UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2006

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

For the transition period from to

Commission file number: 0-18188

PAULSON CAPITAL CORP.

(Exact name of registrant as specified in its charter)

Oregon		93-0589534
(State or other jurisdiction of		(I.R.S. Employer Identification No.)
incorporation or organization)

811 SW Naito Parkway, Portland, Oregon		97204
(Address of principal executive offices)		(Zip Code)

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. Large accelerated filer o Accelerated filer o Non-accelerated filer x

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

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

Common stock, no par value		6,167,132
(Class)		(Outstanding at November 10, 2006)

PAULSON CAPITAL CORP. AND SUBSIDIARY

FORM 10-Q

INDEX

PART I - FINANCIAL INFORMATION

Item 1.	Financial Statements

	Consolidated Balance Sheets - September 30, 2006 and December 31, 2005 (unaudited)

	Consolidated Statements of Operations - Three and Nine Months Ended September 30, 2006 and 2005 (unaudited)

	Consolidated Statements of Cash Flows - Nine Months Ended September 30, 2006 and 2005 (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

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

Paulson Capital Corp. and Subsidiary

Consolidated Balance Sheets

	September 30,		December 31,
	2006		2005
	(Unaudited)
Assets
Cash and cash equivalents	$	119,041	$	129,549
Receivable from clearing organization	4,777,941		12,608,491
Notes and other receivables	1,958,396		1,081,528
Income taxes receivable	143,197		—
Trading securities, at market value	2,455,157		1,558,564
Investment securities, at market value	21,328,018		32,401,808
Underwriter warrants, at estimated fair value	4,545,000		6,275,000
Prepaid and deferred expenses	493,115		674,328
Furniture and equipment, net	295,792		265,791

Total Assets	$	36,115,657	$	54,995,059

Liabilities and Shareholders’ Equity
Accounts payable and accrued liabilities	$	756,490	$	1,243,866
Payable to clearing organization	166,775		3,182,347
Compensation, employee benefits and payroll taxes	679,705		2,105,259
Securities sold, not yet purchased, at market value	2,955		23,033
Dividends payable	—		929,317
Income taxes payable	—		2,338,218
Deferred revenue	500,000		—
Deferred income taxes	466,542		5,408,000

Total Liabilities	2,572,467		15,230,040

Commitments and Contingencies	—		—

Shareholders’ Equity
Preferred stock, no par value; 500,000 shares authorized; none issued	—		—
Common stock, no par value; 20,000,000 shares authorized; shares issued and outstanding: 6,167,132 and 6,195,448	1,831,266		1,817,100
Retained earnings	31,711,924		37,947,919
Total Shareholders’ Equity	33,543,190		39,765,019

Total Liabilities and Shareholders’ Equity	$	36,115,657	$	54,995,059

See accompanying Notes to Consolidated Financial Statements.

Paulson Capital Corp. and Subsidiary

Consolidated Statements of Operations

(Unaudited)

	For the Three Months Ended September 30,						For the Nine Months Ended September 30,
	2006			2005			2006			2005
Revenues
Commissions	$	3,156,476		$	4,335,517		$	11,335,870		$	12,219,843
Corporate finance	1,414,620			2,176,018			4,646,808			2,761,973
Investment income (loss)	(3,170,780		)	820,278			(8,259,811		)	18,334,207
Trading income (loss)	(1,595,605		)	755,231			(1,814,315		)	2,868,057
Interest and dividends	15,203			8,661			41,367			30,806
Other	(680		)	9,544			934			20,878
	(180,766		)	8,105,249			5,950,853			36,235,764

Expenses
Commissions and salaries	3,314,795			5,461,956			11,759,338			15,868,145
Underwriting expenses	188,579			76,078			356,025			210,250
Rent, telephone and quotation services	307,326			291,249			893,592			883,348
Professional fees	155,774			425,406			606,151			1,214,522
Travel and entertainment	45,722			14,161			299,061			175,230
Advertising and promotion	47,542			75,938			133,245			221,248
Settlement expense	185,461			(175,000		)	190,211			343,543
Depreciation and amortization	29,032			22,559			73,509			68,319
Other	367,655			709,491			1,068,688			1,646,493
	4,641,886			6,901,838			15,379,820			20,631,098

