ITEM 1. BUSINESS
Forward-Looking Statements
This report, including, without limitation, Item 7. “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 (the “Exchange Act”). 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.
General
Paulson Capital Corp. (the “Company”), established in 1970, is a holding company whose operating subsidiary, Paulson Investment Company, Inc. ("PIC"), is a full service brokerage firm. Substantially all of our business has historically consisted of the securities brokerage and corporate finance activities conducted through PIC, which has operations in four principal categories, all of them in the financial services industry. These categories are:
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corporate finance revenues consisting principally of underwriting discounts and underwriter warrants;
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securities trading from which we record profit or loss, depending on trading results;
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investment income resulting from earnings on, and increases or decreases in the value of, our investment portfolio; and
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securities brokerage activities for which we earn commission revenues.
In addition, Paulson Capital Properties, LLC, a 100% owned subsidiary, was established for the purpose of purchasing, improving and remarketing underappreciated real estate. Through December 31, 2013, we had not purchased any real estate.
During the second quarter of fiscal 2012 ended June 30, 2012, the Company sold substantially all PIC's retail brokerage business to JHS Capital Advisors, LLC and is focusing its operations on boutique investment banking.
SALE OF RETAIL BROKERAGE OPERATIONS
In February 2012, the Company announced it had reached an agreement with JHS Capital Advisors, LLC (“JHS”) of Tampa, Florida to sell substantially all of its retail brokerage operations, including many of its branch and non-branch offices as well as registered personnel (employees and independent contractors), to JHS. Under the transaction, Paulson advisors became registered representatives of JHS and, through JHS, will continue to use RBC Correspondent Services, a division of RBC Capital Markets, LLC, for custody of client assets and securities, trade execution and portfolio reporting.
The sale closed on April 16, 2012. Under the agreement, the Company was to be paid approximately $1,653,247 net of certain deductions for compensation expenses. $1,107,741 was received at closing, and the balance was paid over three installments on July 16, 2012, October 15, 2012 and January 11, 2013. The final purchase price was subject to recalculation after six months based upon the aggregate gross dealer commissions for the 12 month period ended at that time. After the recalculation, the final purchase price was $1,522,841. As of December 31, 2013, all amounts due under the agreement had been received by the Company.
The agreement also required 12 directors, officers and employees of the Company to enter into non-solicitation agreements pursuant to which they are prohibited from soliciting employees and registered representatives of JHS for two years from the closing date. These 12 people also entered into non-competition agreements which have since expired.
RESTRUCTURING OF THE COMPANY
Management and the Board of Directors have determined that due to market conditions and changes in government regulations, raising money for smaller capitalization and emerging companies has become very difficult for a company with Paulson’s historical structure. Therefore, the Company has begun to take certain steps to reorganize its business. At the 2013 Annual Meeting of Shareholders held on November 8, 2013 (the “2013 Shareholders Meeting”), the Company’s shareholders approved several corporate restructuring proposals. If certain conditions are met, the implementation of these proposals will result in $5.25 million of new investment in the Company as well as a possible reverse split of the Company’s Common Stock and change of the state of incorporation from Oregon to Delaware. Each proposed change is discussed below and in more detail in our definitive Proxy Statement on Schedule 14A filed with the SEC on October 18, 2013 and the results of the Annual Meeting filed under Form 8-K/A on November 18, 2013.
New investments and change in ownership of Paulson Investment Company
In January 2013, the Company began to effect a change of ownership of the broker-dealer license held by our wholly owned subsidiary, Paulson Investment Company, Inc. ("PIC") to allow the expansion of PIC’s boutique investment banking activities. The Company believes that in order for PIC to be successful in the current investment environment, PIC must expand its investment banking capabilities to include early- and late-stage private financings, and that a new management team being formed has the experience and knowledge to execute on this strategy while leveraging the existing broker-dealer platform. Subject to FINRA approval, PIC plans to convert to a new limited liability company owned by its management and outside investors.
In January 2013, PIC received a $1,500,000 loan from a related party investor pursuant to a convertible promissory note bearing 5% simple interest which is due on January 13, 2016. The note is convertible, subject to FINRA approval, into preferred stock of PIC, representing approximately 35% ownership interest in PIC on a fully diluted basis. The noteholder agreed the note would stop accruing interest after April 30, 2013.
During the second quarter of fiscal 2013, PIC issued 215,438 shares of series B preferred stock for $1,500,000. The series B preferred stock is afforded no conversion or voting rights. Upon a liquidation event, the shareholder would be given a liquidation preference equal to 15.79%.
During the fourth quarter of fiscal 2013, PIC received a $700,000 loan from an outside investor pursuant to a convertible promissory note bearing 5% simple interest which is due on July 1, 2014. The note is convertible into 11.6% of the equity of PIC upon the earlier (i) all necessary FINRA and NASDAQ approvals and (ii) July 1, 2014.
The funds from these loans and the preferred stock investment have allowed the Company to expand its investment banking activities on behalf of smaller and emerging companies to include early- and late-stage private financings. During fiscal 2013, the Company added additional personnel, including institutional brokers focused on managing private financings, and two new office locations in New York City and Novato, California.
Formation of Liquidating Trust
The Board of Directors of the Company has also approved the formation of a trust (the "Trust") for the benefit of shareholders of the Company as of the record date of October 11, 2013 (the “Record Date”). The Trust, if and when formed, will hold certain non-operating assets of the Company (the “Trust Assets”). Common shareholders of record as of the Record Date (the “Legacy Shareholders”) will be given non-transferable beneficial interests in the Trust in proportion to their pro rata ownership interest in the common stock of the Company (the “Common Stock”) as of the Record Date. It is expected the Trust Assets will be liquidated and distributed to the Legacy Shareholders over time.
