Pinnacle Summer Investments 10-Q 2006 Q3 Quarterly report

UNITES 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, OR

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

Commission file No. 0-30066

SANDERS MORRIS HARRIS GROUP INC.

(Exact name of registrant as specified in its charter)

Texas	76-0583569
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)

600 Travis, Suite 3100

Houston, Texas 77002

(Address of principal executive office)

Registrant’s telephone number, including area code: (713) 993-4610

Indicate by check mark if 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.

x  Yes o No

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 larger accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o Accelerated filer x  Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

o Yes x No

As of November 3, 2006, the registrant had 24,282,185 outstanding shares of Common Stock, par value $0.01 per share.

SANDERS MORRIS HARRIS GROUP INC. AND SUBSIDIARIES

INDEX

		Page
PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements	2
	Condensed Consolidated Balance Sheet as of September 30, 2006 (unaudited) and December 31, 2005	2
	Condensed Consolidated Statement of Income for the Three and Nine Months Ended September 30, 2006 and 2005 (unaudited)	3
	Condensed Consolidated Statement of Shareholders' Equity for the Nine Months Ended September 30, 2006 (unaudited)	4
	Condensed Consolidated Statement of Cash Flows for the Nine Months Ended September 30, 2006 and 2005 (unaudited)	5
	Notes to Condensed Consolidated Financial Statements (unaudited)	6
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	23
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	33
Item 4.	Controls and Procedures	33
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings	34
Item 6.	Exhibits	35

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

SANDERS MORRIS HARRIS GROUP INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheet

(in thousands, except share and per share amounts)

	September 30,			December 31,
	2006			2005
	(unaudited)
ASSETS
Cash and cash equivalents	$	19,530		$	17,475
Receivables, net of allowance of $231 and $512, respectively
Broker-dealers		58,972			753
Customers		12,770			9,537
Related parties		5,093			6,227
Other		1,473			1,815
Deposits with clearing brokers		1,081			1,073
Securities owned		85,926			73,657
Securities available for sale		1,494			1,884
Furniture and equipment, net		11,539			9,673
Other assets and prepaid expenses		2,055			2,050
Goodwill, net		84,773			84,398
Total assets	$	284,706		$	208,542
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Accounts payable and accrued liabilities	$	21,578		$	21,881
Borrowings		15,355			10,706
Deferred tax liability, net		457			2,408
Securities sold, not yet purchased		17,791			8,168
Consideration payable		2,382			—
Payable to clearing broker-dealers		1,112			2,880
Net liabilities of discontinued operations		225			33
Total liabilities		58,900			46,076
Commitments and contingencies
Minority interests		9,239			7,781
Shareholders' equity:
Preferred stock, $.10 par value; 10,000,000 shares
authorized; no shares issued and outstanding		—			—
Common stock, $.01 par value; 100,000,000 shares
authorized; 25,021,325 and 19,634,260 shares issued, respectively		250			196
Common stock committed, 190,431 shares		2,382			—
Additional paid-in capital		195,251			134,004
Retained earnings		22,124			23,936
Accumulated other comprehensive income		41			30
Treasury stock at cost, 739,402 shares		(3,481	)		(3,481	)
Total shareholders' equity		216,567			154,685
Total liabilities and shareholders' equity	$	284,706		$	208,542

The accompanying notes are an integral part of these condensed consolidated financial statements.

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SANDERS MORRIS HARRIS GROUP INC. AND SUBSIDIARIES

Condensed Consolidated Statement of Income

(in thousands, except per share amounts)

(unaudited)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
Revenues:
Commissions	$	12,868		$	11,827		$	42,869		$	33,264
Investment banking		11,608			8,322			33,597			22,503
Investment advisory and related services		11,064			9,225			28,444			22,332
Principal transactions		3,284			3,099			13,662			7,169
Interest and dividends		1,467			1,118			4,514			3,438
Other income		1,413			820			4,396			2,544
Total revenues		41,704			34,411			127,482			91,250
Expenses:
Employee compensation and benefits		26,370			19,834			78,433			54,045
Floor brokerage, exchange and clearance fees		1,723			1,276			5,471			3,468
Communications and data processing		2,024			1,836			6,260			5,831
Occupancy		2,858			2,206			8,407			6,218
Interest		291			223			804			265
Goodwill impairment charge		—			—			4,456			—
Other general and administrative		5,760			4,250			17,147			10,554
Total expenses		39,026			29,625			120,978			80,381
Income from continuing operations before equity in
(loss) income of limited partnerships, minority
interests and income taxes		2,678			4,786			6,504			10,869
Equity in (loss) income of limited partnerships		(1,671	)		4,168			902			6,569
Income from continuing operations before minority		1,007			8,954			7,406			17,438
interests and income taxes
Minority interests in net income of consolidated
companies		(558	)		(2,814	)		(3,580	)		(4,438	)
Income from continuing operations before income taxes		449			6,140			3,826			13,000
Provision for income taxes		200			2,484			1,501			5,285
Income from continuing operations		249			3,656			2,325			7,715
Loss from discontined operations, net of tax		(547	)		—			(1,565	)		—
Net (loss) income	$	(298	)	$	3,656		$	760		$	7,715
Basic (loss) earnings per share:
From continuing operations	$	0.01		$	0.19		$	0.12		$	0.42
From discontinued operations	$	(0.03	)	$	—		$	(0.08	)	$	-
Net (loss) earnings per share	$	(0.02	)	$	0.19		$	0.04		$	0.42
Diluted (loss) earnings per share:
From continuing operations	$	0.01		$	0.19		$	0.12		$	0.40
From discontinued operations	$	(0.03	)	$	—		$	(0.08	)	$	—
Net (loss) earnings per share	$	(0.02	)	$	0.19		$	0.04		$	0.40
Weighted average common shares outstanding:
Basic		19,561,310			18,845,323			19,225,038			18,587,184
Diluted		19,993,844			19,401,206			19,688,017			19,192,485

The accompanying notes are an integral part of these condensed consolidated financial statements.

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SANDERS MORRIS HARRIS GROUP INC. AND SUBSIDIARIES

Condensed Consolidated Statement of Shareholders' Equity

For the nine months ended September 30, 2006

(in thousands, except shares)

(unaudited)

	Amounts					Shares
Common stock
Balance, beginning of period	$	196					19,634,260
Sale of stock		50					5,000,000
Stock issued pursuant to employee benefit plan		4					387,065
Balance, end of period		250					25,021,325
Common stock committed
Balance, beginning of period		—
Committed for acquisition		2,382					190,431
Balance, end of period		2,382					190,431
Additional paid-in capital
Balance, beginning of period		134,004
Sale of stock		57,897
Stock issued pursuant to employee benefit plan,
including tax benefit		1,583
Amortization of restricted stock grants		1,752
Collection of receivable for shares issued		15
Balance, end of period		195,251
Retained earnings
Balance, beginning of period		23,936
Dividends ($0.135 per share)		(2,572	)
Net income		760		760
Balance, end of period		22,124		760
Accumulated other comprehensive income
Balance, beginning of period		30
Net change in unrealized appreciation
on securities available for sale		17		17
Income tax expense on change in unrealized
appreciation on securities available for sale		(6	)	(6	)
Balance, end of period		41		11
Comprehensive income				771
Treasury stock
Balance, beginning of period		(3,481	)				(739,402	)
Balance, end of period		(3,481	)				(739,402	)
Total shareholders' equity and common shares outstanding	$	216,567					24,472,354

The accompanying notes are an integral part of these condensed consolidated financial statements.

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SANDERS MORRIS HARRIS GROUP INC. AND SUBSIDIARIES

Condensed Consolidated Statement of Cash Flows

For the nine months ended September 30, 2006 and 2005

(in thousands)

(unaudited)

	2006			2005
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	760		$	7,715
Adjustments to reconcile net income to net cash provided by
operating activities:
Realized gain on securities available for sale		(11	)		(2	)
Depreciation		2,135			1,511
Provision for bad debts		360			163
Compensation expense related to amortization of restricted stock grants		1,752			1,466
Goodwill impairment charge		4,456			—
Deferred income taxes		(1,957	)		402
Equity in income of limited partnerships		(902	)		(6,569	)
Minority interests in income of consolidated companies		3,580			4,438
Change in receivables		(1,792	)		(1,572	)
Change in deposits with clearing brokers		(8	)		(731	)
Change in securities owned		(11,367	)		(994	)
Change in other assets and prepaid expenses		(505	)		212
Change in accounts payable and accrued liabilities		(467	)		(3,924	)
Change in securities sold, not yet purchased		9,623			834
Change in payable to clearing broker-dealers		(1,768	)		9
Change in net liabilities of discontinued operations		192			(34	)
Net cash provided by operating activities		4,081			2,924
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures		(4,001	)		(1,876	)
Acquisitions, net of cash acquired of $0 and $421, respectively		—			(16,106	)
Purchase of securities available for sale		—			(1,132	)
Proceeds from sales and maturities of securities available for sale		418			268
Net cash used in investing activities		(3,583	)		(18,846	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from shares issued pursuant to employee benefit plan		1,163			2,102
Tax benefit of stock options exercised		424			568
Collection of receivable for shares issued		15			—
Proceeds from borrowings		8,119			10,500
Repayment of borrowings		(3,470	)		—
Investments by minority interests		47			41
Distributions to minority interests		(2,169	)		(1,083	)
Payments of cash dividends		(2,572	)		(2,342	)
Net cash provided by financing activities		1,557			9,786
Net increase (decrease) in cash and cash equivalents		2,055			(6,136	)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD		17,475			21,678
CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	19,530		$	15,542

The accompanying notes are an integral part of the condensed consolidated financial statements.

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SANDERS MORRIS HARRIS GROUP INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. BASIS OF PRESENTATION

Nature of Operations

Through its operating subsidiaries Sanders Morris Harris Inc. (“Sanders Morris Harris” or “SMH”), Salient Capital Management, LLC (“Salient”), SMH Capital Advisors, Inc. (“SMCA”), Charlotte Capital, LLC, The Edelman Financial Center, LLC (“Edelman”), and Select Sports Group, Ltd (“SSG”), Sanders Morris Harris Group Inc. (“SMHG” or “the Company”) provides a broad range of financial and other professional services, including asset and wealth management (including investment advice and management, financial planning, trust related services, sports representation and management), investment and merchant banking, and institutional services (including institutional sales and trading, prime brokerage, and research). The Company serves a diverse group of institutional, corporate, and individual clients.

