cash equivalents                                                                                        |  | $                 | 231,177    |                  | $ | 43,619    
|Receivable from clearing organization                                                                            |  |                   | 7,919,838  |                  |   | 11,702,341
|Notes and other receivables                                                                                      |  |                   | 658,044    |                  |   | 1,563,530 
|Income taxes receivable                                                                                          |  |                   | 2,647,279  |                  |   |          
|Deferred tax asset                                                                                               |  |                   | 4,477,432  |                  |   |          
|Trading securities, at market value                                                                              |  |                   | 6,396,788  |                  |   | 12,037,368
|Investment securities, at market or estimated fair value                                                         |  |                   | 3,694,036  |                  |   | 8,157,546 
|Underwriter warrants, at estimated fair value                                                                    |  |                   | 2,359,000  |                  |   | 16,373,000
|Prepaid and deferred expenses                                                                                    |  |                   | 646,274    |                  |   | 939,371   
|Furniture and equipment, at cost, net of accumulated depreciation and amortization of $859,202 and $862,616      |  |                   | 117,410    |                  |   | 196,333   
|                                                                                                                 |  |                   |            |                  |   |           
|Total Assets                                                                                                     |  | $                 | 29,147,278 |                  | $ | 51,013,108
|                                                                                                                 |  |                   |            |                  |   |           
|Liabilities and Shareholders Equity                                                                             |  |                   |            |                  |   |           
|Accounts payable and accrued liabilities                                                                         |  | $                 | 894,598    |                  | $ | 3,240,877 
|Payable to clearing organization                                                                                 |  |                   | 1,863,530  |                  |   | 2,463,413 
|Compensation, employee benefits and payroll taxes                                                                |  |                   | 701,454    |                  |   | 2,065,972 
|Securities sold, not yet purchased, at market value                                                              |  |                   | 41,865     |                  |   | 36,259    
|Income taxes payablecurrent                                                                                     |  |                   |           |                  |   | 1,369,710 
|Income taxes payablelong-term                                                                                   |  |                   | 311,000    |                  |   | 297,000   
|Deferred revenue                                                                                                 |  |                   | 300,000    |                  |   | 375,000   
|Underwriter warrantsemployee and independent contractor, at estimated fair value                                |  |                   | 131,000    |                  |   | 651,000   
|Deferred income taxes                                                                                            |  |                   |           |                  |   | 1,821,000 
|                                                                                                                 |  |                   |            |                  |   |           
|Total Liabilities                                                                                                |  |                   | 4,243,447  |                  |   | 12,320,231
|                                                                                                                 |  |                  
|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: 5,942,150 and 6,037,150 |  |                   | 1,950,469  |                  |   | 1,972,319 
|Retained earnings                                                                                                |  |                   | 22,953,362 |                  |   | 36,720,558
|                                                                                                                 |  |                   |            |                  |   |           
|Total Shareholders Equity                                                                                       |  |                   | 24,903,831 |                  |   | 38,692,877
|                                                                                                                 |  |                   |            |                  |   |           
|Total Liabilities and Shareholders Equity                                                                       |  | $                 | 29,147,278 |                  | $ | 51,013,108
|                                                                                                                 |  |                   |            |                  |   |           





See accompanying Notes to Consolidated Financial Statements.



2



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##### Table of Contents

Paulson Capital Corp. and Subsidiary

Consolidated Statements of Operations

(Unaudited)