As of December 31, 2013, the Trust had not yet been formed. Upon its formation, the Trust will hold certain non-operating assets of PIC consisting primarily of underwriter warrants, trading and investment securities, an insurance policy on the life of the Founder of Paulson Capital (or the proceeds from its sale), and cash and accounts receivable (the "Trust Assets"). Once the Trust Assets are transferred to the Trust, PIC and the Company will have no access or rights to the Trust Assets, but the Trust Assets may be subject to the claims of the Company’s general creditors.
Summary of Liquidating Trust Assets
The following is a summary of the assets as of December 31, 2013 that are proposed to be transferred into the Trust. The assets that are actually transferred into the Trust will be those available on the date of transfer:
(1) Represents the estimated intangible value of the Trust's proportionate equity interest in PIC.
(2) Securities are classified as Level 1 in Note 7 - Fair Value Measurements.
(3) Securities are classified as Level 3 in Note 7 - Fair Value Measurements.
In order to assure the availability of funds to satisfy the payment of indemnification obligations in connection with the Proposed Financing (as defined below), PIC shall deposit $250,000 in a segregated bank account, such funds to remain on deposit for 12 months from the date of release of the Investment Funds (as defined below) from escrow. The Investment Funds will be available to settle any claim by the Investors (as defined below) following release from escrow. In addition, PIC shall pay or set aside a sufficient portion of the Trust Assets or pay directly from the Trust for such period as is required to secure and maintain coverage for a period of two years following the date of release of the Investment Funds from escrow under (A) a policy providing for officers' and directors' liability no less favorable and in no lower amounts as is presently provided, and (B) its existing errors and omissions policy. Such obligation may be satisfied by prepayment or deposit in the segregated bank account.
The Company intends to transfer the $7 million life insurance policy on its Founder and Chairman, Chester L.F. Paulson (or the proceeds from its sale) to the Trust. The monthly premiums are presently $15,315.
The Proposed Financing will cause a change in control under Section 382 of the Internal Revenue Code. As a result, future utilization of our net operating losses may be significantly limited. Notwithstanding this limitation, after consummation of the Proposed Financing such losses are generally available to offset unrecognized taxable gains present at the time of the Proposed Financing. Changes in control after the proposed transaction could further limit the ability to utilize all of our loss carryovers. Federal net operating loss carryforwards of $5.5 million at December 31, 2013 fully expire in 2033. State net operating loss carryforwards of $15.8 million at December 31, 2013, expire from 2014 through 2033. State net capital losses of $4.1 million at December 31, 2013 expire from 2014 to 2017.
Proposed Financing
On July 25, 2013, the Company entered into a series of agreements intended to secure investment in the Company of $5,250,000 (the “Investment Funds”) with DKR Ventures, LLC, a Delaware limited liability company, and Hudson Bay Master Fund Ltd., a Cayman Islands limited partnership (collectively, the “Investors”) in a private placement transaction (the “Proposed Financing”) intended to be exempt from registration under the Securities Act of 1933, as amended, subject to satisfaction of certain conditions.
Under the agreements, the Company will complete the private placement of a Unit consisting of (i) 287,773 shares of Common Stock; (ii) 500,000 shares of Series A Preferred Stock; (iii) a Class A Warrant; and (iv) a Class B Warrant. Each share of Series A Preferred Stock has a stated value of $0.806974 and a conversion ratio of 2.305640603 per share of Common Stock, subject to adjustment. Each share of Series B Preferred Stock will be convertible into one share of Common Stock and have a stated value of $0.35 per share (the “Stated Value”) and a conversion ratio equal to one share of Common Stock for each share of Series B Preferred Stock outstanding, equal to a purchase price of $0.35 per share of Common Stock, subject to adjustment. The Class A Warrant is exercisable for up to 7,500,000 shares of Series B Preferred Stock at a per share exercise price of $0.80, subject to adjustment, beginning on the date that is six months following the date of issuance and ending on the date that is five years thereafter. The Class B Warrant is exercisable for up to 13,559,407 shares of Series B Preferred Stock. The purchase price of one share of Common Stock underlying the Class B Warrant is deemed to be $0.35, subject to adjustment, without any payment of consideration by the Holder upon exercise. The Class B Warrant is exercisable beginning on the date that is six months following the date of issuance and ending on the date that is two years thereafter.
The Unit is governed by a “most favored nations” provision pursuant to which the Company will be obligated (with certain exceptions) to issue additional Units to the investor(s) in the event the Company issues securities at a per share price less than $0.35 per share of Common Stock (prior to giving effect to any Reverse Split). Additionally, the holder of the Unit has the right to participate in future offerings of securities by the Company for a period of 24 months, and the Company will be required to file a registration statement covering the resale of the securities underlying the Unit within 180 days from the closing of the sale of the Unit.
The Company and DKR Ventures, LLC, the lead investor in the Proposed Financing, entered into an Interest Preservation Letter Agreement, under which the Company and the investor agreed if, within 18 months from the release from escrow of the securities underlying the Units to the purchasers and the purchase price to the Company, the Company consummates an acquisition in which it issues additional securities as payment therefor, which has the effect of causing the Legacy Shareholders to hold, in the aggregate, less than 5.5% of the outstanding capital stock of the Company (the “Target Percentage”), then the Company shall issue to the Legacy Shareholders, for no additional payment, pro rata in proportion to their interests on the Record Date, that number of shares of the Company's Common Stock necessary for the Legacy Holders to hold, collectively, the Target Percentage.
