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

**WASHINGTOND.C. 20549**

 

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**FORM 10-Q**

 

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

 

**For thequarterly period ended March 31, 2006**

 

**o  ****TRANSITION REPORT UNDER SECTION 13OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For thetransition period from          to**

 

**Commissionfile number: 0-18188**

 

**PAULSON CAPITAL CORP.**

(Exact name of registrant as specified in itscharter)

 

**Oregon**

(State or other jurisdiction of incorporationor organization)

 

**93-0589534**

(IRS employer identification number)

 

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

(Address of principal executive offices)

 

**(503) 243-6000**

(Registrant’s telephone number, includingarea code)

 

**Not Applicable**

(Former name, former address and former yearif changed since last report)

 

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

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act.

 
| Large accelerated filer    o |   | Accelerated filer    o |   | Non-accelerated filer    ý |
|--------------------------------------------------|--------|--------------------------------------------|--------|-----------------------------------------------------|

 

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

 

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

Common stock, no par value, 6,193,340 as of April28, 2006

 

 

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**PAULSONCAPITAL CORP.**

 

**INDEX TO FORM 10-Q**

 
| Part I   - | FINANCIAL  INFORMATION                                                                                                                    |   |
|----------------------|-------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                 |                                                                                                                                      |   |
| Item  1  -      | Financial  Statements:                                                                                                                    |   |
|                 |                                                                                                                                      |   |
|                 | Consolidated  Balance Sheets —    March 31, 2006 (unaudited) and  December 31, 2005 (audited)               |   |
|                 |                                                                                                                                      |   |
|                 | Consolidated  Statements of Operations —**    **For  the Three Months Ended March 31, 2006 and 2005 (unaudited)  |   |
|                 |                                                                                                                                      |   |
|                 | Consolidated  Statement of Shareholders’ Equity —    For the Three  Months Ended March 31, 2006 (unaudited) |   |
|                 |                                                                                                                                      |   |
|                 | Consolidated  Statements of Cash Flows —    For the Three Months Ended  March 31, 2006 and 2005 (unaudited)      |   |
|                 |                                                                                                                                      |   |
|                 | Notes to Consolidated  Interim Financial Statements (unaudited)                                                                           |   |
|                 |                                                                                                                                      |   |
| Item  2 -            | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                               |   |
|                 |                                                                                                                                      |   |
| Item  3 -            | Quantitative  and Qualitative Disclosures About Market Risk                                                                               |   |
|                 |                                                                                                                                      |   |
| Item  4 -            | Controls  and Procedures                                                                                                                  |   |
|                 |                                                                                                                                      |   |
| Part II -       | OTHER INFORMATION                                                                                                                         |   |
|                 |                                                                                                                                      |   |
| Item 1 -             | Legal  Proceedings                                                                                                                        |   |
|                 |                                                                                                                                      |   |
| Item  2 -            | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                              |   |
|                 |                                                                                                                                      |   |
| Item 6 -             | Exhibits                                                                                                                                  |   |
|                 |                                                                                                                                      |   |
| Signatures -         |                                                                                                                                      |   |
|                 |                                                                                                                                      |   |
| Certifications       |                                                                                                                                      |   |

 

2

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**PART I — FINANCIALINFORMATION**

 

ITEM 1. FINANCIALSTATEMENTS

 

PAULSONCAPITAL CORP. AND SUBSIDIARYCONSOLIDATED BALANCESHEETS

 
| ** **                                                                                                                           | ** ** | **03/31/06**    | ** ** | **12/31/05**  | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|---------------|------------|
| ** **                                                                                                                           | ** ** | **(unaudited)** | ** ** | **(audited)** | ** ** |
| **ASSETS**                                                                                                                           |       |            |       |          |       |
|                                                                                                                                 |       |            |       |          |       |
| Cash and cash equivalents                                                                                                            |       | $               | 244,381    |          | $          | 129,549 |   |
| Receivable from clearing organization                                                                                                |       | 8,727,502       |       | 12,608,491    |       |
| Notes and other receivables                                                                                                          |       | 845,087         |       | 1,081,528     |       |
| Trading securities, at market value                                                                                                  |       | 2,150,867       |       | 1,558,564     |       |
| Investment securities, at market value                                                                                               |       | 23,618,202      |       | 32,401,808    |       |
| Underwriter warrants, at estimated fair  value                                                                                       |       | 4,650,000       |       | 6,275,000     |       |
| Prepaid and deferred expenses                                                                                                        |       | 577,147         |       | 674,328       |       |
| Furniture and equipment, net                                                                                                         |       | 251,134         |       | 265,791       |       |
|                                                                                                                                 |       |            |       |          |       |
| Total assets                                                                                                                         |       | $               | 41,064,320 |          | $          | 54,995,059 |   |
|                                                                                                                                 |       |            |       |          |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                        |       |            |       |          |       |
|                                                                                                                                 |       |            |       |          |       |
| **LIABILITIES**                                                                                                                      |       |            |       |          |       |
| Accounts payable and accrued liabilities                                                                                             |       | $               | 392,481    |          | $          | 1,243,866 |   |
| Payable to clearing organization                                                                                                     |       | 262,686         |       | 3,182,347     |       |
| Compensation, employee benefits and payroll  taxes                                                                                   |       | 988,185         |       | 2,105,259     |       |
| Securities sold, not yet purchased, at  market value                                                                                 |       | 84,580          |       | 23,033        |       |
| Dividends payable                                                                                                                    |       | 345             |       | 929,317       |       |
| Income taxes payable                                                                                                                 |       | 1,976,707       |       | 2,338,218     |       |
| Deferred income taxes                                                                                                                |       | 1,164,851       |       | 5,408,000     |       |
|                                                                                                                                 |       |            |       |          |       |
| Total liabilities                                                                                                                    |       | 4,869,835       |       | 15,230,040    |       |
|                                                                                                                                 |       |            |       |          |       |
| **COMMITMENTS AND CONTINGENCIES**                                                                                                    |       | —          |       | —        |       |
|                                                                                                                                 |       |            |       |          |       |
| **SHAREHOLDERS’ EQUITY**                                                                                                        |       |            |       |          |       |
| Preferred stock, no par value; authorized,  500,000 shares; issued and outstanding, no shares                                        |       | —          |       | —        |       |
| Common stock, no par value; authorized,  10,000,000 shares; issued and outstanding, 6,187,940 at 03/31/06 and  6,195,448 at 12/31/05 |       | 1,815,598       |       | 1,817,100     |       |
| Retained earnings                                                                                                                    |       | 34,378,887      |       | 37,947,919    |       |
|                                                                                                                                 |       |            |       |          |       |
| Total shareholders’ equity                                                                                                      |       | 36,194,485      |       | 39,765,019    |       |
|                                                                                                                                 |       |            |       |          |       |
| Total liabilities and shareholders’ equity                                                                                      |       | $               | 41,064,320 |          | $          | 54,995,059 |   |

 

The accompanying notes are an integral partof these statements.