Income (loss) before income taxes	(4,822,652		)	1,203,411			(9,428,967		)	15,604,666

Income tax expense (benefit):
Current	(580,503		)	1,956,954			1,534,136			1,956,954
Deferred	(1,025,833		)	(1,491,288		)	(4,941,458		)	4,269,214
	(1,606,336)			465,666			(3,407,322		)	6,226,168

Net income (loss)	$	(3,216,316	)	$	737,745		$	(6,021,645	)	$	9,378,498

Basic net income (loss) per share	$	(0.52	)	$	0.12		$	(0.97	)	$	1.49

Diluted net income (loss) per share	$	(0.52	)	$	0.12		$	(0.97	)	$	1.49

Shares used in per share calculations:
Basic	6,167,621			6,226,442			6,180,099			6,282,470
Diluted	6,167,621			6,259,444			6,180,099			6,315,350

See accompanying Notes to Consolidated Financial Statements.

Paulson Capital Corp. and Subsidiary

Consolidated Statements of Cash Flows

(Unaudited)

	For the Nine Months Ended September 30,
	2006			2005

Cash flows from operating activities:
Net income (loss)	$	(6,021,645	)	$	9,378,498
Adjustments to reconcile net income (loss) to net cash flows provided by operating activities:
Receipt of underwriter warrants	(2,771,247		)	(1,759,264		)
Unrealized depreciation/expiration of underwriter warrants	3,609,357			3,271,723
Noncash compensation associated with underwriter warrants	891,890			408,541
Depreciation and amortization	73,509			68,319
Deferred income taxes	(4,941,458		)	4,305,690
Loss on disposal of furniture and equipment	7,613			—
Change in assets and liabilities
Receivables from/payable to clearing organization	4,814,978			(499,157		)
Notes and other receivables	(876,868		)	(818,032		)
Trading and investment securities	10,177,197			(16,460,162		)
Prepaid and deferred expenses	181,213			222,964
Accounts payable, accrued liabilities and compensation payables	(1,912,930		)	599,886
Dividends payable	(929,317		)	—
Securities sold, not yet purchased	(20,078		)	21,721
Deferred revenue	500,000			—
Income taxes payable/receivable	(2,481,415		)	2,775,340
Net cash provided by operating activities	300,799			1,516,067

Cash flows from investing activities:
Additions to furniture and equipment	(111,123		)	(96,387		)

Cash flows from financing activities:
Proceeds from stock option exercise	21,030			61,530
Dividends paid to common shareholders	—			(476,564		)
Payments to retire common stock	(221,214		)	(871,347		)
Net cash used in financing activities	(200,184		)	(1,286,381		)

Increase (decrease) in cash and cash equivalents	(10,508		)	133,299

Cash and cash equivalents:
Beginning of period	129,549			132,845

End of period	$	119,041		$	266,144

Supplemental cash flow information:
Cash paid during the period for income taxes	$	4,015,551		$	16,416
Cash paid during the period for interest	—			421

See accompanying Notes to Consolidated Financial Statements.

PAULSON CAPITAL CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Basis of Presentation

The financial information for Paulson Capital Corp. and its wholly-owned subsidiary, Paulson Investment Company, included herein as of September 30, 2006 and December 31, 2005 and for the three and nine-month periods ended September 30, 2006 and 2005 is unaudited; however, such information reflects all adjustments, consisting only of normal recurring adjustments, which, in the opinion of management, are necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods. The financial information as of December 31, 2005 is derived from our 2005 Annual Report on Form 10-K. The interim consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in our 2005 Annual Report on Form 10-K. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for the full year.

Note 2. Dividend

Pursuant to a December 22, 2005 authorization by our Board of Directors, in February 2006, we paid a special cash dividend of $0.30 per share to shareholders of record on January 17, 2006. The dividend paid totaled $0.9 million.

