** **

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON D.C. 20549**

 

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**FORM 10-QSB**

 

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

 

**For the quarterly period ended March 31, 2004**

 

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

 

**For the transition period from              to**

 

**Commission file number: 0-18188**

 

**PAULSON CAPITAL CORP.**

(Exact name of small business issuer as specified in its charter)

 

| **Oregon**                                                     |
|----------------------------------------------------------------|
| (state or other jurisdiction of incorporation or organization) |
|                                                           |
| **93-0589534**                                                 |
| (IRS employer identification number)                           |
|                                                           |
| **811 S.W. Naito Parkway  Portland, OR 97204**                 |
| (Address of principal executive offices)                       |
|                                                           |
| **(503) 243-6000**                                             |
| (Issuer’s telephone number)                               |

 

Indicate by check mark whether the Registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes  ý    No  o

 

Number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date:

 

Common stock, no par value—3,183,461 as of May 12, 2004

 

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

 

 

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**PART I —FINANCIAL INFORMATION**

 

ITEM 1. FINANCIAL STATEMENTS

 

PAULSON CAPITAL CORP. AND SUBSIDIARYCONSOLIDATED BALANCESHEETS

 
|                                                                                                                               |   | **03/31/04**    |       | **12/31/03** |   |
|------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------|------------|--------------|--------|
|                                                                                                                               |   | **(unaudited)** |       |         |   |
| **ASSETS**                                                                                                                         |   |            |       |         |   |
|                                                                                                                               |   |            |       |         |   |
| Cash and cash equivalents                                                                                                          |   | $               | 172,999    |         | $      | 155,314 |   |
| Receivable from clearing organization                                                                                              |   | 8,455,823       |       | 7,162,477    |   |
| Notes and other receivables                                                                                                        |   | 511,540         |       | 666,474      |   |
| Income taxes receivable                                                                                                            |   | 1,089,454       |       | 1,084,900    |   |
| Trading securities, at market value                                                                                                |   | 1,103,844       |       | 1,474,649    |   |
| Investment securities, at market value                                                                                             |   | 15,915,260      |       | 17,588,454   |   |
| Underwriter warrants, at estimated fair value                                                                                      |   | 6,839,400       |       | 6,311,000    |   |
| Prepaid and deferred expenses                                                                                                      |   | 1,286,721       |       | 1,418,537    |   |
| Furniture and equipment, net                                                                                                       |   | 213,243         |       | 208,327      |   |
|                                                                                                                               |   |            |       |         |   |
| Total assets                                                                                                                       |   | $               | 35,588,284 |         | $      | 36,070,132 |   |
|                                                                                                                               |   |            |       |         |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                     |   |            |       |         |   |
|                                                                                                                               |   |            |       |         |   |
| **LIABILITIES**                                                                                                                    |   |            |       |         |   |
| Accounts payable and accrued liabilities                                                                                           |   | $               | 431,695    |         | $      | 446,076 |   |
| Dividends payable                                                                                                                  |   | —          |       | 312,481      |   |
| Payable to clearing organization                                                                                                   |   | 91,382          |       | 496,181      |   |
| Compensation, employee benefits and payroll taxes                                                                                  |   | 1,324,610       |       | 2,075,735    |   |
| Securities sold, not yet purchased, at market value                                                                                |   | 158,781         |       | 19,051       |   |
| Income taxes payable                                                                                                               |   | 113,048         |       | —       |   |
| Deferred income taxes                                                                                                              |   | 3,069,405       |       | 3,125,700    |   |
|                                                                                                                               |   |            |       |         |   |
| Total liabilities                                                                                                                  |   | 5,188,921       |       | 6,475,224    |   |
|                                                                                                                               |   |            |       |         |   |
| **SHAREHOLDERS’ EQUITY**                                                                                                      |   |            |       |         |   |
| Preferred stock, no par value; authorized, 500,000 shares; issued and  outstanding, no shares                                      |   | —          |       | —       |   |
| Common stock, no par value; authorized, 10,000,000 shares; issued and  outstanding, 3,185,311 at 3/31/04 and 3,124,811 at 12/31/03 |   | 1,619,888       |       | 1,173,045    |   |
| Retained earnings                                                                                                                  |   | 28,779,475      |       | 28,421,863   |   |
|                                                                                                                               |   |            |       |         |   |
| Total shareholders’ equity                                                                                                    |   | 30,399,363      |       | 29,594,908   |   |
|                                                                                                                               |   |            |       |         |   |
| Total liabilities and shareholders’ equity                                                                                    |   | $               | 35,588,284 |         | $      | 36,070,132 |   |

 

The accompanying notes are an integral part of these statements.

