PAULSON CAPITAL CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1. Basis of Presentation
The financial information for Paulson Capital Corp. and its wholly-owned subsidiary, Paulson Investment Company, included herein as of June 30, 2006 and December 31, 2005 and for the three and six-month periods ended June 30, 2006 and 2005 is unaudited; however, such information reflects all adjustments, consisting only of normal recurring adjustments, which, in the opinion of management, are necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods. The financial information as of December 31, 2005 is derived from our 2005 Annual Report on Form 10-K. The interim consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in our 2005 Annual Report on Form 10-K. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for the full year.
Note 2. Dividend
Pursuant to a December 22, 2005 authorization by our Board of Directors, in February 2006, we paid a special cash dividend of $0.30 per share to shareholders of record on January 17, 2006. The dividend paid totaled $0.9 million.
Note 3. Stock Split
On March 1, 2006, we announced that our Board of Directors approved a two-for-one stock split of our common stock to be effected in the form of a stock dividend. The stock split was effected on March 29, 2006 by issuing one additional share of common stock for each share of common stock outstanding on March 15, 2006. All prior share and per share amounts have been adjusted for this stock split. Basic and diluted net income per share were adjusted as follows for the three and six-month periods ended June 30, 2005:
| | Three Months
Ended
June 30, 2005 | | Six Months
Ended
June 30, 2005 | |
Basic net income per share, as previously reported | | $ | 1.94 | | $ | 2.74 | |
Basic net income per share, as adjusted | | $ | 0.97 | | $ | 1.37 | |
| | | | | |
Diluted net income per share, as previously reported | | $ | 1.93 | | $ | 2.73 | |
Diluted net income per share, as adjusted | | $ | 0.97 | | $ | 1.37 | |
| | | | | |
Shares used for basic net income per share, as previously reported | | 3,131,752 | | 3,155,406 | |
Shares used for basic net income per share, as adjusted | | 6,263,504 | | 6,310,812 | |
| | | | | |
Shares used for diluted net income per share, as previously reported | | 3,139,811 | | 3,163,421 | |
Shares used for diluted net income per share, as adjusted | | 6,279,622 | | 6,326,842 | |
Note 4. Commitments and Contingencies
In October 2002, we were named as a defendant in a lawsuit filed by Special Situations Fund III, LP and Special Situations Cayman Fund, LP. The lawsuit was filed in the U.S. District Court for the District of New Jersey. It asserts various federal securities law claims and common law fraud and negligent misrepresentation against numerous defendants, including us, arising out of two follow-on offerings of Suprema Specialties, Inc. We participated in one of the two offerings, the August 25, 2000 follow-on offering of Suprema Specialties, Inc., as a member of the underwriting syndicate, agreeing to underwrite 75,000 shares in total, although the amount actually retained by us appears to be only 35,000 shares. The
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stock was sold in the August 25, 2000 offering at a price of $8.00 per share. Plaintiffs seek damages for the purchase of 399,151 shares of Suprema Specialties, Inc. stock between August 25, 2000 and November 14, 2001. The federal district court dismissed the claims against us. On appeal, the U. S. Third Circuit Court of Appeals affirmed the dismissal of the plaintiffs’ claims for violation of Rule 10b-5 but reversed as to the dismissal of claims under Section 11 of the Securities Act of 1933. Subsequently, the plaintiffs stipulated that they will not be asserting a claim for common law fraud against us. The negligent misrepresentation claim remains in the case. We believe our liability under Section 11 is limited to the amount of shares either underwritten or actually retained by us in the offering. Discovery has begun, but has not yet been completed. We believe we have meritorious defenses and intend to defend this matter vigorously.
In December 2005, we received notice of possible claims being asserted against us by two brothers who invested in Wood River Partners LP (“Wood River”). The brothers purchased their interests in Wood River directly from Wood River. One of the individuals was a customer of ours, but the other is not. The brothers have indicated that they paid $1,050,000 for their interests in Wood River. The SEC sued Wood River in October 2005, and a receiver currently runs Wood River. At this point, it is not known how much the individuals might recover through the receivership. The individuals have indicated that they believe they may have claims against us under the Oregon Securities Laws for rescission, interest and attorney fees. We believe we have meritorious defenses and, if litigation is filed, we intend to defend this matter vigorously.
In January 2006, we received notice of a customer complaint against one of our former registered representatives. The customer has indicated that her accounts declined in value by just over $500,000. The customer has asserted that our former registered representative failed to implement strategies and techniques to provide for safety and preservation of capital in her accounts. She asserts that the registered representative made misrepresentations regarding the handling of her accounts. The customer has indicated that she plans to pursue litigation against us if the matter is not resolved. At this time, the customer has requested that the former registered representative compensate her for the decline in value of her account and return any fees earned by the former registered representative. We believe we have meritorious defenses and, if litigation is filed, we intend to defend this matter vigorously.