 

3

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PAULSONCAPITAL CORP. AND SUBSIDIARYCONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)

 
| ** **                                      | ** ** | **Three months ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|
| ** **                                      | ** ** | **03/31/06**                     | ** ** | **03/31/05** | ** ** |
| ** **                                      | ** ** | ** **                       | ** ** | ** ** | ** ** |
| **Revenues**                                    | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Commissions                                     |       | $                                | 4,103,034  |   | $ | 4,141,057 |   |
| Corporate finance                               |       | 53,268                           |       | 119,985 |   |
| Investment income (loss)                        |       | (5,164,766                       | )          | 5,152,499 |   |
| Trading income                                  |       | 35,837                           |       | 702,004 |   |
| Interest and dividends                          |       | 13,168                           |       | 7,691 |   |
| Other                                           |       | 1,173                            |       | 11,169 |   |
| ** **                                      | ** ** | ** **                       | ** ** | ** ** | ** ** |
|                                            |       | (958,286                         | )          | 10,134,405 | ** ** |
| **Expenses**                                    | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Commissions and salaries                        |       | 3,717,009                        |       | 4,254,004 |   |
| Underwriting expenses                           |       | 35,000                           |       | — |   |
| Rent, telephone and quotation services          |       | 296,508                          |       | 306,498 |   |
| Professional fees                               |       | 224,287                          |       | 442,766 |   |
| Travel and entertainment                        |       | 42,032                           |       | 60,146 |   |
| Advertising and promotion expense               |       | 36,034                           |       | 55,695 |   |
| Settlement expense                              |       | —                           |       | 262,168 |   |
| Depreciation and amortization                   |       | 21,873                           |       | 23,057 |   |
| Other                                           |       | 338,969                          |       | 450,282 |   |
| ** **                                      | ** ** | ** **                       | ** ** | ** ** | ** ** |
|                                            |       | 4,711,712                        |       | 5,854,616 | ** ** |
| ** **                                      | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Income before income taxes                      |       | (5,669,998                       | )          | 4,279,789 |   |
| ** **                                      | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Income tax expense (benefit)                    | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Current                                         |       | 2,099,890                        |       | — |   |
| Deferred                                        |       | (4,243,149                       | )          | 1,711,930 |   |
|                                            |       | (2,143,259                       | )          | 1,711,930 | ** ** |
| ** **                                      | ** ** | ** **                       | ** ** | ** ** | ** ** |
| **Net Income (Loss)**                           |       | $                                | (3,526,739 | ) | $ | 2,567,859 |   |
| ** **                                      | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Basic and diluted earnings per share            |       | $                                | (0.57      | ) | $ | 0.40 |   |
| ** **                                      | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Weighted average number of shares  outstanding: | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Basic                                           |       | 6,189,194                        |       | 6,357,694 |   |
| Diluted                                         |       | 6,189,194                        |       | 6,365,906 |   |

 

The accompanying notes are an integral part ofthese statements.

 

4

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PAULSONCAPITAL CORP. AND SUBSIDIARYCONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITYFor the three months ended March 31, 2006

 
| ** **                             | ** ** | **Common Stock** | ** ** | **Retained** | ** ** | ** **   | ** ** |
|----------------------------------------|------------|-----------------------|------------|--------------|------------|--------------|------------|
| ** **                             | ** ** | **Shares**            | ** ** | **Amount**   | ** ** | **Earnings** | ** ** | **Total** | ** ** |
|                                   |       |                  |       |         |       |         |       |   |   |
| Balance at December 31, 2005      |       | 6,195,448             |       | $            | 1,817,100  |         | $          | 37,947,919 |   | $ | 39,765,019 |   |
|                                   |       |                  |       |         |       |         |       |   |   |
| Redemption of common stock (unaudited) |       | (7,508                | )          | (1,502       | )          | (42,293      | )          | (43,795 | ) |
|                                   |       |                  |       |         |       |         |       |   |   |
| Net loss for the period (unaudited)    |       | —                |       | —       |       | (3,526,739   | )          | (3,526,739 | ) |
|                                   |       |                  |       |         |       |         |       |   |   |
| Balance at March 31, 2006 (unaudited)  |       | 6,187,940             |       | $            | 1,815,598  |         | $          | 34,378,887 |   | $ | 36,194,485 |   |

 

The accompanying notes are an integral partof this statement.

 

5

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PAULSON CAPITAL CORP. ANDSUBSIDIARYCONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

 
| ** **                                                                                | ** ** | **Three months ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                | ** ** | **03/31/06**                     | ** ** | **03/31/05** | ** ** |
|                                                                                      |       |                             |       |   |   |
| Cash flows from operating activities                                                      |       |                             |       |   |   |
| Net income (loss)                                                                         |       | $                                | (3,526,739 | ) | $ | 2,567,859 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by operating activities: |       |                             |       |   |   |
| Receipt of underwriter warrants                                                           |       | —                           |       | — |   |
| Unrealized (appreciation)  depreciation/expiration of underwriter warrants                |       | 1,625,000                        |       | (1,584,000 | ) |
| Noncash compensation associated with  underwriter warrants                                |       | —                           |       | — |   |
| Depreciation and amortization                                                             |       | 21,873                           |       | 23,057 |   |
| Deferred income taxes                                                                     |       | (4,243,149                       | )          | 1,711,930 |   |
| Change in assets and liabilities                                                          |       |                             |       |   |   |
| Receivables                                                                               |       | 236,441                          |       | (255,717 | ) |
| Receivables from/payable to clearing  organization                                        |       | 961,328                          |       | (589,956 | ) |
| Trading and investment securities                                                         |       | 8,191,303                        |       | 611,834 |   |
| Prepaid and deferred expenses                                                             |       | 97,181                           |       | 132,403 |   |
| Accounts payable and accrued liabilities                                                  |       | (1,968,459                       | )          | (2,059,342 | ) |
| Dividends payable                                                                         |       | (928,972                         | )          | — |   |
| Securities sold, not yet purchased                                                        |       | 61,547                           |       | 69,557 |   |
| Income taxes payable                                                                      |       | (361,511                         | )          | — |   |
| Loss on disposal of furniture and equipment                                               |       | 1,486                            |       | — |   |
|                                                                                      |       |                             |       |   |   |
| Net cash provided by operating activities                                                 |       | 167,329                          |       | 627,625 |   |
|                                                                                      |       |                             |       |   |   |
| Cash flows from investing activities                                                      |       |                             |       |   |   |
| Additions to furniture and equipment                                                      |       | (8,702                           | )          | (17,988 | ) |
|                                                                                      |       |                             |       |   |   |
| Cash flows from financing activities                                                      |       |                             |       |   |   |
| Dividends paid to common shareholders                                                     |       | —                           |       | (476,564 | ) |
| Payments to retire common stock                                                           |       | (43,795                          | )          | (128,653 | ) |
|                                                                                      |       |                             |       |   |   |
| Net cash (used in) financing activities                                                   |       | (43,795                          | )          | (605,217 | ) |
|                                                                                      |       |                             |       |   |   |
| NET INCREASE IN CASH AND CASH EQUIVALENTS                                                 |       | 114,832                          |       | 4,420 |   |
|                                                                                      |       |                             |       |   |   |
| Cash and cash equivalents at beginning of  period                                         |       | 129,549                          |       | 132,845 |   |
|                                                                                      |       |                             |       |   |   |
| Cash and cash equivalents at end of period                                                |       | $                                | 244,381    |   | $ | 137,265 |   |
|                                                                                      |       |                             |       |   |   |
| Cash paid during the period for:                                                          |       |                             |       |   |   |
|                                                                                      |       |                             |       |   |   |
| Income taxes                                                                              |       | $                                | 2,470,275  |   | $ | 19,527 |   |