The Investment Funds have been placed in escrow pending satisfaction of certain conditions, including approval by the Company’s shareholders which was obtained at the 2013 Shareholder Meeting. The Proposed Financing is expected to close in March 2014. As of December 31, 2013 and March 18, 2014, the Proposed Financing had not yet closed.
On January 29, 2014, the Company closed the private sale of 500,000 shares of its Common Stock to six accredited investors at a price of $0.50 per share for gross proceeds of $250,000. The shares were sold without registration in reliance upon the private transaction exemption set forth in Section 4(a)(2) of the Securities Act of 1933, as amended (the “Securities Act”), and/or Rule 506 of Regulation D promulgated under the Securities Act.
Proposed Increase to the Number of Authorized Shares
At the 2013 Shareholders Meeting, shareholders approved the amendment and restatement of the Company’s Articles of Incorporation to increase the authorized capital stock from 10,000,000 shares of Common Stock, no par value per share, and 500,000 shares of preferred stock, no par value, to 90,000,000 shares of Common Stock, par value $0.0001 per share, and 30,000,000 shares of “Blank Check” Preferred Stock, par value $0.0001 per share. As of December 31, 2013, the Company had 6,093,258 shares of Common Stock issued (including 5,805,485 issued and outstanding, and 287,773 contingently issued upon breaking escrow) and no shares of Preferred Stock issued and outstanding. As of December 31, 2013 and March 18, 2014, the Articles of Incorporation have not yet been amended and restated to change the authorized capital stock.
Under the Company’s 1999 Stock Option Plan, which expired in September 2009, 180,000 shares of Common Stock are reserved for potential future issuance pursuant to the Company’s outstanding options. Pursuant to the Company’s 2013 Equity Incentive Plan as approved by shareholders at the 2013 Shareholders Meeting, the Company has reserved 1,500,000 shares of Common Stock for potential future issuance; options to purchase 300,000 shares have been granted under this plan.
Subsequent to December 31, 2013, the Company closed the private sale of 500,000 shares of its Common Stock to accredited investors at a price of $0.50 per share for gross proceeds of $250,000. As of March 18, 2014, the Company had 6,593,258 shares of Common Stock issued and outstanding and no shares of Preferred Stock issued and outstanding.
Proposed Reverse Stock Split of Common Stock
At the 2013 Shareholders Meeting, shareholders approved the proposal to grant the Board of Directors the authority to effect a reverse stock split of its Common Stock. The proposal permits, but does not require, the Board of Directors to effect a reverse stock split of the issued and outstanding Common Stock at any time prior to 18 months from the date of approval by a ratio of not less than one-for-two and not more than one-for-ten, with the exact ratio to be set within this range at the sole discretion of the Board of Directors. The Board reserves the right to elect to abandon the Reverse Stock Split, including any or all proposed reverse stock split ratios, if it determines, in its sole discretion, that the Reverse Stock Split is no longer in the best interests of the Company and its shareholders.
After any reverse stock split, the Company will continue to be subject to the periodic reporting and other requirements of the Exchange Act. The Company intends to have its Common Stock continue to be listed on the NASDAQ Capital Market under the symbol “PLCC” subject to any decision of our Board of Directors to list our securities on an alternate stock exchange or any change of name and symbol. To avoid the existence of fractional shares of our Common Stock, the Company will pay cash in lieu of fractional shares.
As of the date of this report, the Board of Directors had not acted to effect a reverse stock split of the Common Stock.
Proposed Change of State of Incorporation
At the 2013 Shareholders Meeting, the shareholders approved a proposal to change the Company’s state of incorporation to Delaware from Oregon (the “Reincorporation”). The Board of Directors of the Company believes that the best interests of the Company and its shareholders will be served by changing the Company’s state of incorporation from Oregon to Delaware. The Reincorporation will cause the Company to be governed by the Delaware General Corporation Law rather than by the Oregon Business Corporation Act. Delaware has historically been a leader in adopting and interpreting comprehensive and flexible corporate laws responsive to the legal and business needs of corporations. Reincorporation of the Company will not, in and of itself, result in any change in the name, business, management, or location of the principal executive offices, assets or liabilities of the Company. As of the date of this report, the reincorporation had not yet been effected.
Classification of the Board of Directors
At the 2013 Shareholders Meeting, the shareholders approved an amendment and restatement of the Articles of Incorporation to classify the Board of Directors into three classes with staggered terms, with one class being elected each year to serve a staggered three-year term. Directors in each class were elected at the 2013 Shareholders Meeting. The directors initially elected in Class I serve until the 2014 Annual Meeting of Shareholders, the directors initially elected in Class II serve until the 2015 Annual Meeting of Shareholders, and the directors initially elected in Class III serve until the 2016 Annual Meeting of Shareholders. Beginning with the election of directors to be held at the 2014 Annual Meeting of Shareholders, and going forward, the class of directors to be elected in such year would be elected for a three-year term, and at each successive Annual Meeting of Shareholders, the class of directors to be elected in such year would be elected for a three-year term, so that the term of office of one class of directors shall expire in each year. As of the date of this report, the Articles of Incorporation had not yet been amended and restated to change the classification of the Board of Directors. Details of the above proposals are contained in the Company’s definitive proxy statement on Schedule 14A as filed with the SEC on October 18, 2013.
Overview
Because we operate in the financial services industry, our revenues and earnings are substantially affected by general conditions in financial markets. Further, past performance is not necessarily indicative of results to be expected in future periods. 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 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. 2013 was a very good year for initial public offerings, both in the US and internationally. In the United States, the number of IPO's increased by nearly 75% to 222 and the proceeds were approximately $55 billion, which was an increase of approximately 30% over 2012. Global IPO volume increased by almost 50% to 300 offerings, and proceeds increased by 37% to $137 billion from approximately $100 billion in 2012. The outlook for the IPO market in 2014 is very good, as the continued strength in the market indices and global economic recovery has resulted in an increasing number of companies looking to go public. The recent implementation of the JOBS Act has led to increased interest in new offerings, particularly among smaller and development stage companies.