The Company merged with and acquired its operating subsidiaries from 1999 through 2005. The acquisitions were accounted for using the purchase method and accordingly, results of an acquired entity are included in the Company’s condensed consolidated financial statements from the date of acquisition. As a result the current period results are not comparable to the prior periods.

During the third quarter of 2006, the Company made the decision to close and closed most of the activities of the division known as Fixed Income National, which began operations during the first quarter of 2006. Fixed Income National provided fixed income brokerage services to institutional clients. The operating results of that portion of Fixed Income National that was closed have been recorded as discontinued operations and are not included in the segment discussions. The operating results of the portion of the division that was not discontinued is included in the Institutional Services segment.

Consolidation

The unaudited condensed consolidated financial statements of the Company include the accounts of its subsidiaries. All material intercompany transactions and balances have been eliminated in consolidation.

In management's opinion, the unaudited condensed consolidated financial statements include all adjustments necessary for a fair presentation of our consolidated financial position at September 30, 2006, our results of operations for the three and nine months ended September 30, 2006 and 2005, and our cash flows for the nine months ended September 30, 2006 and 2005. All adjustments are of a normal recurring nature. Interim results are not necessarily indicative of results for a full year.

These financial statements and notes should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

Effects of Recently Issued Accounting Standards

In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123R, Share-Based Payment (Revised 2004). SFAS No. 123R established standards for the accounting for transactions in which an entity (1) exchanges its equity instruments for goods or services, or (2) incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of the equity instruments. SFAS No. 123R eliminated the ability to account for stock-based compensation using APB 25 and requires that such transactions be recognized as compensation cost in the income statement based on their fair values on the date of the grant. SFAS No. 123R was effective for the Company on January 1, 2006. The Company transitioned to fair value based accounting for stock-based compensation using a modified version of prospective application (“modified prospective application”). Under modified prospective application the Company applies SFAS No. 123R to new awards and to awards modified, repurchased, or cancelled after January 1, 2006. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered (generally

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referring to non-vested awards) that were outstanding as of January 1, 2006 must be recognized as the remaining requisite service is rendered during the period of and/or the periods after the adoption of SFAS No. 123R. The attribution of compensation cost for those earlier awards is based on the same method and on the same grant-date fair values previously determined for the pro forma disclosures required for companies that did not adopt the fair value accounting method for stock-based employee compensation. As a result of the adoption of SFAS No. 123R, the Company recognized additional pretax compensation cost of $50,000 in the first nine months of 2006 for stock-based compensation awards outstanding as of December 31, 2005, for which the requisite service was not fully rendered prior to January 1, 2006. Approximately $71,000 remains to be recognized over 1.01 weighted average years. Future levels of compensation cost recognized related to stock-based compensation awards (including the aforementioned expected costs during the period of adoption) may be impacted by new awards and/or modifications, repurchase and cancellations of existing awards before and after the adoption of this standard. (See Note 11.)

In June 2005 the Emerging Issues Task Force (EITF) issued EITF No. 04-5, Investor’s Accounting for an Investment in a Limited Partnership When the Investor Is the Sole General Partner and the Limited Partners Have Certain Rights. In conjunction with EITF No. 04-5, the FASB staff is planning to amend SOP 78-9, Accounting for Investments in Real Estate Ventures to be consistent with EITF No. 04-5. SOP 78-9-1, Interaction of AICPA Statement of Position 78-9 and EITF No. 04-5, presumes that a general partner controls a limited partnership and therefore should consolidate the partnership. This presumption can be overcome if the limited partners have kick-out or substantive participating rights. As all of the limited partnerships for which we act as general partner have kick-out or substantive participating rights, the impact that these new accounting standards had on our consolidated financial statements was minimal. The effective date of SOP 78-9-1 and EITF No. 04-5 was January 1, 2006 for existing limited partnerships. EITF 04-5 and SOP 78-9-1 was effective immediately for new and modified limited partnerships.

On July 13, 2006, FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109, was issued. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The new FASB standard also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

The evaluation of a tax position in accordance with FIN 48 is a two-step process. The first step is a recognition process whereby the enterprise determines whether it is more likely than not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. In evaluating whether a tax position has met the more-likely-than-not recognition threshold, the enterprise should presume that the position will be examined by the appropriate taxing authority that has full knowledge of all relevant information. The second step is a measurement process whereby a tax position that meets the more-likely-than-not recognition threshold is calculated to determine the amount of benefit to recognize in the financial statements. The tax position is measured at the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement.

The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. Earlier application is permitted as long as the enterprise has not yet issued financial statements, including interim financial statements, in the period of adoption. The provisions of FIN 48 are to be applied to all tax positions upon initial adoption of this standard. Only tax positions that meet the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized upon adoption of FIN 48. The Company is evaluating the impact that the pronouncement will have on its condensed consolidated financial statements.

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108 (“SAB 108”). SAB 108 allows for the adjustment of the cumulative effect of prior year immaterial errors in assets and liabilities as of the beginning of the fiscal year, with an offsetting adjustment to the

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opening balance of retained earnings. SAB 108 is effective for the Company for its annual financial statement for the year ended December 31, 2006. We are currently evaluating the potential impacts of adopting SAB 108.

Sale of Stock

On September 29, 2006, the Company closed a secondary public offering of 5,000,000 shares of its common stock, resulting in proceeds of $58.4 million, net of underwriting discounts and other expenses. The Company received the proceeds in October 2006 and used $13.2 million to repay the outstanding balance including accrued interest on one of its revolving credit facilities. The remaining amount was invested in a money market fund. The proceeds are recorded as a receivable from broker-dealers at September 30, 2006.

Reclassifications

Certain reclassifications have been made to the 2005 condensed consolidated financial statements to conform them to the 2006 presentation. The reclassifications had no effect on retained earnings, results of operations or cash flows as previously reported.

2. ACQUISITIONS AND DISPOSITION

On May 10, 2005, the Company acquired a 51% interest in The Edelman Financial Center, LLC, one of the leading financial planning firms in the country. The Company will acquire the remaining 49% of Edelman over four years. Edelman, based in Fairfax, Virginia, manages over $2.7 billion in assets. At the initial closing, SMHG bought 51% of the outstanding membership units of Edelman (“the First Tranche Units”). The Company paid $20.0 million, in a combination of cash and shares of the Company’s common stock for the First Tranche Units and is required to pay additional consideration of approximately $4.8 million in a combination of cash and shares of the Company’s common stock based on the profitability of Edelman for the year ended September 30, 2006. The additional consideration, of which approximately $2.4 million will be in cash, and the Company’s common stock with a value of approximately $2.4 million, is scheduled to be paid during the three months ended December 31, 2006.

In May 2008, the Company will purchase an additional 25% membership interest in Edelman. The Company will pay an amount equal to 25% of a multiple of between 8 and 11 times Edelman’s pretax income for the fiscal year ending December 31, 2007 (the “Second Tranche Consideration”). The multiple will be determined based upon the compound annual growth rate of Edelman’s pretax income for the period beginning January 1, 2007 and ending December 31, 2007 over the pretax income for the period beginning January 1, 2005 and ending December 31, 2005. The Second Tranche Consideration will be paid in a combination of cash and the Company’s common stock.

In May 2009, the Company will purchase all of the remaining issued and outstanding membership interests of Edelman. The Company will pay an amount equal to 24% of a multiple of between 8 and 11 times Edelman’s pretax income for the fiscal year ending December 31, 2008 (the “Third Tranche Consideration”). The multiple will be determined based upon the compound annual growth rate of Edelman’s pretax income for the period beginning January 1, 2008 and ending December 31, 2008 over the pretax income for the period beginning January 1, 2005 and ending December 31, 2005. The Third Tranche Consideration will also be paid in a combination of cash and the Company’s common stock.

The aggregate issuances of common stock may never exceed 20% of the total number of shares of the Company’s common stock issued and outstanding on the initial closing date. The shares of common stock issued were not registered in reliance upon the exemption provided in Section 4(2) of the Securities Act of 1933.

The acquisition was accounted for as a purchase, and accordingly, the financial information of Edelman has been included in the Company’s consolidated financial statements from May 10, 2005. Consideration of

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$24.8 million exceeded the fair market value of identifiable net tangible assets by approximately $25.0 million, which has been recorded as goodwill.

On April 15, 2005, the Company acquired a 50% interest in an investment advisory business of two financial advisors who are based in Colorado Springs, Colorado. The customer accounts were added to those of Sanders Morris Harris and the business operates as SMH Colorado. As the Company may exercise control to a degree greater than its voting interests, the acquisition was accounted for as a purchase, and accordingly, the financial information of SMH Colorado has been included in the Company’s consolidated financial statements from April 15, 2005. The consideration of $2.5 million, consisting of a combination of cash and shares of the Company’s common stock, exceeded the fair market value of identifiable net tangible assets by $2.5 million, which has been recorded as goodwill.

On April 1, 2005, the Company sold its Douglas, Noyes division to a third party. The Company retained cash, receivables, and fixed assets, as well as all accounts payable and accrued liabilities associated with Douglas, Noyes. In April 2006 and continuing thereafter, the Company receives a portion of the investment advisory fees earned by Douglas, Noyes. SMHG recorded no gain or loss on the sale of Douglas, Noyes. Douglas, Noyes, based in New York City provides investment management services.

3. SECURITIES OWNED AND SECURITIES SOLD, NOT YET PURCHASED

Securities owned and securities sold, not yet purchased as of September 30, 2006 and December 31, 2005 were as follows:

	September 30, 2006				December 31, 2005
			Sold, Not Yet				Sold, Not Yet
	Owned		Purchased		Owned		Purchased
	(in thousands)				(in thousands)
	(unaudited)
Marketable:
U.S. government and agency	$	1,223	$	20	$	4,619	$	2,019
Corporate stocks and options		33,152		17,730		18,096		6,149
Corporate bonds		8,624		41		7,933		—
		42,999		17,791		30,648		8,168
Not readily marketable:
Partnerships		35,002		—		34,108		—
Corporate stocks and warrants		7,925		—		8,901		—
	$	85,926	$	17,791	$	73,657	$	8,168

Securities not readily marketable include investment securities (a) for which there is no market on a securities exchange or no independent publicly quoted market, (b) that cannot be publicly offered or sold unless registration has been effected under the Securities Act of 1933, or (c) that cannot be offered or sold because of other arrangements, restrictions, or conditions applicable to the securities or to the Company. Not readily marketable securities consist of investments in limited partnerships, equities, options, and warrants. The investments in limited partnerships are accounted for using the equity method, which approximates fair value, and principally consist of Environmental Opportunities Fund, L.P., Environmental Opportunities Fund II, L.P., Environmental Opportunities Fund II (Institutional), L.P., Corporate Opportunities Fund, L.P., Corporate Opportunities Fund (Institutional), L.P., Sanders Opportunity Fund, L.P., Sanders Opportunity Fund (Institutional), L.P., Tactical Opportunities High Yield Fund, L.P., Life Sciences Opportunity Fund, L.P., Life Sciences Opportunity Fund (Institutional), L.P., Life Sciences Opportunity Fund II, L.P., Life Sciences Opportunity Fund (Institutional) II, L.P., 2003 Houston Energy Partners, L.P., 2005 Houston Energy Partners, L.P., Concept Capital, LLC, Select Sports Group, Ltd., Endowment Advisors, L.P., SMH Private Equity Group I, L.P., SMH Private Equity Group II, L.P., Salient Enhanced Credit Fund, L.P., Salient Total Return Fund, L.P., and Global Hedged Equity Fund, L.P.