 

The accompanying notes are an integral partof these statements.

 

6

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**PAULSON CAPITAL CORP. ANDSUBSIDIARY**

**NOTES TO CONSOLIDATED INTERIMFINANCIAL STATEMENTS**(unaudited)

 

1.     Basis of Presentation

 

These financial statements are those of the Companyand its wholly owned subsidiary, Paulson Investment Company (“PIC”). In theopinion of management, the accompanying unaudited consolidated financialstatements have been prepared pursuant to the rules and regulations of theSecurities and Exchange Commission and include all adjustments (consisting onlyof normal recurring adjustments) necessary to present fairly the Company’sfinancial position as of March 31, 2006 and its results of operations for thethree months ended March 31, 2006 and 2005, and cash flows for the three monthsended March 31, 2006 and 2005. The nature of the Company’s business is suchthat the results of any interim period are not necessarily indicative ofresults for a full fiscal year. The accompanying unaudited financial statementsand related notes should be read in conjunction with the audited financialstatements and Form 10-K of the Company for the fiscal year ended December 31,2005.

 

2.     Dividend

 

On December 22, 2005, the Company announcedthe authorization by the Board of Directors of a $0.30 special cash dividend toshareholders of record on January 17, 2006. The dividend payment date wasFebruary 10, 2006.

 

3.     Securities Owned

 

Gains and losses from the disposition andappreciation/depreciation of trading securities are reflected as tradingrevenues in the statement of operations for the period. Gains and losses fromthe disposition and unrealized gains/losses of investment securities arereflected as investment revenues in the statement of operations for the period.Investment securities may be held for the long term or sold pursuant to theintention of management.

 

4.     Commitments and Contingencies

 

In October 2002, PIC was named as a defendantin a lawsuit filed by Special Situations Fund III, LP and Special SituationsCayman Fund, LP. The lawsuit was filed in U.S. District Court for the Districtof New Jersey. It asserts various federal securities law claims and common lawfraud and negligence against numerous defendants, including PIC, arising out oftwo follow-on offerings of Suprema Specialties, Inc. PIC participated inone of the two offerings, the August 25, 2000 follow-on offering ofSuprema Specialties, Inc., as a member of the underwriting syndicate,agreeing to underwrite 75,000 shares in total, although the amount actuallyretained by PIC appears to be only 35,000 shares. The 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 PIC. On appeal, the United StatesThird Circuit Court of Appeals affirmed the dismissal of the plaintiffs’ claimsfor violation of Rule 10b-5 but reversed as to the dismissal of claims underSection 11 of the Securities Act of 1933. The common law fraud and negligenceclaims also remain in the case. PIC believes its liability under Section 11 islimited to the amount of shares either underwritten or actually retained by PICin the offering. Discovery has not yet begun. PIC believes it has meritoriousdefenses and intends to defend this matter vigorously.

 

In December 2005, PIC received notice of possibleclaims being asserted against it by three individuals who invested in WoodRiver Partners LP(“Wood River”). All of the investors purchased their interestsin Wood River directly from Wood River. One of the individuals was a customerof PIC. Along with his brother, they have indicated that they paid $1,050,000for their interests in Wood River. The other individual has indicated that hepaid $2,700,000 for his interest in Wood River. The SEC sued Wood River inOctober 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 PICunder the Oregon Securities Law for rescission, interest and attorney fees. PICbelieves it has meritorious defenses and, if litigation is filed, PIC intendsto defend this matter vigorously.

 

In January 2006, PIC received notice of a customercomplaint against a former PIC registered representative. The customer hasindicated that her accounts declined in value by just over $500,000. Thecustomer has asserted that the former PIC registered representative failed toimplement strategies and techniques to provide for safety and preservation ofcapital in her accounts. She asserts that the registered representative mademisrepresentations regarding the handling of her accounts. The customer has notindicated that she plans to pursue litigation against PIC. At this time, thecustomer has requested that the former registered representative compensate herfor the decline in value of her account and return any fees earned by theformer registered representative. PIC has not had an opportunity to investigatethis complaint.

 

7

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Anadverse outcome in certain of the matters described above could have a materialadverse effect on PIC or the Company. PIC either has been named in certainother legal proceedings or is aware of certain complaints that may lead tolegal proceedings. The Company believes, based upon information received todate and, where the Company believes it appropriate, discussions with legalcounsel, that resolution of additional pending or threatened litigation willhave no material adverse effect on the consolidated financial condition,results of operations, or business of the Company.

 

5.     Stock Options

 

Prior to January 1, 2006, the Companyaccounted for stock options granted to employees under APB No. 25, “Accountingfor Stock Issued to Employees” and only adopted the disclosure requirements ofSFAS 123, “Accounting for Stock-Based Compensation.” On January 1, 2006, usingthe modified prospective method of adoption, the Company adopted SFAS 123(R), “ShareBased Payment,” which requires that compensation costs relating to share-basedpayments be recognized in the Company’s financial statements rather than adisclosure only in the notes to the financial statements as previously allowed.