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 corporate finance revenues tend to result in sharper fluctuations, on a percentage basis, in net income or loss.
Our investment and 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. As a result, the value of our investment portfolio and securities held in connection with our trading and investment activities has experienced large quarterly fluctuations in income or loss, and our net worth has substantially increased or decreased as our securities holdings are marked to market.
A substantial portion of our corporate finance business consists of acting as placement agent for PIPEs and private placements for microcap and smallcap companies. As a part of our compensation for these activities, we typically receive warrants exercisable to purchase securities of the issuer similar to those that we offer and sell as placement agent. The warrants have varying terms and conditions, and generally have a five-year expiration date and are subject to a restricted period of six months to one year during which we cannot exercise. The exercise price is typically 120% of the price at which the securities were initially sold in the offering in which we participated. 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.
The following table shows the portion of our revenues that was attributable to each revenue category for the last two fiscal years (in thousands):
In 2013 and 2012, none of our revenue was from foreign sources. During 2013, one customer represented 10% or more of our total revenue. During 2012, no customer represented 10% or more of our total revenue. In addition, all of our long-lived assets were located within the U.S.
Clearing Firm
Pursuant to our agreement with RBC Correspondent Services, a division of RBC Capital Markets Corporation (“RBC CS”), RBC CS carries all of our customer securities accounts and performs the following services: (1) preparation and mailing of monthly statements to our customers; (2) settlement of contracts and transactions in securities between us and other broker-dealers and between us and our customers; (3) custody and safe-keeping of securities and cash, the handling of margin accounts, dividends, exchanges, rights offerings and tender offers; and (4) the execution of customer orders placed on an exchange. We determine the amount of commission to be charged to our customers on principal and agency transactions, as well as the price of securities purchased or sold in principal transactions. RBC CS receives compensation based on the number of transactions and revenue sharing arrangements. In the event of a liability arising from a bad debt from a customer, we are required to indemnify RBC CS against any loss. This potential liability is uninsured.
Commissions
As a securities broker, we act as agent for our customers in the purchase and sale of common and preferred stocks, options, warrants and debt securities traded on securities exchanges or in the over-the-counter (“OTC”) market. A portion of our revenue is derived from commissions from customers on these transactions. In the OTC market, transactions with customers in securities may be effected as principal, rather than agent, primarily in securities for which we are a market maker. Customer transactions in securities are effected either on a cash or margin basis.
We also enter into dealer agreements with mutual fund management companies and publicly registered limited partnerships. Commissions on the sale of these securities are derived from the standard dealer discounts, which range from approximately 1% to 8.5% of the purchase price of the securities, depending on the terms of the dealer agreement and the amount of the purchase. We do not generally sell interests in limited partnerships that are not publicly registered.
In the case of corporate finance transactions, described below, a portion of the discount applicable to securities placed by our retail brokerage group is credited to securities brokerage commissions and the commission payable to the broker is recorded as securities brokerage commission expense.
Corporate Finance
While a substantial portion of our corporate finance business consists of acting as placement agent for PIPEs and private placements for microcap and smallcap companies, we also act as managing underwriter of initial and follow-on public offerings for smaller companies. We underwrite the public offerings on a “firm commitment” basis, which means that we agree to purchase a specific amount of securities from the issuer at a discount and resell the securities to the public at a specified price after the registration statement for the offering is declared effective by the Securities and Exchange Commission (the “SEC”). Managing these public offerings involves the risk of loss if we are unable to resell at a profit the securities we are committed to purchase. This risk is usually reduced by including other stock brokerage firms as a part of an underwriting syndicate in which each member commits to purchase a specified amount of the offering. We, and the other underwriters, may also sell a portion of our respective commitments through a “selling group” of other stock brokerage firms that participate in selling the offering but are not subject to an underwriter’s commitment. As an underwriter, we are also subject to potential liability under federal and state securities laws if the registration statement or prospectus contains a material misstatement or omission.
The commitment of our capital between the time a firm commitment underwriting agreement becomes effective and the time we resell the securities constitutes a charge against our net capital. Accordingly, our participation in, or initiation of, underwritings may be limited by the financial requirements of the SEC and the Financial Industry Regulatory Authority (“FINRA”). See “Net Capital Requirements” below.
Between June 1, 1978 and December 31, 2013, we acted as the managing underwriter or co-managing underwriter for 168 public securities offerings, raising approximately $1.2 billion for corporate finance clients. Of these, 95 were initial public offerings. We typically receive 2% to 3% of the aggregate amount of money raised in an offering to cover nonaccountable expenses and between 7% and 9% as compensation to underwriters, selling group members and registered representatives, although these percentages may be lower for larger transactions.
As a part of our compensation for the underwriting activities, we also typically receive warrants exercisable to purchase securities of the issuer similar to those that we offer and sell as placement agent. The warrants have varying terms and conditions, and 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 exercise price is typically 120% of the price at which the securities are initially sold in the offering in which we participated. 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.
In 2013, we completed 12 private offerings, raising $29.8 million for 11 different companies. In 2012, we completed one initial public offering in which we raised $2.8 million for Methes Energies International, as well as one private placement.
Investment Income
We hold securities for investment, which are maintained in investment accounts that are segregated from our trading accounts. Our investment portfolio principally consists of securities purchased for investment and underwriter warrants.
