**UNITEDSTATES****SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

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**FORM 10-Q**

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**(MarkOne)**

**x****                             ****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**For the quarterly period ended March 31, 2007**

**OR**

**o****                                ****TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

For the transition period from           to           

Commission file number: **0-18188**

**PAULSONCAPITAL CORP.**

(Exact name of registrant as specified in its charter)

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

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

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Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.   Yes  x    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 

Acceleratedfiler  o    Acceleratedfiler  o    Non-acceleratedfiler  x

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of the ExchangeAct).

Tes  o    No  

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

| **Common stock, no par value** |   | **6,153,511**                  |
|--------------------------------|--------|--------------------------------|
| (Class)                        |   | (Outstanding at  May 14, 2007) |

 

 

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**PAULSON CAPITAL CORP. AND SUBSIDIARYFORM 10-QINDEX**
| PART I - FINANCIAL  INFORMATION |   | ** **                                                                                      |
|---------------------------------|--------|-------------------------------------------------------------------------------------------------|
|                            |   |                                                                                            |   |   |
| Item 1.                         |   | Financial Statements                                                                            |   |   |
|                            |   |                                                                                            |   |   |
|                            |   | Consolidated Balance Sheets — March 31, 2007 and  December 31, 2006 (unaudited)            |   |   |
|                            |   |                                                                                            |   |   |
|                            |   | Consolidated Statements of Operations - Three Months  Ended March 31, 2007 and 2006 (unaudited) |   |   |
|                            |   |                                                                                            |   |   |
|                            |   | Consolidated Statements of Cash Flows - Three Months  Ended March 31, 2007 and 2006 (unaudited) |   |   |
|                            |   |                                                                                            |   |   |
|                            |   | Notes to Consolidated 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  1A.                       |   | Risk  Factors                                                                                   |   |   |
|                            |   |                                                                                            |   |   |
| Item 2.                         |   | Unregistered  Sales of Equity Securities and Use of Proceeds                                    |   |   |
|                            |   |                                                                                            |   |   |
| Item  6.                        |   | Exhibits                                                                                        |   |   |
|                            |   |                                                                                            |   |   |
| Signatures                      |   |                                                                                            |

 

1

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**PART I -FINANCIAL INFORMATION**

**Item 1.    Financial Statements**

**Paulson Capital Corp. and SubsidiaryConsolidated Balance Sheeets**
| ** **                                                                                                         | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                         | ** ** | **(Unaudited)**          | ** ** | ** **                  | ** ** |
| **Assets**                                                                                                         | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Cash and cash  equivalents                                                                                         |       | $                        | 151,104    |                        | $          | 219,341 |   |
| Receivable from  clearing organization                                                                             |       | 10,667,203               |       | 7,748,968                   |       |
| Notes and other  receivables                                                                                       |       | 1,624,620                |       | 1,651,002                   |       |
| Income taxes  receivable                                                                                           |       | —                   |       | 304,695                     |       |
| Trading  securities, at market value                                                                               |       | 3,627,085                |       | 2,363,824                   |       |
| Investment  securities, at market or estimated fair value                                                          |       | 16,036,363               |       | 19,542,643                  |       |
| Underwriter  warrants, at estimated fair value                                                                     |       | 10,015,000               |       | 5,650,000                   |       |
| Prepaid and  deferred expenses                                                                                     |       | 493,288                  |       | 711,827                     |       |
| Furniture and  equipment, at cost, net of accumulated depreciation and amortization of  $776,723 and $747,759      |       | 248,929                  |       | 271,766                     |       |
| Total Assets                                                                                                       |       | $                        | 42,863,592 |                        | $          | 38,464,066 |   |
|                                                                                                               |       |                     |       |                        |       |
| **Liabilities and Shareholders'  Equity**                                                                          | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Accounts payable  and accrued liabilities                                                                          |       | $                        | 580,220    |                        | $          | 570,823 |   |
| Payable to  clearing organization                                                                                  |       | 155,590                  |       | —                      |       |
| Compensation,  employee benefits and payroll taxes                                                                 |       | 1,153,943                |       | 954,981                     |       |
| Securities sold,  not yet purchased, at market value                                                               |       | 5,277                    |       | 17,244                      |       |
| Income taxes  payable - current                                                                                    |       | 78,151                   |       | —                      |       |
| Income taxes  payable - long-term                                                                                  |       | 190,000                  |       | —                      |       |
| Deferred revenue                                                                                                   |       | 450,000                  |       | 475,000                     |       |
| Deferred income  taxes                                                                                             |       | 2,906,248                |       | 1,670,000                   |       |
| Total  Liabilities                                                                                                 |       | 5,519,429                |       | 3,688,048                   |       |
|                                                                                                               |       |                     |       |                        |       |
| **Commitments and Contingencies**                                                                                  |       | —                   |       | —                      |       |
|                                                                                                               |       |                     |       |                        |       |
| **Shareholders' Equity**                                                                                           |       |                     |       |                        |       |
| Preferred stock,  no par value; 500,000 shares authorized; none issued                                             |       | —                   |       | —                      |       |
| Common stock, no  par value; 20,000,000 shares authorized; shares issued and outstanding: 6,163,511  and 6,179,011 |       | 1,989,782                |       | 1,920,293                   |       |
| Retained  earnings                                                                                                 |       | 35,354,381               |       | 32,855,725                  |       |
| Total  Shareholders' Equity                                                                                        |       | 37,344,163               |       | 34,776,018                  |       |
| Total Liabilities and  Shareholders' Equity                                                                        |       | $                        | 42,863,592 |                        | $          | 38,464,066 |   |

See accompanyingNotes to Consolidated Financial Statements.