 

SFAS 123(R) applies to new awards and toawards modified, repurchased, or cancelled after the required effective date,as well as to the unvested portion of awards outstanding as of the requiredeffective date (January 1, 2006). The Company did not grant any stock optionsduring the three month period ending March 31, 2006, and there was no unvestedportion of awards outstanding as of January 1, 2006. As a result, no sharebased compensation expense has been recorded in the accompanying ConsolidatedStatements of Operations.

 

Upon adoption of FAS 123(R), the Companymaintained its method of valuation of employee stock options granted using theBlack-Scholes option pricing model which was previously used for the disclosureonly provisions allowed under SFAS 123. The Company’s determination of fairvalue of share based payment awards on the date of grant using an optionpricing model is affected by the Company’s stock price as well as assumptionsregarding a number of variables, including risk free interest rate, theexpected dividend yield, the expected option life, and expected volatility overthe term of the awards. To the extent share based payment awards are granted infuture periods, the Company will recognize the related expense over therequisite service period based on the portion of awards that are ultimatelyexpected to vest during the period.

 

6.     Earnings Per Share

 

The following table is a reconciliation of thenumerators and denominators of the basic and diluted per share computations foreach of the three months ended March 31, 2006 and March 31, 2005.

 
| ** **                                                                 | ** ** | **Income (Loss)** | ** ** | **Weighted  Average Shares** | ** ** | **Per Share  Amount** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------|------------|-----------------------------------|------------|----------------------------|------------|
| ** **                                                                 | ** ** | **(Numerator)**        | ** ** | **(Denominator)**                 | ** ** | ** **                 | ** ** |
|                                                                       |       |                   |       |                              |       |                       |       |
| Three Months Ended March 31, 2006 loss  available to common shareholders   |       | $                      | (3,526,739 | )                                 | 6,189,644  |                       | $          | (0.57 | ) |
|                                                                       |       |                   |       |                              |       |                       |       |
| Effect of dilutive securities – options                               |       | —                 |       | —                            |       |                       |       |
|                                                                       |       |                   |       |                              |       |                       |       |
| Diluted earnings per share                                                 |       | $                      | (3,526,739 | )                                 | 6,189,644  |                       | $          | (0.57 | ) |
|                                                                       |       |                   |       |                              |       |                       |       |
| Three Months Ended March 31, 2005 Income  available to common shareholders |       | $                      | 2,567,859  |                              | 6,357,694  |                       | $          | 0.40 |   |
|                                                                       |       |                   |       |                              |       |                       |       |
| Effect of dilutive securities – options                               |       | —                 |       | 8,212                             |       |                       |       |
|                                                                       |       |                   |       |                              |       |                       |       |
| Diluted earnings per share                                                 |       | $                      | 2,567,859  |                              | 6,365,906  |                       | $          | 0.40 |   |

 

For the three months ending March 31, 2006, theCompany had stock options covering 193,000 shares that were not considered inthe diluted earnings per share calculation since their effect would have beenantidilutive.

 

8

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7.     Recently Issued Accounting Pronouncements

 

In September 2005, the Securities ExchangeCommission announced that the compliance date for non-accelerated filers andforeign private issuers pursuant to Section 404 of the Sarbanes-Oxley Acthas been extended. Under the latest extension, a company that is not requiredto file its annual and quarterly reports on an accelerated basis and a foreignprivate issuer filing its annual report on Form 20-F or 40-F, must beginto comply with the internal control over financial reporting requirements forits first fiscal year ending on or after July 15, 2007. This extension isthe second one-year extension from the originally established July 15,2005 compliance date. The Commission similarly has extended the compliance datefor these companies relating to requirements regarding evaluation of internalcontrol over financial reporting and management certification requirements. TheCompany will, therefore, be required to comply with Section 404 of theSarbanes-Oxley Act for the year ended December 31, 2007.

 

8.     Reclassifications

 

Certain 2005 amounts havebeen reclassified to conform to the 2006 presentation.

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

**General**

 

FORWARD-LOOKINGSTATEMENTS

 

This report, including, without limitation, “Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” contains or incorporates both historical and “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities Exchange Act of 1934,as amended. Words such as “anticipates,” “believes,” “expects,” “intends,” “future”and similar expressions identify forward-looking statements. Any such forward-lookingstatements in this report reflect our current views with respect to futureevents and financial performance and are subject to a variety of factors thatcould cause our actual results to differ materially from historical results orfrom anticipated results expressed or implied by such forward-lookingstatements. Because of such factors, we cannot assure you that the resultsanticipated in this report will be realized. As noted elsewhere in this report,various aspects of our business are subject to extreme volatility often as aresult of factors beyond our ability to anticipate or control. In particular,factors, such as the condition of the securities markets, which are in turnbased on popular perceptions of the health of the economy generally, can beexpected to affect the volume of our business as well as the value of thesecurities maintained in our trading and investment accounts. Other factorsthat may affect our future financial condition or results of operations includethe following:

 

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

 

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

 

•                  We are subject to a very high degree ofregulation and are responsible for compliance with applicable regulations byall of our personnel. A significant regulatory infraction by us or any of ourregistered representatives could result in significant penalties, including theloss of our license to conduct securities business in one or morejurisdictions.

 

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

 

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

 

9

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**Overview**

 

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

 

•      securities brokerage activities forwhich PIC earns commission revenues;

•      corporate finance revenuesconsisting principally of underwriting discounts and underwriter warrants;

•      securities trading from which PICrecords profit or loss, depending on trading results; and

•      investment income resulting fromearnings on, and increases or decreases in the value of, PIC’s investmentportfolio.

 

Because we operate in the financial servicesindustry, our revenues and earnings are substantially affected by generalconditions in financial markets. In our securities brokerage and corporatefinance business, the amount of our revenues depends on levels of marketactivity requiring the services we provide. Our investment banking activity,which consists primarily of acting as the managing underwriter of initial andfollow-on public offerings for smaller companies, is similarly affected by thestrength of the market for new equity offerings, which has historicallyexperienced substantial cyclical fluctuation. Although we attempt to matchoperating costs with activity levels, many of our expenses are either fixed ordifficult to change on short notice. Accordingly, fluctuations in brokerage andinvestment banking revenues tend to result in sharper fluctuations, on apercentage basis, in net income or loss.