 

2

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

 
|                                           |   | **Three  months ended** |      |
|------------------------------------------------|--------|-------------------------|-----------|
|                                           |   | **03/31/04**            |      | **03/31/03** |   |
|                                           |   |                    |      |   |   |
| **Revenues**                                   |   |                    |      |   |   |
| Commissions                                    |   | $                       | 5,237,631 |   | $ | 2,437,785 |   |
| Corporate finance                              |   | 4,009,488               |      | 25,363 |   |
| Investment loss                                |   | (2,001,275              | )         | (4,228,074 | ) |
| Trading income (loss)                          |   | 444,195                 |      | (415,591 | ) |
| Interest and dividends                         |   | 4,798                   |      | 19,806 |   |
| Other                                          |   | 915                     |      | 805 |   |
|                                           |   |                    |      |   |   |
|                                           |   | 7,695,752               |      | (2,159,906 | ) |
| **Expenses**                                   |   |                    |      |   |   |
| Commissions and salaries                       |   | 5,662,749               |      | 2,450,516 |   |
| Underwriting expenses                          |   | 252,458                 |      | — |   |
| Rent, telephone and quotation services         |   | 303,543                 |      | 265,512 |   |
| Interest expense                               |   | 73                      |      | — |   |
| Professional fees                              |   | 264,139                 |      | 146,039 |   |
| Bad debt expense                               |   | 40,000                  |      | 30,000 |   |
| Travel and entertainment                       |   | 55,066                  |      | 39,481 |   |
| Depreciation and amortization                  |   | 30,865                  |      | 38,680 |   |
| Other                                          |   | 510,994                 |      | 268,309 |   |
|                                           |   |                    |      |   |   |
|                                           |   | 7,119,887               |      | 3,238,537 |   |
|                                           |   |                    |      |   |   |
| Earnings (loss) before income taxes            |   | 575,865                 |      | (5,398,443 | ) |
|                                           |   |                    |      |   |   |
| Income tax expense (benefit)                   |   |                    |      |   |   |
| Current                                        |   | 274,548                 |      | — |   |
| Deferred                                       |   | (56,295                 | )         | — |   |
|                                           |   | 218,253                 |      | — |   |
|                                           |   |                    |      |   |   |
| **Net  Earnings (Loss)**                       |   | $                       | 357,612   |   | $ | (5,398,443 | ) |
|                                           |   |                    |      |   |   |
| Basic and diluted earnings (loss) per share    |   | $                       | 0.11      |   | $ | (1.73 | ) |
|                                           |   |                    |      |   |   |
| Weighted average number of shares outstanding: |   |                    |      |   |   |
| Basic                                          |   | 3,161,322               |      | 3,121,900 |   |
| Diluted                                        |   | 3,187,743               |      | 3,121,900 |   |

 

The accompanying notes are an integral part of these statements.

 

3

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PAULSON CAPITAL CORP. AND SUBSIDIARYCONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITYFor the years ended December 31, 2002 and 2003and the three month period ended March 31, 2004

 
|                                                                       |   | **Common  Stock** |   | **Retained  Earnings** |      |
|----------------------------------------------------------------------------|--------|-------------------|--------|------------------------|-----------|
|                                                                       |   | **Shares**        |   | **Amount**             |      |   |
| Balance at December 31, 2001                                          |   | 3,163,062         |   | $                      | 1,062,428 |   | $ | 32,068,531 |   |
|                                                                       |   |              |   |                   |      |   |   |
| Stock options exercised                                                    |   | 8,000             |   | 35,500                 |      | — |   |
|                                                                       |   |              |   |                   |      |   |   |
| Redemption of common stock                                                 |   | (45,251           | )      | (11,188                | )         | (301,158 | ) |
|                                                                       |   |              |   |                   |      |   |   |
| Net loss for the year                                                      |   | —            |   | —                 |      | (7,011,154 | ) |
|                                                                       |   |              |   |                   |      |   |   |
| Balance at December 31, 2002                                          |   | 3,125,811         |   | $                      | 1,086,740 |   | $ | 24,756,219 |   |
|                                                                       |   |              |   |                   |      |   |   |
| Stock options exercised and income tax benefit from stock option  exercise |   | 14,000            |   | 90,055                 |      | — |   |
|                                                                       |   |              |   |                   |      |   |   |
| Redemption of common stock                                                 |   | (15,000           | )      | (3,750                 | )         | (62,152 | ) |
|                                                                       |   |              |   |                   |      |   |   |
| Dividends to common shareholders                                           |   | —            |   | —                 |      | (312,481 | ) |
|                                                                       |   |              |   |                   |      |   |   |
| Net income for the year                                                    |   | —            |   | —                 |      | 4,040,277 |   |
|                                                                       |   |              |   |                   |      |   |   |
| Balance at December 31, 2003                                          |   | 3,124,811         |   | $                      | 1,173,045 |   | $ | 28,421,863 |   |
|                                                                       |   |              |   |                   |      |   |   |
| Stock options exercised and income tax benefit from stock option  exercise |   | 60,500            |   | 446,843                |      | — |   |
|                                                                       |   |              |   |                   |      |   |   |
| Net earnings for the year to date (unaudited)                              |   | —            |   | —                 |      | 357,612 |   |
|                                                                       |   |              |   |                   |      |   |   |
| Balance at March 31, 2004 (unaudited)                                      |   | 3,185,311         |   | $                      | 1,619,888 |   | $ | 28,779,475 |   |

 

The accompanying notes are an integral part of these statements.