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**PaulsonCapital Corp. and SubsidiaryConsolidated Statements of Operations(unaudited)**

 
| ** **                              | ** ** | **For the Three Months Ended March 31,** | ** ** |
|-----------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                              | ** ** | **2007**                                                               | ** ** | **2006** | ** ** |
| **Revenues**                            |       |                                                                   |       |   |   |
| Commissions                             |       | $                                                                      | 4,116,568  |   | $ | 4,103,034 |   |
| Corporate  finance                      |       | 995,511                                                                |       | 53,268 |   |
| Investment  income (loss)               |       | 3,184,344                                                              |       | (5,164,766 | ) |
| Trading income                          |       | 1,340,076                                                              |       | 35,837 |   |
| Interest and  dividends                 |       | 34,173                                                                 |       | 13,168 |   |
| Other                                   |       | 25,375                                                                 |       | 1,173 |   |
|                                    |       | 9,696,047                                                              |       | (958,286 | ) |
|                                    |       |                                                                   |       |   |   |
| **Expenses**                            |       |                                                                   |       |   |   |
| Commissions and  salaries               |       | 3,964,709                                                              |       | 3,717,009 |   |
| Underwriting  expenses                  |       | 159,955                                                                |       | 35,000 |   |
| Rent, telephone  and quotation services |       | 313,235                                                                |       | 296,508 |   |
| Professional  fees                      |       | 203,945                                                                |       | 224,287 |   |
| Bad debt expense                        |       | 47,689                                                                 |       | 1,517 |   |
| Travel and  entertainment               |       | 35,380                                                                 |       | 42,032 |   |
| Advertising and  promotion expense      |       | 48,006                                                                 |       | 36,034 |   |
| Settlement  expense                     |       | 79,717                                                                 |       | — |   |
| Depreciation and  amortization          |       | 28,964                                                                 |       | 21,873 |   |
| Other                                   |       | 314,048                                                                |       | 337,452 |   |
|                                    |       | 5,195,648                                                              |       | 4,711,712 |   |
|                                    |       |                                                                   |       |   |   |
| Income (loss) before  income taxes      |       | 4,500,399                                                              |       | (5,669,998 | ) |
|                                    |       |                                                                   |       |   |   |
| Income tax expense  (benefit):          |       |                                                                   |       |   |   |
| Current                                 |       | 486,955                                                                |       | 2,099,890 |   |
| Deferred                                |       | 1,236,247                                                              |       | (4,243,149 | ) |
|                                    |       | 1,723,202                                                              |       | (2,143,259 | ) |
|                                    |       |                                                                   |       |   |   |
| Net income (loss)                       |       | $                                                                      | 2,777,197  |   | $ | (3,526,739 | ) |
|                                    |       |                                                                   |       |   |   |
| Basic net income (loss)  per share      |       | $                                                                      | 0.45       |   | $ | (0.57 | ) |
|                                    |       |                                                                   |       |   |   |
| Diluted net income  (loss) per share    |       | $                                                                      | 0.45       |   | $ | (0.57 | ) |
|                                    |       |                                                                   |       |   |   |
| Shares used in per  share calculations: |       |                                                                   |       |   |   |
| Basic                                   |       | 6,157,672                                                              |       | 6,189,194 |   |
| Diluted                                 |       | 6,166,906                                                              |       | 6,189,194 |   |

See accompanyingNotes to Consolidated Financial Statements.