|                                       |  |                                          |             |   |                                         |   |           |      |  |   |             |   |  |   |           
|-------------------------------------- |  | ---------------------------------------- | ----------- | - | --------------------------------------- | - | --------- | ---- |  | - | ----------- | - |  | - | ----------
|                                       |  | For the Three Months Ended September 30, |             |   | For the Nine Months Ended September 30,
|                                       |  | 2008                                     |             |   | 2007                                    |   |           | 2008 |  |   | 2007       
|Revenues                               |  |                                          |             |   |                                         |   |           |      |  |   |             |   |  |   |           
|Commissions                            |  | $                                        | 3,239,163   |   |                                         | $ | 4,090,223 |      |  | $ | 11,251,895  |   |  | $ | 12,810,762
|Corporate finance                      |  |                                          |            |   |                                         |   | 21,230    |      |  |   | 395,389     |   |  |   | 4,467,037 
|Investment income (loss)               |  |                                          | (4,262,800  | ) |                                         |   | 1,672,110 |      |  |   | (16,337,021 | ) |  |   | 4,227,946 
|Trading income (loss)                  |  |                                          | (5,273,518  | ) |                                         |   | 58,344    |      |  |   | (2,721,476  | ) |  |   | 1,769,107 
|Interest and dividends                 |  |                                          | 13,112      |   |                                         |   | 48,988    |      |  |   | 40,583      |   |  |   | 119,987   
|Other                                  |  |                                          | 25,771      |   |                                         |   | 60,121    |      |  |   | 82,667      |   |  |   | 232,196   
|                                       |  |                                          |             |   |                                         |   |           |      |  |   |             |   |  |   |           
|                                       |  |                                          | (6,258,272  | ) |                                         |   | 5,951,016 |      |  |   | (7,287,963  | ) |  |   | 23,627,035
|Expenses                               |  |                                          |             |   |                                         |   |           |      |  |   |             |   |  |   |           
|Commissions and salaries               |  |                                          | 3,022,404   |   |                                         |   | 3,669,120 |      |  |   | 10,550,804  |   |  |   | 12,452,211
|Underwriting expenses                  |  |                                          | 4,755       |   |                                         |   | 14,529    |      |  |   | 318,761     |   |  |   | 323,993   
|Rent, telephone and quotation services |  |                                          | 305,565     |   |                                         |   | 313,066   |      |  |   | 894,182     |   |  |   | 930,246   
|Professional fees                      |  |                                          | 154,046     |   |                                         |   | 151,828   |      |  |   | 627,604     |   |  |   | 497,001   
|Bad debt expense                       |  |                                          | 9,113       |   |                                         |   | 27,192    |      |  |   | 14,289      |   |  |   | 182,041   
|Travel and entertainment               |  |                                          | 55,869      |   |                                         |   | 107,505   |      |  |   | 257,096     |   |  |   | 184,689   
|Advertising and promotion              |  |                                          | 50,653      |   |                                         |   | 92,820    |      |  |   | 165,239     |   |  |   | 177,546   
|Settlement expense                     |  |                                          | 44,800      |   |                                         |   | 190,000   |      |  |   | 76,800      |   |  |   | 499,717   
|Depreciation and amortization          |  |                                          | 27,603      |   |                                         |   | 29,267    |      |  |   | 84,787      |   |  |   | 85,594    
|Other                                  |  |                                          | 372,139     |   |                                         |   | 349,184   |      |  |   | 1,147,316   |   |  |   | 1,125,043 
|                                       |  |                                          |             |   |                                         |   |           |      |  |   |             |   |  |   |           
|                                       |  |                                          | 4,046,947   |   |                                         |   | 4,944,511 |      |  |   | 14,136,878  |   |  |   | 16,458,081
|                                       |  |                                          |             |   |                                         |   |           |      |  |   |             |   |  |   |           
|Income (loss) before income taxes      |  |                                          | (10,305,219 | ) |                                         |   | 1,006,505 |      |  |   | (21,424,841 | ) |  |   | 7,168,954 
|Income tax expense (benefit):          |  |                                          |             |   |                                         |   |           |      |  |   |             |   |  |   |           
|Current                                |  |                                          | (2,344,366  | ) |                                         |   | 714,423   |      |  |   | (1,819,568  | ) |  |   | 1,461,025 
|Deferred                               |  |                                          | (1,612,634  | ) |                                         |   | (377,823  | )    |  |   | (6,298,432  | ) |  |   | 1,259,950 
|                                       |  |                                          |             |   |                                         |   |           |      |  |   |             |   |  |   |           
|                                       |  |                                          | (3,957,000  | ) |                                         |   | 336,600   |      |  |   | (8,118,000  | ) |  |   | 2,720,975 
|                                       |  |                                          |             |   |                                         |   |           |      |  |   |             |   |  |   |           
|Net income (loss)                      |  | $                                        | (6,348,219  | ) |                                         | $ | 669,905   |      |  | $ | (13,306,841 | ) |  | $ | 4,447,979 
|                                       |  |                                          |             |   |                                         |   |           |      |  |   |             |   |  |   |           
|Basic net income (loss) per share      |  | $                                        | (1.07       | ) |                                         | $ | 0.11      |      |  | $ | (2.23       | ) |  | $ | 0.73      
|                                       |  |                                          |             |   |                                         |   |           |      |  |   |             |   |  |   |           
|Diluted net income (loss) per share    |  | $                                        | (1.07       | ) |                                         | $ | 0.11      |      |  | $ | (2.23       | ) |  | $ | 0.72      
|                                       |  |                                          |             |   |                                         |   |           |      |  |   |             |   |  |   |           
|Shares used in per share calculations: |  |                                          |             |   |                                         |   |           |      |  |   |             |   |  |   |           
|Basic                                  |  |                                          | 5,942,150   |   |                                         |   | 6,087,341 |      |  |   | 5,975,581   |   |  |   | 6,129,613 
|                                       |  |                                          |             |   |                                         |   |           |      |  |   |             |   |  |   |           
|Diluted                                |  |                                          | 5,942,150   |   |                                         |   | 6,097,321 |      |  |   | 5,975,581   |   |  |   | 6,139,665 
|                                       |  |                                          |             |   |                                         |   |           |      |  |   |             |   |  |   |           



See accompanying Notes to
Consolidated Financial Statements.



3



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Paulson Capital Corp. and Subsidiary

Consolidated Statements of Cash Flows

(Unaudited)



|                                                                                               |  |                                         |             |   |      |   |            |  
|---------------------------------------------------------------------------------------------- |  | --------------------------------------- | ----------- | - | ---- | - | ---------- | -
|                                                                                               |  | For the Nine Months Ended September 30, |            
|                                                                                               |  | 2008                                    |             |   | 2007 |  
|Cash flows from operating activities:                                                          |  |                                         |             |   |      |   |            |  
|Net income (loss)                                                                              |  | $                                       | (13,306,841 | ) |      | $ | 4,447,979  |  
|Adjustments to reconcile net income (loss) to net cash flows provided by operating activities: |  |                                         |             |   |      |   |            |  
|Receipt of underwriter warrants                                                                |  |                                         | (462,320    | ) |      |   | (3,052,009 | )
|Unrealized (appreciation) depreciation/expiration of underwriter warrants                      |  |                                         | 14,476,320  |   |      |   | (5,668,719 | )
|Unrealized depreciation of underwriter warrantsemployee and independent contractor            |  |                                         | (520,000    | ) |      |   |           |  
|Non-cash compensation associated with underwriter warrants                                     |  |                                         |            |   |      |   | 688,728    |  
|Depreciation and amortization                                                                  |  |                                         | 84,787      |   |      |   | 85,594     |  
|Deferred income taxes                                                                          |  |                                         | (6,298,432  | ) |      |   | 1,259,950  |  
|Deferred revenue                                                                               |  |                                         | (75,000     | ) |      |   | (75,000    | )
|Change in assets and liabilities:                                                              |  |                                         |             |   |      |   |            |  
|Receivables from/payable to clearing organization                                              |  |                                         | 3,182,620   |   |      |   | (2,153,773 | )
|Notes and other receivables                                                                    |  |                                         | 905,486     |   |      |   | 104,278    |  
|Income taxes receivable                                                                        |  |                                         | (2,647,279  | ) |      |   | 304,695    |  
|Trading and investment securities                                                              |  |                                         | 10,104,090  |   |      |   | 2,764,719  |  
|Prepaid and deferred expenses                                                                  |  |                                         | 293,097     |   |      |   | (31,985    | )
|Accounts payable, accrued liabilities and compensation payables                                |  |                                         | (3,710,798  | ) |      |   | 271,690    |  
|Securities sold, not yet purchased                                                             |  |                                         | 5,606       |   |      |   | 232,904    |  
|Income taxes payablecurrent                                                                   |  |                                         | (1,369,710  | ) |      |   | 1,107,299  |  
|Income taxes payablelong-term                                                                 |  |                                         | 14,000      |   |      |   | 128,000    |  
|                                                                                               |  |                                         |             |   |      |   |            |  
|Net cash provided by operating activities                                                      |  |                                         | 675,626     |   |      |   | 414,350    |  
|                                                                                               |  |                                        
|Cash flows from investing activities:                                                          |  |                                         |             |   |      |   |            |  
|Additions to furniture and equipment                                                           |  |                                         | (5,863      | ) |      |   | (33,729    | )
|                                                                                               |  |                                        
|Cash flows from financing activities:                                                          |  |                                         |             |   |      |   |            |  
|Proceeds from stock option exercise                                                            |  |                                         |            |   |      |   | 77,110     |  
|Payments to retire common stock                                                                |  |                                         | (482,205    | ) |      |   | (664,113   | )
|                                                                                               |  |                                         |             |   |      |   |            |  
|Net cash used in financing activities                                                          |  |                                         | (482,205    | ) |      |   | (587,003   | )
|                                                                                               |  |                                         |             |   |      |   |            |  
|                                                                                               |  |                                        
|Increase (decrease) in cash and cash equivalents                                               |  |                                         | 187,558     |   |      |   | (206,382   | )
|                                                                                               |  |                                        
|Cash and cash equivalents:                                                                     |  |                                         |             |   |      |   |            |  
|Beginning of period                                                                            |  |                                         | 43,619      |   |      |   | 219,341    |  
|                                                                                               |  |                                         |             |   |      |   |            |  
|End of period                                                                                  |  | $                                       | 231,177     |   |      | $ | 12,959     |  
|                                                                                               |  |                                         |             |   |      |   |            |  
|                                                                                               |  |                                        
|Supplemental cash flow information:                                                            |  |                                         |             |   |      |   |            |  
|Cash paid during the period for income taxes                                                   |  | $                                       | 2,260,298   |   |      | $ | 415,236    |  
|                                                                                               |  |                                        
|Supplemental non-cash information:                                                             |  |                                         |             |   |      |   |            |  
|Effect of adoption of FIN 48                                                                   |  | $                                       |            |   |      | $ | 90,000     |  