On or about March 30 2006, we were added as an additional respondent in an NASD arbitration matter. The claimants seek approximately $2 million in damages against numerous respondents. Of that amount, claimants’ attorney has indicated that the claimants seek approximately $200,000 in damages against us. We have filed a motion to dismiss the claims against us, which is currently pending. The arbitration hearing is scheduled for January 2007. We believe we have meritorious defenses and, if our motion to dismiss is denied, we intend to defend this matter vigorously.
An adverse outcome in certain of the matters described above could have a material adverse effect on our results of operations, cash flow or financial condition. We have either been named in certain other legal proceedings or are aware of certain complaints that may lead to legal proceedings. We believe, based upon information received to date and, where we believe it appropriate, based on discussions with legal counsel, that resolution of additional pending or threatened litigation will have not have a material adverse effect on our results of operations, cash flow or financial condition.
Note 5. Stock-Based Compensation
Adoption of SFAS No. 123R
Effective January 1, 2006, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment,” which establishes accounting for equity instruments exchanged for employee services. Under the provisions of SFAS No. 123R, stock-based compensation cost for equity classified awards is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the employee’s requisite service period (generally the vesting period of the equity award). Prior to January 1, 2006, we accounted for share-based compensation to employees in accordance with Accounting Principles Board Option No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and
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related interpretations. We also followed the disclosure requirements of SFAS No. 123, “Accounting for Stock-Based Compensation.”
We elected to adopt the modified prospective transition method as provided by SFAS No. 123R and, accordingly, financial statement amounts for the prior periods presented in this Form 10-Q have not been restated to reflect the fair value method of expensing stock-based compensation. Under this method, the provisions of SFAS No. 123R apply to all awards granted or modified after the date of adoption. We did not have any unrecognized expense related to awards outstanding at the date of adoption since they were all fully vested. For future awards, expense calculated pursuant to SFAS No. 123R will be recognized as compensation expense using the Black-Scholes option pricing model over the requisite service period. The cumulative effect of the change in accounting principle from APB 25 to SFAS No. 123R was not material.
There were no options granted and no pro forma stock-based compensation expense as if the method prescribed by SFAS No. 123, “Accounting for Stock-Based Compensation,” had been applied in measuring compensation expense in the prior periods presented.
1999 Stock Option Plan
Our 1999 Stock Option Plan (the “Plan”) reserves 1.0 million shares of our common stock for issuance upon exercise of options granted under the plan. At June 30, 2006, 521,000 options were available for grant and 708,000 shares of our common stock were reserved for issuance related to the Plan. The Plan provides for the grant of incentive stock options and nonqualified stock options. There were no options granted during the first six months of 2006.
Certain information regarding options outstanding and exercisable as of June 30, 2006 was as follows:
| | Options
Outstanding and
Exercisable | |
Number | | 187,000 | |
Weighted average per share exercise price | | $ | 3.93 | |
Aggregate intrinsic value | | $ | 406,315 | |
Weighted average remaining contractual term | | 1.7 years | |
As of June 30, 2006, there was no unrecognized stock-based compensation.
Stock-Based Compensation
We estimate the fair value of stock options using the Black-Scholes option pricing model. This valuation model takes into account the exercise price of the award, as well as a variety of significant assumptions. We believe that the valuation technique and the approach utilized to develop the underlying assumptions are appropriate in calculating the fair values of our stock options. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by persons who receive equity awards. There were no stock options granted during the three and six-month periods ended June 30, 2006 or 2005.
Since our options are fully vested upon the date of grant, we recognize the related stock-based compensation expense at that time. Shares to be issued upon the exercise of stock options will come from newly issued shares.
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Certain information regarding our stock-based compensation was as follows:
| | Three and Six Months
Ended June 30, | |
| | 2006 | | 2005 | |
Weighted average grant-date per share fair value of share options granted | | $ | — | | $ | — | |
Total intrinsic value of share options exercised | | 25,230 | | 22,420 | |
Stock-based compensation recognized in results of operations | | — | | — | |
Cash received from options exercised | | 21,030 | | 61,530 | |
Tax deduction realized related to stock options exercised | | 25,230 | | 22,420 | |
| | | | | | | |
Note 6. Earnings Per Share
Following is a reconciliation of our shares used for our basic net income (loss) per share and our diluted net income (loss) per share:
| | Three Months Ended June 30, | | Six Months Ended June 30, | |
| | 2006 | | 2005 | | 2006 | | 2005 | |
Shares used for basic income (loss) per share | | 6,183,719 | | 6,263,504 | | 6,186,441 | | 6,310,812 | |
Effect of dilutive stock options | | 47,880 | | 16,118 | | — | | 16,030 | |
Shares used for diluted net income (loss) per share | | 6,231,599 | | 6,279,622 | | 6,186,441 | | 6,326,842 | |
| | | | | | | | | |
Stock options not included in diluted net income (loss) per share because their effect would have been antidilutive | | — | | — | | 187,000 | | — | |
Note 7. Selection of New Clearing Firm
In June 2006, we announced that, effective September 2006, RBC Dain Correspondent Services (“DCS”) will become our new clearing firm, replacing National Financial Services, LLC (“NFS”).