 

Our investment income or loss and, to alesser extent, our trading income or loss is affected by changes in marketvaluation of securities generally and, in particular, by changes in valuationof the equity securities of microcap companies in which our investments andtrading activities tend to be concentrated. Equity markets in general, andmicrocap equity markets in particular, have always experienced significantvolatility and this volatility has, in recent years, been extreme. The resultsof this volatility on the value of our investment portfolio and securities heldin connection with our trading and investment activities include largequarterly fluctuations in income or loss from these operations and substantialincreases or decreases in our net worth as our securities holdings are markedto market.

 

A substantial portion of our investmentbanking business consists of acting as managing underwriter of initial andfollow-on public offerings for microcap and smallcap companies. As apart of our compensation for this activity, we typically receive warrantsexercisable to purchase securities identical to those that we offer and sell tothe public. The warrants generally have a five-year expiration date and vestimmediately. The warrants are generally subject to a restriction period of sixmonths to one-year in which PIC cannot exercise the warrants. The exerciseprice is typically 120% of the price at which the securities are initially soldto the public. Accordingly, unless there is at least a 20% increase in theprice of these securities at some time more than six months and less than fiveyears after the offering, the warrants will remain “under water” and willultimately expire unexercised.

 

### **CriticalAccounting Policies**

###  

The following discussion and analysis of ourfinancial condition and results of operations is based upon our consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States. In preparing ourconsolidated financial statements, we must make estimates and judgments thataffect the reported amounts of assets and liabilities, revenues and expenses,and related disclosure of contingent assets and liabilities at the date of ourfinancial statements. Actual results are likely to differ from these estimatesunder different assumptions and conditions.

 

The critical accounting policies describedbelow include those that reflect significant judgments and uncertainties, whichpotentially could produce materially different results under differentassumptions and conditions. We believe our critical accounting policies arelimited to those described below.

 

*Revenue Recognition*.Securities transactions and related revenue are recorded on a trade date basis.Manager’s fees, underwriter’s fees, and other underwriting revenues arerecognized at the time the underwriting is completed. Tax shelter revenue isrecognized at the time individual tax shelter units are sold. Revenue from thereceipt of underwriter warrants, received in corporate finance transactions, isrecognized on the date the warrants are received based on the estimated fairvalue of the securities received as estimated using the Black-Scholesoption-pricing model taking into account the exercise price, remaining life ofthe warrant, the current price of the underlying stock and its expectedvolatility, expected dividends on the stock and the risk-free interest rate forthe remaining term of the warrant.

 

10

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*Use of Estimates*. We are required to estimate the value ofall derivative securities that we hold at the date of any financial statementsand to include that value, and changes in such value, in those financialstatements. Accordingly, the aggregate estimated value of our warrants as ofthe date of any balance sheet is recorded as an asset on that balance sheet.When a new warrant is received as a result of our investment banking activity,its estimated value is included in corporate finance revenue on the date onwhich it is earned. Subsequently, any change in estimated value is recorded asinvestment income or loss. When a warrant is exercised, the book value isadjusted to reflect the value of the securities purchased, net of the exerciseprice, and the adjustment amount is recorded as income or loss for the relevantperiod. If a warrant expires unexercised, the book value is adjusted to zeroand the decrease is recorded as a loss in the relevant period.

 

We estimate the value of our underwriterwarrants using the Black-Scholes Option Pricing Model. The Black-Scholes modelrequires us to use historical price data combined with various assumptions andjudgments as inputs for the model. The most influential factor in this model isprice volatility, which we calculate for each company’s warrants based on eachcompany’s own historical stock price movements as well as an index ofhistorical prices for comparable companies. When we initially receive a newunderwriter warrant from an initial public offering, its calculated volatilityfactor 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 eachunderwriter warrant approaches its expiration date, its volatility factor isderived primarily from the historical prices of its underlying common stock. Wecannot assure you that we will ultimately be able to exercise any of ourwarrants in a way that will realize the value that we attribute to them in ourfinancial statements based on this model.

 

In addition to our underwriter warrants, wehold other securities, some of which have very limited liquidity and some ofwhich do not have a readily ascertainable market value. According to accountingprinciples generally accepted in the United States of America (US GAAP), we arerequired to carry these securities at estimated fair value. The Company’sestimates regarding the fair value of not readily marketable securities aresignificant estimates and these estimates could change in the near term.

 

As a result of the factors described above,our revenues and earnings are subject to substantial fluctuation from period toperiod based on a variety of circumstances, many of which are beyond ourcontrol. An increase in financial market activity generally, and/or an increasein equity valuations generally, will normally result in increases in ourrevenues, earnings and net worth as our activity levels and the value of ourinvestment portfolio increase. Conversely, a general market retrenchment willtypically lead to decreased revenues, earnings and net worth as a result bothof decreased activity and the need to adjust high investment portfolio valuesto lower levels. Accordingly, results for any historical period are notnecessarily indicative of similar results for any future period.

 

**Results of Operations**

 

PIC’s revenues and operating results are influencedby fluctuations in the equity underwriting markets as well as general economicand market conditions, particularly conditions in the over-the-counter market,where PIC’s investment account, trading inventory positions and underwriterwarrants are heavily concentrated. Significant fluctuations can occur in PIC’srevenues and operating results from one period to another. PIC’s results ofoperations depend upon many factors, such as the number of companies that areseeking public financing, the quality and financial condition of thosecompanies, market conditions in general, the performance of previous PICunderwritings and interest in certain industries by investors. As a result,revenues and income derived from these activities may vary significantly fromyear to year. In the tables below, “Corporate Finance” revenues are a functionof total proceeds from offerings done during the period, compensation peroffering, and the fair value of underwriter warrants received. “InvestmentIncome” includes realized gains from the exercise of underwriter warrants,gains and losses from the sales of investment securities, and unrealized gainsand losses from underwriter warrants and other investment securities. “TradingIncome” is the net gain or loss from trading positions before commissions paidto the representatives in the trading department.