From time to time, we make investments as a principal in companies that are, or are expected to be, corporate finance clients. The investment may be as convertible debt in anticipation of a public offering, in which case, if the offering is successful, the principal and interest are either converted to equity or repayable from the offering proceeds. If the offering is not successful, the debt is typically converted to equity. We also make investments in companies that are not anticipating an immediate public offering. In such cases, the investment is typically made in the form of the purchase of restricted equity securities. Typically, these type of investments have ranged from $50,000 to $1.0 million. At December 31, 2013, we held securities of 5 privately held companies in our investment accounts with a fair value of $1.1 million.
Trading Income and Market Making
In addition to executing trades as an agent, we may act as a principal in executing trades in equity securities and corporate debt securities. At December 31, 2013, we did not make a market in any securities, but maintained the ability to make markets should we choose to do so in the future.
Our market making activities are conducted both with other dealers in the “wholesale market” and with our customers. Transactions with customers are effected as principal at a net price equal to the current interdealer price plus or minus the approximate equivalent of a brokerage commission. In such transactions, the commission is recorded as securities brokerage commissions revenue while any profit or loss attributable to a change in value of the security in our trading account is recorded as trading profit or loss. Our transactions as principal expose us to risk because securities positions are subject to fluctuations in fair value and liquidity. Profits or losses on trading and investment positions depend upon the skills of the employees in our trading department and employees responsible for taking investment positions. The trading department is headquartered in our Portland, Oregon office.
Limitations on Investment and Trading Securities
The size of our investment and trading securities positions at any date may not be representative of our exposure on any other date, because the securities positions vary substantially depending upon economic and market conditions, the allocation of capital among types of inventories, underwriting commitments, customer demands and trading volume. The aggregate value of inventories that we may carry are limited by certain requirements under the SEC’s net capital rules. See “Net Capital Requirements” below.
Regulation
PIC is registered with the SEC as a broker-dealer under the Exchange Act and is a member of FINRA. PIC is also registered as a broker-dealer under the laws of all 50 states, Washington, D.C. and Puerto Rico.
PIC is a member of the Securities Investor Protection Corporation ("SIPC"), which provides, in the event of the liquidation of a broker-dealer, protection for customers' accounts (including the customer accounts of other securities firms when it acts on their behalf as a clearing broker) held by the firm of up to $500,000 for each customer, subject to a limitation of $100,000 for claims for cash balances. SIPC is funded through assessments on registered broker-dealers.
The securities business is subject to extensive regulation under federal and state laws. The principal purpose of regulation and discipline of broker-dealers is the protection of customers and the securities markets rather than protection of creditors and stockholders of broker-dealers. The SEC is the federal agency charged with administration of the federal securities laws. Much of the regulation of broker-dealers, however, has been delegated to self-regulatory organizations, principally FINRA. These self-regulatory organizations adopt rules (subject to approval by the SEC) that govern the industry and conduct periodic examinations of member broker-dealers. Securities firms are also subject to regulation and examination by state securities commissions in the states in which they are registered
The regulations to which broker-dealers are subject cover all aspects of the securities business, including sales methods, trading practices among broker-dealers, capital structure of securities firms, record keeping and the conduct of directors, officers and employees. Additional legislation, changes in rules promulgated by the SEC and by self-regulatory bodies or changes in the interpretation or enforcement of existing laws and rules often directly affect the method of operation and profitability of broker-dealers. The SEC, FINRA and state regulatory authorities may conduct administrative proceedings that can result in censure, fine, suspension or expulsion of a broker-dealer, its officers or employees.
Net Capital Requirements
We are required to maintain minimum “net capital” under the SEC’s net capital rule of not less than 6.67% of our “aggregate indebtedness” or $100,000, whichever is greater. In general, net capital consists of the broker-dealer’s net worth, adjusted by numerous factors specified in the applicable regulations. In particular, the value of securities that can be included in net capital is subject to reduction in fair value or principal amount. The amount of the required reduction, or “haircut,” depends on the nature of the security. As of December 31, 2013, we had net capital of $6.6 million, which exceeded our minimum requirement of $0.5 million by $6.1 million. The ratio of aggregate indebtedness of $7.0 million to net capital of $6.6 million at December 31, 2013, was 1.06 to 1.
In a public offering in which we act as an underwriter, we must have sufficient net capital to cover the amount of securities underwritten, applying the applicable formula mandated by the SEC, during the period between effectiveness and the closing of the transaction, usually 3 business days. This results in a significant temporary increase in our required net capital. Although this has never happened, in some cases, the amount of securities underwritten by us could be limited by our net capital. Any significant reduction in our net capital, even if we were still in compliance with the SEC’s net capital rule for its retail and trading activities, could have a material adverse effect on our ability to continue our investment banking activities.
Industry and Competition
All aspects of our business are highly competitive. In our general brokerage activities, we compete directly with numerous other broker-dealers, some of which are large well-known firms. Many of our competitors employ extensive advertising and actively solicit potential clients in order to increase business. In addition, brokerage firms compete by furnishing investment research publications to existing clients, the quality and breadth of which are considered important in the development of new business and the retention of existing clients. We also compete with a number of smaller regional brokerage firms.
Some commercial banks and thrift institutions offer securities brokerage services. Many commercial banks offer a variety of investment banking services. Competition among financial services firms also exists for investment representatives and other personnel.