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4. SECURITIES AVAILABLE FOR SALE

Securities available for sale at September 30, 2006 were as follows:

	Amortized		Gross Unrealized					Estimated
	Cost		Gains		Losses			Fair Value
	(in thousands)
U.S. Government and agency obligations	$	718	$	4	$	(8	)	$	714
Corporate bonds		250		—		—			250
Marketable equity securities		459		90		(19	)		530
Total	$	1,427	$	94	$	(27	)	$	1,494

The contractual maturities of debt securities available for sale at September 30, 2006, were as follows (in thousands):

Due before 5 years	$	742
Due after 25 years through 30 years	$	221

Gross realized gains on sales of securities available for sale were $12,000 for the nine months ended September 30, 2006 and $21,000 for the nine months ended September 30, 2005. Gross realized losses on securities available for sale were $1,000 for the nine months ended September 30, 2006 and $19,000 for the nine months ended September 30, 2005.

5. INCOME TAXES

The differences between the effective tax rate reflected in the income tax provision from continuing operations and the statutory federal rate were as follows:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2006		2005		2006		2005
	(in thousands)
Tax computed using the statutory rate	$	153	$	2,149	$	1,301	$	4,550
State income taxes and other		47		335		200		735
Total	$	200	$	2,484	$	1,501	$	5,285

6. BORROWINGS

During May 2005, the Company entered into a $15.0 million revolving credit facility with a bank. The line of credit expires in May 2007, unless extended. Borrowings under the line of credit bear interest based on LIBOR. The interest rate on the Company’s borrowings ranged from 5.85% to 6.97% during 2006. The credit facility is secured by a pledge of ownership interests in two of the Company’s subsidiaries. Debt covenants require the Company to maintain certain debt-to-EDITDA and liquidity to funded debt ratios, as well as minimum assets under management. At September 30, 2006, the Company was not in compliance with its debt-to-EBITDA covenant. The Company has received a waiver from the bank dated effective September 30, 2006, and was in full compliance with the credit agreement as of October 4, 2006. The outstanding balance on the line of credit was $13.0 million at September 30, 2006, but was paid in full on October 4, 2006.

During December 2005, Salient entered into a $2.5 million revolving credit facility with a bank. The line of credit expires in December 2007. Borrowings under the line of credit bear interest based on LIBOR. The interest rate of Salient’s borrowings ranged from 6.03% to 7.05% during 2006. The credit facility is

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unsecured and not subject to financial covenants; however, SMHG and the principals of Salient guarantee payment. The outstanding balance on the line of credit was $ 855,000 at September 30, 2006.

During December 2005, Edelman entered into a $1.5 million construction loan agreement with a bank. Proceeds from the loan were used to build out Edelman’s new office facilities. The loan is not subject to financial covenants and is secured by Edelman’s property and other assets and guaranteed by Mr. Edelman and SMHG. Beginning in January 2006 and ending in December 2006, interest will be paid in monthly installments at an interest rate, which is based on prime. The interest rate on Edelman’s borrowings ranged from 6.75% to 7.75% during 2006. Principal and interest payments will be made in equal monthly installments beginning in January 2007 and ending in December 2013. At September 30, 2006, the outstanding balance on the loan was $1.5 million.

7. COMMITMENTS AND CONTINGENCIES

In April 2004, the Company acquired a 69% interest in Charlotte Capital from a previous investor. Employees of Charlotte Capital retained a 31% ownership interest in the firm. Employees of Charlotte Capital can earn up to an additional 9% ownership interest by achieving specified revenue run rates during the 36-month period beginning January 1, 2006 and ending December 31, 2009. No additional consideration has been earned as of September 30, 2006.

The Company is required to pay approximately $2.4 million in cash and is obligated to grant shares of its common stock to the minority shareholder of Edelman Financial Center based on the profitability of Edelman for the year ended September 30, 2006. The number of shares to be granted will be equal to approximately $2.4 million divided by the average of the high and low sales prices multiplied by the daily trading volume on each of the ten trading days immediately preceding the date of delivery of the shares to the minority shareholder of Edelman. Those shares are scheduled to be issued prior to December 31, 2006.

The Company has issued letters of credit in the amounts of $1.0 million, $199,000, $144,000, and $92,000 to the owners of four of the offices that we lease to secure payment of our lease obligations for those facilities. The Company has issued a letter of credit in the amount of $100,000 to secure the payment of the deductible portion of the Company’s workers compensation insurance policy.

The Company has uncommitted financing arrangements with clearing brokers that finance our customer accounts, certain broker-dealer balances, and firm trading positions. Although these customer accounts and broker-dealer balances are not reflected on the consolidated balance sheet for financial accounting reporting purposes, the Company has generally agreed to indemnify these clearing brokers for losses they may sustain in connection with the accounts, and therefore, retains risk on these accounts. The Company is required to maintain certain cash or securities on deposit with our clearing brokers.

In the normal course of business, the Company enters into underwriting commitments. There were no firm underwriting commitments open at September 30, 2006.

The NASD initially conducted an inspection of our prime brokerage and private investment or hedge fund support operations based in our New York office in November 2004. Subsequent to such inspection, the NASD opened an investigation and requested the production of additional documents and materials on twelve occasions in 2005 and 2006 with respect to our prime brokerage and related hedge fund operations and has conducted formal interviews of a number of our employees involved in these operations. On August 16, 2006, Sanders Morris Harris received a “Wells letter” notification from the NASD, which states that the staff of the NASD has made a preliminary determination to recommend that disciplinary action be brought against Sanders Morris Harris and four of its employees based on alleged violations of certain conduct rules of the NASD, including NASD Conduct Rule 2110 relating to the alleged improper payment of soft dollar commissions to a fund manager and relating to the alleged improper sharing of commissions by two employees contrary to a written contract with an investment adviser and representations to the investors in one private investment partnership; NASD Conduct Rule 2210 relating to the content of hedge fund advertising materials; SEC Rule 17a-4 and NASD Conduct Rules 2210 and 3110 relating to the retention of

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certain email, instant messages, and advertising materials; NASD Conduct Rules 1031 and 2110 relating to the activities of an unregistered employee; and NASD Conduct Rules 2110 and 3010 relating to the written supervisory procedures of Sanders Morris Harris for its hedge fund and prime brokerage operations. Under the Wells procedure, Sanders Morris Harris has an opportunity to respond to the NASD before any action is taken against it. Sanders Morris Harris submitted its response to the NASD on October 11, 2006. There is no assurance that a prompt resolution can be reached or that the ultimate impact on the Company will not be material. Discussions have commenced between the staff of the NASD and our legal counsel with respect to the alleged violations.

We are aware that a company for which Sanders Morris Harris acted as placement agent in a private placement of convertible preferred shares in June 2005 has experienced a significant decline in its net sales, a significant increase in its net loss, and currently has negative working capital. While the company has obtained financing to meet its short-term working capital requirements, there is no assurance that it will be able to sustain its business. We have received written and oral communications from a number of the purchasers of securities in the offering expressing their dissatisfaction and indicating that they may seek legal recourse with respect to the offering. No litigation has been filed at this time. While we believe Sanders Morris Harris has valid defenses to any claims and is entitled to indemnification and contribution provisions of the placement agent agreement, the costs of defending any litigation filed naming Sanders Morris Harris could be significant and an adverse determination could have a material effect on quarterly or annual operating results in the period in which it is resolved. Two managing directors of Sanders Morris Harris served as directors of the company from June 2005 to June 2006.

The Company is a party to various legal proceedings that are of an ordinary or routine nature incidental to its operations. The Company believes it has adequately reserved for such litigation matters and that they will not have a material adverse effect on consolidated financial position, results of operations or cash flows.

The Company and its subsidiaries have obligations under operating leases with initial noncancelable terms in excess of one year that expire by 2014.

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8. (LOSS) EARNINGS PER COMMON SHARE

Basic and diluted (loss) earnings per share computations for the periods indicated were as follows:

	Three Months Ended September 30,
	2006			2005
	(in thousands, except per share amounts)
Computation of basic and diluted (loss) earnings per common share:
Income from continuing operations	$	249		$	3,656
Loss from discontinued operations, net of tax		(547	)		—
Net (loss) income	$	(298	)	$	3,656
Weighted average common shares outstanding		19,370,879			18,845,323
Weighted average common shares committed		190,431			—
Total basic shares outstanding		19,561,310			18,845,323
Common shares issuable under stock option plan		773,335			894,771
Less shares assumed repurchased with proceeds		(340,801	)		(338,888	)
Weighted average common shares outstanding		19,993,844			19,401,206
Basic (loss) earnings per share:
From continuing operations	$	0.01		$	0.19
From discontinued operations	$	(0.03	)	$	—
Net (loss) earnings per share	$	(0.02	)	$	0.19
Diluted (loss) earnings per share:
From continuing operations	$	0.01		$	0.19
From discontinued operations	$	(0.03	)	$	—
Net (loss) earnings per share	$	(0.02	)	$	0.19

	Nine Months Ended September 30,
	2006			2005
	(in thousands, except per share amounts)
Computation of basic and diluted earnings per common share:
Income from continuing operations	$	2,325		$	7,715
Loss from discontinued operations, net of tax		(1,565	)		—
Net income	$	760		$	7,715
Weighted average common shares outstanding		19,160,863			18,587,184
Weighted average common shares committed		64,175			—
Total basic shares outstanding		19,225,038			18,587,184
Common shares issuable under stock option plan		873,335			904,771
Less shares assumed repurchased with proceeds		(410,356	)		(299,470	)
Weighted average common shares outstanding		19,688,017			19,192,485
Basic earnings (loss) per share:
From continuing operations	$	0.12		$	0.42
From discontinued operations	$	(0.08	)	$	—
Net earnings (loss) per share	$	0.04		$	0.42
Diluted earnings (loss) per share:
From continuing operations	$	0.12		$	0.40
From discontinued operations	$	(0.08	)	$	—
Net earnings (loss) per share	$	0.04		$	0.40

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Outstanding stock options (172,500 for the three months ended September 30, 2006, and 22,500 for the three months ended September 30, 2005; and 72,500 for the nine months ended September 30, 2006, and 12,500 for the nine months ended September 30, 2005) have not been included in diluted earnings per common share because to do so would have been antidilutive for the periods presented.