Note 8. Repurchases of Common Stock
In the first six months of 2006, we repurchased a total of 31,316 shares of our common stock for a weighted average price of $6.50 per share, which totaled $203,000. The amount paid above the original issue price, which totaled $197,000, was offset against retained earnings.
Note 9. New Accounting Pronouncements
FASB Interpretation No. 48
In July 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” which defines the threshold for recognizing the benefits of tax return positions in the financial statements as “more-likely-than-not” to be sustained by the taxing authority. Interpretation No. 48 applies to all tax positions accounted for under SFAS No. 109, “Accounting for Income Taxes.” Interpretation No. 48 is effective as of the beginning of the first fiscal year beginning after December 15, 2006. We are currently analyzing the effects of adopting Interpretation No. 48 and do not expect any material affect on our financial position.
SFAS No. 156
In March 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 156, “Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140.” SFAS No. 156 amends SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities,” with respect to accounting for separately recognized servicing assets and servicing liabilities. SFAS No. 156 is effective for fiscal years that begin after September 15, 2006, with early adoption permitted as of the beginning of an entity’s fiscal year. We do not have any servicing assets or servicing liabilities and, accordingly, the adoption of SFAS No. 156 will not have any effect on our results of operations, financial condition or cash flows.
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SFAS No. 155
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No 133 and 140.” SFAS No. 155 resolves implementation issues addressed in Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” SFAS No. 155 is effective for fiscal years that begin after September 15, 2006, with early adoption permitted as of the beginning of an entity’s fiscal year. We do not have any beneficial interests in securitized financial assets and, accordingly, the adoption of SFAS No. 155 will not have any effect on our results of operations, financial condition or cash flows.
Note 10. Reclassifications
Certain amounts in the prior period financial statements have been reclassified to conform to the current period presentation.
Note 11. Subsequent Events
In July 2006, we completed an initial public offering where we raised approximately $16.5 million for Ascent Solar Technologies, Inc.
In August 2006, we settled one of our outstanding legal matters for $180,000, which will be recorded as a component of settlement expense in the third quarter of 2006.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward Looking Statements and Risk Factors
This report, including, without limitation, “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains or incorporates both historical and “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Words such as “anticipates,” “believes,” “expects,” “intends,” “future” and similar expressions identify forward-looking statements. Any such forward-looking statements in this report reflect our current views with respect to future events and financial performance and are subject to a variety of factors that could cause our actual results to differ materially from historical results or from anticipated results expressed or implied by such forward-looking statements. Because of such factors, we cannot assure you that the results anticipated in this report will be realized. As noted elsewhere in this report, various aspects of our business are subject to extreme volatility often as a result of factors beyond our ability to anticipate or control. In particular, factors, such as the condition of the securities markets, which are in turn based on popular perceptions of the health of the economy generally, can be expected to affect the volume of our business as well as the value of the securities maintained in our trading and investment accounts. Other factors that may affect our future financial condition or results of operations include the following:
· The performance of companies whose securities we have underwritten or otherwise sold to our customers may affect our reputation with other potential syndicate and selling group members and institutional and other retail accounts and may also affect the amount of money in our customers’ portfolios available for the kinds of investments that we offer.
· The value of our investment portfolio, including the value of securities without a readily ascertainable market value, that we have estimated for the purpose of reporting on our financial condition and results of operations, may be significantly and adversely affected by changes in the value of the companies themselves or of comparable companies whose stock values we use in estimating the value of our portfolio securities.
· We are subject to a very high degree of regulation and are responsible for compliance with applicable regulations by all of our personnel. A significant regulatory infraction by us or any of our registered representatives could result in significant penalties, including the loss of our license to conduct securities business in one or more jurisdictions.
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· Alternatives available to our customers to transact securities’ trades could affect our ability to continue to execute our brokerage customers’ transactions.
· The loss of our Chairman, Chester Paulson, could have a material adverse impact on our business.