 

4

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

 
|                                                                                        |   | **Three months  ended** |    |
|---------------------------------------------------------------------------------------------|--------|-------------------------|---------|
|                                                                                        |   | **03/31/04**            |    | **03/31/03** |   |
|                                                                                        |   |                    |    |   |   |
| Cash flows from operating activities                                                        |   |                    |    |   |   |
| Net earnings (loss)                                                                         |   | $                       | 357,612 |   | $ | (5,398,443 | ) |
| Adjustments to reconcile net earnings (loss) to net cash provided by  operating activities: |   |                    |    |   |   |
| Receipt of underwriter warrants                                                             |   | (2,858,966              | )       | — |   |
| Unrealized depreciation and expiration of underwriter warrants                              |   | 1,670,636               |    | 876,200 |   |
| Noncash compensation associated with underwriter warrants                                   |   | 659,930                 |    | — |   |
| Depreciation and amortization                                                               |   | 30,865                  |    | 38,680 |   |
| Deferred income taxes                                                                       |   | (56,295                 | )       | — |   |
| Change in assets and liabilities                                                            |   |                    |    |   |   |
| Receivables                                                                                 |   | 154,934                 |    | (236,548 | ) |
| Receivables from/payable to clearing organization                                           |   | (1,698,145              | )       | 170,661 |   |
| Trading and investment securities                                                           |   | 2,043,999               |    | 4,600,845 |   |
| Prepaid and deferred expenses                                                               |   | 131,816                 |    | (42,475 | ) |
| Accounts payable and accrued liabilities                                                    |   | (765,504                | )       | (169,502 | ) |
| Securities sold, not yet purchased                                                          |   | 139,730                 |    | 34,811 |   |
| Income taxes payable/receivable                                                             |   | 108,494                 |    | 194,645 |   |
|                                                                                        |   |                    |    |   |   |
| Net cash provided by (used in) operating activities                                         |   | (80,894                 | )       | 68,874 |   |
|                                                                                        |   |                    |    |   |   |
| Cash flows from investing activities                                                        |   |                    |    |   |   |
| Additions to furniture and equipment                                                        |   | (35,783                 | )       | (29,146 | ) |
|                                                                                        |   |                    |    |   |   |
| Net cash used in investing activities                                                       |   | (35,783                 | )       | (29,146 | ) |
|                                                                                        |   |                    |    |   |   |
| Cash flows from financing activities                                                        |   |                    |    |   |   |
| Proceeds from exercise of stock options and tax benefit from stock  option exercise         |   | 446,843                 |    | — |   |
| Dividends paid to common shareholders                                                       |   | (312,481                | )       |   |   |
| Payments to retire common stock                                                             |   | —                  |    | (34,995 | ) |
|                                                                                        |   |                    |    |   |   |
| Net cash provided by (used in) financing activities                                         |   | 134,362                 |    | (34,995 | ) |
|                                                                                        |   |                    |    |   |   |
| NET INCREASE IN CASH AND CASH EQUIVALENTS                                                   |   | 17,685                  |    | 4,733 |   |
|                                                                                        |   |                    |    |   |   |
| Cash and cash equivalents at beginning of period                                            |   | 155,314                 |    | 97,630 |   |
|                                                                                        |   |                    |    |   |   |
| Cash and cash equivalents at end of period                                                  |   | $                       | 172,999 |   | $ | 102,363 |   |
|                                                                                        |   |                    |    |   |   |
| Cash paid during the period for:                                                            |   |                    |    |   |   |
|                                                                                        |   |                    |    |   |   |
| Interest                                                                                    |   | $                       | —  |   | $ | — |   |
| Income taxes                                                                                |   | $                       | 5,162   |   | $ | 5,225 |   |

 

The accompanying notes are an integral part of these statements.

 

5

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**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**(unaudited)

 

1.Basis of Presentation

 

Theaccompanying unaudited consolidated financial statements have been prepared inaccordance with the instructions for interim financial statements in Item310(b) of Regulation S-B, and therefore do not include all information andfootnotes required by accounting principles generally accepted in the UnitedStates of America (US GAAP) for complete financial statements.  In the opinion of management, the interimfinancial statements include all adjustments (consisting only of normalrecurring adjustments) necessary to state fairly the information showntherein.  The nature of the Company’sbusiness is such that the results of any interim period are not necessarilyindicative of results for a full fiscal year.

 

2.Securities Owned

 

Gainsand losses from the disposition of trading securities are reflected as tradingrevenues in the income statement for the period. Gains and losses from thedisposition of investment securities are reflected as investment revenues inthe income statement for the period.

 

3.Commitments and Contingencies

 

In January 2002, PIC wasserved in an arbitration brought by one of its former customers, PatriciaWeber, against PIC and its registered representative Melvin Vukcevich.  The arbitration claim alleges unsuitablesecurities recommendations, misrepresentation, breach of fiduciary duty andnegligence.  The claimant is seekingdamages of $255,000, interest, an additional return on her portfolio, punitivedamages and attorney fees.  PIC hasfiled its answer.  The case is scheduledfor binding arbitration in Los Angeles, California beginning May 25, 2004.  PIC believes it has meritorious defenses andintends to defend the matter vigorously.