Note 3. Stock Split

On March 1, 2006, we announced that our Board of Directors approved a two-for-one stock split of our common stock to be effected in the form of a stock dividend. The stock split was effected on March 29, 2006 by issuing one additional share of common stock for each share of common stock outstanding on March 15, 2006. All prior share and per share amounts have been adjusted for this stock split. Basic and diluted net income per share were adjusted as follows for the three and nine-month periods ended September 30, 2005:

	Three Months Ended September 30, 2005		Nine Months Ended September 30, 2005
Basic net income per share, as previously reported	$	0.24	$	2.99
Basic net income per share, as adjusted	$	0.12	$	1.49

Diluted net income per share, as previously reported	$	0.24	$	2.97
Diluted net income per share, as adjusted	$	0.12	$	1.49

Shares used for basic net income per share, as previously reported	3,113,221		3,141,235
Shares used for basic net income per share, as adjusted	6,226,442		6,282,470

Shares used for diluted net income per share, as previously reported	3,129,722		3,157,675
Shares used for diluted net income per share, as adjusted	6,259,444		6,315,350

Note 4. Commitments and Contingencies

In October 2002, we were named as a defendant in a lawsuit filed by Special Situations Fund III, LP and Special Situations Cayman Fund, LP. The lawsuit was filed in the U.S. District Court for the District of New Jersey. It asserts various federal securities law claims and common law fraud and negligent misrepresentation against numerous defendants, including us, arising out of two follow-on offerings of Suprema Specialties, Inc. We participated in one of the two offerings, the August 25, 2000 follow-on offering of Suprema Specialties, Inc., as a member of the underwriting syndicate, agreeing to underwrite

75,000 shares in total, although the amount actually retained by us appears to be only 35,000 shares. The stock was sold in the August 25, 2000 offering at a price of $8.00 per share. Plaintiffs seek damages for the purchase of 399,151 shares of Suprema Specialties, Inc. stock between August 25, 2000 and November 14, 2001. The federal district court dismissed the claims against us. On appeal, the U. S. Third Circuit Court of Appeals affirmed the dismissal of the plaintiffs’ claims for violation of Rule 10b-5 but reversed as to the dismissal of claims under Section 11 of the Securities Act of 1933. Subsequently, the plaintiffs stipulated that they will not be asserting a claim for common law fraud against us. The negligent misrepresentation claim remains in the case. We believe our liability under Section 11 is limited to the amount of shares either underwritten or actually retained by us in the offering. Discovery has begun, but has not yet been completed. We believe we have meritorious defenses and intend to defend this matter vigorously.

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

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

An adverse outcome in certain of the matters described above could have a material adverse effect on our results of operations, cash flow or financial condition. We have either been named in certain other legal proceedings or are aware of certain complaints that may lead to legal proceedings. We believe, based upon information received to date and, where we believe it appropriate, based on discussions with legal counsel, that resolution of additional pending or threatened litigation will have not have a material adverse effect on our results of operations, cash flow or financial condition.

Note 5. Stock-Based Compensation

Adoption of SFAS No. 123R

Effective January 1, 2006, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment,” which establishes accounting for equity instruments exchanged for employee services. Under the provisions of SFAS No. 123R, stock-based compensation cost for equity classified awards is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the employee’s requisite service period (generally the vesting period of the equity award). Prior to January 1, 2006, we accounted for share-based compensation to employees in accordance with Accounting Principles Board Option No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and related interpretations. We also followed the disclosure requirements of SFAS No. 123, “Accounting for Stock-Based Compensation.”

We elected to adopt the modified prospective transition method as provided by SFAS No. 123R and, accordingly, financial statement amounts for the prior periods presented in this Form 10-Q have not been restated to reflect the fair value method of expensing stock-based compensation. Under this method, the

provisions of SFAS No. 123R apply to all awards granted or modified after the date of adoption. We did not have any unrecognized expense related to awards outstanding at the date of adoption since they were all fully vested. For future awards, expense calculated pursuant to SFAS No. 123R will be recognized as compensation expense using the Black-Scholes option pricing model over the requisite service period. The cumulative effect of the change in accounting principle from APB 25 to SFAS No. 123R was not material.

There were no options granted and no pro forma stock-based compensation expense as if the method prescribed by SFAS No. 123, “Accounting for Stock-Based Compensation,” had been applied in measuring compensation expense in the prior periods presented.