Overview
Substantially all of our business consists of the securities brokerage and corporate finance activities of our wholly-owned subsidiary, Paulson Investment Company, Inc., which has operations in four principal categories, all of them in the financial services industry. These categories are:
· securities brokerage activities for which we earn commission revenues;
· corporate finance revenues consisting principally of underwriting discounts and underwriter warrants;
· securities trading from which we record profit or loss, depending on trading results; and
· investment income resulting from earnings on, and increases or decreases in the value of, our investment portfolio.
Because we operate in the financial services industry, our revenues and earnings are substantially affected by general conditions in financial markets. In our securities brokerage business, the amount of our revenues depends on levels of market activity requiring the services we provide. Our corporate finance activity, which consists of acting as the managing underwriter of initial and follow-on public offerings, private investments in a public equity (“PIPEs”) and private placements for smaller companies, is similarly affected by the strength of the market for new equity offerings, which has historically experienced substantial cyclical fluctuation. Although we attempt to match operating costs with activity levels, many of our expenses are either fixed or difficult to change on short notice. Accordingly, fluctuations in brokerage and corporate finance revenues tend to result in sharper fluctuations, on a percentage basis, in net income or loss.
Our investment income or loss and, to a lesser extent, our trading income or loss is affected by changes in market valuation of securities generally and, in particular, by changes in valuation of the equity securities of microcap companies in which our investments and trading activities tend to be concentrated. Equity markets in general, and microcap equity markets in particular, have always experienced significant volatility and this volatility has, in recent years, been extreme. The result of this volatility on the value of our investment portfolio and securities held in connection with our trading and investment activities include large quarterly fluctuations in income or loss from these operations and substantial increases or decreases in our net worth as our securities holdings are marked to market.
A substantial portion of our corporate finance business consists of acting as managing underwriter of initial and follow-on public offerings for microcap and smallcap companies. As a part of our compensation for these activities, we typically receive warrants exercisable to purchase securities identical to those that we offer and sell to the public. The warrants generally have a five-year expiration date and vest immediately. The warrants are generally subject to a restricted period of six months to one-year in which we cannot exercise the warrants. The exercise price is typically 120% of the price at which the securities are initially sold to the public. Accordingly, unless there is at least a 20% increase in the price of these securities at some time more than six months and less than five years after the offering, the warrants will remain “under water” and will ultimately expire unexercised. We also receive warrants in connection with our PIPEs, which have varying terms and conditions.
Critical Accounting Policies and Use of Estimates
Except for the addition of the Stock-Based Compensation information below, we reaffirm the critical accounting policies and estimates as reported in our Annual Report on Form 10-K for the year ended December 31, 2005, which was filed with the Securities and Exchange Commission on March 29, 2006.
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Stock-Based Compensation
On January 1, 2006, we adopted SFAS No. 123R, which requires the measurement and recognition of compensation expense for all share based payment awards granted to our employees and directors. Upon adoption of SFAS No. 123R, we maintained our method of valuation of employee stock options granted using the Black-Scholes option pricing model which was previously used for the disclosure only provisions allowed under SFAS No. 123. Our determination of fair value of share based payment awards on the date of grant using an option pricing model is affected by our stock price as well as assumptions regarding a number of variables, including risk free interest rate, the expected dividend yield, the expected option life, and expected volatility over the term of the awards. To the extent share based payment awards are granted in future periods, we will recognize the related expense over the requisite service period based on the portion of awards that are ultimately expected to vest during the period.
Results of Operations
Our revenues and operating results are influenced by fluctuations in the equity markets as well as general economic and market conditions, particularly conditions in the over-the-counter market, where our investment and trading positions and the underlying stock for the underwriter warrants are heavily concentrated. Significant fluctuations can occur in our revenues and operating results from one period to another. Our results of operations depend upon many factors, such as the number of companies that are seeking financing, the quality and financial condition of those companies, market conditions in general, the performance of our previous underwritings and interest in certain industries by investors. As a result, revenues and income derived from these activities may vary significantly from year to year. Our revenues include the following:
· Commissions, which represent amounts earned from our retail securities brokerage activities;
· Corporate finance revenues, which are a function of total proceeds from offerings done during the period, compensation per offering and the fair value of underwriter warrants received;
· Investment income (loss), which includes (i) the unrealized appreciation and depreciation of securities held based on quoted market prices, (ii) the unrealized appreciation and depreciation of securities held that are not readily marketable, based upon our estimate of their fair value, (iii) realized gains and losses on the sale of securities with quoted market prices and securities that are not readily marketable, and (iv) the unrealized appreciation and depreciation of underwriter warrants held; and
· Trading income (loss), which is the gain or loss from trading positions before commissions paid to the representatives in the trading department.