 

In March 2002, PIC andone of its registered representatives, Marvin Cox, were named as defendants inlawsuits filed by Louis Barinaga and Stuart Mackenzie, former PICcustomers.  The claims of Barinaga andMackenzie relate to purchases of convertible notes of E.com, which werepurchased directly from E.com.  Barinagaand Mackenzie allege that PIC and Mr. Cox participated in and materially aidedthe sale of the notes and, therefore, are liable under state securities law.  Barinaga and Mackenzie allege damages of$717,000 and $165,000, respectively, plus interest and attorney fees. PICasserted that the claims are subject to arbitration. Plaintiffs have abatedtheir lawsuit and refiled their claims before the NASD.  Claimant Barinaga amended his arbitrationstatement of claim to include claims for breach of fiduciary duty, violationsof federal and state securities laws, fraud and negligence relating totransactions in stock of e.Digital. Barinaga’s amended statement of claim also names UBS PaineWebber, Inc.as a respondent.  Barinaga claims thatCox, PIC and UBS PaineWebber, Inc.’s actions prevented him from realizing inexcess of $12 million on sales of e.Digital stock.  Barinaga seeks $12,165,103 plus interest and fees on thee.Digital claims.  The e.Digital stockin question was subject to an agreement entered into between Barinaga and UBSPaineWebber, Inc.  Discovery into thesenew claims is in a very early stage.  Ahearing has been set to begin on January 24, 2005.  PIC believes it has meritorious defenses andintends to defend this matter vigorously.

 

In October 2002, PIC wasnamed as a defendant in a lawsuit filed by Special Situations Fund III, LP andSpecial Situations Cayman Fund, LP.  Thelawsuit was filed in U.S. District Court for the District of New Jersey.  It asserts various federal securities lawclaims and common law fraud and negligence against numerous defendants,including PIC, arising out of two secondary offerings of Suprema Specialties,Inc.  PIC participated in one of the twoofferings, the August 25, 2000 secondary offering of Suprema Specialties,Inc., as a member of the underwriting syndicate, underwriting 75,000 shares intotal.  The plaintiffs seek damages forthe purchase of 399,151 shares of Suprema Specialties, Inc. stock betweenAugust 25, 2000 and November 14, 2001.  The second round of motions to dismiss is currently pending.  Discovery has not yet started.  PIC believes it has meritorious defenses andintends to defend this matter vigorously.

 

In November 2003, PIC broughtan arbitration claim with the NASD against some of its registeredrepresentatives for payment of a promissory note in the amount of $75,000.  The registered representatives have filedcounterclaims alleging that PIC made various misrepresentations and breachedits fiduciary and contractual obligations to them.  The registered representatives are seeking in excess of$500,000.  PIC has not had anopportunity to fully investigate this claim, but currently believes it hasmeritorious defenses and intends to defend this matter vigorously.  A hearing is currently set for June 15,2004.

 

6

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In January 2004, PIC and oneof its registered representatives, David Harris, were named as respondents inan NASD complaint filed by a former customer of PIC, Patricia Mendelsohn.  Claimant Mendelsohn alleges that Harrisrecommended unsuitable investments and caused her losses of approximately$90,000.  Claimant Mendelsohn alsoalleges that PIC failed to adequately supervise Harris while he was handlingher account.  Discovery has not yetstarted.  PIC believes it hasmeritorious defenses and intends to defend this matter vigorously.

 

In April 2004, PIC and one ofits registered representatives, Keith McGrath, were named as defendants in acomplaint filed in federal court in New Jersey by a former customer of PIC,Michael Tursi.  Plaintiff Tursi allegesthat PIC and McGrath, along with several other defendants, mishandled hisinvestment accounts over a period of roughly two years.  Plaintiff Tursi alleges common law andstatutory claims for securities fraud. The total damages sought are $1.3 million.  Discovery has not yet started. PIC believes it has meritorious defenses and intends to defend thismatter vigorously.

 

Anadverse outcome in certain of the matters described above could have a materialadverse effect on PIC or the Company. PIC also has been named in certain otherlegal proceedings and has received notice that certain customers may commencelegal proceedings against PIC. The Company has no additional legal proceedingsother than through PIC. The Company believes, based upon information receivedto date and, where the Company believes it appropriate, discussions with legalcounsel, that resolution of this additional pending or threatened litigationwill have no material adverse effect on the consolidated financial condition,results of operations, or business of the Company.

 

4.Stock Options

 

TheCompany has a stock-based employee compensation plan. As allowed under SFAS No.123 “Accounting for Stock-Based Compensation,” the Company continues to accountfor stock options for employees under APB No. 25, “Accounting for Stock Issuedto Employees,” and has adopted the disclosure only requirements of SFAS No.123. There were no stock option grants in the three month periods ended March31, 2004 and March 31, 2003.

 

5. Earnings Per Share

 

The following table is a reconciliation of the numerators anddenominators of the basic and diluted per share computations for each of theperiods ended March 31, 2004 and March 31, 2003.

 

 
|                                                                       |   | **Income  (Numerator)** |       | **Weighted  Average  Shares  (Denominator)** |      | **Per  Share  Amount** |   |
|----------------------------------------------------------------------------|--------|-------------------------|------------|----------------------------------------------|-----------|------------------------|--------|
|                                                                       |   |                    |       |                                         |      |                   |   |
| Three Months Ended March 30, 2004  Income available to common stockholders |   | $                       | 357,612    |                                         | 3,161,322 |                   | $      | .11 |   |
|                                                                       |   |                    |       |                                         |      |                   |   |
| Effect of dilutive securities  Stock options                               |   | —                  |       | 26,421                                       |      |                   |   |
|                                                                       |   |                    |       |                                         |      |                   |   |
| Diluted earnings per share  Earnings available to common stockholders      |   | $                       | 357,612    |                                         | 3,187,743 |                   | $      | .11 |   |
|                                                                       |   |                    |       |                                         |      |                   |   |
| Three Months Ended March 30, 2003  Loss available to common stockholders   |   | $                       | (5,398,443 | )                                            | 3,121,900 |                   | $      | (1.73 | ) |