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**Paulson Capital Corp. and SubsidiaryConsolidated Statements of Cash Flows(unaudited)**
| ** **                                                                                      | ** ** | **For the Three Months Ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2007**                                                          | ** ** | **2006** | ** ** |
| **Cash  flows from operating activities:**                                                      |       |                                                              |       |   |   |
| Net income (loss)                                                                               |       | $                                                                 | 2,777,197  |   | $ | (3,526,739 | ) |
| Adjustments to reconcile net income (loss) to net  cash flows provided by operating activities: |       |                                                              |       |   |   |
| Receipt of underwriter warrants                                                                 |       | (375,519                                                          | )          | — |   |
| Unrealized (appreciation) depreciation/expiration of  underwriter warrants                      |       | (4,075,987                                                        | )          | 1,625,000 |   |
| Noncash compensation associated with underwriter  warrants                                      |       | 86,506                                                            |       | — |   |
| Depreciation and amortization                                                                   |       | 28,964                                                            |       | 21,873 |   |
| Deferred income taxes (net of income tax benefit of  stock option exercises)                    |       | 1,236,248                                                         |       | (4,243,149 | ) |
| Loss on asset disposition                                                                       |       | —                                                            |       | 1,486 |   |
| Deferred revenue                                                                                |       | (25,000                                                           | )          | — |   |
| Change in assets and liabilities:                                                               |       |                                                              |       |   |   |
| Receivables from/payable to clearing organization                                               |       | (2,762,645                                                        | )          | 961,328 |   |
| Notes and other receivables                                                                     |       | 26,382                                                            |       | 236,441 |   |
| Income taxes receivable                                                                         |       | 304,695                                                           |       | — |   |
| Trading and investment securities                                                               |       | 2,243,019                                                         |       | 8,191,303 |   |
| Prepaid and deferred expenses                                                                   |       | 218,539                                                           |       | 97,181 |   |
| Accounts payable, accrued liabilities and  compensation payables                                |       | 208,359                                                           |       | (1,968,459 | ) |
| Securities sold, not yet purchased                                                              |       | (11,967                                                           | )          | 61,547 |   |
| Income taxes payable - current                                                                  |       | 78,151                                                            |       | (361,511 | ) |
| Income taxes payable - long term                                                                |       | 100,000                                                           |       | — |   |
| Net cash provided by operating activities                                                       |       | 56,942                                                            |       | 1,096,301 |   |
|                                                                                            |       |                                                              |       |   |   |
| **Cash  flows from investing activities:**                                                      |       |                                                              |       |   |   |
| Additions to furniture and equipment                                                            |       | (6,127                                                            | )          | (8,702 | ) |
|                                                                                            |       |                                                              |       |   |   |
| **Cash  flows from financing activities:**                                                      |       |                                                              |       |   |   |
| Proceeds from stock option exercise                                                             |       | 77,110                                                            |       | — |   |
| Dividends paid to common shareholders                                                           |       | —                                                            |       | (928,972 | ) |
| Payments to retire common stock                                                                 |       | (196,162                                                          | )          | (43,795 | ) |
| Net cash used in financing activities                                                           |       | (119,052                                                          | )          | (972,767 | ) |
|                                                                                            |       |                                                              |       |   |   |
| Increase  (decrease) in cash and cash equivalents                                               |       | (68,237                                                           | )          | 114,832 |   |
|                                                                                            |       |                                                              |       |   |   |
| **Cash  and cash equivalents:**                                                                 |       |                                                              |       |   |   |
| Beginning of period                                                                             |       | 219,341                                                           |       | 129,549 |   |
|                                                                                            |       |                                                              |       |   |   |
| End of period                                                                                   |       | $                                                                 | 151,104    |   | $ | 244,381 |   |
|                                                                                            |       |                                                              |       |   |   |
| **Supplemental  cash flow information:**                                                        |       |                                                              |       |   |   |
| Cash paid during the  period for income taxes                                                   |       | $                                                                 | 4,190      |   | $ | 2,470,275 |   |

 

**Supplemental non-cash flow information:**

As of January 1, 2007, we adopted FASB InterpretationNo. 48, “Accounting for Uncertainty in Income Taxes.’’ As a result, we recorded an adjustment of$90,000 from retained earnings to income taxes payable - long-term.

See accompanyingNotes to Consolidated Financial Statements.

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

**Note 1. Basis of Presentation**

Thefinancial information for Paulson Capital Corp. and its wholly-ownedsubsidiary, Paulson Investment Company, included herein as of March 31, 2007and December 31, 2006 and for the three-month periods ended March 31, 2007 and2006 is unaudited; however, such information reflects all adjustments,consisting only of normal recurring adjustments, which, in the opinion ofmanagement, are necessary for a fair presentation of the financial position,results of operations and cash flows for the interim periods. The financialinformation as of December 31, 2006 is derived from our 2006 Annual Report onForm 10-K. The interim consolidated financial statements should be read inconjunction with the consolidated financial statements and the notes theretoincluded in our 2006 Annual Report on Form 10-K. The results of operations forthe interim periods presented are not necessarily indicative of the results tobe expected for the full year.

**Note 2. Commitments and Contingencies **

# InOctober 2002, we were named as a defendant in a lawsuit filed by SpecialSituations Fund III, LP and Special Situations Cayman Fund, LP. The lawsuit wasfiled in U.S. District Court for the District of New Jersey. It asserts variousfederal securities law claims and common law fraud and negligence againstnumerous defendants, including us, arising out of two follow-on offerings ofSuprema Specialties, Inc.  Weparticipated in one of the two offerings, the August 25, 2000 follow-onoffering of Suprema Specialties, Inc., as a member of the underwritingsyndicate, underwriting 75,000 shares in total. 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 us. On appeal, the U.S. Third CircuitCourt of Appeals affirmed the dismissal of the plaintiffs’ claims for violationof Rule 10b-5 but reversed as to the dismissal of claims under Section 11 ofthe Securities Act of 1933. Subsequently, the plaintiffs stipulated that theywill not be asserting a claim for common law fraud against us. The negligentmisrepresentation claim remains in the case. We believe our liability underSection 11 is limited to the amount of shares either underwritten or actuallyretained by us in the offering. Discovery has begun, but has not yet beencompleted. We believe we have meritorious defenses and intend to defend thismatter vigorously.