9. GOODWILL

During the three months ended September 30, 2006, the Company recorded goodwill of $4.8 million representing additional consideration to be paid to the minority shareholder of Edelman Financial Center based on the profitability of Edelman for the year ended September 30, 2006.

During the nine months ended September 30, 2006, the Company recognized goodwill impairment charges totaling $4.5 million related to its ownership of Charlotte Capital. The principal factor contributing to our decision to record the impairment charge related to the continuing decline of assets under management and to the fact that Charlotte Capital is not profitable at the current level of assets under management. Charlotte Capital’s assets under management have declined from $429 million at December 31, 2004 to $170 million at September 30, 2006, primarily due to portfolio performance that has lagged the benchmark returns for the small and small/mid cap value styles that Charlotte Capital follows. Charlotte Capital provides investment management services to ten institutional investors, the loss of any one of which could have a material adverse impact on Charlotte Capital’s assets under management and, consequently, Charlotte Capital’s revenues and earnings.

10. SUBSEQUENT EVENT

On October 30, 2006, Charlotte Capital made the decision to terminate its existing advisory agreements and wind up its business. The assets and liabilities of the business consist primarily of accounts receivable from customers and obligations incurred in the normal course of business. We do not anticipate material losses associated with the closure of the business. The condensed consolidated financials of the Company as of September 30, 2006, do not reflect any expense or liability associated with this exit activity.

11. BUSINESS SEGMENT INFORMATION

SMHG operates through four business segments: Asset and Wealth Management, which can be further divided into Asset Management and Retail Brokerage; Institutional Services, which can be further divided into Institutional Brokerage and Prime Brokerage; Investment Banking; and Corporate and Other. The business segments are based upon factors such as the services provided and distribution channels served. Certain services are provided to customers through more than one of our business segments.

During the third quarter of 2006, the Company made the decision to close and closed most of the activities of the division known as Fixed Income National, which began operations during the first quarter of 2006. Fixed Income National provided fixed income brokerage services to institutional clients. The operating results of that portion of Fixed Income National that was closed have been recorded as discontinued operations and are not included in the segment discussions. The operating results of the portion of the division that was not discontinued is included in the Institutional Services segment.

Asset and Wealth Management

The Asset Management segment provides investment advisory, wealth and investment management, financial planning, and trust services to institutional and individual clients. The Company earns an advisory fee based on such factors as the amount of assets under management and the type of services provided. The asset management segment may also earn commission revenues from the sale of equity, fixed income, mutual fund, and annuity products; and sales credits from the distribution of investment banking issues. In addition, performance fees may be earned for exceeding performance benchmarks for the investment portfolios in the limited partnerships that we manage.

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The Retail Brokerage segment distributes a range of financial products through its branch distribution network, including equity and fixed income securities, mutual funds, and annuities. Retail revenues consist of commissions and principal credits earned on equity and fixed income transactions in customer brokerage accounts, distribution fees earned from mutual funds, fees earned from managed accounts, and net interest on customers’ margin loan and credit account balances. Additionally, retail revenues include sales credits from investment banking transactions such as the distribution of underwritings that we co-manage or in which we participate and private placements of securities in which we serve as placement agent. The firm employs registered representatives and also licenses independent financial advisors.

Institutional Services

The Institutional Brokerage segment distributes equity and fixed income products through its distribution network to its institutional clients. Institutional revenues consist of commissions and principal credits earned on transactions in customer brokerage accounts, net interest on customers’ margin loan and credit account balances, and sales credits from the distribution of investment banking products.

The Prime Brokerage segment provides trade execution, clearing, custody and other back-office services to hedge funds and other professional traders. Prime broker revenues consist of commissions and principal credits earned on equity, and fixed income transactions; interest income from securities lending services to customers; and net interest on customers’ margin loan and credit account balances.

Investment Banking

The Investment Banking segment provides corporate securities underwriting, private financings, and financial advisory services. The Company participates in corporate securities distributions as a manager, co-manager or member of an underwriting syndicate or of a selling group in public offerings managed by other underwriters. Fees earned for our role as an advisor, manager, or underwriter are included in the investment banking segment. Sales credits associated with the distribution of investment banking products are reported in Retail Brokerage, Institutional Brokerage, or Asset Management depending on the relevant distribution channel.

Corporate and Other

The Corporate and Other segment include realized and unrealized gains and losses on the Company’s investment portfolios and interest and dividends earned on our cash and securities positions. Unallocated corporate revenues and expenses are included in Corporate and Other. Gains and losses from sports representation and management services performed by SSG are included in Corporate and Other.

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The following summarizes certain financial information of each reportable business segment for the Three and Nine Months in the period ended September 30, 2006 and 2005, respectively. SMHG does not analyze asset information in all business segments.

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
	(in thousands)
Revenues:
Asset and Wealth Management
Asset Management	$	15,693		$	12,340		$	44,912		$	29,534
Retail Brokerage		3,965			3,765			13,868			11,794
Asset and Wealth Management Total		19,658			16,105			58,780			41,328
Institutional Services
Institutional Brokerage		5,196			6,547			17,922			19,404
Prime Brokerage		9,036			4,978			25,204			13,855
Institutional Services Total		14,232			11,525			43,126			33,259
Investment Banking		8,634			5,465			23,975			13,414
Corporate and Other		(820	)		1,316			1,601			3,249
Total	$	41,704		$	34,411		$	127,482		$	91,250
Income (loss) from continuing operations before equity in
(loss) income of limited partnerships, minority interest
and income taxes:
Asset and Wealth Management
Asset Management	$	4,801		$	3,396		$	12,285		$	7,747
Retail Brokerage		(16	)		136			(971	)		927
Asset and Wealth Management Total		4,785			3,532			11,314			8,674
Institutional Services
Institutional Brokerage		(102	)		966			147			2,605
Prime Brokerage		269			390			1,389			1,388
Institutional Services Total		167			1,356			1,536			3,993
Investment Banking		3,018			2,140			8,566			4,756
Corporate and Other		(5,292	)		(2,242	)		(14,912	)		(6,554	)
Total	$	2,678		$	4,786		$	6,504		$	10,869
Equity in (loss) income of limited partnerships:
Asset and Wealth Management
Asset Management	$	(1,727	)	$	3,459		$	395		$	5,637
Retail Brokerage		—			—			—			—
Asset and Wealth Management Total		(1,727	)		3,459			395			5,637
Institutional Services
Institutional Brokerage		—			—			—			—
Prime Brokerage		—			—			—			—
Institutional Services Total		—			—			—			—
Investment Banking		—			—			—			—
Corporate and Other		56			709			507			932
Total	$	(1,671	)	$	4,168		$	902		$	6,569

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	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
	(in thousands)
Minority interests in net income of consolidated
companies:
Asset and Wealth Management
Asset Management	$	(558	)	$	(2,698	)		(3,580	)		(4,251	)
Retail Brokerage		—			—			—			—
Asset and Wealth Management Total		(558	)		(2,698	)		(3,580	)		(4,251	)
Institutional Services
Institutional Brokerage		—			—			—			—
Prime Brokerage		—			—			—			—
Institutional Services Total		—			—			—			—
Investment Banking		—			—			—			—
Corporate and Other		—			(116	)					(187	)
Total	$	(558	)	$	(2,814	)	$	(3,580	)	$	(4,438	)
Income (loss) from continuing operations before income taxes:
Asset and Wealth Management
Asset Management	$	2,516		$	4,157		$	9,100		$	9,134
Retail Brokerage		(16	)		136			(971	)		927
Asset and Wealth Management Total		2,500			4,293			8,129			10,061
Institutional Services
Institutional Brokerage		(102	)		966			147			2,605
Prime Brokerage		269			390			1,389			1,388
Institutional Services Total		167			1,356			1,536			3,993
Investment Banking		3,018			2,140			8,566			4,756
Corporate and Other		(5,236	)		(1,649	)		(14,405	)		(5,810	)
Total	$	449		$	6,140		$	3,826		$	13,000

12. ACCOUNTING FOR STOCK BASED COMPENSATION PLANS

Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123R, Share-Based Payment (Revised 2004), which requires the Company to recognize the cost of all stock-based compensation in its consolidated financial statements. The Company’s equity-classified awards are measured at grant-date fair value and are not subsequently remeasured. The valuation of equity instruments underlying stock-based compensation, and the period during which the expense is recognized is based on assumptions related to stock volatility, interest rates, vesting terms, and dividend yields. Changes in these assumptions, including forfeiture rates, could have significant impacts on the expense recognized. The Company recognized additional pretax compensation expense of $128,000 during the third quarter of 2006, and $213,000 for the nine months ended September 30, 2006 as a result of the adoption of SFAS No. 123R, which includes compensation expense relating to stock-based compensation awards outstanding as of December 31, 2005 and grants made subsequent to December 31, 2005.

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The following table illustrates the pro forma effect on net income and earnings per share as if the Company had applied the fair value recognition provisions of SFAS No. 123 for the three and nine months ended in September 30, 2005.

	Three Months			Nine Months
	(in thousands, except per share amounts)
Net income as reported	$	3,656		$	7,715
Deduct: Total stock based employee compensation
expense determined under fair value based
method for all awards, net of related tax effects		(27	)		(114	)
Pro forma income	$	3,629		$	7,601
Earnings per share:
Basic-as reported	$	0.19		$	0.42
Basic-pro forma	$	0.19		$	0.41
Diluted-as reported	$	0.19		$	0.40
Diluted-pro forma	$	0.19		$	0.40

Under its 1998 Incentive Plan, as amended, (the Incentive Plan), the Company has reserved 25% of the outstanding common stock of the Company, or 4,000,000 shares of common stock, whichever is greater, for the purpose of issuing incentive awards under the Incentive Plan. The Company had 2,290,026 shares of common stock available for grant under the Incentive Plan at September 30, 2006.

The Company has two types of stock-based compensation awards: (1) stock options, and (2) restricted common stock.