The following tables set forth the changes in our operating results in the three and six-month periods ended June 30, 2006 compared to the three and six-month periods ended June 30, 2005:
| | Three Months Ended
June 30, | | Increase | | %
Increase | |
| | 2006 | | 2005 | | (Decrease) | | (Decrease) | |
Revenues: | | | | | | | | | |
Commissions | | $ | 4,076,360 | | $ | 3,743,269 | | $ | 333,091 | | 8.9 | % |
Corporate finance | | 3,178,920 | | 465,970 | | 2,712,950 | | 582.2 | |
Investment income | | 75,735 | | 12,361,430 | | (12,285,695 | ) | (99.1 | ) |
Trading income (loss) | | (254,547 | ) | 1,410,822 | | (1,665,369 | ) | (118.0 | ) |
Interest and dividends | | 12,996 | | 14,454 | | (1,458 | ) | (10.1 | ) |
Other | | 440 | | 165 | | 275 | | 166.7 | |
Total revenues | | 7,089,904 | | 17,996,110 | | (10,906,206 | ) | (60.6 | ) |
Expenses: | | | | | | | | | |
Commissions and salaries | | 4,727,534 | | 6,152,185 | | (1,424,651 | ) | (23.2 | ) |
Underwriting expenses | | 132,446 | | 134,172 | | (1,726 | ) | (1.3 | ) |
Rent, telephone and quotation services | | 289,758 | | 285,601 | | 4,157 | | 1.5 | |
Professional fees | | 226,090 | | 346,350 | | (120,260 | ) | (34.7 | ) |
Travel and entertainment | | 211,307 | | 100,923 | | 110,384 | | 109.4 | |
Settlement expense | | 4,750 | | 256,375 | | (251,625 | ) | (98.1 | ) |
All other | | 434,337 | | 599,038 | | (164,701 | ) | (27.5 | ) |
Total expenses | | 6,026,222 | | 7,874,644 | | (1,848,422 | ) | (23.5 | ) |
Income before income taxes | | $ | 1,063,682 | | $ | 10,121,466 | | $ | (9,057,784 | ) | (89.5 | ) |
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| | Six Months Ended
June 30, | | Increase | | %
Increase | |
| | 2006 | | 2005 | | (Decrease) | | (Decrease) | |
Revenues: | | | | | | | | | |
Commissions | | $ | 8,179,394 | | $ | 7,884,326 | | $ | 295,068 | | 3.7 | % |
Corporate finance | | 3,232,188 | | 585,955 | | 2,646,233 | | 451.6 | |
Investment income (loss) | | (5,089,031 | ) | 17,513,929 | | (22,602,960 | ) | (129.1 | ) |
Trading income (loss) | | (218,710 | ) | 2,112,826 | | (2,331,536 | ) | (110.4 | ) |
Interest and dividends | | 26,164 | | 22,145 | | 4,019 | | 18.1 | |
Other | | 1,614 | | 11,334 | | (9,720 | ) | (85.8 | ) |
Total revenues | | 6,131,619 | | 28,130,515 | | (21,998,896 | ) | (78.2 | ) |
Expenses: | | | | | | | | | |
Commissions and salaries | | 8,444,543 | | 10,406,189 | | (1,961,646 | ) | (18.9 | ) |
Underwriting expenses | | 167,446 | | 134,172 | | 33,274 | | 24.8 | |
Rent, telephone and quotation services | | 586,266 | | 592,099 | | (5,833 | ) | (1.0 | ) |
Professional fees | | 450,377 | | 789,116 | | (338,739 | ) | (42.9 | ) |
Travel and entertainment | | 253,339 | | 161,069 | | 92,270 | | 57.3 | |
Settlement expense | | 4,750 | | 518,543 | | (513,793 | ) | (99.1 | ) |
All other | | 831,213 | | 1,128,072 | | (296,859 | ) | (26.3 | ) |
Total expenses | | 10,737,934 | | 13,729,260 | | (2,991,326 | ) | (21.8 | ) |
Income (loss) before income taxes | | $ | (4,606,315 | ) | $ | 14,401,255 | | $ | (19,007,570 | ) | (132.0 | ) |
Revenues
Commissions increased 8.9% and 3.7%, respectively, in the three and six-month periods ended June 30, 2006 compared to the same periods of 2005. The total number of trades, including mutual fund trades, executed by our brokers were 27,215 and 53,683 in the three and six-month periods ended June 30, 2006, respectively, compared to 24,380 and 54,064, respectively, in the comparable periods of 2005. We had 96 brokers at June 30, 2006 compared to 95 brokers at June 30, 2005.