 

7

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ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOR PLAN OF OPERATION

 

**General**

 

FORWARD-LOOKINGSTATEMENTS

 

This report, including, without limitation, “Item 2. Management’s Discussionand Analysis of Financial Condition and Results of Operations,” contains orincorporates both historical and “forward-looking” statements within themeaning of Section 27A of the Securities Act of 1933, as amended, and Section21E of the Securities Exchange Act of 1934, as amended. Words such as“anticipates”, “believes”, “expects”, “intends”, “future” and similarexpressions identify forward-looking statements.  Any such forward-looking statements in this report reflect ourcurrent views with respect to future events and financial performance and aresubject to a variety of factors that could cause our actual results to differmaterially from historical results or from anticipated results expressed orimplied by such forward-looking statements. Because of such factors, we cannot assure you that the resultsanticipated in this report will be realized. As noted elsewhere in this report, various aspects of our business aresubject to extreme volatility often as a result of factors beyond our abilityto anticipate or control.  Inparticular, factors, such as the condition of the securities markets, which arein turn based on popular perceptions of the health of the economy generally,can be expected to affect the volume of our business as well as the value ofthe securities maintained in our trading and investment accounts.  Other factors that may affect our futurefinancial condition or results of operations include the following:

 

•                  The performanceof companies whose securities we have underwritten or otherwise sold to ourcustomers may affect our reputation with other potential syndicate and sellinggroup members and institutional and other retail accounts and may also affectthe amount of money in our customers’ portfolios available for the kinds ofinvestments that we offer.

 

•                  The value of ourinvestment portfolio, including the value of securities without a readilyascertainable market value, that we have estimated for the purpose of reportingon our financial condition and results of operations, may be significantly andadversely affected by changes in the value of the companies themselves or ofcomparable companies whose stock values we use in estimating the value of ourportfolio securities.

 

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

 

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

 

•                  The loss of ourChairman, Chester Paulson, could have a material adverse impact on ourbusiness.

 

**Overview**

 

Substantially all of our business consists of the securities brokerageand investment banking activities of our wholly owned subsidiary, PaulsonInvestment Company, Inc., or PIC.  PIChas operations in four principal categories, all of them in the financialservices industry.  These categoriesare:

 

•                  securitiesbrokerage activities for which PIC earns commission revenues;

•                  corporatefinance revenues consisting principally of underwriting discounts andunderwriter warrants;

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

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

 

Because weoperate in the financial services industry, our revenues and earnings aresubstantially affected by general conditions in financial markets. In oursecurities brokerage and corporate finance business, the amount of our revenuesdepends on levels of market activity requiring the services we provide.  Our investment banking activity, whichconsists 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 match operating costs with activity levels, manyof our expenses are either fixed or difficult 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 a lesser extent, our tradingincome or loss is affected by changes in market valuation of securitiesgenerally and, in particular, by changes in valuation of the equity securitiesof microcap companies in which

 

8

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our investments and tradingactivities tend to be concentrated. Equity markets in general, and microcap equity markets in particular,have always experienced significant volatility and this volatility has, inrecent 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 investment banking business consists ofacting as managing underwriter of initial and follow-on public offerings formicrocap companies.  As a part of ourcompensation for this activity, we typically receive warrants exercisable topurchase securities identical to those that we offer and sell to thepublic.  The warrants are notexercisable for the first year after the offering in which they are earned andare thereafter exercisable for four years, after which they expire.  The exercise price is typically 120% of theprice at which the securities are initially sold to the public. Accordingly,unless there is at least a 20% increase in the price of these securities atsome time more than one and less than five years after the offering, thewarrants will remain “under water” and will ultimately expire unexercised.

 

### **Critical Accounting Policies**

 

The following discussion and analysis of our financial condition andresults of operations is based upon our consolidated financial statements,which have been prepared in accordance with US GAAP.  In preparing our consolidated financial statements, we must makeestimates and judgments that affect the reported amounts of assets andliabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities at the date of our financial statements.  Actual results are likely to differ fromthese estimates under different assumptions and conditions.

 

The critical accounting policies described below include those thatreflect significant judgments and uncertainties, which potentially couldproduce materially different results under different assumptions andconditions.  We believe our criticalaccounting policies are limited to those described below.

 

*Use of Estimates.*Weare required to estimate the value of all derivative securities that we hold atthe date of any financial statements and to include that value, and changes insuch value, in those financial statements. Accordingly, the aggregate estimated value of our warrants as of thedate of any balance sheet is recorded as an asset on that balance sheet.  When a new warrant is received as a resultof our investment banking activity, its estimated value is included incorporate finance revenue on the date on which it is earned.  Subsequently, any change in estimated valueis recorded as investment income or loss. When a warrant is exercised, the book value is adjusted to reflect thevalue of the securities purchased, net of the exercise price, and theadjustment amount is recorded as income or loss for the relevant period. If thewarrant expires unexercised, the book value is adjusted to zero and thedecrease is recorded as a loss in the relevant period.