Stock Options

The Incentive Plan provides for the issuance to eligible employees of, among other things, incentive and non-qualified stock options that may expire up to 10 years from the date of grant. The outstanding options vest over one to five year service periods and have an exercise price equal to the closing price of the Company’s stock on the date of the grant. Unvested options on the date of termination of employment are forfeited within 90 days of termination. Typically, new shares are issued upon the exercise of stock options.

During the nine months ended September 30, 2006, 119,436 options were exercised for which the Company received proceeds of $627,000. During the nine months ended September 30, 2005, 141,757 options were exercised for which the Company received proceeds of $742,000.

As a result of the adoption of SFAS No. 123R, the Company recognized additional pretax compensation cost of $50,000 in the first nine months of 2006 for stock-based compensation awards outstanding as of December 31, 2005, for which the requisite service was not fully rendered prior to January 1, 2006. Approximately $71,000 remains to be recognized over 1.01 weighted average years. During the nine months ended September 30, 2006, 150,000 options were granted with a weighted average fair value of $547,000.

The intrinsic value of stock options exercised totaled $1.2 million during the nine months ended September 30, 2006 and $1.6 million for the nine months ended September 30, 2005.

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The following table sets forth pertinent information regarding stock option transactions for the nine months ended September 30, 2006.

				Weighted
	Number			Average
	of Shares			Exercise Price
Outstanding at January 1, 2006		915,271		$	6.42
Granted		150,000			15.19
Exercised		(119,436	)		5.20
Outstanding at September 30, 2006		945,835		$	5.11
Options exercisable at December 31, 2005		850,271		$	5.98
Options exercisable at September 30, 2006		804,585		$	6.76
Options available for grant at December 31, 2005		1,360,889
Options available for grant at September 30, 2006		2,290,026

The following table summarizes information related to stock options outstanding and exercisable at September 30, 2006:

	Options Outstanding						Options Exercisable
��	Number		Wgtd. Avg.				Number		Wgtd. Avg.
Range of	Outstanding		Remaining		Wgtd. Avg.		Exercisable		Remaining		Wgtd. Avg.
Exercise Prices	at 9/30/2006		Contr. Life		Exercise Price		at 9/30/2006		Contr. Life		Exercise Price
$4.44-$6.04		615,835		3.28	$	4.83		615,835		3.28	$	4.83
$7.91-$10.00		25,000		6.38		8.16		25,000		6.38		8.16
$12.02-$17.20		305,000		8.71		14.27		163,750		8.20		13.80
$4.44-$17.20		945,835		5.11		7.96		804,585		4.38		6.76

The aggregate intrinsic value of options outstanding at September 30, 2006, was $4.3 million. The aggregate intrinsic value of options exercisable at September 30, 2006, was $4.6 million.

The fair value of options at date of grant was estimated using the Black-Scholes option-pricing model with the following weighted-average assumptions:

	Nine Months Ended
	September 30,
	2006			2005
Estimated life in years		10.00			10.00
Interest rate		4.878% - 5.093	%		4.049% - 4.210	%
Volatility		19.24% - 19.51	%		22.23% - 26.58	%
Dividend yield		1.23% - 1.24	%		1.05% - 1.17	%

Restricted Common Stock

The Incentive Plan permits the Company to grant restricted common stock to its employees. Additionally, eligible employees and consultants are allowed to purchase in lieu of salary, commission, or bonus, shares of the Company’s restricted common stock at a price equal to 66.6% of the 20-day average of the closing sales prices for a share of the Company’s common stock, ending on the day prior to the date the shares were issued. All shares are valued at the closing price on the date the shares are issued. The value of

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restricted shares granted, less consideration paid, if any, is amortized to compensation expense over the one to five-year vesting periods assuming continued employment through such date.

Employees deferred compensation of $536,000 during the nine months ended September 30, 2006, and $306,000 during the nine months ended September 30, 2005, that was used to purchase restricted common stock. The Company recognized compensation expense of $1.8 million during the nine months ended September 30, 2006, and $1.5 million during the nine months ended September 30, 2005, related to its restricted common stock plan.

The following table summarizes certain information related to restricted common stock grants at September 30, 2006:

			Weighted
	Number of		Average
	Shares		Grant Date Fair Value
Nonvested at January 1, 2006		378,059	$	13.60
Nonvested at September 30, 2006		525,450	$	14.55
For the nine months ended September 30, 2006:
Granted		268,840	$	15.14
Vested		120,436	$	12.87
Forfeited		1,211		—

During the nine months ended September 30, 2006, the Company granted 268,840 restricted common shares with a weighted average grant date fair value of $15.14. During the nine months ended September 30, 2005, the Company granted 123,496 restricted common shares with a weighted average grant date fair value of $16.59. During the nine months ended September 30, 2006, 120,436 restricted common shares vested with a weighted average grant date fair value of $12.87. During the nine months ended September 30, 2005,189,361 restricted common shares vested with a weighted average grant date fair value of $9.01. At September 30, 2006, total unrecognized compensation cost, net of estimated forfeitures related to nonvested restricted stock totaled $5.0 million and is expected to be recognized over the next 58 months.

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13. SUPPLEMENTAL CASH FLOW INFORMATION

	Nine Months Ended
	September 30,
	2006			2005
	(in thousands)
	(unaudited)
Cash paid for income taxes, net	$	606		$	5,807
Cash paid for interest		631			193
Noncash activities:
Acquisitions and consolidation:
Fixed assets		—			338
Other assets		—			250
Goodwill		4,831			22,676
Accounts payable and accrued liabilties		(67	)		(811	)
Minority interest		—			(97	)
Commitment to issue common stock		(2,382	)		—
Sale of stock:
Receivable from broker-dealers		58,544			—
Common stock		(50	)		—
Additional paid in capital		(57,897	)		—
Other assets		(500	)		—
Accounts payable		(97	)		—
Consideration payable		(2,382	)		—

14. RELATED PARTIES

The Company had receivables from related parties totaling $5.1 million at September 30, 2006, primarily consisting of $3.6 million of notes receivable from employees and consultants representing, primarily loans made to induce the employees and consultants to affiliate with the Company.

15. DISCONTINUED OPERATIONS

During the third quarter of 2006, the Company made the decision to close and closed most of the activities in the division known as Fixed Income National. The Company exited the mortgage-backed, agency, and high-grade corporate bond businesses in New York City, but will continue the high-yield and syndicate activities. In conjunction with the discontinuance of certain activities of the Fixed Income National division, during the nine months ended September 30, 2006 the Company recorded a loss of $1.6 million, net of tax, for operating losses, and for costs related to the exit of the business including compensation commitments, abandoned leases, and other expenses.

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A summary of selected financial information of discontinued operations for the three and nine months ended September 30, 2006 is as follows (in thousands):

	Three			Nine
	Months			Months
Operating activities:
Revenues	$	1		$	837
Expenses		685			3,147
Loss from discontinued operations before income taxes		684			2,310
Benefit for income taxes		257			865
Net loss from operations, net of tax		(427	)		(1,445	)
Costs related to exit of business, net of tax		(120	)		(120	)
Loss from discontinued operations, net of tax	$	(547	)	$	(1,565	)

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

The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements and their related notes.

Overview

Sanders Morris Harris Group (the “Company” or “SMHG”) is a holding company that, through its subsidiaries and affiliates, provides asset and wealth management, investment banking, and institutional services to a large and diversified group of clients and customers, including individuals, corporations, and financial institutions. A summary of these services follows:

Asset and Wealth Management provides investment advisory, wealth and investment management, financial planning, and trust services, to high net worth and mass affluent individuals and institutions, including investment strategies and alternatives, tax efficient estate and financial planning, trusts, and agent/fiduciary investment management services, throughout their financial life cycle, as well as private client brokerage services. In addition, we provide specialized asset management products and services in specific investment styles to corporations and institutions both through internal marketing efforts and externally through formal sub-advisory relationships and other distribution arrangements with third parties.

Investment Banking includes capital raising, public offerings and private placements of equity and debt securities, financial advisory services, including advice on mergers, acquisitions and restructurings, and merchant banking services.

Institutional Services provides institutional equity and fixed income brokerage, institutional research, prime brokerage, and proprietary trading to a broad array of institutions throughout North America, Europe, and Asia, including banks, retirement funds, mutual funds, endowments, investment advisors, and insurance companies.

We have expanded both the range and depth of services offered to our clients through a combination of acquisitions and internal expansion. This growth has necessitated that we add additional personnel, as well as production-related incentive compensation plans. We have also improved and expanded our infrastructure including facilities, technology, and information services, to enable us to better compete with other firms that offer services similar to ours.

Our financial services business is affected by general economic conditions. Our revenues relating to asset-based advisory services and managed accounts are typically from fees based on the market value of assets under management or administration. The growth in assets under our management resulted in higher management fees for us. While growth in assets under management has resulted in higher management fees for us, the instability in the overall stock market, lower trading volume, and reduced commission rates have had a negative impact on our commission revenue.

We closely monitor our operating environment to enable us to respond promptly to market cycles. In addition, we seek to lessen earnings volatility by controlling expenses, increasing fee-based business, and developing new revenue sources. Nonetheless, operating results of any specific period should not be considered representative of future performance.

The discussion of the Company’s results of operations below may contain forward-looking statements. These statements, which reflect management’s beliefs and expectations, are subject to risks and uncertainties that may cause actual results to differ materially. For a discussion of the risks and uncertainties that may affect the Company’s future results, please see “Competition” and “Government Regulation” in Part I, Item 1, “Risk Factors” in Part I, Item 1A, and “Factors Affecting Forward-Looking Statements” in Part II, Item 7, and other items throughout the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

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Beginning in the first quarter of 2006, the Company’s retail brokerage business is included in Asset and Wealth Management and the Company’s prime brokerage business is included in institutional services.

Components of Revenue and Expenses

Revenue. Our revenues are comprised primarily of (1) commission revenue from retail, prime and institutional brokerage transactions, (2) fees from asset-based advisory services, asset management, financial planning, and fiduciary services (3) principal transactions, and (4) investment banking revenue from corporate finance fees, merger and acquisition fees, and merchant banking fees. We also earn interest on cash held and dividends received from the equity and fixed income securities held in our corporate capital accounts and have realized and unrealized gains (or losses) on securities in our inventory account.