See accompanying Notes to Consolidated Financial Statements.



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##### Table of Contents

PAULSON CAPITAL CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Basis of Presentation

The financial information for Paulson Capital Corp. and its wholly-owned subsidiary, Paulson Investment Company, included herein as of September 30, 2008 and December 31, 2007 and for the three and
nine-month periods ended September 30, 2008 and 2007 is unaudited; however, such information reflects all adjustments, consisting only of normal recurring adjustments, which, in the opinion of management, are necessary for a fair presentation
of the financial position, results of operations and cash flows for the interim periods. The financial information as of December 31, 2007 is derived from our Annual Report on Form 10-K for the year ended December 31, 2007. The interim
consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2007. The results of operations for the
interim periods presented are not necessarily indicative of the results to be expected for the full year.

Note 2. Earnings Per Share

Following is a reconciliation of our shares used for our basic net income (loss) per share and our diluted net income (loss) per share:



|                                                                                                                    |  |                                 |  |                                |  |           |  |          
|------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- |  | ------------------------------ |  | --------- |  | ---------
|                                                                                                                    |  | Three Months EndedSeptember 30, |  | Nine Months EndedSeptember 30,
|                                                                                                                    |  | 2008                            |  | 2007                           |  | 2008      |  | 2007     
|Shares used for basic income (loss) per share                                                                       |  | 5,942,150                       |  | 6,087,341                      |  | 5,975,581 |  | 6,129,613
|Effect of dilutive stock options                                                                                    |  |                                |  | 9,980                          |  |          |  | 10,052   
|                                                                                                                    |  |                                 |  |                                |  |           |  |          
|Shares used for diluted net income (loss) per share                                                                 |  | 5,942,150                       |  | 6,097,321                      |  | 5,975,581 |  | 6,139,665
|                                                                                                                    |  |                                 |  |                                |  |           |  |          
|Stock options not included in diluted net income (loss) per share because their effect would have been antidilutive |  | 95,000                          |  |                               |  | 95,000    |  |         
|                                                                                                                    |  |                                 |  |                                |  |           |  |          

Note 3. Repurchases of Common Stock

In the first nine months of 2008, we repurchased a total of 95,000 shares of our common stock for a weighted average price of $5.07 per share, which totaled approximately $482,000. The amount paid above the original
issue price, which totaled $22,000, was offset against retained earnings. The plan to repurchase up to a total of 600,000 shares of our common stock was approved by our Board of Directors in September 2001 and does not have an expiration date. In
addition, in June 2008, our Board of Directors approved the repurchase of up to a total of an additional 200,000 shares of our common stock. This authorization also does not have an expiration date. As of September 30, 2008, 256,876 shares
remained available for repurchase.

Note 4. Unrecognized Tax Benefits

During the three and nine-month periods ended September 30, 2008, accrued interest on unrecognized tax benefits increased $4,000 and $14,000, respectively, as a result of tax positions taken in prior periods.



5



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##### Table of Contents

Note 5. Fair Value Measurements

Effective January 1, 2008, we adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements, for our financial assets and liabilities.
The adoption of this portion of SFAS No. 157 did not have any effect on our financial position or results of operations and we do not expect the adoption of the provisions of SFAS No. 157 related to non-financial assets and liabilities to
have an effect on our financial position or results of operations.

Various inputs are used in determining the fair value of our financial assets and
liabilities and are summarized into three broad categories:

| |  |  | Level 1  quoted prices in active markets for identical securities;
| | - |  | -------------------------------------------------------------------

| |  |  | Level 2  other significant observable inputs, including quoted prices for similar securities, interest rates, prepayment speeds, credit risk, etc.; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Level 3  significant unobservable inputs, including our own assumptions in determining fair value.
| | - |  | ---------------------------------------------------------------------------------------------------

The inputs or methodology used for valuing securities are not necessarily an indication of the risk associated with investing in those securities.