 

We estimate the value of our underwriter warrants using theBlack-Scholes Option Pricing Model. The Black-Scholes model requires us to usehistorical price data combined with various assumptions and judgments as inputsfor the model.  The most influentialfactor in this model is price volatility, which we calculate for each company’swarrants based on each company’s own historical stock price movements as wellas an index of historical prices for comparable companies.  When we initially receive a new underwriterwarrant from an initial public offering, its calculated volatility factor isentirely based on the volatility of an index of comparable companies, sincethere is no price history for a new publicly traded company.  As each underwriter warrant approaches itsexpiration date, its volatility factor is derived primarily from the historicalprices of its underlying common stock. We cannot assure you that we will ultimately be able to exercise any ofour warrants in a way that will realize the value that we attribute to them inour financial statements based on this model. As of March 31, 2004, ourunderwriter warrants, based on the Black-Scholes Option Pricing Model, werevalued at approximately $6.8 million, up from the estimated value of $6.3million as of December 31, 2003.

 

In addition toour underwriter warrants, we hold other securities, some of which have verylimited liquidity and some of which do not have a readily ascertainable marketvalue.  According to US GAAP, we arerequired to carry these securities at estimated fair value.

 

As a result of the factors described above, our revenues and earningsare subject to substantial fluctuation from period to period based oncircumstances, many of which are beyond our control.  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 will typically lead to decreasedrevenues, earnings and net worth as a result both of decreased activity and theneed to adjust high investment portfolio values to lower levels.  Accordingly, results for any historicalperiod are not necessarily indicative of similar results for any future period.

 

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**Results of Operations**

 

PIC’s revenues and operating results are influenced by fluctuations inthe equity underwriting markets as well as general economic and marketconditions, particularly conditions in the over-the-counter market, where PIC’sinvestment account, trading inventory positions and underwriter warrants areheavily concentrated.  Significantfluctuations can occur in PIC’s revenues and operating results from one periodto another.  PIC’s results of operationsdepend upon many factors, such as the number of companies that are seekingpublic financing, the quality and financial condition of those companies,market conditions in general, the performance of previous PIC underwritings andinterest in certain industries by investors. As a result, revenues and income derived from these activities may varysignificantly from year to year.  In thetables below, “Corporate Finance” revenues are a function of total proceedsfrom offerings done during the period, compensation per offering, and the fairvalue of underwriter warrants received. “Investment Income” includes realized gains from the exercise ofunderwriter warrants, gains and losses from the sales of investment securities,and unrealized gains and losses from underwriter warrants and other investmentsecurities.  “Trading Income” is the netgain or loss from trading positions before commissions paid to therepresentatives in the trading department.

 

**Summary of Changes inMajor Categoriesof Revenues and Expense**

 
|                         |   | **Dollar  Change** |      | **Percent  Change** |   | **03/30/04  vs. 03/30/03** |   |
|------------------------------|--------|--------------------|-----------|---------------------|--------|----------------------------|--------|
| Revenues:                    |   |               |      |                |   |                       |   |   |   |
| Sales Commissions            |   | $                  | 2,799,846 |                | 114.9  |                       | $      | 5,237,631 |   | $ | 2,437,785 |   |
| Corporate Finance            |   | 3,984,125          |      | 15,708.4            |   | 4,009,488                  |   | 25,363 |   |
| Investment Income            |   | 2,226,799          |      | N/A                 |   | (2,001,275                 | )      | (4,228,074 | ) |
| Trading Income               |   | 859,786            |      | N/A                 |   | 444,195                    |   | (415,591 | ) |
| Other                        |   | (14,898            | )         | (72.3               | )      | 5,713                      |   | 20,611 |   |
|                         |   |               |      |                |   |                       |   |   |   |
| Total                        |   | $                  | 9,855,658 |                | N/A    |                       | $      | 7,695,752 |   | $ | (2,159,906 | ) |
|                         |   |               |      |                |   |                       |   |   |   |
| Expenses:                    |   |               |      |                |   |                       |   |   |   |
| Commissions and Salaries     |   | 3,212,233          |      | 131.1               |   | 5,662,749                  |   | 2,450,516 |   |
| Underwriting Expenses        |   | 252,458            |      | N/A                 |   | 252,458                    |   | — |   |
| Rent, Telephone & Quotes |   | 38,031             |      | 14.3                |   | 303,543                    |   | 265,512 |   |
| Other                        |   | 378,628            |      | 72.5                |   | 901,137                    |   | 522,509 |   |
|                         |   |               |      |                |   |                       |   |   |   |
| Total                        |   | $                  | 3,881,350 |                | 119.8  |                       | $      | 7,119,887 |   | $ | 3,238,537 |   |
|                         |   |               |      |                |   |                       |   |   |   |
| Pretax Income (Loss)         |   | $                  | 5,974,308 |                | N/A    |                       | $      | 575,865 |   | $ | (5,398,443 | ) |

 

**Three Months EndedMarch 31, 2004 vs. Three Months Ended March 31, 2003**

 

**Revenues**

 

Total revenues for the first quarter of 2004 increased a total of$9,855,658, to $7,695,752 from negative $2,159,906 for the first quarter of2003. As shown in the table above, sales commissions rose $2,799,846, or 114.9percent, to $5,237,631 in the first quarter of 2004 from $2,437,785 in thefirst quarter of 2003. This increase is primarily the result of increasedtrading activity in the first part of 2004 relative to the first part of 2003.The Nasdaq Composite Index was up 48.7 percent at the end of the first quarterof 2004, to 1,994.2, up from 1,341.2 as of March 31, 2003. PIC’s focus is onvery small capitalization issues, especially those tied to PIC’s corporatefinance clients.