Corporate finance income of $3.2 million in both the three and six-month periods ended June 30, 2006 primarily represented commissions earned from one initial public offering in which we raised $19.5 million for American Mold Guard, Inc., as well as the Black-Scholes value of the underwriter warrants received in connection with that offering. In addition we completed several private transactions, including two PIPEs.
Corporate finance income of $0.5 million and $0.6 million, respectively, in the three and six-month periods ended June 30, 2005 primarily included commissions related to a small initial public offering in which we raised $3.0 million for Nuvim, Inc., as well as the Black-Scholes value of the underwriter warrants received in connection with that offering. In addition we completed other small private transactions.
Investment income (loss) decreased $12.3 million and $22.6 million, respectively, in the three and six-month periods ended June 30, 2006 compared to the same periods of 2005, primarily due to net losses related to underwriter warrants and unrealized depreciation of securities held in the 2006 periods compared to net gains related to the underwriter warrants and appreciation of securities held in the 2005 periods as detailed in the following table:
| | Three Months Ended June 30, | | Six Months Ended June 30, | |
| | 2006 | | 2005 | | 2006 | | 2005 | |
Net unrealized gain (loss) related to underwriter warrants | | $ | (314,144 | ) | $ | 322,400 | | (1,939,144 | ) | $ | 1,906,400 | |
Net unrealized appreciation (depreciation) of securities held based on quoted market prices or, for securities that are not readily marketable, our estimate of their fair market value | | 925 | | 9,046,842 | | (9,599,337 | ) | 11,351,839 | |
Net realized gains on the sale of securities with quoted market prices and securities that are not readily marketable | | 388,954 | | 2,992,188 | | 6,449,450 | | 4,255,690 | |
| | $ | 75,735 | | $ | 12,361,430 | | (5,089,031 | ) | $ | 17,513,929 | |
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Investment income (loss) is volatile from period to period due to the fact that it is driven by the market value or fair value of the securities and underwriter warrants held.
Trading income decreased $1.7 million and $2.3 million, respectively, in the three and six-month periods ended June 30, 2006 compared to the same periods of 2005, primarily due to lower prices for several of the securities we hold in our trading inventories. Our focus is on very small capitalization issues, especially those tied to our corporate finance clients. Trading income can be volatile from period to period based on the fact that it is driven by the market value of the securities in which we make a market.
Expenses
Total expenses decreased $1.8 million and $3.0 million, respectively, in the three and six-month periods ended June 30, 2006 compared to the same periods of 2005, primarily due to decreases in commissions and salaries, professional fees, settlement expense and other, partially offset by increases in travel and entertainment.
Commissions and salaries decreased $1.4 million and $2.0 million, respectively, in the three and six-month periods ended June 30, 2006 compared to the same periods of 2005, primarily due to the fact that we do not pay trading and investment commissions on trading and investment losses. There were no significant changes in salary expense for the periods presented.
Professional fees decreased $0.1 million and $0.3 million, respectively, in the three and six-month periods ended June 30, 2006 compared to the same periods of 2005, primarily due to significant decreases in legal activity as a result of the settlement of certain cases during the 2005 periods.
The $0.1 million increase in travel and entertainment expense in both the three and six-month periods ended June 30, 2006 compared to the same periods of 2005 was primarily due to a corporate finance/incentive conference held in June 2006 with no comparable conference in 2005.
Settlement expense in the 2005 periods related to amounts required to settle certain legal matters.
Other expense includes items such as depreciation and amortization, advertising and promotion, dues and subscriptions and other office expenses. Other expense decreased $0.2 million and $0.3 million, respectively, in the three and six-month periods ended June 30, 2006 compared to the same periods of 2005, primarily due to a $40,000 and $60,000 decrease, respectively, in advertising and promotion due to a greater focus in our advertising campaigns, as well as net decreases in various other expense categories.
Income (Loss) Before Income Taxes
A reconciliation of income (loss) before income taxes without the effect of underwriter warrants to income (loss) before income taxes as reported was as follows:
| | Three Months Ended June 30, | | Six Months Ended June 30, | |
| | 2006 | | 2005 | | 2006 | | 2005 | |
Income (loss) before income taxes, without effect of underwriter warrants | | $ | (146,318 | ) | $ | 9,591,466 | | $ | (4,191,315 | ) | $ | 12,287,255 | |
Increase (decrease) in Black-Scholes value of underwriter warrants | | (314,144 | ) | 322,400 | | (1,939,144 | ) | 1,906,400 | |
Black-Scholes value of underwriter warrants received during the period, net of compensation | | 1,524,144 | | 207,600 | | 1,524,144 | | 207,600 | |
Income (loss) before income taxes, as reported | | $ | 1,063,682 | | $ | 10,121,466 | | $ | (4,606,315 | ) | $ | 14,401,255 | |
Because of changes in the underlying securities and other factors, significant fluctuations in the value of underwriter warrants often occur from period to period, affecting the comparability of our revenues and operating results.