Following are the disclosures related to our financial assets and (liabilities) pursuant to SFAS No. 157 (in thousands):



|                                                           |  |                    |       |   |             |        
|---------------------------------------------------------- |  | ------------------ | ----- | - | ----------- | -------
|                                                           |  | September 30, 2008
|                                                           |  | Fair Value         |       |   | Input Level
|Trading securities                                         |  | $                  | 6,397 |   |             | Level 1
|Investment securities, marketable                          |  |                    | 1,364 |   |             | Level 1
|Investment securities, not readily marketable              |  |                    | 2,330 |   |             | Level 3
|Underwriter warrants                                       |  |                    | 2,359 |   |             | Level 3
|Underwriter warrants  employee and independent contractor |  |                    | (131  | ) |             | Level 3

Following is a summary of activity related to our Level 3 financial assets and liabilities (in thousands):



|                                                                                             |  |                     |         |   |                                                        |   |      |                                          |  |   |      
|-------------------------------------------------------------------------------------------- |  | ------------------- | ------- | - | ------------------------------------------------------ | - | ---- | ---------------------------------------- |  | - | -----
|                                                                                             |  | UnderwriterWarrants |         |   | UnderwriterWarrants Employee andIndependentContractor |   |      | NotReadilyMarketableInvestmentSecurities
|Balance, December 31, 2007                                                                   |  | $                   | 16,373  |   |                                                        | $ | (651 | )                                        |  | $ | 1,946
|Fair value of warrants received, included as a component of corporate finance revenue        |  |                     | 462     |   |                                                        |   |     |                                          |  |   |     
|Net unrealized gain (loss), included as a component of investment income (loss)              |  |                     | (13,679 | ) |                                                        |   | 476  |                                          |  |   | 384  
|Value of warrants exercised and expired, included as a component of investment income (loss) |  |                     | (797    | ) |                                                        |   | 44   |                                          |  |   |     
|                                                                                             |  |                     |         |   |                                                        |   |      |                                          |  |   |      
|Balance, September 30, 2008                                                                  |  | $                   | 2,359   |   |                                                        | $ | (131 | )                                        |  | $ | 2,330
|                                                                                             |  |                     |         |   |                                                        |   |      |                                          |  |   |      

Valuation of Trading Securities and Marketable Investment Securities

The fair value of our trading securities and our marketable investment securities is determined based on quoted market prices.

Valuation of Not Readily Marketable Investment Securities

The
fair value of our not readily marketable investment securities are estimated using generally accepted valuation approaches, including the asset, income and market approaches.



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Valuation of Underwriter Warrants

We estimate the value of our underwriter warrants using the Black-Scholes Option Pricing Model. The Black-Scholes model requires us to use five inputs including: stock price, risk free rate, exercise price, time
remaining on the warrant and price volatility. After stock price, the most influential factor in this model is price volatility, which we calculate for each companys warrants based on each companys own historical closing stock prices as
well as an index of historical prices for comparable companies. When we initially receive a new underwriter warrant from an initial public offering, its calculated volatility factor is entirely based on the volatility of an index of comparable
companies, since there is no price history for a new publicly traded company. As each underwriter warrant approaches its expiration date, its volatility factor is derived primarily from the historical prices of its underlying common stock. We cannot
assure you that we will ultimately be able to exercise any of our warrants in a way that will realize the value that we attribute to them in our financial statements based on this model.

Note 6. New Subsidiary

In the third quarter of 2008, we formed a new 100% owned subsidiary for the purpose of
purchasing underappreciated real estate, improving it and remarketing it. Through September 30, 2008, we had not purchased any real estate.

Note 7. New Accounting Pronouncements

SFAS No. 162

In May 2008, the Financial Accounting Standards Board (FASB) issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles, which identifies the sources of accounting
principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States. SFAS
No. 162 is effective 60 days following the Securities and Exchange Commissions approval of the Public Company Accounting Oversight Board amendments to AU Section 4311, The Meaning of Present Fairly in Conformity With Generally
Accepted Accounting Principles. We believe that our accounting principles and practices are consistent with the guidance in SFAS No. 162, and, accordingly, we do not expect the adoption of SFAS No. 162 to have a material effect on
our financial position or results of operations.

SFAS No. 161

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, which requires certain disclosures related to derivative instruments. SFAS No. 161 is
effective prospectively for interim periods and fiscal years beginning after November 15, 2008. We do not have any derivative instruments that fall under the guidance of SFAS No. 161 and, accordingly, the adoption of SFAS No. 161 will
not have any effect on our financial position or results of operations.

SFAS No. 159

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, which permits entities to choose to
measure many financial instruments and certain other items at fair value. The adoption of the provisions of SFAS No. 159 effective January 1, 2008 did not have any effect on our financial position or results of operations.



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|Item 2. | Managements Discussion and Analysis of Financial Condition and Results of Operations
|------- | -------------------------------------------------------------------------------------

Forward Looking Statements and Risk Factors

This report, including, without limitation, Item 2.
Managements Discussion and Analysis of Financial Condition and Results of Operations, contains or incorporates both historical and forward-looking statements within the meaning of Section 27A of the Securities Act
of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Words such as anticipates, believes, expects, intends, future and similar expressions identify
forward-looking statements. Any such forward-looking statements in this report reflect our current views with respect to future events and financial performance and are subject to a variety of factors that could cause our actual results to differ
materially from historical results or from anticipated results expressed or implied by such forward-looking statements. Because of such factors, we cannot assure you that the results anticipated in this report will be realized. As noted elsewhere in
this report, various aspects of our business are subject to extreme volatility often as a result of factors beyond our ability to anticipate or control. In particular, factors, such as the condition of the securities markets, which are in 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 of the securities maintained in our trading and investment accounts. Other factors that may affect our future
financial condition or results of operations include the following:

| |  |  | Aspects of our business are volatile and affected by factors beyond our control.
| | - |  | --------------------------------------------------------------------------------

| |  |  | Our ability to attract and retain customers may be affected by our reputation.
| | - |  | ------------------------------------------------------------------------------

| |  |  | We are subject to extensive regulation that could result in investigations, fines or other penalties.
| | - |  | -----------------------------------------------------------------------------------------------------

| |  |  | We face intense competition in our industry.
| | - |  | --------------------------------------------

| |  |  | Our future success depends on retaining existing management and hiring and assimilating new key employees, and our inability to attract or retain key personnel
would materially harm our business and results of operations.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | We are subject to an increased risk of legal proceedings, which may result in significant losses to us that we cannot recover. Claimants in these proceedings may be
customers, employees, or regulatory agencies, among others, seeking damages for mistakes, errors, negligence or acts of fraud by our employees.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | As a public company, we are subject to complex legal and accounting requirements that require us to incur substantial expense and expose us to risk of
non-compliance.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Our directors control approximately 60 percent of our common stock and may have interests differing from those of other stockholders.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------