 

Corporate finance revenues increased to $4,009,488, for the firstquarter of 2004 compared to $25,363 for the first quarter of 2003. Corporatefinance revenues increased as a result of two transactions completed during thefirst quarter of 2004 compared with no transactions completed during the firstquarter of 2003, and the receipt of underwriter warrants as compensation forthe Company’s underwriting efforts. The first quarter 2004 corporate financetransactions raised approximately $20 million for corporate finance clients. Inaddition, during the first quarter of 2004, the Company received underwriterwarrants valued using the Black-Scholes option-pricing model, resulting inunrealized revenue of $2,199,036 (net of $659,930 compensation expense) at thetime of receipt. Because the Company had no corporate finance transactions inthe first quarter of 2003, there were no underwriter warrants received duringthat quarter.

 

Investment income increased $2,226,799, from a loss of $4,228,074 inthe first quarter of 2003 to a loss of $2,001,275 in the first quarter of 2004.Investment income consists of (1) the unrealized and realized appreciation anddepreciation of securities held based on quoted market prices, (2) theunrealized and realized appreciation and depreciation of securities held thatare not readily marketable, based upon the Company’s estimate of their fairvalue, and (3) the unrealized appreciation and depreciation of underwriterwarrants held by the Company.  Thedepreciation of underwriter warrants (net of warrant expiration) totaled$1,670,636 during the first quarter of 2004. There was no change in theunrealized appreciation/depreciation of securities not readily marketableduring the first quarter of 2004. The remainder of the investment income totalfor the first quarter of 2004 is the result of the

 

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unrealized and realizeddepreciation of securities with quoted market prices.

 

Trading income increased $859,786 to a gain of $444,195 in the firstquarter of 2004 from a loss of $415,591 in the first quarter of 2003. Thisincrease was primarily due to increased trading activity in securitiesgenerally as well as in the securities of PIC’s corporate finance clients,resulting from robust activity in the stock market. Generally, favorable marketconditions result in increased revenues for PIC.

 

**Expenses**

 

Total expenses increased by $3,881,350 in the first quarter of 2004from the first quarter of 2003, an increase of 119.8 percent to $7,119,887 from$3,238,537. The largest dollar and percentage increase was in commissions andsalaries.  Commissions and salariesincreased $3,212,233, or 131.1 percent, to $5,662,749 in the first quarter of2004 from $2,450,516 in the first quarter of 2003. This increase is primarilydue to increased commission expense resulting from greater trading activity andincreased compensation related to the corporate finance transactions completedduring the first quarter of 2004. In addition, the Company accrued a total of$179,800 in profit sharing/bonus expense for the first quarter of 2004, ascompared to no accrual for the first quarter of 2003. Underwriting expensesincreased by $252,458 from the first quarter of 2003 because of the twounderwriting transactions completed. Rent, telephone and quotation expensesincreased to $303,543 in the first quarter of 2004, up from $265,512 in thefirst quarter of 2003, an increase of 14.3 percent. The increase is primarilythe result of the adding of additional retail stock brokers during the firstquarter of 2004. Other expenses increased 72.5 percent, to $901,137 in thefirst quarter of 2004, up from $522,509 in the first quarter of 2003. Theincrease in other expenses is partially the result of an increase inprofessional fees (primarily legal) from $264,139 in the first quarter of 2004,as compared to $146,039 in the first quarter of 2003. In addition, advertising andpromotion fees increased approximately $30,000 in the first quarter of 2004, ascompared to the first quarter of 2003, as a result of the Company’s retentionof a public relations/advertising firm. The remainder of the increase in otherexpenses consists of increases in various other expenses.

 

**Income**

 

The Company had a pretax income of $575,865 in the first quarter of2004 compared to a pretax loss of $5,398,443 in the first quarter of 2003 dueto significant increases in all revenue categories except other revenue.Independent of investment income or loss, the Company would have had pretaxincome of $2,577,140 in the first quarter of 2004, compared to a pretax loss of$1,170,369 in the first quarter of 2003. Independent of the change in theBlack- Scholes value of the underwriter warrants and the income and expenseassociated with the receipt of the underwriter warrants, the Company would havehad pretax income totaling $47,465 for the first quarter of 2004, as comparedto a loss of $4,522,243 for the first quarter of 2003. Because of theBlack-Scholes value of underwriter warrants and other factors, significantfluctuations can occur in PIC’s revenues and operating results from one periodto another.  The Company also had incometax expense of $218,253 for the first quarter of 2004, compared to zero for thefirst quarter of 2003.

 

**Liquidity and Capital Resources**

 

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

 

PICborrows money from its clearing firm in the ordinary course of its business,pursuant to an understanding under which the clearing firm agrees to financePIC’s trading accounts.  As of March 31,2004, no net loans were outstanding pursuant to this arrangement.  PIC and the Company are generally able tomeet their compensation and other obligations out of current liquid assets.