1999 Stock Option Plan

Our 1999 Stock Option Plan (the “Plan”) reserves 1.0 million shares of our common stock for issuance upon exercise of options granted under the Plan. At September 30, 2006, 521,000 options were available for grant and 708,000 shares of our common stock were reserved for issuance related to the Plan. The Plan provides for the grant of incentive stock options and nonqualified stock options. Activity under the Plan in the first nine months of 2006 was as follows:

	Options Outstanding		Weighted Average Exercise Price
Outstanding at December 31, 2005	193,000		$	3.92
Granted	—
Exercised	(6,000	)	3.51
Forfeited	—
Outstanding at September 30, 2006	187,000		3.93

Certain information regarding options outstanding and exercisable as of September 30, 2006 was as follows:

	Options Outstanding and Exercisable
Number	187,000
Weighted average per share exercise price	$	3.93
Aggregate intrinsic value	$	344,605
Weighted average remaining contractual term	1.5 years

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

Stock-Based Compensation

We estimate the fair value of stock options using the Black-Scholes option pricing model. This valuation model takes into account the exercise price of the award, as well as a variety of significant assumptions. We believe that the valuation technique and the approach utilized to develop the underlying assumptions are appropriate in calculating the fair values of our stock options. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by persons who receive equity awards. There were no stock options granted during the three and nine-month periods ended September 30, 2006 or 2005.

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

Certain information regarding our stock-based compensation was as follows:

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

There was no activity in the three months ended September 30, 2006 or 2005.

Note 6. Earnings Per Share

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

	Three Months Ended September 30,		Nine Months Ended September 30,
	2006	2005	2006	2005
Shares used for basic income (loss) per share	6,167,621	6,226,442	6,180,099	6,282,470
Effect of dilutive stock options	—	33,002	—	32,880
Shares used for diluted net income (loss) per share	6,167,621	6,259,444	6,180,099	6,315,350

Stock options not included in diluted net income (loss) per share because their effect would have been antidilutive	187,000	—	187,000	—

Note 7. Selection of New Clearing Firm

In September 2006, RBC Dain Correspondent Services (“DCS”) became our new clearing firm, replacing National Financial Services, LLC (“NFS”).

Note 8. Repurchases of Common Stock

In the first nine months of 2006, we repurchased a total of 34,316 shares of our common stock for a weighted average price of $6.45 per share, which totaled $221,000. The amount paid above the original issue price, which totaled $214,000, was offset against retained earnings.

Note 9. New Accounting Pronouncements

SFAS No. 157

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which establishes a single authoritative definition of fair value, sets out a framework for measuring fair value and requires additional disclosures about fair-value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the provisions of SFAS No. 157 and the potential effect on our financial position and results of operations.

Staff Accounting Bulletin No. 108

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” which addresses how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in current-year financial statements. SAB No. 108 requires companies to quantify misstatements using both the balance sheet and income statement approaches and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors. SAB No. 108 is effective for annual financial statements covering the first fiscal year ending after November 15, 2006. We are not currently aware of any material

misstatements and, accordingly, we believe that the implementation of SAB No. 108 will not have any material effect on our financial position or results of operations.

FASB Interpretation No. 48

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” which defines the threshold for recognizing the benefits 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 all tax positions accounted for under SFAS No. 109, “Accounting for Income Taxes.” Interpretation No. 48 is effective as of the beginning of the first fiscal year beginning after December 15, 2006. We are currently analyzing the effects of adopting Interpretation No. 48 and have not yet determined if the adoption will have a material effect on our financial position.

Note 10. Reclassifications

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

Note 11. Subsequent Events

In October 2006, we entered into a settlement with our former insurance company, AIG, in relation to a prior settlement related to certain investment transactions. We will receive approximately $280,000 after payments to our attorneys related to this matter. We do not expect any future activity in regard to this matter.

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

Forward Looking Statements and Risk Factors

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

· The performance of companies whose securities we have underwritten or otherwise sold to our customers may affect our reputation with other potential syndicate and selling group members and institutional and other retail accounts and may also affect the amount of money in our customers’ portfolios available for the kinds of investments that we offer.

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

· We are subject to a very high degree of regulation and are responsible for compliance with applicable regulations by all of our personnel. A significant regulatory infraction by us or any of our

registered representatives could result in significant penalties, including the loss of our license to conduct securities business in one or more jurisdictions.