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Liquidity and Capital Resources
Our primary sources of liquidity include our cash and cash equivalents and receivables from our clearing organization, offset by payables to our clearing organization.
In addition, our sources of liquidity include our trading positions, investment positions, borrowings on those positions and profits realized upon the sale of the securities underlying underwriter warrants exercised. The liquidity of the market for many of our securities holdings, however, varies with trends in the stock market. Since many of the securities we hold are thinly traded, and we are, in many cases, a primary market maker in the issues held, any significant sales of our positions could adversely affect the liquidity of the issues held. In general, falling prices in OTC securities (which make up most of our trading positions) lead to decreased liquidity in the market for these issues, while rising prices in OTC issues tend to increase the liquidity of the market for these securities.
We believe our liquidity is sufficient to meet our needs for both the short and long-term horizon. Our liquidity could be negatively affected by protracted unfavorable market conditions.
As a securities broker-dealer, we are required by SEC regulations to meet certain liquidity and capital standards. We believe we were in compliance with these standards at June 30, 2006.
We borrow money from our clearing firm, National Financial Services (“NFS”), in the ordinary course of business, pursuant to an understanding under which NFS agrees to finance our trading accounts. As of June 30, 2006, we had $9.3 million available to borrow from NFS and no net loans were outstanding pursuant to this arrangement. We are generally able to meet our compensation and other obligations out of current liquid assets.
Following the lapse of restrictions upon issuance, capital available from the sale of the underlying securities of underwriter warrants exercised can fluctuate significantly from period to period as the value of the underlying securities fluctuates with overall market and individual company financial condition or performance. There is no public market for the underwriter warrants. The securities receivable upon exercise of the underwriter warrants cannot be resold unless the issuer has registered these securities with the SEC and with the states in which the securities will be sold unless exemptions are available. Any delay or other problem in the registration of these securities would have an adverse impact upon our ability to obtain funds from the exercise of the underwriter warrants and the resale of the underlying securities. At June 30, 2006, we owned 13 underwriter warrants, all but two of which were exercisable. Three of the warrants had an exercise price below the June 30, 2006 market price of the securities receivable upon exercise. The intrinsic value of these warrants was $1.3 million at June 30, 2006. There is little or no direct relationship between the intrinsic value of our underwriter warrants at the end of any given period and the fair value calculated using the Black-Scholes option pricing model. The prices of the securities underlying the underwriter warrants are very volatile, and substantial fluctuations in our estimate of their value can be expected in the future. In the six months ended June 30, 2006, we exercised one underwriter warrant, which resulted in net proceeds of $0.7 million upon the sale of the related securities.
Cash provided by operating activities in the first six months of 2006 totaled $0.3 million, primarily due to our net loss of $2.8 million and net non-cash income items of $3.5 million being offset by changes in our operating assets and liabilities as discussed in more detail below.
Our net receivable from our clearing organization decreased $3.7 million to $5.7 million at June 30, 2006 from $9.4 million at December 31, 2005, primarily due to the results of the activity in our trading and investment accounts, as well as the timing of general corporate expenditures.
Notes and other receivables, which primarily represent employee and independent broker advances and expenses in excess of commission earnings, commissions receivable and amounts receivable from corporate finance clients, decreased $0.4 million to $0.7 million at June 30, 2006 from $1.1 million at December 31, 2005, primarily due to payments received from corporate finance clients.
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Changes in our trading and investment securities are dependent on the purchase and sale of securities during the period, as well as changes in their fair market values during the period.
Prepaid and deferred expenses decreased $0.3 million to $0.4 million at June 30, 2006 from $0.7 million at December 31, 2005, primarily due to the amortization of registration fees for our registered representatives and of insurance premiums.
Accounts payable decreased $0.8 million to $0.4 million at June 30, 2006 from $1.2 million at December 31, 2005, primarily due to the payment of $0.5 million of settlements during the first half of 2006, which were related to the fiscal 2005 settlements.
Compensation, employee benefits and payroll taxes decreased $1.3 million to $0.8 million at June 30, 2006 from $2.1 million at December 31, 2005, primarily due to the payment of commissions that were accrued at December 31, 2005. Accruals for commissions were lower in 2006 due to weaker results of operations.
Dividends payable of $0.9 million at December 31, 2005 represented a special dividend, which was authorized by the Board of Directors, of $0.30 per share to shareholders of record on January 17, 2006. The dividend payment was made on February 10, 2006.