Overview

Substantially all of our business consists of the
securities brokerage and corporate finance activities of our wholly-owned subsidiary, Paulson Investment Company, Inc., which has operations in four principal categories, all of them in the financial services industry. These categories are:

| |  |  | securities brokerage activities for which we earn commission revenues;
| | - |  | ----------------------------------------------------------------------

| |  |  | corporate finance revenues consisting principally of underwriting discounts and underwriter warrants;
| | - |  | -----------------------------------------------------------------------------------------------------

| |  |  | securities trading from which we record profit or loss, depending on trading results; and
| | - |  | -----------------------------------------------------------------------------------------

| |  |  | investment income resulting from earnings on, and increases or decreases in the value of, our investment portfolio.
| | - |  | -------------------------------------------------------------------------------------------------------------------

Because we operate in the financial services industry, our revenues and earnings are substantially affected by general conditions in financial markets. In our securities
brokerage business, the amount of our revenues depends on levels of market activity requiring the services we provide. Our corporate finance activity, which consists of acting as the managing underwriter of initial and follow-on public offerings,
private investments in public equity (PIPEs) and private placements for smaller companies, is similarly affected by the strength of the market for new equity offerings, which has historically experienced substantial cyclical fluctuation.
The number of initial public offerings (IPOs) in the U.S. has declined for three straight quarters as volatility in the U.S. economy continues. During the first nine months of 2008,



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54 companies completed IPOs in the U.S., with proceeds totaling $31.2 billion. This compares to 195 IPOs in the same period of 2007, with proceeds totaling
$44.7 billion. With the VISA IPO excluded from the 2008 results, the IPOs in the first nine months of 2008 raised $13.3 billion. During the third quarter of 2008, 12 companies completed IPOs, raising a total of $1.9 billion. This was the slowest
quarter since the second quarter of 2003, when 5 IPOs raised $1.6 billion. Although we attempt to match operating costs with activity levels, many of our expenses are either fixed or difficult to change on short notice. Accordingly, fluctuations in
brokerage and corporate finance revenues tend to result in sharper fluctuations, on a percentage basis, in net income or loss.

Our investment and trading
income or loss is affected by changes in market valuation of securities generally and, in particular, by changes in valuation of the equity securities of microcap companies in which our investments and trading activities tend to be concentrated.
Equity markets in general, and microcap equity markets in particular, have always experienced significant volatility and this volatility has, in recent years, been extreme. The result of this volatility on the value of our investment portfolio and
securities held in connection with our trading and investment activities include large quarterly fluctuations in income or loss from these operations and substantial increases or decreases in our net worth as our securities holdings are marked to
market.

A substantial portion of our corporate finance business consists of acting as managing underwriter of initial and follow-on public offerings for
microcap and smallcap companies. As a part of our compensation for these activities, we typically receive warrants exercisable to purchase securities similar to those that we offer and sell to the public. The warrants generally have a five-year
expiration date and vest immediately. The warrants are generally subject to a restricted period of six months to one-year during which we cannot exercise. The exercise price is typically 120% of the price at which the securities were initially sold
to the public. Accordingly, unless there is at least a 20% increase in the price of these securities at some time more than six months and less than five years after the offering, the warrants will remain under water and will ultimately
expire unexercised. We also receive warrants in connection with PIPEs, which have varying terms and conditions.

In the third quarter of 2008, we formed a
new 100% owned subsidiary for the purpose of purchasing underappreciated real estate, improving it and remarketing it. Through September 30, 2008, we had not purchased any real estate.

Critical Accounting Policies and Use of Estimates

With the exception
of the adoption of SFAS No. 157 as described in Note 5 of Notes to Consolidated Financial Statements, we reaffirm the critical accounting policies and estimates as reported in our Annual Report on Form 10-K for the year ended December 31,
2007, which was filed with the Securities and Exchange Commission on March 31, 2008.

Results of Operations

Our revenues and operating results are influenced by fluctuations in the equity markets as well as general economic and market conditions, particularly conditions in the
over-the-counter market, where our investment and trading positions and the underlying stock for the underwriter warrants are heavily concentrated. Significant fluctuations can occur in our revenues and operating results from one period to another.
Our results of operations depend upon many factors, such as the number of companies that are seeking financing, the quality and financial condition of those companies, market conditions in general, the performance of our previous underwritings and
interest in certain industries by investors. As a result, revenues and income derived from these activities may vary significantly from period to period. Our revenues include the following:

| |  |  | Commissions, which represent amounts earned from our retail securities brokerage activities;
| | - |  | --------------------------------------------------------------------------------------------

| |  |  | Corporate finance revenues, which are a function of total proceeds from offerings done during the period, compensation per offering and the fair value of
underwriter warrants received;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | Investment income (loss), which includes (i) the unrealized appreciation and depreciation of securities held based on quoted market prices, (ii) the
unrealized appreciation and depreciation of securities held that are not readily marketable, based upon our estimate of their fair value, (iii) realized gains and losses on the sale of securities with quoted market prices and securities that
are not readily marketable, (iv) income on the exercise of underwriter warrants, and (v) the unrealized appreciation and depreciation of underwriter warrants held; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Trading income (loss), which is the gain or loss from trading positions before commissions paid to the representatives in the trading department.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------

The following tables set forth the changes in our operating results in the three and nine-month periods ended September 30, 2008
compared to the three and nine-month periods ended September 30, 2007 (dollars in thousands):