· Alternatives available to our customers to transact securities’ trades could affect our ability to continue to execute our brokerage customers’ transactions.

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

Overview

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

· securities brokerage activities for which we earn commission revenues;

· corporate finance revenues consisting principally of underwriting discounts and underwriter warrants;

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

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

Because we operate in the financial services industry, our revenues and earnings are substantially affected by general conditions in financial markets. In our securities brokerage business, the amount of our revenues depends on levels of market activity requiring the services we provide. Our corporate finance activity, which consists of acting as the managing underwriter of initial and follow-on public offerings, private investments in a public equity (“PIPEs”) and private placements for smaller companies, is similarly affected by the strength of the market for new equity offerings, which has historically experienced substantial cyclical fluctuation. Although we attempt to match operating costs with activity levels, many of our expenses are either fixed or difficult to change on short notice. Accordingly, fluctuations in brokerage and corporate finance revenues tend to result in sharper fluctuations, on a percentage basis, in net income or loss.

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

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

Critical Accounting Policies and Use of Estimates

Except for the addition of the Stock-Based Compensation information below, we reaffirm the critical accounting policies and estimates as reported in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2006, which was filed with the Securities and Exchange Commission on May 15, 2006.

Stock-Based Compensation

On January 1, 2006, we adopted SFAS No. 123R, which requires the measurement and recognition of compensation expense for all share based payment awards granted to our employees and directors. Upon adoption of SFAS No. 123R, we maintained our method of valuation of employee stock options granted using the Black-Scholes option pricing model which was previously used for the disclosure only provisions allowed under SFAS No. 123. Our determination of fair value of share based payment awards on the date of grant using an option pricing model is affected by our stock price as well as assumptions regarding a number of variables, including risk free interest rate, the expected dividend yield, the expected option life, and expected volatility over the term of the awards. To the extent share based payment awards are granted in future periods, we will recognize the related expense over the requisite service period based on the portion of awards that are ultimately expected to vest during the period.

Results of Operations

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

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

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

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

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

The following tables set forth the changes in our operating results in the three and nine-month periods ended September 30, 2006 compared to the three and nine-month periods ended September 30, 2005:

	Three Months Ended									%
	September 30,						Increase			Increase
	2006			2005			(Decrease)			(Decrease)
Revenues:
Commissions	$	3,156,476		$	4,335,517		$	(1,179,041	)	(27.2	)%
Corporate finance	1,414,620			2,176,018			(761,398		)	(35.0	)
Investment income (loss)	(3,170,780		)	820,278			(3,991,058		)	(486.5	)
Trading income (loss)	(1,595,605		)	755,231			(2,350,836		)	(311.3	)
Interest and dividends	15,203			8,661			6,542			75.5
Other	(680		)	9,544			(10,224		)	(107.1	)
Total revenues (loss)	(180,766		)	8,105,249			(8,286,015		)	(102.2	)
Expenses:
Commissions and salaries	3,314,795			5,461,956			(2,147,161		)	(39.3	)
Underwriting expenses	188,579			76,078			112,501			147.9
Rent, telephone and quotation services	307,326			291,249			16,077			5.5
Professional fees	155,774			425,406			(269,632		)	(63.4	)
Travel and entertainment	45,722			14,161			31,561			222.9
Advertising and promotion	47,542			75,938			(28,396		)	(37.4	)
Settlement expense	185,461			(175,000		)	360,461			206.0
Depreciation and amortization	29,032			22,559			6,473			28.7
All other	367,655			709,491			(341,836		)	(48.2	)
Total expenses	4,641,886			6,901,838			(2,259,952		)	(32.7	)
Income (loss) before income taxes	$	(4,822,652	)	$	1,203,411		$	(6,026,063	)	(500.7	)%