The securities industry has become more concentrated and more competitive since we were founded, as numerous securities firms have either ceased operations or have been acquired by or merged into other firms. In addition, the 2008 financial crisis had an unprecedented impact on the financial services industry. Many of the biggest investment banks, including Bear Stearns, and Lehman Bros. no longer exist, and Goldman Sachs and Morgan Stanley have become bank holding companies. These developments resulted in uncertainty in the securities industry that abated somewhat in late 2009. The surviving investment banks have reported inconsistent recent results from their investment banking activities; much of their current revenue and profit growth has come from their other lines of business.
The securities industry has experienced substantial commission discounting by broker-dealers competing for brokerage business. In addition, specialized firms offer “discount” services to individual customers. These firms generally effect transactions for their customers on an “execution only” basis without offering other services such as portfolio valuation, investment recommendations and research. Discount brokerage firms may offer their services over the Internet, further decreasing offered commission rates and increasing ease of use for customers. Competition within the discount brokerage segment is fierce. Weaker online trading volumes and falling commission rates have prompted the discount brokers to merge in order to expand their client base, achieve operating synergies, and diversify their business away from heavy reliance on trading commissions. In addition, rapid growth in the mutual fund industry is presenting potential customers of ours with an increasing number of alternatives to traditional stock brokerage accounts.
In our investment banking activities, we compete with other brokerage firms, venture capital firms, banks and all other sources of capital for small, growing companies. Since we generally manage offerings smaller than $45 million, we do not typically compete with the investment banking departments of large, well-known national brokerage firms. Nevertheless, we have, in the past, occasionally managed larger offerings. In addition, large national and regional investment banking firms occasionally manage offerings of a size that is competitive with us, typically for fees and compensation less than that charged by us. When the market for initial public offerings is active, many small regional firms that do not typically engage in investment banking activities also begin to compete with us.
Employees
At December 31, 2013, we had 38 employees (of which 37 were full-time). Of these, 14 were executives and support staff and 24 were involved in brokerage activities and compensated primarily on a commission basis.
ITEM 1A.
ITEM 1A. RISK FACTORS
As a Smaller Reporting Company, information regarding Risk Factors is not required. However, the following risk factor, which is not inclusive of all risks applicable to us, should be considered as part of any investment decision regarding our stock.
Our stock may be delisted from The NASDAQ Capital Market, which could affect its market price and liquidity.
We are required to continually meet the listing requirements of The NASDAQ Capital Market (including a minimum bid price for our common stock of $1.00 per share) to maintain the listing of our common stock on The NASDAQ Capital Market. On February 24, 2014, we received a deficiency letter from The NASDAQ Stock Market indicating that for 30 consecutive trading days our common stock had a closing bid price below the $1.00 per share minimum. In accordance with NASDAQ Marketplace Rules, we were provided a compliance period of 180 calendar days, or until August 25, 2014, to regain compliance with this requirement. We can regain compliance with the minimum closing bid price requirement if the bid price of our common stock closes at $1.00 per share or higher for a minimum of 10 consecutive business days. If we do not regain compliance with the minimum closing bid price requirement during the initial 180-day compliance period, we will be granted an additional 180-day compliance period if we comply with The NASDAQ Capital Market's continued listing requirement for market value of publicly held shares and all other applicable listing requirements except the bid price requirement. If we do not regain compliance with the minimum closing bid price requirement during this second 180-day compliance period, NASDAQ will provide written notice that our securities will be delisted from The NASDAQ Capital Market. At such time, we are entitled to appeal the delisting determination to a NASDAQ Listing Qualifications Panel. We cannot provide any assurance that our stock price will recover within the permitted grace period. If our common stock is delisted, it could be more difficult to buy or sell our common stock and to obtain accurate quotations, and the price of our stock could suffer a material decline. Delisting may also impair our ability to raise capital.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not applicable.
ITEM 2.
ITEM 2. PROPERTIES
The Company has signed an 18-month sublease for 4,359 square feet of office space in Portland, Oregon commencing in April 2013; a five-year lease for 5,480 square feet of office space in New York City commencing in June 2013; and a two-year lease for 2,875 square feet of office space in Novato, California commencing in October 2013.
The future minimum payments for each of the next five years and thereafter required for leases were as follows:
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We have been named in and subject to various proceedings and claims arising primarily from our securities business activities, including lawsuits, arbitration claims, class actions and regulatory matters. Some of these claims have sought substantial compensatory, punitive or indeterminate damages. We are also involved in other reviews, investigations and proceedings by governmental and self-regulatory agencies regarding our business, certain of which may result in adverse judgments, settlements, fines, penalties, injunctions or other relief. Because litigation is inherently unpredictable, particularly in cases where claimants seek substantial or indeterminate damages or when investigations and proceedings are in the early stages, we cannot predict with certainty the losses or range of losses related to such matters, how such matters will be resolved, when they will ultimately be resolved, or what the eventual settlement, fine, penalty or other relief might be. Consequently, we cannot estimate losses or ranges of losses for matters where there is only a reasonable possibility that a loss may have been incurred. Although the ultimate outcome of these matters cannot be ascertained at this time, it is the opinion of management, after consultation with counsel, that the resolution of the foregoing matters will not have a material adverse effect on our consolidated financial statements, taken as a whole; such resolution may, however, have a material effect on the operating results in any future period, and, depending on the outcome and timing of any particular matter, may be material to the operating results for any period depending on the operating results for that period. We have provided loss allowances for such matters when the likelihood of them occurring is probable and the amount can be reasonably estimated. The ultimate resolution may differ materially from the amounts provided. Settlement expense totaled $208,000 and $199,000 in 2013 and 2012, respectively. At December 31, 2013, we had $52,500 accrued for pending legal matters.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURE
Not Applicable
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY
SECURITIES
Stock Prices and Dividends
Our Common Stock trades on the NASDAQ Capital Market under the symbol “PLCC,” but it is not actively traded. The following table sets forth the high and low closing sale prices of our Common Stock for each quarter in the two years ended December 31, 2013.