 

Anothersource of capital to PIC and the Company has been the underwriter warrantsissued to PIC in connection with its corporate finance activities and the saleof the underlying securities. The underwriter warrants are not exercisable forthe first year after the offerings in which they are earned and are thereaftergenerally exercisable for four years, after which they expire.  The exercise price is typically 120% of theprice at which we initially sold the securities to the public.  Accordingly, unless there is at least a 20%increase in the price of these securities at some time more than one and lessthan five years after the offering, the warrants will remain “under water” andwill ultimately expire unexercised. There is no public market for the underwriter warrants. The securitiesreceivable upon exercise of the underwriter warrants cannot be resold unlessthe issuer has registered these securities with the SEC and with the states inwhich the securities will be sold unless exemptions are available.  Any delay or other problem in theregistration of these securities would have an adverse

 

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impact upon PIC’s ability to obtain funds fromthe exercise of the underwriter warrants and the resale of the underlyingsecurities.  At March 31, 2004, PIC owned23 underwriter warrants (from 17 issuers), all but five of which were currentlyexercisable; five had an exercise price below the current market price of thesecurities receivable upon exercise. The intrinsic value of these five warrants is $406,682. 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 pricesof the securities underlying the underwriter warrants are very volatile, andsubstantial fluctuations in the Company’s estimate of their value can beexpected in the future.

 

In the threemonths ended March 31, 2004, $80,894 of net cash was used in operatingactivities.  The major adjustments toreconcile this result to the Company’s net income include the following itemsthat provided cash to operating activities: noncash compensation associatedwith underwriter warrants of $659,930; unrealized depreciation and expirationof underwriter warrants of $1,670,636, and net change in trading and investmentsecurities of $2,043,999. The following items resulted in a use of cash foroperating activities: an increase in receivable/payable from clearingorganization of $1,698,145, and the receipt of underwriter warrants of$2,858,966. Net cash used in investing activities in the first quarter of 2004was for additions to furniture and equipment of $35,783. Net cash provided byfinancing activities in the first quarter of 2004 totaled $134,362, resultingfrom proceeds from the exercise of employee stock options and income taxbenefit from stock option exercise and dividends paid to common shareholders.

 

Asa securities broker-dealer, PIC is required by SEC regulations to meet certainliquidity and capital standards.  Webelieve we are in compliance with these standards.

 

AtMarch 31, 2004, the Company had no material commitments for capitalexpenditures.

 

In general, the primary sources of PIC’s, and therefore the Company’s,liquidity, includes PIC’s trading positions, borrowings on those positions andprofits realized upon the exercise of underwriter warrants. All of thesesources depend in large part on the trend in the general markets for OTCsecurities.  Rising OTC price levelswill tend to increase the value and liquidity of PIC’s trading positions, theamount that can be borrowed from Correspondent Services Corporation based uponthose positions, and the value of PIC’s underwriter warrants.  The Company believes its liquidity issufficient to meet its needs for both the short and long term horizon. TheCompany’s liquidity could be affected by protracted unfavorable marketconditions.

 

**Inflation**

 

BecausePIC’s assets are primarily liquid, they are not significantly affected byinflation.  The rate of inflationaffects PIC’s expenses, such as employee compensation, office leasing andcommunications costs.  These costs maynot readily be recoverable in the price of services offered by theCompany.  To the extent inflationresults in rising interest rates and has other adverse effects in the securitiesmarkets and the value of securities held in inventory or PIC’s investmentaccount, it may adversely affect the Company’s financial position and resultsof operations.

 

ITEM3.  CONTROLS AND PROCEDURES

 

(a)                                  Our management, with the participation of ourPresident and Chief Financial Officer conducted an evaluation of our disclosurecontrols and procedures, as such terms are defined under Rules 13a-15(e) and15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, asof the end of the period covered by this report. Based on their evaluation, ourPresident and Chief Financial Officer concluded that our disclosure controlsand procedures were effective.

 

(b)                                 There have been no significant changes(including corrective actions with regard to significant deficiencies ormaterial weaknesses) in our internal controls or in other factors that couldsignificantly affect these controls subsequent to the date of the evaluationreferenced in paragraph (a) above.

 

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**PART IIOTHER INFORMATION**

 

Item1. Legal Proceedings.

 

SeeNote 3 to Condensed Consolidated Financial Statements in Part 1.

 

Item2. Changes in Securities.

 

None

 

Item3. Defaults upon Senior Securities.

 

None

 

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

 

None

 

Item5. Other Information.

 

None

 

Item6. Exhibits and Reports on Form 8-K

 

(a)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.     |

 

(b)No Reports on Form 8-K were filed during the quarter ended March 31, 2004.

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
|                |   | PAULSON  CAPITAL CORP. |
|---------------------|--------|------------------------|
|                |   |                   |
|                |   |                   |
| Date:  May 12, 2004 |   | By:                    | /s/  CHESTER L.F. PAULSON |   |
|                |   |                   | Chester  L.F. Paulson |
|                |   |                   | President  Principal Executive Officer |
|                |   |                   |   |
| Date:  May 12, 2004 |   | By:                    | /s/  CAROL RICE |   |
|                |   |                   | Carol  Rice |
|                |   |                   | Chief  Financial Officer  Principal Financial Officer |

 

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