|                                       |  |                                 |         |                    |      |   |                     |  |   |         |   |  |        |   
|-------------------------------------- |  | ------------------------------- | ------- | ------------------ | ---- | - | ------------------- |  | - | ------- | - |  | ------ | --
|                                       |  | Three Months EndedSeptember 30, |         | Increase(Decrease) |      |   | %Increase(Decrease) | 
|                                       |  | 2008                            |         |                    | 2007 |   |                    
|Revenues:                              |  |                                 |         |                    |      |   |                     |  |   |         |   |  |        |   
|Commissions                            |  | $                               | 3,239   |                    |      | $ | 4,090               |  | $ | (851    | ) |  | (20.8  | )%
|Corporate finance                      |  |                                 |        |                    |      |   | 21                  |  |   | (21     | ) |  | (100.0 | ) 
|Investment income (loss)               |  |                                 | (4,263  | )                  |      |   | 1,672               |  |   | (5,935  | ) |  | *      |   
|Trading income (loss)                  |  |                                 | (5,273  | )                  |      |   | 59                  |  |   | (5,332  | ) |  | *      |   
|Interest and dividends                 |  |                                 | 13      |                    |      |   | 49                  |  |   | (36     | ) |  | (73.5  | ) 
|Other                                  |  |                                 | 26      |                    |      |   | 60                  |  |   | (34     | ) |  | (56.7  | ) 
|                                       |  |                                 |         |                    |      |   |                     |  |   |         |   |  |        |   
|Total revenues (loss)                  |  |                                 | (6,258  | )                  |      |   | 5,951               |  |   | (12,209 | ) |  | *      |   
|Expenses:                              |  |                                 |         |                    |      |   |                     |  |   |         |   |  |        |   
|Commissions and salaries               |  |                                 | 3,022   |                    |      |   | 3,669               |  |   | (647    | ) |  | (17.6  | ) 
|Underwriting expenses                  |  |                                 | 5       |                    |      |   | 15                  |  |   | (10     | ) |  | (66.7  | ) 
|Rent, telephone and quotation services |  |                                 | 305     |                    |      |   | 313                 |  |   | (8      | ) |  | (2.6   | ) 
|Professional fees                      |  |                                 | 154     |                    |      |   | 152                 |  |   | 2       |   |  | 1.3    |   
|Bad debt expense                       |  |                                 | 9       |                    |      |   | 27                  |  |   | (18     | ) |  | (66.7  | ) 
|Travel and entertainment               |  |                                 | 56      |                    |      |   | 107                 |  |   | (51     | ) |  | (47.7  | ) 
|Advertising and promotion              |  |                                 | 51      |                    |      |   | 93                  |  |   | (42     | ) |  | (45.2  | ) 
|Settlement expense                     |  |                                 | 45      |                    |      |   | 190                 |  |   | (145    | ) |  | (76.3  | ) 
|Depreciation and amortization          |  |                                 | 28      |                    |      |   | 29                  |  |   | (1      | ) |  | (3.4   | ) 
|Other                                  |  |                                 | 372     |                    |      |   | 349                 |  |   | 23      |   |  | 6.6    |   
|                                       |  |                                 |         |                    |      |   |                     |  |   |         |   |  |        |   
|Total expenses                         |  |                                 | 4,047   |                    |      |   | 4,944               |  |   | (897    | ) |  | (18.1  | ) 
|                                       |  |                                 |         |                    |      |   |                     |  |   |         |   |  |        |   
|Income (loss) before income taxes      |  | $                               | (10,305 | )                  |      | $ | 1,007               |  | $ | (11,312 | ) |  | *      |   
|                                       |  |                                 |         |                    |      |   |                     |  |   |         |   |  |        |   



|                                       |  |                                |         |                    |      |   |                     |  |   |         |   |  |       |   
|-------------------------------------- |  | ------------------------------ | ------- | ------------------ | ---- | - | ------------------- |  | - | ------- | - |  | ----- | --
|                                       |  | Nine Months EndedSeptember 30, |         | Increase(Decrease) |      |   | %Increase(Decrease) | 
|                                       |  | 2008                           |         |                    | 2007 |   |                    
|Revenues:                              |  |                                |         |                    |      |   |                     |  |   |         |   |  |       |   
|Commissions                            |  | $                              | 11,252  |                    |      | $ | 12,811              |  | $ | (1,559  | ) |  | (12.2 | )%
|Corporate finance                      |  |                                | 395     |                    |      |   | 4,467               |  |   | (4,072  | ) |  | (91.2 | ) 
|Investment income (loss)               |  |                                | (16,337 | )                  |      |   | 4,228               |  |   | (20,565 | ) |  | *     |   
|Trading income (loss)                  |  |                                | (2,722  | )                  |      |   | 1,769               |  |   | (4,491  | ) |  | *     |   
|Interest and dividends                 |  |                                | 41      |                    |      |   | 120                 |  |   | (79     | ) |  | (65.8 | ) 
|Other                                  |  |                                | 83      |                    |      |   | 232                 |  |   | (149    | ) |  | (64.2 | ) 
|                                       |  |                                |         |                    |      |   |                     |  |   |         |   |  |       |   
|Total revenues                         |  |                                | (7,288  | )                  |      |   | 23,627              |  |   | (30,915 | ) |  | *     |   
|Expenses:                              |  |                                |         |                    |      |   |                     |  |   |         |   |  |       |   
|Commissions and salaries               |  |                                | 10,551  |                    |      |   | 12,452              |  |   | (1,901  | ) |  | (15.3 | ) 
|Underwriting expenses                  |  |                                | 319     |                    |      |   | 324                 |  |   | (5      | ) |  | (1.5  | ) 
|Rent, telephone and quotation services |  |                                | 894     |                    |      |   | 930                 |  |   | (36     | ) |  | (3.9  | ) 
|Professional fees                      |  |                                | 628     |                    |      |   | 497                 |  |   | 131     |   |  | 26.4  |   
|Bad debt expense                       |  |                                | 14      |                    |      |   | 182                 |  |   | (168    | ) |  | (92.3 | ) 
|Travel and entertainment               |  |                                | 257     |                    |      |   | 185                 |  |   | 72      |   |  | 38.9  |   
|Advertising and promotion              |  |                                | 165     |                    |      |   | 177                 |  |   | (12     | ) |  | (6.8  | ) 
|Settlement expense                     |  |                                | 77      |                    |      |   | 500                 |  |   | (423    | ) |  | (84.6 | ) 
|Depreciation and amortization          |  |                                | 85      |                    |      |   | 86                  |  |   | (1      | ) |  | (1.2  | ) 
|Other                                  |  |                                | 1,147   |                    |      |   | 1,125               |  |   | 22      |   |  | 2.0   |   
|                                       |  |                                |         |                    |      |   |                     |  |   |         |   |  |       |   
|Total expenses                         |  |                                | 14,137  |                    |      |   | 16,458              |  |   | (2,321  | ) |  | (14.1 | ) 
|                                       |  |                                |         |                    |      |   |                     |  |   |         |   |  |       |   
|Income (loss) before income taxes      |  | $                              | (21,425 | )                  |      | $ | 7,169               |  | $ | (28,594 | ) |  | *     |   
|                                       |  |                                |         |                    |      |   |                     |  |   |         |   |  |       |   



|* | Not meaningful.
|- | ---------------



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Revenues

The
global economic turmoil, which worsened significantly in the third quarter of 2008, had a negative impact on our results of operations in the three and nine-month periods ended September 30, 2008. For example, for the period from
January 1, 2008 to October 31, 2008, the Dow Jones Industrial average and the NASDAQ composite indices decreased 28.4% and 34.1%, respectively.