	Nine Months Ended								%
	September 30,					Increase			Increase
	2006			2005		(Decrease)			(Decrease)
Revenues:
Commissions	$	11,335,870		$	12,219,843	$	(883,973	)	(7.2	)%
Corporate finance	4,646,808			2,761,973		1,884,835			68.2
Investment income (loss)	(8,259,811		)	18,334,207		(26,594,018		)	(145.1	)
Trading income (loss)	(1,814,315		)	2,868,057		(4,682,372		)	(163.3	)
Interest and dividends	41,367			30,806		10,561			34.3
Other	934			20,878		(19,944		)	(95.5	)
Total revenues	5,950,853			36,235,764		(30,284,911		)	(83.6	)
Expenses:
Commissions and salaries	11,759,338			15,868,145		(4,108,807		)	(25.9	)
Underwriting expenses	356,025			210,250		145,775			69.3
Rent, telephone and quotation services	893,592			883,348		10,244			1.2
Professional fees	606,151			1,214,522		(608,371		)	(50.1	)
Travel and entertainment	299,061			175,230		123,831			70.7
Advertising and promotion	133,245			221,248		(88,003		)	(39.8	)
Settlement expense	190,211			343,543		(153,332		)	(44.6	)
Depreciation and amortization	73,509			68,319		5,190			7.6
All other	1,068,688			1,646,493		(577,805		)	(35.1	)
Total expenses	15,379,820			20,631,098		(5,251,278		)	(25.5	)
Income (loss) before income taxes	$	(9,428,967	)	$	15,604,666	$	(25,033,633	)	(160.4	)%

Revenues

Commissions decreased $1.2 million and $0.9 million, respectively, in the three and nine-month periods ended September 30, 2006 compared to the same periods of 2005. The total number of trades, including mutual fund trades, executed by our brokers were 22,918 and 76,601 in the three and nine-month periods ended September 30, 2006, respectively, compared to 26,554 and 79,657, respectively, in the comparable periods of 2005. We had 91 brokers at September 30, 2006 compared to 94 brokers at September 30, 2005.

Corporate finance income of $1.4 million in the three-month period ended September 30, 2006 primarily represented commissions earned from one initial public offering in which we raised $16.5 million for Ascent Solar Technologies, Inc., as well as the Black-Scholes value of the underwriter warrants received

in connection with that offering. The corporate finance income of $4.6 million in the nine-month period ended September 30, 2006 also included commissions earned from a public offering in which we raised $19.5 million for American Mold Guard, Inc., as well as the Black-Scholes value of the underwriter warrants received in connection with that offering. In addition we completed several private transactions, including PIPEs, during the three and nine-month periods ended September 30, 2006.

Corporate finance income of $2.2 million in the three-month period ended September 30, 2005 primarily included commissions earned from one initial public offering in which we raised $10.7 million for ICOP Digital, Inc., as well as the Black-Scholes value of the underwriter warrants received in connection with that offering. Corporate finance income of $2.8 million in the nine-month period ended September 30, 2005 also included commissions related to a small initial public offering in which we raised $3.0 million for Nuvim, Inc., as well as the Black-Scholes value of the underwriter warrants received in connection with that offering. In addition we completed other small private transactions during these periods.

Investment income decreased $4.0 million and $26.6 million, respectively, in the three and nine-month periods ended September 30, 2006 compared to the same periods of 2005 as detailed in the following table:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
Net unrealized gain (loss) related to underwriter warrants	$	(1,670,213	)	$	(5,178,123	)	$	(3,609,357	)	$	(3,271,723	)
Net unrealized appreciation (depreciation) of securities held based on quoted market prices or, for securities that are not readily marketable, our estimate of their fair market value	(1,743,253		)	(2,925,541		)	(11,342,590		)	8,426,298
Net realized gains on the sale of securities with quoted market prices and securities that are not readily marketable	242,686			8,923,942			6,692,136			13,179,632
	$	(3,170,780	)	$	820,278		$	(8,259,811	)	$	18,334,207

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

Trading income decreased $2.4 million and $4.7 million, respectively, in the three and nine-month periods ended September 30, 2006 compared to the same periods of 2005 to a loss of $1.6 million and a loss of $1.8 million, respectively, in the 2006 periods. These losses are primarily due to lower volume and lower prices for several of the securities we hold in 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 based on the fact that it is driven by the market value of the securities in which we make a market.