* The Company's Common Stock was suspended from trading on The NASDAQ Capital Market from November 21, 2013 until January 8, 2014 while the Company was subject to a listing review. On February 19, 2014, the NASDAQ Listing Qualifications Panel granted the Company's request for continued listing of our Common Stock on the The NASDAQ Capital Market.
As of December 31, 2013, we had 50 registered shareholders of record and 382 beneficial shareholders.
No dividends were declared or paid in 2013. Net capital requirements may limit our ability to pay future dividends to our shareholders.
During 2012, we paid two special cash dividends to our common shareholders. In March 2012, the Board of Directors approved a special cash dividend of $0.05 per common share payable April 16, 2012 to shareholders of record April 4, 2012. In December 2012, the Board approved a special cash dividend of $0.15 per share payable December 28, 2012 to shareholders of record December 14, 2012.
Equity Compensation Plan Information
See Item 12. for Equity Compensation Plan Information.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
As a Smaller Reporting Company, this information is not required.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
Substantially all of our business has historically consisted of the securities brokerage and corporate finance activities of our majority-owned subsidiary, Paulson Investment Company, Inc. (“PIC”), which has operations in four principal categories, all of them in the financial services industry. These categories are:
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corporate finance revenues consisting principally of underwriting discounts and underwriter warrants;
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securities trading from which we record profit or loss, depending on trading results;
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investment income resulting from earnings on, and increases or decreases in the value of, our investment portfolio; and
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securities brokerage activities for which we earn commission revenues.
During the second quarter of fiscal 2012 ended June 30, 2012, the Company sold substantially all of PIC's retail brokerage business to JHS Capital Advisors, LLC. and PIC is focusing its operations on boutique investment banking.
In addition, Paulson Capital Properties, LLC, a 100% owned subsidiary, was established for the purpose of purchasing, improving and remarketing underappreciated real estate. Through December 31, 2013, we had not purchased any real estate.
Because we operate in the financial services industry, our revenues and earnings are substantially affected by general conditions in financial markets. Further, past performance is not necessarily indicative of results to be expected in future periods. 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 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.
Global IPO volume increased by almost 50% and proceeds increased by 37% in 2013 compared to 2012, as 300 offerings were completed for proceeds of approximately $137 billion. Much of the increase was due to the strength in the US IPO market, where the number of IPO's rose by nearly 75% to 222. US IPO proceeds rose approximately 30% in 2013 to $55 billion. The outlook for the IPO market in 2014 is very good, as the continued strength in the market indices and global economic recovery has resulted in an increasing number of companies looking to go public. The recent implementation of the JOBS Act has led to increased interest in new offerings, particularly among smaller and development stage companies.
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 corporate finance revenues tend to result in sharper fluctuations, on a percentage basis, in net income or loss.
Our investment and 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. As a result, the value of our investment portfolio and securities held in connection with our trading and investment activities has experienced large quarterly fluctuations in income or loss, and our net worth has substantially increased or decreased as our securities holdings are marked to market.
A substantial portion of our corporate finance business consists of acting as placement agent of PIPEs and private placements for microcap and smallcap companies. As a part of our compensation for these activities, we typically receive warrants exercisable to purchase securities of the issuer similar to those that we offer and sell as placement agent. The warrants have varying terms and conditions, and generally have a five-year expiration date and are subject to a restricted period of six months to one-year during which we cannot exercise. The exercise price is typically 120% of the price at which the securities were initially sold in the offering in which we participated. 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.
CRITICAL ACCOUNTING POLICIES AND USE OF ESTIMATES
The following discussion and analysis of our financial condition and results of operations is based, in part, upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. In preparing our consolidated financial statements, we must make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our financial statements. Actual results are likely to differ from these estimates under different assumptions and conditions.
As a result of the factors described below, our revenues and earnings are subject to substantial fluctuation from period to period based on a variety of circumstances, many of which are beyond our control. An increase in financial market activity, and/or an increase in equity valuations, will generally result in increases in our revenues, earnings and net worth as our activity levels and the value of our investment portfolio increase. Conversely, a general market retrenchment will typically lead to decreased revenues, earnings and net worth as a result of both decreased activity and the need to adjust high investment portfolio values to lower levels. Accordingly, results for any historical period are not necessarily indicative of similar results for any future period.
The critical accounting policies described below include those that reflect significant judgments and uncertainties, which potentially could produce materially different results under different assumptions and conditions. We believe our critical accounting policies are limited to those described below.
Revenue Recognition
Securities transactions and related commissions revenue, including the sale of investment company shares, are recorded on a trade date basis. Underwriter’s fees and other underwriting revenues are recognized at the time the underwriting is completed. Revenue from sales of other securities including tax deferred units and insurance products is recorded when the units are sold. Revenue from the receipt of underwriter warrants is recognized when the underwriting is completed and the warrants are received based on the estimated fair value of the securities received as estimated using the Black-Scholes option-pricing model taking into account the exercise price, remaining life of the warrant, the current price of the underlying stock and its expected volatility, expected dividends on the stock and the risk-free interest rate for the remaining term of the warrant.
Value of Underwriter Warrants and Underwriter Warrants Payable to Employees
We are required to estimate the value of all securities that we hold at the date of any financial statements and to include that value, and changes in such value, in our financial statements. Accordingly, the aggregate fair value of our underwriter warrants is recorded as an asset on the balance sheets. When a new warrant is received, its fair value is included in corporate finance revenue on the date on which it is earned. Subsequently, any change in fair value is recorded as investment income or loss. When a warrant is exercised, the fair value is adjusted to reflect the value of the securities purchased, net of the exercise price, and the adjustment amount is recorded as income or loss for the relevant period. If a warrant expires unexercised, the fair value is adjusted to zero and the decrease is recorded as a loss in the relevant period.