# In December 2005,we received notice of possible claims being asserted against us by twoindividuals who invested in Wood River Partners LP (“Wood River”). Theinvestors purchased their interests in Wood River directly from Wood River. Oneof the individuals was a customer of ours. Along with his brother, they haveindicated that they paid $1,050,000 for their interests in Wood River. The SECsued Wood River in October 2005, and a receiver currently runs Wood River. Atthis point, it is not known how much the individuals might recover through thereceivership. The individuals have indicated that they believe they may haveclaims against us under the Oregon Securities Law for rescission, interest andattorney fees. We believe we have meritorious defenses and, if litigation isfiled, we intend to defend this matter vigorously.

# In January 2007,Timothy Touloukian (“Touloukian”) filed an NASD arbitration against us seeking$5 million in compensatory damages based upon alleged claims of breach ofcontract, breach of implied contractual duties, indemnification, negligentmisrepresentation and negligence. Touloukian was employed as a registeredrepresentative by us from November 2002 through December 2003.  Touloukian’s claims against us arise out of aNASD investigation of Touloukian regarding the trading of mutual funds.Touloukian subsequently entered into an Acceptance Waiver and Consent (“AWC”)with the NASD, resulting in a fine and suspension. Touloukian asserts that theNASD’s investigation and subsequent AWC have caused Touloukian to loseemployment opportunities and damage his earning capacity in the future. In hisarbitration Statement of Claim, Touloukian seeks to hold us responsible for

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# the allegeddamages resulting from his diminished earning capacity. We have just started torespond to the arbitration claims. Our Answer to the Statement of Claim is dueJune 14, 2007. We believe we have meritorious defenses and intend to defendthis matter vigorously.

An adverse outcome incertain of the matters described above could have a material adverse effect onus. We also have been named in or threatened with certain other legalproceedings. We believe, based upon information received to date and, where webelieve it appropriate, discussions with legal counsel, that resolution ofadditional pending or threatened litigation will have no material adverseeffect on our consolidated financial condition, results of operations or ourbusiness.

**Note 3. Stock-Based Compensation**

Duringthe first quarter of 2007, 22,000 options were exercised at a weighted averageexercise price of $3.51 per share.  AtMarch 31, 2007, we had 95,000 options outstanding at a weighted averageexercise price of $4.20 per share.

**Note 4. Earnings Per Share**

Followingis a reconciliation of our shares used for our basic net income (loss) pershare and our diluted net income (loss) per share: 
| ** **                                                                                                            | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Shares used for  basic income (loss) per share                                                                        |       | 6,157,672                                        |       | 6,189,194 |   |
| Effect of  dilutive stock options                                                                                     |       | 9,234                                            |       | — |   |
| Shares used for  diluted net income (loss) per share                                                                  |       | 6,166,906                                        |       | 6,189,194 |   |
|                                                                                                                  |       |                                             |       |   |   |
| Stock options not  included in diluted net income (loss) per share because their effect would  have been antidilutive |       | —                                           |       | 193,000 |   |

 

**Note 5.Repurchases of Common Stock**

In the first three months of 2007, we repurchased a total of 37,500shares of our common stock for a weighted average price of $5.23 per share,which totaled approximately $196,000. The amount paid above the original issueprice, which totaled $189,000, was offset against retained earnings. The plan to repurchase up to a total of600,000 shares of our common stock was approved by our Board of Directors inSeptember 2001 and does not have an expiration date. As of March 31, 2007,278,237 shares remained available for purchase.

**Note 6.Adoption of Interpretation No. 48**

In July 2006, the FASB issued Interpretation No. 48, “Accounting forUncertainty in Income Taxes,” which defines the threshold for recognizing thebenefits of tax return positions in the financial statements as “more-likely-than-not”to be sustained by the taxing authority. Interpretation No. 48 applies to alltax positions accounted for under SFAS No. 109, “Accounting for Income Taxes.”Interpretation No. 48 is effective as of the beginning of the first fiscal yearbeginning after December 15, 2006.

We adopted theprovisions of Interpretation No. 48 on January 1, 2007. In accordance with paragraph19, we elected to treat interest and penalties accrued on unrecognized taxbenefits as tax expense within our financial statements. Upon adoption, we adjusted our financialstatements to reflect those tax positions that are more-likely-than-not to besustained as of the adoption date. The adjustment totaled $90,000 and wasrecorded directly as a reduction to our retained earnings balance on January 1,2007.

At the date of adoption,we had unrecognized tax benefits of $174,000, all of which would have an impacton the effective tax rate if recognized. Interest and penalties accrued onunrecognized tax benefits on the

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date of adoption were$16,000. We do not believe it is reasonably possible that the total amount ofunrecognized benefits will significantly increase or decrease within the next12 months.

During the quarter endedMarch 31, 2007, unrecognized tax benefits increased $4,000 as a result of taxpositions taken in prior periods and $17,000 as a result of tax positions takenduring the current quarter.  There wereno decreases in prior unrecognized tax benefits resulting from settlements withtaxing authorities or the lapse of applicable statutes of limitation.

The tax years whichremain open to examination in the U.S., our only major taxing jurisdiction,were 2003 through 2006.

**Note 7.Reclassifications**

Certain amounts in the prior period financial statements have beenreclassified to conform to the current period presentation.

**Note 8.Subsequent Event**

On May1, 2007, we paid $210,000 in connection with a previously settled legal claim.Of this amount, $190,000 was accrued as a component of accounts payable andaccrued liabilities on our balance sheet as of December 31, 2006, and the fullamount was accrued as of March 31, 2007. We expect to receive $145,000 ininsurance recovery on this claim, which will be recorded as an offset tosettlement expense in the period received.