Commissions decreased 20.8% and 12.2%, respectively, in the three and nine-month periods ended September 30, 2008 compared to the same periods of 2007, primarily as a result of poor market conditions. We had 98 registered
representatives at September 30, 2008 compared to 95 at December 31, 2007.

We did not have any corporate finance income during the third quarter
of 2008. The nine-month period ended September 30, 2008 included underwriting discounts earned from the following:

| |  |  | an initial public offering in which we raised $5.1 million for Healthy Fast Foods, Inc., as well as the Black-Scholes value of the underwriter warrants received in
connection with that offering.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

We did not complete any corporate finance transactions during the third quarter of 2007. Corporate
finance income in the nine-month period ended September 30, 2007 included underwriting discounts earned from the following:

| |  |  | an initial public offering in the first quarter of 2007 in which we raised $9.8 million for Converted Organics Inc., as well as the Black-Scholes value of the
underwriter warrants received in connection with that offering;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | an initial public offering in the second quarter of 2007 in which we raised $14.0 million for Vaughan Foods Inc., as well as the Black-Scholes value of the
underwriter warrants received in connection with that offering;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | one private offering during the second quarter of 2007 in which we raised $2.8 million for our client; and
| | - |  | ----------------------------------------------------------------------------------------------------------

| |  |  | one private transaction completed during the first quarter of 2007 in which we raised $2.2 million for our client.
| | - |  | ------------------------------------------------------------------------------------------------------------------

Investment income (loss) included the following (in thousands):



|                                                                                                                                                                          |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                                                                                                                                                          |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                                                                                                                                                                          |  | 2008                            |        |   | 2007                           |   |        | 2008 |  |   | 2007    |  
|Net unrealized appreciation (depreciation) related to underwriter warrants                                                                                                |  | $                               | (2,869 | ) |                                | $ | 1,037  |      |  | $ | (14,476 | ) |  | $ | 5,669  |  
|Net unrealized depreciation of underwriter warrants  employee and independent contractor                                                                                 |  |                                 | 77     |   |                                |   |       |      |  |   | 520     |   |  |   |       |  
|Net unrealized depreciation of securities held based on quoted market prices or, for securities that are not readily marketable, our estimate
of their fair value         |  |                                 | (1,420 | ) |                                |   | (2,024 | )    |  |   | (2,956  | ) |  |   | (4,742 | )
|Net realized gains (losses) on the sale of securities with quoted market prices, securities that are not readily marketable and from the
exercise of underwriter warrants |  |                                 | (51    | ) |                                |   | 2,659  |      |  |   | 575     |   |  |   | 3,301  |  
|                                                                                                                                                                          |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|                                                                                                                                                                          |  | $                               | (4,263 | ) |                                | $ | 1,672  |      |  | $ | (16,337 | ) |  | $ | 4,228  |  
|                                                                                                                                                                          |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  

We exercised zero and two underwriter warrants, respectively, in the three and nine-month periods ended
September 30, 2008 compared to two and three in the same periods of 2007. Generally, when we exercise a warrant to obtain the underlying common stock, the common stock is subsequently sold in the near term and the related gain is reflected as a
component of investment income.

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



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securities in which we have a concentration can significantly affect our investment income from period to period.

Trading income decreased $5.3 million and $4.5 million, respectively, in the three and nine-month periods ended September 30, 2008 compared to the same periods of
2007. In the three and nine-month periods ended September 30, 2008, trading income was negatively affected by difficult conditions in the market, especially the significant downturn in the third quarter of 2008. Our focus is on very small
capitalization issues, especially those tied to our corporate finance clients. Trading income (loss) can be volatile from period to period because it is driven by the market value of the securities in which we make a market.

Expenses

Total expenses decreased $0.9 million and $2.3
million, respectively, in the three and nine-month periods ended September 30, 2008 compared to the same periods of 2007, primarily due to decreases in commissions and salaries, bad debt expense and settlement expense as described in more
detail below.

Commissions and salaries decreased $0.6 million and $1.9 million, respectively, in the three and nine-month periods ended September 30,
2008 compared to the same periods of 2007. The decreases were primarily due to lower commissions earned on lower commission revenue and lower compensation as a result of fewer investment banking transactions. Retail commissions as a percentage of
retail sales was comparable between the current year and prior year periods.

Bad debt expenses are recorded for specific amounts when they are determined
by management to be uncollectible. Bad debt expense in the nine-month period ended September 30, 2007 included a $104,000 write-off of a loan to a potential corporate finance client.

Travel and entertainment expense increased $72,000 in the nine-month period ended September 30, 2008 compared to the same period of 2007, primarily due to a more
expensive investment banking conference in 2008 as compared to the conference in 2007.

Settlement expense of $45,000 and $77,000 in the three and
nine-month periods ended September 30, 2008, respectively, was related to current legal matters that were recently resolved. Settlement expense of $0.2 million in the three-month period ended September 30, 2007 was related to the
settlement of a legal claim in November 2007 that was expensed during the third quarter of 2007. The $0.5 million of settlement expense in the nine-month period ended September 30, 2007 also included an accrual for $0.2 million in connection
with a legal claim that settled in July 2007.

Liquidity and Capital Resources

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

In addition, our sources of liquidity include our trading positions, investment positions, borrowings on those positions and profits realized upon the sale of the
securities underlying underwriter warrants exercised. The liquidity of the market for many of our securities holdings, however, varies with trends in the stock market. Since many of the securities we hold are thinly traded, and we are, in many
cases, a primary market maker in the issues held, any significant sales of our positions could adversely affect the liquidity of the issues held. In general, falling prices in NASDAQ securities (which make up most of our trading positions) lead to
decreased liquidity in the market for these issues, while rising prices in NASDAQ issues tend to increase the liquidity of the market for these securities.