Expenses

Total expenses decreased $2.3 million and $5.3 million, respectively, in the three and nine-month periods ended September 30, 2006 compared to the same periods of 2005, primarily due to decreases in commissions and salaries, professional fees and other expenses. These decreases were partially offset in the three-month period ended September 30, 2006 compared to the same period of 2005 by an increase in settlement expense.

Commissions and salaries decreased $2.1 million and $4.1 million, respectively, in the three and nine-month periods ended September 30, 2006 compared to the same periods of 2005. Retail commissions as a percentage of retail sales is comparable year over year. However, we do not pay trading and investment commissions on trading and investment losses, accordingly, we have had a significant decrease in trading and investment commissions in the 2006 periods compared to the 2005 periods. In addition, there was a $35,000 increase in salaries in the third quarter of 2006 compared to the third quarter of 2005 as we hired a Sarbanes-Oxley manager and made a few management pay adjustments.

Professional fees decreased $0.3 million and $0.6 million, respectively, in the three and nine-month periods ended September 30, 2006 compared to the same periods of 2005, primarily due to significant decreases in legal activity as a result of the settlement of certain cases during the 2005 periods.

Settlement expense in the 2006 periods related to the settlement of one matter in the third quarter of 2006. The credit to settlement expense in the three-month period ended September 30, 2005 related to a change in estimate of settlement expense. Settlement expense in the nine-month period ended September 30, 2005 also included amounts required to settle certain legal matters.

Other expense includes items such as dues and subscriptions, charitable contributions, bad debt expense and other office expenses. Other expense decreased $0.3 million and $0.6 million, respectively, in the three and nine-month periods ended September 30, 2006 compared to the same periods of 2005, primarily due to a $270,000 and $250,000 decrease, respectively, in charitable contributions as well as net decreases in various other expense categories.

Income (Loss) Before Income Taxes

We generated losses before income taxes in the three and nine-month periods ended September 30, 2006 compared to income before income taxes in the comparable periods of 2005 due to the decreases in revenues, partially offset by decreases in expenses in the 2006 periods compared to the 2005 periods as discussed above.

In addition, because of changes in the underlying securities and other factors, significant fluctuations in the value of underwriter warrants often occur from period to period, affecting the comparability of our revenues and operating results.

Liquidity and Capital Resources

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

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

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

As a securities broker-dealer, we are required by SEC regulations to meet certain liquidity and capital standards. We believe we were in compliance with these standards at September 30, 2006.

Following the lapse of restrictions upon issuance, capital available from the sale of the underlying securities of underwriter warrants exercised can fluctuate significantly from period to period as the value of the underlying securities fluctuates with overall market and individual company financial condition or performance. There is no public market for the underwriter warrants. The securities receivable upon exercise of the underwriter warrants cannot be resold unless the issuer has registered these securities with the SEC and with the states in which the securities will be sold unless exemptions are available. Any delay or other problem in the registration of these securities would have an adverse impact upon our ability to obtain funds from the exercise of the underwriter warrants and the resale of the underlying securities. At September 30, 2006, we owned 14 underwriter warrants from 13 issuers, all but two of which

were exercisable. One of the warrants had an exercise price below the September 30, 2006 market price of the securities receivable upon exercise. The intrinsic value of this warrant was $0.7 million at September 30, 2006. There is little or no direct relationship between the intrinsic value of our underwriter warrants at the end of any given period and the fair value calculated using the Black-Scholes option pricing model. The prices of the securities underlying the underwriter warrants are very volatile, and substantial fluctuations in our estimate of their value can be expected in the future. In the nine-month period ended September 30, 2006, we exercised one underwriter warrant, which resulted in net proceeds of $0.7 million upon the sale of the related securities.

Cash provided by operating activities in the first nine months of 2006 totaled $0.3 million, primarily due to our net loss of $6.0 million and net non-cash income items of $3.1 million being offset by changes in our operating assets and liabilities as discussed in more detail below.

Our net receivable from our clearing organization decreased $4.8 million to $4.6 million at September 30, 2006 from $9.4 million at December 31, 2005, primarily due to the results of the activity in our trading and investment accounts, as well as the timing of general corporate expenditures.