**Item 2.    Management’s Discussion and Analysis of Financial Conditionand Results of Operations**

**ForwardLooking Statements and Risk Factors**

This report, including, without limitation, “Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” contains or incorporatesboth historical and “forward-looking” statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended. Words such as “anticipates,” “believes,”“expects,” “intends,” “future” and similar expressions identify forward-lookingstatements. 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 cannotassure you that the results anticipated in this report will be realized. Asnoted elsewhere in this report, various aspects of our business are subject toextreme volatility often as a result of factors beyond our ability toanticipate or control. In particular, factors, such as the condition of thesecurities markets, which are in turn based on popular perceptions of thehealth of the economy generally, can be expected to affect the volume of ourbusiness as well as the value of the securities maintained in our trading andinvestment accounts. Other factors that may affect our future financialcondition or results of operations include the following:

·                  Aspects of our business arevolatile and affected by factors beyond our control.

·                  Our ability to attract andretain customers may be affected by our reputation.

·                  We are subject to extensiveregulation that could result in investigations, fines or other penalties.

·                  We face intense competitionin our industry.

·                  Our future success dependson retaining existing management and hiring and assimilating new key employees,and our inability to attract or retain key personnel would materially harm ourbusiness and results of operations.

·                  We are subject to an increased risk of legalproceedings, which may result in significant losses to us that we cannotrecover. Claimants in these proceedings may be customers, employees, orregulatory agencies, among others, seeking damages for mistakes, errors,negligence or acts of fraud by our employees.

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·                  As a public company, we aresubject to complex legal and accounting requirements that require us to incursubstantial expense and expose us to risk of non-compliance.

·                  Our directors control approximately 60percent of our common stock and may have interests differing from those ofother stockholders.

**Overview**

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

·                  securitiesbrokerage activities for which we earn commission revenues;

·                  corporatefinance revenues consisting principally of underwriting discounts andunderwriter warrants;

·                  securitiestrading from which we record profit or loss, depending on trading results; and

·                  investmentincome resulting from earnings on, and increases or decreases in the value of,our investment portfolio.

Becausewe operate in the financial services industry, our revenues and earnings aresubstantially affected by general conditions in financial markets. In oursecurities brokerage business, the amount of our revenues depends on levels ofmarket activity requiring the services we provide. Our corporate financeactivity, which consists of acting as the managing underwriter of initial andfollow-on public offerings, private investments in a public equity (“PIPEs”)and private placements 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 andcorporate finance revenues tend to result in sharper fluctuations, on apercentage basis, in net income or loss.

Ourinvestment income or loss and, to a lesser extent, our trading income or lossis affected by changes in market valuation of securities generally and, inparticular, by changes in valuation of the equity securities of microcapcompanies in which our investments and trading activities tend to beconcentrated. Equity markets in general, and microcap equity markets inparticular, have always experienced significant volatility and this volatilityhas, in recent years, been extreme. The result of this volatility on the valueof our investment portfolio and securities held in connection with our tradingand investment activities include large quarterly fluctuations in income orloss from these operations and substantial increases or decreases in our networth as our securities holdings are marked to market.

Asubstantial portion of our corporate finance business consists of acting asmanaging underwriter of initial and follow-on public offerings for microcap andsmallcap companies. As a part of our compensation for these activities, wetypically receive warrants exercisable to purchase securities similar to thosethat we offer and sell to the public. The warrants generally have a five-yearexpiration date and vest immediately. The warrants are generally subject to arestricted period of six months to one-year during which we cannot exercise.The exercise price is typically 120% of the price at which the securities wereinitially sold to the public. Accordingly, unless there is at least a 20%increase in the price of these securities at some time more than six months andless than five years after the offering, the warrants will remain “under water”and will ultimately expire unexercised. We also receive warrants in connectionwith our PIPEs, which have varying terms and conditions.

**CriticalAccounting Policies and Use of Estimates**

Withthe exception of the adoption of Interpretation No. 48 as described in Note 6of Notes to Consolidated Financial Statements, we reaffirm the criticalaccounting policies and estimates as reported in our Annual Report on Form 10-Kfor the year ended December 31, 2006, which was filed with the Securities andExchange Commission on April 2, 2007.

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**Results of Operations**

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

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

·                  Corporatefinance revenues, which are a function of total proceeds from offerings doneduring the period, compensation per offering and the fair value of underwriterwarrants received;

·                  Investmentincome (loss), which includes (i) the unrealized appreciation anddepreciation of securities held based on quoted market prices, (ii) theunrealized appreciation and depreciation of securities held that are not readilymarketable, based upon our estimate of their fair value, (iii) realizedgains and losses on the sale of securities with quoted market prices andsecurities that are not readily marketable, and (iv) the unrealizedappreciation and depreciation of underwriter warrants held; and

·                  Trading income(loss), which is the gain or loss from trading positions before commissionspaid to the representatives in the trading department.