Income taxes payable decreased $1.3 million to $1.0 million at June 30, 2006 from $2.3 million at December 31, 2005, primarily due to $3.5 million of income tax payments made during the first six months of 2006, partially offset by the accrual for fiscal 2006 taxes payable related to realized gains on investments.
Deferred income taxes decreased $3.9 million to $1.5 million at June 30, 2006 from $5.4 million at December 31, 2005, primarily due to a $9.6 million unrealized loss on securities.
Capital expenditures of $85,000 in the first six months of 2006 were primarily for leasehold improvements at our Salem, Oregon office. At June 30, 2006, we did not have any material commitments for capital expenditures.
In September 2001, our Board of Directors approved a stock repurchase program pursuant to which we are authorized to repurchase up to 600,000 shares of our common stock. Through June 30, 2006, we had repurchased a total of 278,142 shares and 321,858 shares remained available for repurchase. This repurchase program does not have an expiration date.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
There have been no material changes in our reported market risks or risk management policies since the filing of our Form 10-Q for the quarter ended March 31, 2006, which was filed with the Securities and Exchange Commission on May 15, 2006.
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Item 4. Controls and Procedures
Disclosure Controls and Procedures
Our management has evaluated, under the supervision and with the participation of our President and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report as defined in Rule 13a-15(b) or Rule 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”). Based on that evaluation, our President and our Chief Financial Officer have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are effective in ensuring that information required to be disclosed in our Exchange Act reports is (1) recorded, processed, summarized and reported in a timely manner, and (2) accumulated and communicated to our management, including our President and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Changes in Internal Controls
There has been no change in our internal control over financial reporting that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
See Note 4 of Notes to Consolidated Financial Statements in Part I, Item 1.
Item 1A. Risk Factors
Our Annual Report on Form 10-K for the year ended December 31, 2005 includes a detailed discussion of our risk factors. There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K. Accordingly, the information in this Form 10-Q should be read in conjunction with the risk factors and information disclosed in our Annual Report on Form 10-K for the year ended December 31, 2005, which was filed with the Securities and Exchange Commission on March 29, 2006. See also Part I, Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this report under the heading “Forward Looking Statements and Risk Factors.”
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
We repurchased the following shares of our common stock during the second quarter of 2006:
| | Total number
of shares
purchased | | Average
price paid
per share | | Total number of
shares purchased
as part of publicly
announced plan | | Maximum number
of shares that may
yet be purchased
under the plan | |
April 1 to April 30 | | 600 | | $ | 7.25 | | 254,934 | | 345,066 | |
May 1 to May 31 | | 14,400 | | 6.91 | | 269,334 | | 330,666 | |
June 1 to June 30 | | 8,808 | | 6.35 | | 278,142 | | 321,858 | |
Total | | 23,808 | (1) | 6.71 | | 278,142 | | 321,858 | |
| | | | | | | | | | |
(1) Of the 23,808 shares, 6,000 were purchased from our executive officers and employees (and their affiliates), not as open-market purchases, at an average price of $7.00 per share.
The plan to repurchase up to a total of 600,000 shares of our common stock was approved by our Board of Directors in September 2001 and does not have an expiration date.
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Item 4. Submission of Matters to a Vote of Security Holders
Our annual meeting of the shareholders was held on June 8, 2006. The following action was approved:
1. To elect the following persons to serve as directors of Paulson Capital Corp. until the next annual meeting of shareholders and until their successors are duly elected and qualified:
Name | | Number of Shares
Voting For | | Number of Shares
Withheld Voting | |
Chester L. F. Paulson | | 5,965,927 | | 92,068 | |
Jacqueline M. Paulson | | 5,972,327 | | 85,668 | |
Steve Kleemann | | 6,053,995 | | 4,000 | |
Shannon P. Pratt | | 6,053,995 | | 4,000 | |
Paul Shoen | | 6,053,995 | | 4,000 | |
Item 6. Exhibits
The following exhibits are filed herewith and this list is intended to constitute the exhibit index:
10.1 | | Fully Disclosed Clearing Agreement between RBC Dain Correspondent Services and Paulson Investment Company, Inc. |
31.1 | | Certification of Principal Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934. |
31.2 | | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934. |
32.1 | | Certification of Principal Executive Officer pursuant to Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350. |
32.2 | | Certification of Chief Financial Officer pursuant to Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350. |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: August 11, 2006 | PAULSON CAPITAL CORP. |
| |
| By | /s/ CHESTER L. F. PAULSON |
| Chester L. F. Paulson
President and Chief Executive Officer
Principal Executive Officer |
| | |
| By | /s/ KAREN L. JOHANNES |
| Karen L. Johannes
Chief Financial Officer
Principal Financial Officer |
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