Expenses. Our expenses consist of (1) compensation and benefits, (2) floor brokerage and clearing costs, and (3) other expenses. Compensation and benefits have both a variable component based on revenue production, and a fixed component. The variable component includes institutional and retail sales commissions, bonuses, overrides, and other incentives. Retail and institutional commissions are based on competitive commission schedules. Employees of the investment banking group and the research group receive a salary and discretionary bonuses as compensation. The fixed component includes administrative and executive salaries, payroll taxes, employee benefits, and temporary employee costs. Compensation and benefits is our largest expense item and includes wages, salaries, and benefits. During the third quarter of 2006, compensation and benefits represented 68% of total expenses and 63% of total revenue, compared to 67% of total expenses and 58% of total revenue during the third quarter of 2005. During the first nine months of 2006, compensation and benefits represented 65% of total expenses and 62% of total revenues compared to 67% of total expenses and 59% of total revenues for the same period in 2005. Compensation and benefits expense, total expenses, and total revenues included in the above calculations do not include discontinued operations.

Floor brokerage, exchange, and clearance expenses include clearing and trade execution costs associated with the retail, prime, and institutional brokerage business at SMH. SMH clears its transactions through several clearing firms, including Pershing LLC, a member of BNY Securities Group and a subsidiary of The Bank of New York, Goldman Sachs Execution & Clearing, L.P., ADP Clearing & Outsourcing, Inc., and First Clearing Corporation.

Other expenses include (1) occupancy and equipment expenses, such as rent and utility charges for facilities, and (2) communications and data processing expenses, such as third-party systems, data, and software providers.

Results of Operations

Three Months Ended September 30, 2006 Compared to Three Months Ended September 30, 2005

The Company expanded its institutional fixed income brokerage operations during the first quarter of 2006 when a team formerly employed by Advest Group joined the Company. The new division is known as Fixed Income National. During the third quarter of 2006 most of the division was closed and the Company recorded a loss from discontinued operations.

Total revenues were $41.7 million in the third quarter of 2006 compared to $34.4 million for the same quarter in 2005, an increase of $7.3 million, or 21% reflecting the conversion of customer accounts to fee-based from commission-based at Edelman, and growth in investment banking and proprietary trading operations. Total expenses for the third quarter of 2006 increased $9.4 million, or 32% to $39.0 million from $29.6 million in the same quarter of the previous year as the result of increased employee compensation and benefits tied to the increase in revenue and changes in connection with the closure of the Fixed Income National division. Equity in income of limited partnerships declined to a loss of $1.7 million in 2006 from income of $4.2 million in 2005, reflecting the negative impact that the decline in values of energy related securities had on the value of the investment portfolios of the limited partnerships that we manage. Net

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income attributable to minority interest declined to $558,000 during the third quarter of 2006 from $2.8 million during the same period in 2005, primarily due to the decline in value of the investment portfolios of the limited partnerships that we account for using the equity method. The income from continuing operations for the three-month period ended September 30, 2006, totaled $249,000, compared to $3.7 million in the same period in 2005 resulting from the decline in the values of the investment portfolios, and increased compensation costs. Basic and diluted loss per share was $0.02 for the three months ended September 30, 2006, compared to income of $0.19 for the same period in 2005.

Commissions revenue increased to $12.9 million in the third quarter of 2006 from $11.8million for the same period in 2005, primarily as a result of growth in our proprietary trading operations. Investment banking revenue increased to $11.6 million during the third quarter of 2006 from $8.3 million in the same period of 2005, principally due to an increase in advisory fees. Revenues from investment advisory and related services fees increased to $11.1 million in the third quarter of 2006 from $9.2 million in the same quarter of 2005 primarily due to the conversion of customer accounts to fee-based from commission-based at Edelman. Principal transactions revenue totaled $3.3 million for the third quarter of 2006 versus $3.1 million in the third quarter of 2005 reflecting growth in our proprietary trading operations. Interest and dividend income increased to $1.5 million in the third quarter of 2006 from $1.1 million in the same period last year, due to higher margin interest reflecting an increase in margin balances and due to higher earnings from the financing of proprietary trading accounts. Other income increased from $820,000 during the third quarter of 2005 to $1.4 million during the same period in 2006 due to an increase in fees earned on the Company’s cash balance and customer credit balances at its clearing firms resulting from higher deposit balances.

During the three months ended September 30, 2006, employee compensation and benefits increased to $26.4 million from $19.8 million in the same period last year due to more employees and higher revenues during 2006. Floor brokerage, exchange and clearance fees increased to $1.7 million in the third quarter of 2006 from $1.3 million in the same quarter of 2005 reflecting higher clearing and execution costs resulting from the increased trading volume in our proprietary trading operations. Occupancy costs totaled $2.9 million during the third quarter of 2006, compared to $2.2 million in the prior year quarter due to expansion of our New York City offices and the addition of two new retail offices. Other general and administrative expenses increased to $5.8 million during the third quarter of 2006 from $4.3 million in the third quarter of last year mainly due to our growth.

Our effective tax rate from continuing operations was 44.5% for the three months ended September 30, 2006 and 40.5% for the three months ended September 30, 2005. The impact of the nondeductibility of permanent tax differences on a reduced level of taxable income caused the effective tax rate in 2006 to exceed that of 2005.

During the three months ended September 30, 2006, the Company recorded a loss from discontinued operations in the amount of $547,000, net of tax, or $0.03 per basic and diluted share related to its decision to close most of the activities in the division known as Fixed Income National. The loss includes operating losses during the third quarter, as well as accruals for compensation commitments, abandoned leases, and other expenses that will be paid in subsequent periods.

RESULTS BY SEGMENT

During the third quarter of 2006, the Company made the decision to close and closed most of the activities of the division known as Fixed Income National, which began operations during the first quarter of 2006. Fixed Income National provided fixed income brokerage services to institutional clients. The operating results of that portion of Fixed Income National that was closed have been recorded as discontinued operations and are not included in the segment discussions. The operating results of the portion of the division that was not discontinued is included in the Institutional Services segment.

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Asset and Wealth Management

Asset Management

	Three Months Ended September 30,
	2006		2005
	(in thousands)
Revenues	$	15,693	$	12,340
Income before income taxes	$	2,516	$	4,157

Revenues from asset management increased to $15.7 million from $12.3 million, and income before income taxes decreased to $2.5 million from $4.2 million. Commission revenues increased to $3.2 million from $1.7 million, while investment management and related service fees increased to $10.6 million from $9.0 million. The revenue growth is primarily due to the conversion of customer accounts to fee-based from commission-based in our Edelman division. After deducting the costs of mutual fund expenses, Edelman retains a larger portion of the client service fee under a fee-based arrangement than a commission-based arrangement. Total expenses rose to $10.9 million from $9.0 million due to the higher revenues. Equity in income of limited partnerships declined to a loss of $1.7 million in 2006 from income of $3.5 million in 2005, reflecting the negative impact that the decline in values of energy related securities had on the value of the investment portfolios of the limited partnerships that we manage. Minority interests in net income of consolidated companies reflect the portion of net income attributable to minority interest ownership of entities included in this segment’s consolidated financial statements. Income attributable to minority interests, which reduces SMHG’s pretax income, declined to $558,000 million in 2006 from $2.7 million in 2005, principally due to the decline in value of the investment portfolios of the limited partnerships that we account for using the equity method.

Retail Brokerage

	Three Months Ended September 30,
	2006			2005
	(in thousands)
Revenues	$	3,965		$	3,765
(Loss) income before income taxes	$	(16	)	$	136

Revenues from retail brokerage increased to $4.0 million from $3.8 million, and income before income taxes declined to a loss of $16,000 from a profit of $136,000. While revenues increased modestly, expenses increased slightly more resulting in a small loss in the 2006 period.

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Institutional Services

Institutional Brokerage

	Three Months Ended September 30,
	2006			2005
	(in thousands)
Revenues	$	5,196		$	6,547
(Loss) income before income taxes	$	(102	)	$	966

Revenues from institutional brokerage declined to $5.2 million from $6.5 million, and income before income taxes declined to a loss of $102,000 from income of $966,000. Commission revenue declined from $4.2 million to $2.7 million reflecting a decline in both the number of shares traded in our institutional equity division and the commission revenue per share traded. These declines are largely the result of the growth in electronic trading strategy execution software that replaces, in some cases, the role of traditional traders. Principal revenue declined from $1.2 million to $634,000 due to a reduction in the volume of fixed income trading activity. These declines were partially offset by an increase of approximately $900,000 in sales credits from syndicate and investment banking activities, reflecting a higher volume of shares allocated to the institutional division. Total expenses declined to $5.3 million from $5.6 million in 2005 primarily due to the startup of the Fixed Income National division during the first quarter of 2006.

Prime Brokerage

	Three Months Ended September 30,
	2006		2005
	(in thousands)
Revenues	$	9,036	$	4,978
Income before income taxes	$	269	$	390

Revenues from prime brokerage increased to $9.0 million from $5.0 million, while income before income taxes declined to $269,000 from $390,000. Commission revenue increased to $4.8 million from $3.6million, while principal transaction revenue increased to $3.6 million from $1.2 million, reflecting growth in proprietary trading activities. Total expenses increased to $8.8 million during 2006 from $4.6 million during the third quarter of 2005 reflecting increased compensation and other costs related to proprietary trading activities. Compensation and other costs when measured as a percentage of proprietary trading revenues are higher than similar costs associated with other revenue sources.

InvestmentBanking

	Three Months Ended September 30,
	2006		2005
	(in thousands)
Revenues	$	8,634	$	5,465
Income before income taxes	$	3,018	$	2,140

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Revenues from investment banking increased to $8.6 million from $5.5 million, and income before income taxes increased to $3.0 million from $2.1 million. The revenue increase is primarily due to increased revenues from advisory fees during 2006. Total expenses increased to $5.6 million from $3.3 million in 2005 due to higher compensation costs related to the higher revenues and to higher occupancy costs caused by the division’s relocation to larger offices in the New York area.

Corporate and Other

	Three Months Ended September 30,
	2006			2005
	(in thousands)
Revenues	$	(820	)	$	1,316
Loss before income taxes	$	(5,236	)	$	(1,649	)

Revenues from corporate and other declined to a negative $820,000 from $1.3 million, and the loss before income taxes increased to $5.2 million from $1.6 million. The revenue decline is due primarily to losses in our investment portfolios. During 2006, our investment portfolios declined by $1.4 million, compared to a gain of $1.3 million in the prior year. Small energy stocks, which comprise a significant portion of our investment portfolios, declined sharply late in the third quarter of 2006. Total expenses increased to $4.5 million from $3.5 million. Included in the 2006 expenses was $383,000 of legal costs related to the NASD inspection of our prime brokerage operations.

Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005

Total revenues were $127.5 million in the nine months of 2006 compared to $91.3 million for the same period in 2005, an increase of $36.2 million, or 40% reflecting the acquisition of Edelman in May 2005, and growth in the investment banking and proprietary trading operations. Total expenses for the nine months of 2006 increased $40.6 million, or 51% to $121.0 million from $80.4 million in the same period of the previous year. The Company recorded a goodwill impairment charge in the amount of $4.5 million during 2006 associated with its Charlotte Capital division. Income attributable to minority interests decreased to $3.6 million from $4.4 million during the nine months of 2005, primarily due to decline in equity in income from limited partnerships. Income from continuing operations for the nine-month period ended September 30, 2006, declined $5.4 million, or 70% to $2.3 million from $7.7 million in the same period in 2005. Basic income per share from continuing operations was $0.12 for the nine months ended September 30, 2006 compared to $0.42 for the same period in 2005. Diluted income per share from continuing operations was $0.12 for the nine months ended September 30, 2006, compared to $0.40 for the same period in 2005.

Commissions revenue increased to $42.9 million in the nine months of 2006 from $33.3 million for the same period in 2005, primarily as a result of the Edelman acquisition and growth in proprietary trading operations. Investment banking revenue increased to $33.6 million during the nine months of 2006 from $22.5 million in the same period of 2005, principally due to an increase in private placement and advisory fees. Revenues from investment advisory and related services fees increased to $28.4 million in the nine months of 2006 from $22.3 million in the same period of 2005 primarily due to the acquisition of Edelman during 2005. Principal transactions revenue totaled $13.7 million for the nine months of 2006 versus $7.2 million in the nine months of 2005 reflecting growth in our proprietary trading operations. Interest and dividend income increased to $4.5 million in the nine months of 2006 from $3.4 million in the same period last year, due to higher margin interest reflecting an increase in margin balances and to higher revenues from the financing of proprietary trading accounts. Other income increased from $2.5 million during the nine months of 2005 to $4.4 million during the same period in 2006 due to an increase in fees earned on the Company’s cash balance and customer credit balances at its clearing firms resulting from higher deposit balances.

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During the nine months ended September 30, 2006, employee compensation and benefits increased to $78.4 million from $54.0 million in the same period last year due to more employees and higher revenues during 2006. Floor brokerage, exchange and clearance fees increased to $5.5 million in the nine months of 2006 from $3.5 million in the same period of 2005 reflecting higher clearing and execution costs resulting from the increased trading volume in proprietary trading accounts. Communication and data processing costs increased to $6.3 million in 2006 from $5.8 million in the same period last year resulting primarily from increased personnel and additional offices. Occupancy costs totaled $8.4 million during the nine months of 2006, compared to $6.2 million in the prior year period due to expansion of our New York City offices, and the addition of Edelman. Interest expense totaled $804,000 during the nine months of 2006 compared to $265,000 during the same period in 2005, due to the addition of three credit facilities during 2005. The Company recorded a goodwill impairment charge in the amount of $4.5 million during 2006 associated with its Charlotte Capital division. Other general and administrative expenses increased to $17.1 million during the nine months of 2006 from $10.6 million in the nine months of last year mainly due to our growth.

Our effective tax rate from continuing operations was 39.2% for the nine months ended September 30, 2006 compared to 40.7% for the nine months ended September 30, 2005.

During the nine months ended September 30, 2006, the Company recorded a loss from discontinued operations in the amount of $1.6 million, net of tax, or $0.08 per basic and diluted share, related to its decision to close most of the activities in the division known as Fixed Income National. The loss includes operating losses during the third quarter, as well as accruals for compensation commitments, abandoned leases, and other expenses that will be paid in subsequent periods.

Results by Segment

During the third quarter of 2006, the Company made the decision to close and closed most of the activities of the division known as Fixed Income National, which began operations during the first quarter of 2006. Fixed Income National provided fixed income brokerage services to institutional clients. The operating results of that portion of Fixed Income National that was closed have been recorded as discontinued operations and are not included in the segment discussions. The operating result of the portion of the division that was not discontinued is included in the Institutional Services segment.

Asset and Wealth Management

Asset Management

	Nine Months Ended September 30,
	2006		2005
	(in thousands)
Revenues	$	44,912	$	29,534
Income before income taxes	$	9,100	$	9,134

Revenues from asset management increased to $44.9 million from $29.5 million, and income before income taxes remained constant at $9.1 million. Commission revenues increased to $11.0 million from $4.0 million, while investment management and related service fees increased to $27.4 million from $21.5 million. Other income increased from $917,000 during 2005 to $2.9 million in 2006, primarily due to an increase in insurance commissions. The revenue growth is primarily due to the acquisition of Edelman in May 2005. Total expenses rose to $32.6 million from $21.8 million due to the higher revenues. Equity in income of limited partnerships declined to $395,000 in 2006 from $5.6 million in 2005, reflecting the negative impact that the decline in values of energy related securities had on the value of the investment portfolios of the limited partnerships that we manage. Minority interests in net income of consolidated companies reflect the portion of net income attributable to minority interest ownership of entities included in this segment’s

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consolidated financial statements. Income attributable to minority interests, which reduces SMHG’s pretax income, declined to $3.6 million in 2006 from $4.3 million in 2005, principally due to the decline in value of the investment portfolios of the limited partnerships that we account for using the equity method.

Retail Brokerage

	Nine Months Ended September 30,
	2006			2005
	(in thousands)
Revenues	$	13,868		$	11,794
(Loss) income before income taxes	$	(971	)	$	927

Revenues from retail brokerage increased to $13.9 million from $11.8 million, and income before income taxes declined to a loss of $971,000 from income of $927,000. Commission revenues increased to $7.6million from $6.6 million due primarily to two new offices. Sales credits from investment banking transactions increased to $3.0 million from $2.4 million due to an increase in fees earned from the Company’s participation in syndicate transactions. Revenues from insurance commissions increased $289,000 due to higher sales of insurance annuity products. Total expenses increased to $14.8 million from $10.9 million in 2005 primarily due to costs associated with the opening of two new retail offices, and to an increase in legal expenses related to arbitration claims against the Company.

Institutional Services

Institutional Brokerage

	Nine Months Ended September 30,
	2006		2005
	(in thousands)
Revenues	$	17,922	$	19,404
Income before income taxes	$	147	$	2,605

Revenues from institutional brokerage declined to $17.9 million from $19.4 million, and income before taxes declined to $147,000 from income of $2.6 million. Commission revenue decreased to $11.0 million from $12.2 million, due to decline in both the number of shares traded in our institutional equity division and the commission revenue per share traded. Sales credits from investment banking transactions declined $160,000 representing a reduction in investment banking transactions. These declines are largely the result of the growth in electronic trading strategy execution software that replaces, in some cases, the role of traditional traders. Total expenses increased to $17.8 million from $16.8 million in 2005 primarily due to the startup of the Fixed Income National division during the first quarter of 2006.

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Prime Brokerage

	Nine Months Ended September 30,
	2006		2005
	(in thousands)
Revenues	$	25,204	$	13,855
Income before income taxes	$	1,389	$	1,388

Revenues from prime brokerage increased to $25.2 million from $13.9 million, and income before taxes remained constant at $1.4 million. Commission revenue increased to $13.2 million from $10.3 million, while principal transaction revenue increased to $10.2 million from $2.7 million, reflecting growth in proprietary trading activities. Interest and dividend income increased from $636,000 to $1.6 million reflecting higher earnings from the financing of the proprietary trading accounts. Total expenses increased to $23.8 million during 2006 from $12.5 million during 2005 reflecting increased compensation and other costs related to proprietary trading activities. Compensation and other costs when measured as a percentage of proprietary trading revenues are higher than similar costs associated with other revenue sources.

InvestmentBanking

	Nine Months Ended September 30,
	2006		2005
	(in thousands)
Revenues	$	23,975	$	13,414
Income before income taxes	$	8,566	$	4,756

Revenues from investment banking increased to $24.0 million from $13.4 million, and income before taxes increased to $8.6 million from $4.8 million. The revenue increase is primarily due to increased revenues from private placement transactions and advisory fees during 2006. Total expenses increased to $15.4 million from $8.7 million in 2005 due to higher compensation costs related to the higher revenues and to higher occupancy costs caused by the division’s relocation to larger offices in the New York area.

Corporate and Other

	Nine Months Ended September 30,
	2005			2005
	(in thousands)
Revenues	$	1,601		$	3,249
Loss before income taxes	$	(14,405	)	$	(5,810	)

Revenues from corporate and other decreased to $1.6 million from $3.2 million, and the loss before income taxes increased to $14.4 million from $5.8 million. The Company recorded a goodwill impairment charge in the amount of $4.5 million during 2006 related to its Charlotte Capital division.

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Liquidity and Capital Resources

We intend to satisfy a large portion of our funding needs with our own capital resources, consisting mainly of internally generated earnings and liquid assets we currently hold.

On September 29, 2006, the Company closed a secondary public offering of 5,000,000 shares of its common stock, resulting in proceeds of $58.4 million, net of underwriting discounts and other expenses. The Company received the proceeds in October 2006 and used $13.2 million to repay the outstanding balance including accrued interest on one of its revolving credit facilities. The remaining amount was invested in a money market fund. The proceeds are recorded as a receivable from broker-dealers at September 30, 2006.

At September 30, 2006, we had approximately $19.5 million in cash and cash equivalents, which together with receivables from broker-dealers, deposits with clearing brokers, marketable securities owned, and securities available for sale represented approximately 44% of our total assets at the end of the third quarter.

For the nine months ended September 30, 2006, net cash provided by operations totaled $4.1 million versus $2.9 during the first nine months of 2005.

Securities owned increased by $11.4 million, net of equity in income of limited partnerships of $902,000, during the nine months of 2006, while securities sold, not yet purchased increased by $9.6 million and payables to clearing brokers increased by $1.8 million. The increases in securities owned, securities sold, not yet purchased and payables to clearing brokers is primarily due to the trading portfolios of our proprietary trading operations. The Company’s proprietary trading operations carry both long and short fixed income and equity securities. These trading operations generally seek to generate profits based on trading spreads, rather than through speculation on the direction of the market. We employ hedging strategies designed to insulate the net value of our trading inventories from fluctuations in the general level of interest rates and equity price variances. We finance a portion of our trading positions through our clearing broker-dealers.

Capital expenditures for the third quarter of 2006 were $4.0 million, mainly for the purchase of furniture, computer equipment and software, as well as for leasehold improvements, necessary for our growth.