The following tables set forth the changes in ouroperating results in the three-month period ended March 31, 2007 compared tothe three-month period ended March 31, 2006 (dollars in thousands):

 
| ** **                             | ** ** | **Three Months Ended  March 31,** | ** ** | **Increase** | ** ** | **%  Increase** | ** ** |
|----------------------------------------|------------|--------------------------------------------------|------------|--------------|------------|-----------------|------------|
| ** **                             | ** ** | **2007**                                         | ** ** | **2006**     | ** ** | **(Decrease)**  | ** ** | **(Decrease)** | ** ** |
| Revenues:                              | ** ** | ** **                                       | ** ** | ** **   | ** ** | ** **      | ** ** | ** ** | ** ** |
| Commissions                            |       | $                                                | 4,117      |         | $          | 4,103           |       | $ | 14 |   | 0.3 | % |
| Corporate finance                      |       | 996                                              |       | 53           |       | 943             |       | 1,779.2 |   |
| Investment income (loss)               |       | 3,184                                            |       | (5,165       | )          | 8,349           |       | n/a |   |
| Trading income                         |       | 1,340                                            |       | 36           |       | 1,304           |       | 3,622.2 |   |
| Interest and dividends                 |       | 34                                               |       | 13           |       | 21              |       | 161.5 |   |
| Other                                  |       | 25                                               |       | 2            |       | 23              |       | 1,150.0 |   |
| Total revenues (loss)                  |       | 9,696                                            |       | (958         | )          | 10,654          |       | n/a |   |
| Expenses:                              |       |                                             |       |         |       |            |       |   |   |
| Commissions and salaries               |       | 3,965                                            |       | 3,717        |       | 248             |       | 6.7 |   |
| Underwriting expenses                  |       | 160                                              |       | 35           |       | 125             |       | 357.1 |   |
| Rent, telephone and quotation services |       | 313                                              |       | 297          |       | 16              |       | 5.4 |   |
| Professional fees                      |       | 204                                              |       | 224          |       | (20             | )          | (8.9 | ) |
| Bad debt expense                       |       | 48                                               |       | 2            |       | 46              |       | 2,300.0 |   |
| Travel and entertainment               |       | 35                                               |       | 42           |       | (7              | )          | (16.7 | ) |
| Advertising and promotion              |       | 48                                               |       | 36           |       | 12              |       | 33.3 |   |
| Settlement expense                     |       | 80                                               |       | —       |       | 80              |       | n/a |   |
| Depreciation and amortization          |       | 29                                               |       | 22           |       | 7               |       | 31.8 |   |
| Other                                  |       | 314                                              |       | 337          |       | (23             | )          | (6.8 | ) |
| Total expenses                         |       | 5,196                                            |       | 4,712        |       | 484             |       | 10.3 |   |
| Income (loss) before  income taxes     |       | $                                                | 4,500      |         | $          | (5,670          | )          | $ | 10,170 |   | n/a |   |

 

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***Revenues***

Commissionswere flat in the three-month period ended March 31, 2007 compared to the sameperiod of 2006. The total number of trades, including mutual fund trades,executed by our brokers were 25,400 in the three-month period ended March 31,2007 compared to 26,500 in the comparable period of 2006. We had 85 brokers atMarch 31, 2007 compared to 96 brokers at March 31, 2006.

Thedecrease in the number of brokers at March 31, 2007 compared to March 31, 2006,was due to our strategy of having fewer, but higher producing brokers. As lowerproducing brokers have left, we have not filled the positions.

Corporate finance incomeof $1.0 million in the three-month period ended March 31, 2007 primarilyrepresented underwriting discounts earned from one initial public offering inwhich we raised $9.8 million for ConvertedOrganics Inc., as well as the Black-Scholes value of the underwriterwarrants received in connection with that offering. In addition we completed one private transaction during thethree-month period ended March 31, 2007.

Corporatefinance income of $53,000 in the three-month period ended March 31, 2006primarily included underwriting discounts earned from a few small privatetransactions.

Investmentincome increased $8.3 million in the three-month period ended March 31, 2007compared to the same period of 2006 as detailed in the following table (inthousands):
| ** **                                                                                                                                                                          | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                                                                                          | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Net unrealized  gain (loss) related to underwriter warrants                                                                                                                         |       | $                                                | 4,076      |   | $ | (1,625 | ) |
| Net unrealized  appreciation (depreciation) of securities held based on quoted market prices  or, for securities that are not readily marketable, our estimate of their  fair value |       | (1,137                                           | )          | (9,600 | ) |
| Net realized  gains on the sale of securities with quoted market prices and securities that  are not readily marketable                                                             |       | 245                                              |       | 6,060 |   |
|                                                                                                                                                                                |       | $                                                | 3,184      |   | $ | (5,165 | ) |

 

Investmentincome (loss) is volatile from period to period due to the fact that it isdriven by the market value or fair value of the securities and underwriterwarrants held. In addition, the performance of the securities in which we havea concentration can significantly affect our investment income from period toperiod.

Tradingincome increased $1.3 million in the three-month period ended March 31, 2007compared to the same period of 2006 to $1.3 million in the first quarter of2007 compared to $36,000 in the first quarter of 2006. The income in the firstquarter of 2007 was due to highly favorable results for certain securities thatwe were holding in our trading inventories. The first quarter of 2006 resultsreflected lower volume and lower prices for several of the securities we heldin our trading inventories. Our focus is on very small capitalization issues,especially those tied to our corporate finance clients. Trading income (loss)can be volatile from period to period because it is driven by the market valueof the securities in which we make a market.