Notes and other receivables, which primarily represent employee and independent broker advances and expenses in excess of commission earnings, commissions receivable and amounts receivable from corporate finance clients, increased $0.9 million to $2.0 million at September 30, 2006 from $1.1 million at December 31, 2005, primarily due to additional advances to corporate finance clients, offset by payments received.

Trading and investment securities combined decreased $10.2 million to $23.8 million at September 30, 2006 compared to $34.0 million at December 31, 2005. Changes in our trading and investment securities are dependent on the purchase and sale of securities during the period, as well as changes in their fair market values during the period.

Underwriter warrants decreased $1.8 million to $4.5 million at September 30, 2006 compared to $6.3 million at December 31, 2005. A roll-forward of the value of the warrants was as follows:

Balance, December 31, 2005	$	6,275,000
Fair value of warrants received, net of employee compensation	1,879,357
Net unrealized loss on value of warrants	(2,988,719		)
Value of warrants exercised and expired	(620,638		)
Balance, September 30, 2006	$	4,545,000

Prepaid and deferred expenses decreased $0.2 million to $0.5 million at September 30, 2006 from $0.7 million at December 31, 2005, primarily due to the amortization of registration fees for our registered representatives and of insurance premiums.

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

Compensation, employee benefits and payroll taxes decreased $1.4 million to $0.7 million at September 30, 2006 from $2.1 million at December 31, 2005, primarily due to the payment of commissions that were accrued at December 31, 2005. Accruals for commissions were lower in 2006 due to weaker results from operations.

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

Income taxes payable decreased $2.5 million to a receivable of $143,000 at September 30, 2006 from a payable of $2.3 million at December 31, 2005, primarily due to $4.0 million of income tax payments made during the first nine months of 2006, partially offset by the accrual for fiscal 2006 taxes payable related to realized gains on investments.

Deferred revenue of $0.5 million at September 30, 2006 relates to amounts received from DCS based on the execution of a five-year agreement, which is being amortized at the rate of $8,333 per month through September 2011.

Deferred income taxes payable decreased $4.9 million to $0.5 million at September 30, 2006 from $5.4 million at December 31, 2005, primarily due to a $13 million unrealized loss on securities.

Capital expenditures of $111,000 in the first nine months of 2006 were primarily for leasehold improvements at our Salem, Oregon office. At September 30, 2006, we did not have any material commitments for capital expenditures.

In September 2001, our Board of Directors approved a stock repurchase program pursuant to which we are authorized to repurchase up to 600,000 shares of our common stock. Through September 30, 2006, we had repurchased a total of 281,142 shares and 318,858 shares remained available for repurchase. This repurchase program does not have an expiration date.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

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

Item 4. Controls and Procedures

Disclosure Controls and Procedures

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

Changes in Internal Controls

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

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

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

Item 1A. Risk Factors

Our Annual Report on Form 10-K for the year ended December 31, 2005 includes a detailed discussion of our risk factors. There have been no material changes from 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 conjunction with the risk factors and information disclosed in our Annual Report on Form 10-K for the year ended December 31, 2005, which was filed with the Securities and Exchange Commission on March 29, 2006. See also Part I, Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this report under the heading “Forward Looking Statements and Risk Factors.”

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

We repurchased the following shares of our common stock during the third quarter of 2006:

	Total number of shares purchased		Average price paid per share		Total number of shares purchased as part of publicly announced plan	Maximum number of shares that may yet be purchased under the plan
July 1 to July 31	3,000		$	5.92	281,142	318,858
August 1 to August 31	—		—		—	—
September 1 to September 30	—		—		—	—
Total	3,000	(1)	$	5.92	281,142	318,858

(1) None of the 3,000 shares were purchased from our executive officers or employees (or their affiliates).

The plan to repurchase up to a total of 600,000 shares of our common stock was approved by our Board of Directors in September 2001 and does not have an expiration date.

Item 6. Exhibits

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

31.1		Certification of Principal Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934.
31.2		Certification of 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.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Date: November 20, 2006	PAULSON CAPITAL CORP.


	By		/s/ CHESTER L. F. PAULSON
	Chester L. F. Paulson
	President and Chief Executive Officer
	Principal Executive Officer


	By	/s/ KAREN L. JOHANNES
	Karen L. Johannes
	Chief Financial Officer
	Principal Financial Officer