 

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**Summary of Changes in Major Categoriesof Revenues and Expense**

 

**Three Months Ended March 31, 2006v. March 31, 2005**

 
| ** **                        | ** ** | ** **              | ** ** | ** **              | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------|------------|-------------------------|------------|-------------------------|------------|----------------------------------|------------|
| ** **                        | ** ** | **Increase/(Decrease)** | ** ** | **Percent Change** | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** |
| Revenues:                         |       |                    |       |                    |       |                             |       |   |   |
| Sales Commissions                 |       | $                       | (38,023    | )                       | (1.0       | )                                | $          | 4,103,034 |   | $ | 4,141,057 |   |
| Corporate Finance                 |       | (66,717                 | )          | (55.6                   | )          | 53,268                           |       | 119,985 |   |
| Investment Income                 |       | (10,317,265             | )          | (200.2                  | )          | (5,164,766                       | )          | 5,152,499 |   |
| Trading Income                    |       | (666,167                | )          | (94.9                   | )          | 35,837                           |       | 702,004 |   |
| Other                             |       | (4,519                  | )          | (24.0                   | )          | 14,341                           |       | 18,860 |   |
|                              |       |                    |       |                    |       |                             |       |   |   |
| Total                             |       | (11,092,691             | )          | (109.5                  | )          | (958,286                         | )          | 10,134,405 |   |
|                              |       |                    |       |                    |       |                             |       |   |   |
| Expenses:                         |       |                    |       |                    |       |                             |       |   |   |
| Commissions and Salaries          |       | (536,995                | )          | (12.6                   | )          | 3,717,009                        |       | 4,254,004 |   |
| Settlement Expense                |       | (262,168                | )          | NA                      |       | —                           |       | 262,168 |   |
| Rent, Telephone & Quotes |       | (9,990                  | )          | (3.3                    | )          | 296,508                          |       | 306,498 |   |
| Professional Fees                 |       | (218,479                | )          | (49.3                   | )          | 224,287                          |       | 442,766 |   |
| Other                             |       | (115,272                | )          | (19.5                   | )          | 473,908                          |       | 589,180 |   |
|                              |       |                    |       |                    |       |                             |       |   |   |
| Total                             |       | (1,142,904              | )          | (19.5                   | )          | 4,711,712                        |       | 5,854,616 |   |
|                              |       |                    |       |                    |       |                             |       |   |   |
| Pretax Income (Loss)              |       | $                       | (9,949,787 | )                       | (232.5     | )                                | $          | (5,669,998 | ) | $ | 4,279,789 |   |

 

**Three Months Ended March 31, 2006 vs. Three Months Ended March 31, 2005**

 

**Revenues**

 

Total revenues for the first quarter of 2006 decreased$11.1 million from the same quarter of the prior year primarily as a result ofa decrease in investment income. Investment income decreased approximately $10.3million in the first quarter of 2006 as compared to the first quarter of 2005.Investment income can be volatile period-over-period based on the fact it isdriven by the market value or fair value of the securities and underwriterwarrants held by the Company. Investment income consists of (1) theunrealized appreciation and depreciation of securities held based on quotedmarket prices, (2) the unrealized appreciation and depreciation ofsecurities held that are not readily marketable, based upon the Company’sestimate of their fair value, (3) the realized gain and loss on the saleof securities with quoted market prices and securities that are not readilymarketable, and (4) the unrealized appreciation and depreciation ofunderwriter warrants held by the Company. The net depreciation/expiration/exerciseof underwriter warrants of approximately $1.6 million during the first quarterof 2006, compared unfavorably to the net appreciation of underwriter warrantsof $1.6 million first quarter of 2005. During the first quarter of 2006, theCompany’s realized gains totaled $6.6 million and unrealized losses totaled $11.2million including the unrealized loss on the underwriter warrants. There was nochange in the estimated fair value of securities not readily marketable duringthe first quarter of 2006.

 

Corporate finance revenue decreased approximately$66,700 from the first quarter of 2005 to the first quarter of 2006. TheCompany did not complete an initial public offering in either of the tworespective quarters. In addition to initial public offerings, the Companycompletes other types of offerings including private investments in publicentities (PIPEs) as well transactions in which another investment banking firmis the lead underwriter. The Company completed fewer PIPEs and other offeringsin the first quarter of 2006 as compared to the first quarter of 2005.

 

As shown in the table above, sales commissions—whichare commissions generated from the retail stock brokerage business—decreased approximately$38,000 during the first quarter of 2006 as a result of a modest decrease intrading activity. The total number of customer trades executed by the Company’sstock brokers in the first quarter of 2006 was about 26,500 compared to about 29,700trades in the first quarter of 2005.

 

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Trading income decreased approximately $666,000 inthe first quarter of 2006 as compared to the first quarter of 2005, as a resultof weaker performance from a couple of the securities in which the Companymakes a market. PIC’s focus is on very small capitalization issues, especiallythose tied to PIC’s corporate finance clients. Trading income can be volatileperiod-over-period based on the fact it is driven by the market value or fairvalue of the securities in which the Company makes a market.

 

**Expenses**

 

Total expenses decreased approximately $1.1 millionin the first quarter of 2006 from the first quarter of 2005, a decrease of 19.5percent. The largest dollar decrease was in commissions and salaries with adecrease of approximately $537,000 in the first quarter of 2006 as compared tothe same period of the prior year. This decrease is primarily attributable tolower commission expense resulting from lower revenues. There was nosignificant difference in administrative salary expense between the tworespective quarters. During the first quarter of 2005 the Company hadsignificant activity related to legal settlements, with comparably lessactivity during the first quarter of 2006 resulting in an approximate $218,000decrease in professional fees. Settlement expense decreased approximately$262,000 as a result of no actual or estimated legal settlements during the firstquarter of 2006. Other expenses decreased approximately $115,000, or 19.5percent. The decrease in other expenses is attributable to an approximate $18,000decrease in travel and entertainment as the Company sponsored a brokerappreciation trip in the first quarter of 2005 with no comparable trip in thefirst quarter of 2006 and a $20,000 decrease in advertising and promotion asthe Company became more focused in its advertising strategy. The remainder ofthe net decrease in other expenses consists of increases and decreases invarious expense categories.

 

**Income**

 

The Company had pretax loss of approximately $5.7million in the first quarter of 2006 compared to pretax income of approximately$4.3 million in the first quarter of 2005. Independent of the change in theBlack-Scholes value of the underwriter warrants and the income and expenseassociated with the receipt of the underwriter warrants during the firstquarter of each respective year, the Company would have had pretax loss totaling$4.0 million for the first quarter of 2006, compared with pretax income ofapproximately $2.7 million for the first quarter of 2005. Because of changes inthe values of underlying securities and other factors, significant fluctuationsin the value of underwriter warrants often occur in PIC’s revenues andoperating results from one period to another.

 

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**Liquidity and Capital Resources**

 

The majority of PIC’sassets are cash and assets readily convertible to cash. PIC’s securitiesinventory is stated at market value for the securities that are readilymarketable and estimated fair value for the securities that are not readilymarketable. The liquidity of the market for many of PIC’s securities holdings,however, varies with trends in the stock market. Since many of the securitiesheld by PIC are thinly traded, and PIC is in many cases a primary market makerin the issues held, any significant sales of PIC’s positions could adverselyaffect the liquidity of the issues held. In general, falling prices in OTCsecurities (which make up most of PIC’s trading positions) lead to decreasedliquidity in the market for these issues, while rising prices in OTC issuestend to increase the liquidity of the market for these securities.