***Expenses***

Totalexpenses increased $0.5 million in the three-month period ended March 31, 2007compared to the same period of 2006, primarily due to increases in commissionsand salaries, underwriting expenses, bad debt expense and settlement expense.

Commissionsand salaries increased $248,000 in the three-month period ended March 31, 2007compared to the same period of 2006. The increase was primarily due to highercommissions on higher commission and corporate finance revenue. Retailcommissions as a percentage of retail sales was comparable period over period.

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Underwritingexpense increased $125,000 in the three-month period ended March 31, 2007compared to the same period of 2006, primarily due to the completion of oneinitial public offering in the first quarter of 2007 with no comparabletransaction in the first quarter of 2006.

Baddebt expenses are recorded for specific amounts when they are determined bymanagement to be uncollectible. For the three-month periods ended March 31,2007 and 2006, receivables of $48,000 and $2,000, respectively, weredetermined by management to be uncollectible and written off to bad debtexpense.

Settlementexpense of $80,000 in the first quarter of 2007 is related to a $63,000adjustment for open claims and the payment of $17,000 for the settlement ofother matters.

***Liquidity and Capital Resources***

Ourprimary sources of liquidity include our cash and cash equivalents andreceivables from our clearing organization, offset by payables to our clearingorganization.

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

Webelieve our liquidity is sufficient to meet our needs for both the short andlong-term horizon. Our liquidity could be negatively affected by protractedunfavorable market conditions.

As asecurities broker-dealer, we are required by SEC regulations to meet certainliquidity and capital standards. We believe we were in compliance with thesestandards at March 31, 2007.

Followingthe lapse of restrictions upon issuance, capital available from the sale of theunderlying securities of underwriter warrants exercised can fluctuatesignificantly from period to period as the value of the underlying securitiesfluctuates with overall market and individual company financial condition orperformance. There is no public market for the underwriter warrants. Thesecurities receivable upon exercise of the underwriter warrants cannot beresold unless the issuer has registered these securities with the SEC and withthe states in which the securities will be sold unless exemptions are available.Any delay or other problem in the registration of these securities would havean adverse impact upon our ability to obtain funds from the exercise of theunderwriter warrants and the resale of the underlying securities.

AtMarch 31, 2007, we owned 16 underwriter warrants from 15 issuers, all but fourof which were exercisable. Four of the warrants had an exercise price below theMarch 31, 2007 market price of the securities receivable upon exercise. Theintrinsic value of these warrants was $0.9 million at March 31, 2007. There islittle or no direct relationship between the intrinsic value of our underwriterwarrants at the end of any given period and the fair value calculated using theBlack-Scholes option pricing model. The prices of the securities underlying theunderwriter warrants are very volatile, and substantial fluctuations in ourestimate of their value can be expected in the future.

Cashprovided by operating activities in the first quarter of 2007 totaled $57,000,primarily due to our net income of $2.8 million being offset by net non-cashincome items of $3.1 million and changes in our operating assets andliabilities as discussed in more detail below.

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Ournet receivable from our clearing organization increased $2.8 million to $10.5million at March 31, 2007 from $7.7 million at December 31, 2006, primarily dueto the results of the activity in our trading and investment accounts, as wellas the timing of general corporate expenditures.

Tradingand investment securities combined decreased $2.2 million to $19.7 million atMarch 31, 2007 compared to $21.9 million at December 31, 2006. Changes in ourtrading and investment securities are dependent on the purchase and sale ofsecurities during the period, as well as changes in their fair market valuesduring the period.

Underwriterwarrants increased $4.3 million to $10.0 million at March 31, 2007 compared to$5.7 million at December 31, 2006.  Aroll-forward of the value of the warrants was as follows (in thousands):
| **Balance,  December 31, 2006**                                |   | $      | 5,650  |   |
|----------------------------------------------------------------|--------|--------|--------|--------|
| Fair value of  warrants received, net of employee compensation |   | 289    |   |
| Net unrealized  gain on value of warrants                      |   | 4,076  |   |
| Value of  warrants exercised and expired                       |   | — |   |
| **Balance, March 31, 2007**                                    |   | $      | 10,015 |   |

 

Compensation,employee benefits and payroll taxes payable increased $0.2 million to $1.2million at March 31, 2007 from $1.0 million at December 31, 2006, primarily dueto strong retail results in the last month of the first quarter of 2007compared to the last month of the fourth quarter of 2006.

Incometaxes receivable decreased $0.6 million to a payable of $0.3 million at March31, 2007 from a receivable of $0.3 million at December 31, 2006, primarily dueto receipt of refunds and adjustments made for the adoption of InterpretationNo. 48 during the first quarter of 2007. See also Note 6 of Notes toConsolidated Financial Statements.

Deferredrevenue of $450,000 at March 31, 2007 related to amounts received from ourclearing firm based on the execution of a five-year agreement, which is beingamortized at the rate of $8,333 per month through September 2011.

Deferredincome taxes payable increased $1.2 million to $2.9 million at March 31, 2007from $1.7 million at December 31, 2006, primarily due to a $3.2 million netunrealized gain on securities and underwriter warrants during the first quarterof 2007.