We believe our cash and receivable from clearing organization at September 30, 2008 is sufficient to meet our needs for at least the next twelve-month period from September 30, 2008, which allows us to hold our investment
securities for the long-term. Our liquidity could be negatively affected by protracted unfavorable market conditions. As discussed above, the major market indices have declined significantly during 2008.



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As a securities broker-dealer, we are required by SEC regulations to meet certain liquidity and capital standards. We
believe we were in compliance with these standards at September 30, 2008.

Following the lapse of restrictions upon issuance, capital available from
the sale of the underlying securities of underwriter warrants exercised can fluctuate significantly from period to period as the value of the underlying securities fluctuates with overall market and individual company financial condition or
performance. There is no public market for the underwriter warrants. The securities receivable upon exercise of the underwriter warrants cannot be resold unless the issuer has registered these securities with the SEC and with the states in which the
securities will be sold unless exemptions are available. Any delay or other problem in the registration of these securities would have an adverse impact upon our ability to obtain funds from the exercise of the underwriter warrants and the resale of
the underlying securities.

At September 30, 2008, we owned 16 underwriter warrants from 15 issuers, all but 2 of which were exercisable. None of the
warrants had an exercise price below the September 30, 2008 market price of the securities receivable upon exercise. There is little or no direct relationship between the intrinsic value of our underwriter warrants at the end of any given
period and the fair value calculated using the Black-Scholes option pricing model. The prices of the securities underlying the underwriter warrants are very volatile, and substantial fluctuations in our estimate of their value can be expected in the
future.

Cash provided by operating activities totaled $0.7 million in the nine-month period ended September 30, 2008, primarily due to our net loss
of $13.3 million being offset by net non-cash expense items of $7.2 million and changes in our operating assets and liabilities as discussed in more detail below.

Our net receivable from our clearing organization decreased $3.1 million to $6.1 million at September 30, 2008 from $9.2 million at December 31, 2007, primarily due to the results of the activity in our trading and investment
accounts, as well as the timing of general corporate expenditures.

Notes and other receivables decreased $0.9 million to $0.7 million at
September 30, 2008 from $1.6 million at December 31, 2007, due to repayment of a $1.1 million note from one of our corporate finance clients, partially offset by amounts loaned to a different corporate finance client.

Income taxes receivable, current increased $4.0 million to $2.6 million at September 30, 2008 from a payable of $1.4 million at December 31, 2007, primarily
due to losses in the current period and our ability to carry back our losses for a refund of taxes paid in previous periods.

Deferred income tax assets
increased $6.3 million to $4.5 million at September 30, 2008 from a liability of $1.8 million at December 31, 2007, primarily due to the decrease in the value of our underwriter warrants, as well as unrealized losses on our investment
securities.

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

A summary of activity related to the value of our underwriter warrants was as follows (in thousands):



|                                         |  |   |         |  
|---------------------------------------- |  | - | ------- | -
|Balance, December 31, 2007               |  | $ | 16,373  |  
|Fair value of warrants received          |  |   | 462     |  
|Net unrealized loss on value of warrants |  |   | (13,679 | )
|Value of warrants exercised or expired   |  |   | (797    | )
|                                         |  |   |         |  
|Balance, September 30, 2008              |  | $ | 2,359   |  
|                                         |  |   |         |  

Accounts payable and accrued liabilities decreased $2.3 million to $0.9 million at September 30, 2008 from
$3.2 million at December 31, 2007, primarily due to a decrease in amounts payable to certain



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employees as a result of a decrease in the market value of stock related to the exercise of underwriter warrants.

Compensation, employee benefits and payroll taxes decreased $1.4 million to $0.7 million at September 30, 2008 from $2.1 million at December 31, 2007,
primarily due to less commissions payable due to reduced commissions revenue.

Deferred revenue of $0.3 million at September 30, 2008 related to
amounts received from our clearing firm based on the execution of a five-year agreement, and is being amortized at the rate of $8,333 per month through September 2011.

Underwriter warrants  employee and independent contractor of $0.1 million at September 30, 2008 represented the estimated fair value of underwriter warrants held for which the gain from the sale of the
related stock upon exercise is due to certain employees.

In September 2001, our Board of Directors approved a stock repurchase program pursuant to which
we are authorized to repurchase up to 600,000 shares of our common stock. In addition, in June 2008, our Board of Directors approved the repurchase of up to a total of an additional 200,000 shares of our common stock. During the nine-month period
ended September 30, 2008, we repurchased a total of 95,000 shares for $482,000 and, at September 30, 2008, 256,876 shares remained available for repurchase. These repurchase programs do not have an expiration date.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet
arrangements that have or are reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital
resources.

New Accounting Pronouncements

See Note 7
of Notes to Consolidated Financial Statements.



|Item 3. | Quantitative and Qualitative Disclosures About Market Risk
|------- | ----------------------------------------------------------

Not required for smaller reporting companies.



|Item 4T. | Controls and Procedures
|-------- | -----------------------

Disclosure Controls and
Procedures

Our management has evaluated, under the supervision and with the participation of our President and our Chief Financial Officer, the
effectiveness of our disclosure controls and procedures as of the end of the period covered by this report as defined in Rule 13a-15(e) or Rule 15d-15(e) under the Securities Exchange Act of 1934 (the Exchange Act). Based on that
evaluation, our President and our Chief Financial Officer have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are effective in ensuring that 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 our Chief Financial Officer, as appropriate, to allow timely
decisions regarding required disclosure.

Changes in Internal Control Over Financial Reporting

There has been no change in our internal control over financial reporting that occurred during our last fiscal quarter that has materially affected, or is reasonably
likely to materially affect, our internal control over financial reporting.



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PART II - OTHER INFORMATION



|Item 6. | Exhibits
|------- | --------

The following exhibits are filed herewith and this
list is intended to constitute the exhibit index:



|     |  |                                                                                                                                                             
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------
|     | 
|31.1 |  | Certification of Principal Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934.                           
|     | 
|31.2 |  | Certification of Principal 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 Principal 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 the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



|                        |  |  |  |                       |  |                                      
|----------------------- |  |  |  | --------------------- |  | -------------------------------------
|Date: November 14, 2008 |  |  |  | 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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