At September 30, 2006, SMH, our registered broker-dealer subsidiary, was in compliance with the net capital requirements of the Securities and Exchange Commission's Uniform Net Capital Rules and had capital in excess of the required minimum. Salient Trust Co., LTA was in compliance with the Texas Department of Banking net capital requirement and had capital in excess of the required minimum.

In view of the inherent difficulty of predicting the outcome of legal proceedings, particularly where the plaintiffs seek substantial or indeterminate damages or where novel legal theories or a large number of parties are involved, we cannot state with confidence what the eventual outcome of currently pending matters will be, what the timing of the ultimate resolution of these matters will be, or what the eventual result in each pending matter will be. Based on currently available information, we have established reserves for certain litigation matters and our management does not believe that resolution of any matter will have a material adverse effect on our liquidity or financial position although, depending on our results for a particular period, an adverse determination could have a material effect on quarterly or annual operating results in the period in which it is resolved.

Factors Affecting Forward-Looking Statements

This quarterly report on Form 10-Q includes "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended (the "Acts"). These forward-looking statements may relate to such matters as anticipated financial performance, future revenues or earnings, business prospects, projected ventures, new products, anticipated market performance and similar matters. The Private Securities Litigation Reform Act of 1995

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provides a safe harbor for forward-looking statements. To comply with the safe harbor, the Company cautions readers that a variety of factors could cause the Company's actual results to differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. These risks and uncertainties, many of which are beyond the Company's control, include, but are not limited to (1) trading volume in the securities markets; (2) volatility of the securities markets and interest rates; (3) changes in regulatory requirements, which could affect the demand for the Company's services or the cost of doing business; (4) general economic conditions, both domestic and foreign, especially in the regions where the Company does business; (5) changes in the rate of inflation and related impact on securities markets; (6) competition from existing financial institutions and other new participants in the securities markets; (7) legal developments affecting the litigation experience of the securities industry; (8) successful implementation of technology solutions; (9) changes in valuations of the Company’s trading and warrant portfolios resulting from mark-to-market adjustments; (10) dependence on key personnel; and (11) demand for the Company's services. The Company does not undertake to publicly update or revise any forward-looking statements.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Market Risks

During the nine months ended September 30, 2006, there has been no material changes to the information contained in Part II, Item 7A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

At September 30, 2006, securities owned by the Company were recorded at a fair value of $85.9 million, including $43.0 million in marketable securities, $35.0 million representing the Company’s investments in limited partnerships and $7.9 million representing other not readily marketable securities.

At September 30, 2006, Salient had securities available for sale with a fair value of $1.5 million. These securities have an original cost of $1.4 million, and are subject to equity price risk. At September 30, 2006, the unrealized increase in market value totaling $67,000 less tax of $26,000 has been included as a separate component of shareholders’ equity.

Item 4. Controls and Procedures

Our management, including our Chief Executive Officer and Chief Financial Officer, have conducted an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Exchange Act), as of the end of the fiscal period covered by this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective in ensuring that the information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. There have been no changes made in our internal controls over financials reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Many aspects of our business involve substantial risks of liability. In the normal course of business, we have been and in the future may be named as defendant or co-defendant in lawsuits and arbitration proceedings involving primarily claims for damages. We are also involved in a number of regulatory matters arising out of the conduct of our business. There can be no assurance that these matters will not have a material adverse effect on our results of operation in any future period and a significant judgment could have a material adverse impact on our consolidated financial position, results of operations, and cash flows. In addition to claims for damages and monetary sanctions that may be made against us, we incur substantial costs in investigating and defending claims and regulatory matters.

The NASD initially conducted an inspection of our prime brokerage and private investment or hedge fund support operations based in our New York office in November 2004. Subsequent to such inspection, the NASD opened an investigation and requested the production of additional documents and materials on twelve occasions in 2005 and 2006 with respect to our prime brokerage and related hedge fund operations and has conducted formal interviews of a number of our employees involved in these operations. On August 16, 2006, Sanders Morris Harris received a “Wells letter” notification from the NASD, which states that the staff of the NASD has made a preliminary determination to recommend that disciplinary action be brought against Sanders Morris Harris and four of its employees based on alleged violations of certain conduct rules of the NASD, including NASD Conduct Rule 2110 relating to the alleged improper payment of soft dollar commissions to a fund manager and relating to the alleged improper sharing of commissions by two employees contrary to a written contract with an investment adviser and representations to the investors in one private investment partnership; NASD Conduct Rule 2210 relating to the content of hedge fund advertising materials; SEC Rule 17a-4 and NASD Conduct Rules 2210 and 3110 relating to the retention of certain email, instant messages, and advertising materials; NASD Conduct Rules 1031 and 2110 relating to the activities of an unregistered employee; and NASD Conduct Rules 2110 and 3010 relating to the written supervisory procedures of Sanders Morris Harris for its hedge fund and prime brokerage operations. Under the Wells procedure, Sanders Morris Harris has an opportunity to respond to the NASD before any action is taken against it. Sanders Morris Harris submitted its response to the NASD on October 11, 2006. There is no assurance that a prompt resolution can be reached or that the ultimate impact on the Company will not be material. Discussions have commenced between the staff of the NASD and our legal counsel with respect to the alleged violations.

We are aware that a company for which Sanders Morris Harris acted as placement agent in a private placement of convertible preferred shares in June 2005 has experienced a significant decline in its net sales, a significant increase in its net loss, and currently has negative working capital. While the company has obtained financing to meet its short-term working capital requirements, there is no assurance that it will be able to sustain its business. We have received written and oral communications from a number of the purchasers of securities in the offering expressing their dissatisfaction and indicating that they may seek legal recourse with respect to the offering. No litigation has been filed at this time. While we believe Sanders Morris Harris has valid defenses to any claims and is entitled to indemnification and contribution provisions of the placement agent agreement, the costs of defending any litigation filed naming Sanders Morris Harris could be significant and an adverse determination could have a material effect on quarterly or annual operating results in the period in which it is resolved. Two managing directors of Sanders Morris Harris served as directors of the company from June 2005 to June 2006.

In view of the inherent difficulty of predicting the outcome of legal proceedings, particularly where the plaintiffs seek substantial or indeterminate damages or where novel legal theories or a large number of parties are involved, we cannot state with confidence what the eventual outcome of currently pending matters will be, what the timing of the ultimate resolution of these matters will be, or what the eventual result in each pending matter will be. Based on currently available information, we have established reserves for certain litigation matters and our management does not believe that resolution of any matter will have a material adverse effect on our liquidity or financial position although, depending on our results for a particular period, an adverse determination could have a material effect on quarterly or annual operating results in the period in which it is resolved.

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Item 6. Exhibits

Exhibit

Number Description

3.1 Articles of Incorporation of the Company, as amended (Filed as Exhibit 3.1 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2001 (File No. 000-30066), and incorporated herein by reference).

3.2 Amended and Restated Bylaws of the Company (Filed as Exhibit 3.2 to the Company’s Quarterly report on Form 10-Q for the quarter ended June 30, 2004 (File No. 000-30066), and incorporated herein by reference).

†10.01 Sanders Morris Harris Group Inc. 1998 Incentive Plan as amended (Filed as Appendix A to the Definitive Proxy Statement on Schedule 14A of the Company dated May 3, 2002 (File No. 000-30066), and incorporated herein by reference).

†10.02 Sanders Morris Harris Group Inc. Capital Incentive Program (Filed as Exhibit 10.1 to the Company’s Form 10-Q for the quarter ended September 30, 2001 (File No. 000-30066), and incorporated herein by reference).

†10.03 Form of Option Agreement pursuant to 1998 Incentive Plan (Filed as Exhibit 10.03 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 (File No. 000-30066), and incorporated herein by reference).

†10.04 Form of Restricted Stock Agreement pursuant to 1998 Incentive Plan (Filed as Exhibit 10.04 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 (File No. 000-30066), and incorporated herein by reference).

10.05 Sublease Agreement dated January 19, 1994, between Texas Commerce Bank National Association and Harris Webb & Garrison, Inc., as amended by that certain First Amendment to Sublease Agreement dated February 23, 1994, the Second Amendment to Sublease Agreement dated April 26, 1994, and the Third Amendment to Sublease Agreement dated January 19, 1995 (Filed as Exhibit 10.16 to the Proxy Statement/Prospectus of the Company dated December 31, 1998 (File No. 333-65417), and incorporated herein by reference).

10.06 On-Line Services Agreement dated as of June 1, 2005, between Innovest Systems, LLC and Pinnacle Trust Co., LTA. (Filed as Exhibit 10.05 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005 (File No. 000-30066), and incorporated herein by reference).

10.07 Office Lease Agreement and related amendments dated September 25, 1996, between Texas Tower limited and Sanders Morris Mundy Inc. (Filed as Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2000 (File No. 000-30066), and incorporated herein by reference).

10.08 Credit Agreement dated as of May 9, 2005, between Sanders Morris Harris Group Inc. and JPMorgan Chase Bank, National Association (Filed as Exhibit 10.7 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005 (File No. 000-30066), and incorporated herein by reference).

10.09 Reorganization and Purchase Agreement dated as of May 10, 2005, among Sanders Morris Harris Group Inc., The Edelman Financial Center, Inc., The Edelman Financial Center, LLC, and Fredric M. Edelman (Filed as Exhibit 2.1 to the Company’s Current Report on Form 8-K dated May 10, 2005 (File No. 000-30066), and incorporated herein by reference).

10.10 Agreement and Amendment to Credit Agreement dated as of May 8, 2006, between Sanders Morris Harris Group Inc. and JPMorgan Chase Bank, National Association (Filed as Exhibit 10.10 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2006 (File No. 000-30066), and incorporated herein by reference).

10.11 Agreement and Amendment to Credit Agreement dated as of February 27, 2006, between Sanders Morris Harris Group, Inc. and JPMorgan Chase Bank, National Association (Filed as Exhibit 10.11 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2006 (File No. 000-30066), and incorporated herein by reference).

*31.1 Rule 13a-14(a)/15d - 14(a) Certification of Chief Executive Officer.

*31.2 Rule 13a-14(a)/15d - 14(a) Certification of Chief Financial Officer.

*32.1 Certification Pursuant to18 U.S.C. 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

*32.2 Certification Pursuant to 18 U.S.C. 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

* Filed herewith.

† Management contract or compensation plan or arrangement.

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SIGNATURES

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

SANDERS MORRIS HARRIS GROUP INC.

By:  /s/ BEN T. MORRIS

Ben T. Morris

Chief Executive Officer

By:  /s/ RICK BERRY

Rick Berry

Chief Financial Officer

Date:November 8, 2006

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