 

PIC borrows money from National Financial Services,its clearing firm, in the ordinary course of its business, pursuant to anunderstanding under which the clearing firm agrees to finance PIC’s tradingaccounts. As of March 31, 2006, no net loans were outstanding pursuant to thisarrangement. PIC and the Company are generally able to meet their compensationand other obligations out of current liquid assets.

 

Another source of capital to PIC and the Company hasbeen the underwriter warrants issued to PIC in connection with its corporatefinance activities and the sale of the underlying securities. There is nopublic market for the underwriter warrants. The securities receivable uponexercise of the underwriter warrants cannot be resold unless the issuer 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 PIC’sability to obtain funds from the exercise of the underwriter warrants and theresale of the underlying securities. At March 31, 2006, PIC owned 14underwriter warrants, all of which were then exercisable; one had an exerciseprice below the March 31, 2006 market price of the securities receivable uponexercise. The intrinsic value of this warrant is $1.2 million. There is littleor no direct relationship between the intrinsic value of PIC’s underwriterwarrants at the end of any given period and the fair value calculated using theBlack-Scholes pricing model, as described more fully in Critical AccountingPolicies above. The prices of these securities are influenced by generalmovements in the prices of OTC securities as well as the success of the issuersof the underwriter warrants. The prices of the securities underlying theunderwriter warrants are very volatile, and substantial fluctuations in theCompany’s estimate of their value can be expected in the future. In the threemonths ended March 31, 2006, the Company exercised one underwriter warrant.

 

In the three months ended March 31, 2006,approximately $167,000 of net cash was provided by operating activities. Themajor adjustments to reconcile this result to the Company’s net income includethe following items that are positive adjustments to or provided cash tooperating activities: depreciation/expiration/exercise of underwriter warrantsof approximately $1.6 million; a decrease in trading and investment securitiesof $8.2 million; and a decrease in receivable from clearing organization ofapproximately $961,000. The following items are negative adjustments to or ause of cash for operating activities: a decrease in deferred income taxliability of approximately $4.2 million; a decrease in accounts payable andaccrued liabilities of approximately $2.0 million; a decrease in dividendspayable of approximately $929,000; and a decrease in current income taxespayable of approximately $361,000. Net cash used in investing activities in thefirst three months of 2006 consisted of additions to furniture and equipment ofapproximately $8,700. Net cash used in financing activities in the first threemonths of 2006 consisted of payment of approximately $44,000 to retire commonstock. As a securities broker-dealer, PIC is required by SEC regulations tomeet certain liquidity and capital standards. We believe we are in compliancewith these standards.

 

At March 31, 2006, the Company had no materialcommitments for capital expenditures.

 

In general, the primary sources of PIC’s, andtherefore the Company’s, liquidity include PIC’s trading positions, borrowingson those positions and profits realized upon the exercise of underwriterwarrants. All of these sources depend in large part on the trend in the generalmarkets for OTC securities. Rising OTC price levels will tend to increase thevalue and liquidity of PIC’s trading positions, the amount that can be borrowedfrom National Financial Services based upon those positions, and the value ofPIC’s underwriter warrants. The Company believes its liquidity is sufficient tomeet its needs for both the short and long term horizon. The Company’sliquidity could be affected by protracted unfavorable market conditions.

 

**Inflation**

 

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

 

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OFMARKET RISK

 

Market risk is the risk of loss to the Companyresulting primarily from changes in equity prices and to a significantly lesserextent, interest rates and foreign currency rates. The Company has exposure tomarket risk through the market-making and trading operations of PIC, itsbroker-dealer subsidiary. In connection with these activities, PIC maintainsinventories in order to ensure availability of securities and to facilitateclient transactions as well as trading for its own proprietary equityinvestment account. PIC was a market-maker for 46 equity securities from 42different issuers and no tax exempt or taxable debt obligations at March 31,2006.

 
| ** **                                                        | ** ** | **March 31, 2006**                 | ** ** | **December 31, 2005**                                | ** ** |
|-------------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                        | ** ** | **Trading and  investment  securities** | ** ** | **Securities sold but  not yet purchased** | ** ** | **Trading and  investment  securities** | ** ** | **Securities sold but  not yet purchased** | ** ** |
| Marketable equity and other securities at  fair value             |       | $                                            | 25,749,122 |                                                           | $          | 84,580 |   | $ | 33,955,365 |   | $ | 23,033 |   |
|                                                              |       |                                         |       |                                                           |       |   |   |   |   |
| Marketable debt securities                                        |       | 19,947                                       |       |                                                           |       | 5,007 |   | — |   |
|                                                              |       |                                         |       |                                                           |       |   |   |   |   |
| Total marketable equity, debt and other  securities at fair value |       | $                                            | 25,769,069 |                                                           | $          | 84,580 |   | $ | 33,960,372 |   | $ | 23,033 |   |

 

Changes in the value of PIC’s trading inventoriesand its proprietary investment accounts result primarily from fluctuations inequity prices as well as changes in interest rates and general market andeconomic conditions. PIC’s primary method of controlling risk in its tradinginventories and investment accounts is through daily monitoring and use ofposition limits. PIC’s trading inventories consist primarily of Nasdaq andover-the-counter equity securities: as of March 31, 2006, the equity tradinginventory limit was $2 million and the fixed income limit was $500,000. PIC’strading activities were within these limits at March 31, 2006. Position limitsin trading inventory accounts are monitored on a daily basis as are limitexceptions. Debt obligation trading inventories are relatively small, since,for the most part, these securities are purchased only upon orders fromcustomers. Consolidated positions and exposure reports are prepared andreviewed monthly by the Senior Vice President of Trading. Trading also monitorsinventory levels and trading results on a monthly basis, with particular focuson position concentration, liquidity and volatility. Trading prepares summaryresults every month to record each position at fair market value, which canrequire adjustments for lack of liquidity, high concentration or other reasons.