InSeptember 2001, our Board of Directors approved a stock repurchase programpursuant to which we are authorized to repurchase up to 600,000 shares of ourcommon stock. During the first quarter of 2007, we repurchased a total of37,500 shares and, at March 31, 2007, 278,327 shares remained available forrepurchase. This repurchase program does not have an expiration date.

**Off-BalanceSheet Arrangements**

We donot have any off-balance sheet arrangements that have or are reasonably likelyto have a material current or future effect on our financial condition, changesin financial condition, revenues or expenses, results of operations, liquidity,capital expenditures or capital resources.

**NewAccounting Pronouncements**

Therehas been no change in new accounting pronouncements since the filing of ourForm 10-K for the year ended December 31, 2006, which was filed with theSecurities and Exchange Commission on April 2, 2007.

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

There have been nomaterial changes in our reported market risks or risk management policies sincethe filing of our Form 10-K for the year ended December 31, 2006, which wasfiled with the Securities and Exchange Commission on April 2, 2007.

**Item 4.  Controls and Procedures**

***Disclosure Controls andProcedures***

Ourmanagement has evaluated, under the supervision and with the participation ofour President and our Chief Financial Officer, the effectiveness of ourdisclosure controls and procedures as of the end of the period covered by thisreport as defined in Rule 13a-15(e) or Rule 15d-15(e) under the SecuritiesExchange Act of 1934 (the “Exchange Act”). Based on that evaluation, ourPresident and our Chief Financial Officer have concluded that, as of the end ofthe period covered by this report, our disclosure controls and procedures areeffective in ensuring that information required to be disclosed in our ExchangeAct reports is (1) recorded, processed, summarized and reported in a timelymanner, and (2) accumulated and communicated to our management, including ourPresident and our Chief Financial Officer, as appropriate, to allow timelydecisions regarding required disclosure.

***Changes in Internal Control Over Financial Reporting***

Therehas been no change in our internal control over financial reporting thatoccurred during our last fiscal quarter that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

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**PART II - OTHER INFORMATION**

**Item 1.**    **Legal Proceedings**

SeeNote 2 of Notes to Consolidated Financial Statements in Part I, Item 1.

**Item 1A.  Risk Factors**

OurAnnual Report on Form 10-K for the year ended December 31, 2006 includes adetailed discussion of our risk factors. There have been no material changesfrom the risk factors previously disclosed in our Annual Report on Form 10-K.Accordingly, the information in this Form 10-Q should be read in conjunctionwith the risk factors and information disclosed in our Annual Report on Form10-K for the year ended December 31, 2006, which was filed with the Securitiesand Exchange Commission on April 2, 2007. See also Part I, Item 2 “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” in thisreport under the heading “ForwardLooking Statements and Risk Factors.”

**Item 2.  Unregistered Sales of Equity Securitiesand Use of Proceeds**

Werepurchased the following shares of our common stock during the first quarterof 2007:
| ** **                 | ** ** | **Total number  of shares  purchased** | ** ** | **Average  price paid  per share** | ** ** | **Total number of   shares purchased  as part of publicly  announced plan** | ** ** | **Maximum number  of shares that may  yet be purchased  under the plan** | ** ** |
|----------------------------|------------|--------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|
| January 1 to  January 31   |       | 25,500                                           |       | $                                            | 5.25       |                                                                                                                | 309,763    |                                                                                                             | 290,237    |   |
| February 1 to  February 28 |       | 12,000                                           |       | 5.18                                         |       | 321,763                                                                                                             |       | 278,237                                                                                                          |       |
| March 1 to March  31       |       | —                                           |       | —                                       |       | —                                                                                                              |       | —                                                                                                           |       |
| Total                      |       | 37,500                                           |       | 5.23                                         |       | 321,763                                                                                                             |       | 278,237                                                                                                          |       |
|                            |            |                                                  |            |                                              |            |                                                                                                                     |            |                                                                                                                  |            |  |

 

Theplan to repurchase up to a total of 600,000 shares of our common stock wasapproved by our Board of Directors in September 2001 and does not have anexpiration date.  

**Item 6.  Exhibits**

Thefollowing exhibits are filed herewith and this list is intended to constitutethe exhibit index:
| 31.1 |   | Certification of Principal Executive Officer  pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act  of 1934.                            |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934.                                 |
| 32.1 |   | Certification of Principal Executive Officer pursuant  to Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934  and 18 U.S.C. Section 1350. |
| 32.2 |   | Certification of Chief Financial Officer pursuant to  Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 and  18 U.S.C. Section 1350.     |

 

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**SIGNATURES**

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.
| Date: May 14, 2007 |   | PAULSON CAPITAL CORP.                  |
|--------------------|--------|----------------------------------------|
|               |   |                                   |
|               |   | By                                     | /s/ CHESTER L.  F. PAULSON |
|               |   | Chester L. F.  Paulson                 |
|               |   | President and  Chief Executive Officer |
|               |   | Principal  Executive Officer           |
|               |   |                                   |   |
|               |   | By                                     |  /s/ KAREN L. JOHANNES |
|               |   | Karen L.  Johannes                     |
|               |   | Chief Financial  Officer               |
|               |   | Principal  Financial Officer           |

 

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