 

**Value at Risk**

 

In addition to the management procedures andprocesses we use to monitor and limit risk, we also apply an industry standardstatistical model known as Value-at-Risk (“VaR”) to the public securities inour portfolios to estimate the potential losses that could arise from changesin market conditions. VaR seeks to predict the risk of loss based on historicaland/or market-implied price and volatility patterns by estimating the probabilityof the value of a financial instrument rising above or falling below aspecified amount. Our non-public investments are not included in the VaRanalysis because the model requires historical trading prices as one of itsinputs. Our bond position ($19,900) at March 31, 2006 is subject to the riskassociated with the loss in value from a change in interest rates. Based on thesize of the position we concluded that the potential loss from our bond holdingis negligible so the bond was not included in the VaR analysis. Ourcalculations are based on a methodology that uses a one-day interval and a 95%confidence level, which means that there was a 5% chance that our securitiesportfolios could suffer a loss equivalent to the VaR on any one trading dayduring the past year.

 

The following table sets forth the VaR for ouroverall portfolio of public equities for the year ended March 31, 2006:

 
| ** **                             | ** ** | **Investments** | ** ** | **Trading** | ** ** |
|----------------------------------------|------------|-----------------|------------|-------------|------------|
| VaR                                    |       | $               | 1,033,721  |        | $          | 44,355 |   |
| Portfolio value (net)                  |       | $               | 18,117,306 |        | $          | 2,023,726 |   |
| VaR as a percentage of portfolio value |       | 5.7             | %          | 2.2         | %          |

 

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The VaR on equities is based on a calculation of thevolatility of each equity, the current position value of each equity, and acorrelation matrix of all equities included in the portfolio. Both thevolatility and correlation in the formula are based on historical closingprices for the past year. Other inputs include selecting the confidence level(usually 95-99%) and time horizon (usually 1 day) for the measurement. We havehad to make adjustments to the formula for certain equities which are veryilliquid and do not trade every day; in these instances, we have used theclosing prices from the previous day as the price for the days when there wereno trades.

 

VaR calculations have inherent limitations,particularly in the case of low volume, small cap equities, which constitutes alarge percentage of our portfolio value. The historical data on which the VaRis based may not accurately predict future market risk and the calculationhas no input that reflects the liquidity of the equities in the portfolio, sothe VaR for a one-day horizon does not capture the market risk of positionsthat could not be liquidated, or that could only be liquidated at a very lowprice in any one-day period. There can be no assurance that the actual losseswould not exceed the VaR for any one-day period.

 

**Equity Price Risk**

 

PIC is exposed to significant equity price risk as aresult of its customer transactions and market-making activity in equitysecurities and its concentrations in a limited number of equities, many ofwhich are related to its investment banking projects. PIC’s broker-dealeractivities are client-driven, with the objective of meeting its clients’ needswhile earning a trading profit to compensate for the risk associated withcarrying inventories in equities, many of which are volatile, and some of whichare illiquid, micro and small cap securities. PIC attempts to reduce the riskof loss inherent in this activity by monitoring these securities positionscontinuously throughout each day. The average aggregate inventory held in PIC’sproprietary investment accounts during the quarter ended March 31, 2006 wasapproximately $27.6 million. Prices of the marketable equities held in theseaccounts are readily available and monitored on a continuous basis.

 

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**Interest Rate Risk**

 

 PIC has verylittle direct exposure to interest rate risk. A relatively minor amount of PIC’strading inventory consists of debt obligations, and any of these positions PICmight have occasionally are in its trading inventory for only a very short time.However, to the extent that interest rate fluctuations affect general marketconditions and cause investors to shift away from or more heavily into equityinvesting, interest rates can have an effect on the value of PIC’s equitypositions.

 

**Foreign Currency Risk**

 

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

 

ITEM 4. CONTROLS AND PROCEDURES

 

(a)           Our management, with theparticipation of our President and Chief Financial Officer, conducted anevaluation of our disclosure controls and procedures, as such terms are definedunder Rules 13a-15(e) and 15d-15(e) promulgated under theSecurities Exchange Act of 1934, as amended, as of the end of the period coveredby this report. Based on their evaluation, our President and Chief FinancialOfficer concluded that our disclosure controls and procedures were effective.

 

(b)           For the quarter ended March 31, 2006,there have been no changes in our internal control over financial reportingthat have materially affected or are reasonably likely to materially affect ourinternal control over financial reporting.

 

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**PART IIOTHER INFORMATION**

 

Item 1. Legal Proceedings.

 

See Note 4 to Condensed Consolidated FinancialStatements in Part I.

 

Item1A. Risk Factors

 

No material changes.

 

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

 

**Issuer Purchases of EquitySecurities**

 
| **Period**           | ** ** | **(a)  Paulson Capital  Corp. Total  Number of Shares  Purchased** | ** ** | **(b)  Paulson Capital Corp.  Average Price Paid  per Share** | ** ** | **(c)  Total Number of  Shares  Purchased as Part of  Publicly Announced  Plans  or Programs** | ** ** | **(d)  Maximum Number of  Shares that May Yet  Be Purchased Under  The Plans or  Programs** | ** ** |
|----------------------|------------|----------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------|------------|
| 01/01/06 to 01/31/06 |       | 7,500                                                                                  |       | $                                                                                      | 5.84       |                                                                                                                              | 7,500      |                                                                                                                                     | 345,674    |   |
| 02/01/06 to 02/28/06 |       | 8                                                                                      |       | $                                                                                      | 5.75       |                                                                                                                              | 8          |                                                                                                                                     | 345,666    |   |
| 03/01/06 to 03/31/06 |       | —                                                                                 |       | —                                                                                 |       | —                                                                                                                            |       | 345,666                                                                                                                                  |       |
| Total                |       | 7,508                                                                                  | (1)   | $                                                                                      | 5.84       |                                                                                                                              | 7,508      |                                                                                                                                     | 345,666    |   |

 

All of the shares reflected in column (c) wereopen-market transactions as part of a corporate plan for stock repurchase. Thestock repurchase plan, approved by the board of directors on September 17,2001, authorizes the repurchase of up to 600,000 shares; a total of 254,334shares have been repurchased through March 31, 2006. There is no expirationdate on the stock repurchase plan.

 

Item3. Defaults upon Senior Securities.

 

None

 

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

 

None

 

Item5. Other Information.

 

None

 

Item 6. Exhibits

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

 

18

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**SIGNATURES**

 

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

 

 
|               | PAULSON CAPITAL CORP. |
|--------------------|-----------------------|
|               |                  |   |
|               |                  |   |
| Date: May 15, 2006 | By:                   | /s/ CHESTER L.F. PAULSON |
|               |                  | Chester L.F. Paulson |
|               |                  | President |
|               |                  | Principal Executive Officer |
|               |                  |   |
| Date: May 15, 2006 | By:                   | /s/ KAREN L. JOHANNES |
|               |                  | Karen L. Johannes |
|               |                  | Chief Financial Officer |
|               |                  | Principal Financial Officer |

 

19

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