We estimate the value of our underwriter warrants using the Black-Scholes Option Pricing Model. The Black-Scholes model requires us to use five inputs including: price, risk free rate, exercise price, time remaining on the warrant and price volatility. After stock price, the most influential factor in this model is price volatility, which we calculate for each company's warrants based on each company's own historical stock closing prices as well as an index of historical prices for comparable companies. When we initially receive a new underwriter warrant from an initial public offering, its calculated volatility factor is entirely based on the volatility of an index of comparable companies, since there is no price history for a new publicly traded company. For publicly traded companies, as each underwriter warrant approaches its expiration date, its volatility factor is derived primarily from the historical prices of its underlying common stock. Private company underwriter warrant valuations use the volatility index of comparable companies. There is no assurance that we will ultimately be able to exercise any of our warrants in a way that will realize the value that has been recorded in our financial statements based on this model. Underwriter warrants payable to employees represent warrants that are held by PIC, but are distributable to employees as compensation at December 31, 2013. At December 31, 2013, the value of underwriter warrants was $5.276 million and underwriter warrants payable to employees was $3.641 million, which were each included as a separate line item on the consolidated balance sheets.
Fair Value of Investments
In addition to our underwriter warrants, we hold other securities, some of which have very limited liquidity and some of which do not have a readily ascertainable fair value. We are required to carry these securities at fair value. The fair value of not readily marketable securities is estimated by management using available information including the following: quoted market prices of similar securities (i.e., unrestricted shares of the same company); price of recent known trades of the same or similar securities; the cost of the security, if recently purchased, adjusted for changes in the financial condition of the issuer; all other information available from review of available documents related to the issuer or discussions with management of the issuer. Changes in the value of these securities are reflected currently in our results of operations as a component of investment income. Our estimates regarding the fair value of securities that are not readily marketable are significant estimates and these estimates could change in the near term. At December 31, 2013, the fair value of investments which do not have a readily ascertainable fair value was $1.1 million and was included as a component of trading and investment securities owned on our consolidated balance sheet.
Notes and Other Receivables
Notes and other receivables generally are stated at their outstanding unpaid principal balance. Interest income on receivables is recognized on an accrual basis. Receivables are reviewed on a regular and continual basis by our management and, if events or changes in circumstances cause us to doubt the collectability of the contractual payments, a receivable will be assessed for impairment. The Company considers a receivable to be impaired when, based on upon current information and events, it believes it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the receivable agreement. When we determine collection to be doubtful, an allowance for amounts receivable is recorded and the receivable is placed on a non-performing (non-accrual) status. Payments received on non-accrual receivables are applied first to reduce the outstanding interest, and are then applied to the receivable unless we determine impairment is likely in which case payments are applied to the outstanding receivable balance (cost recovery method). Interest received on impaired receivables is recorded using the cash receipts method unless management determines further impairment is probable. No impairment loss is recorded if the carrying amount of the receivable (principal and accrued interest) is expected to be fully recovered through borrower payments and enforcement of action against the borrower's collateral, if any. The conclusion that a receivable may become uncollectible, in whole or in part, is a matter of judgment. We do not have a formal risk rating system. Receivables and the related accrued interest are analyzed on an individual and continuous basis for recoverability. Delinquencies are determined based upon contractual terms. A provision is made for doubtful accounts to adjust the allowance for doubtful accounts to an amount considered to be adequate, with due consideration to workout agreements, to provide for unrecoverable receivables and receivables, including impaired receivables, other receivables, and accrued interest. Uncollectible receivables and related interest receivable are charged directly to the allowance account once it is determined that the full amount is not collectible.
Legal Reserves
We record reserves related to legal proceedings resulting from lawsuits and arbitrations, which arise from our business activities. Some of these lawsuits and arbitrations claim substantial amounts, including punitive damage claims. Management has determined that it is likely that ultimate resolution in favor of the claimant will result in losses to us on certain of these claims. We have, after consultation with outside legal counsel and consideration of facts currently known by management, recorded estimated losses to the extent we believe certain claims are probable of loss and the amount of the loss can be reasonably estimated. Factors considered by management in estimating our liability are the loss and damages sought by the claimant/plaintiff, the merits of the claim, the amount of loss in the client’s account, the possibility of wrongdoing on the part of our employee and/or independent contractor, the total cost of defending the litigation, the likelihood of a successful defense against the claim, and the potential for fines and penalties from regulatory agencies. Results of litigation and arbitration are inherently uncertain, and management’s assessment of risk associated therewith is subject to change as the proceedings evolve. After discussion with legal counsel, management, based on its understanding of the facts, accrues what they consider appropriate to reserve against probable loss for certain claims, which is included in the consolidated balance sheets under the caption “accounts payable and accrued expenses.” At December 31, 2013, we had $52,500 accrued for pending legal matters.
Income Taxes
Benefits for uncertain tax positions are recognized when they are considered “more-likely-than-not” to be sustained by the taxing authority. At December 31, 2013, we did not have any unrecognized tax benefits which would have an impact on the effective tax rate if recognized. If we generate income before income taxes in future periods, our conclusion about the realizability of our deferred tax assets and therefore the appropriateness of the valuation allowance could change in a future period and we could record a substantial gain in our consolidated statements of operations when that occurs.
Stock-Based Compensation
Stock-based compensation for equity 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). Our awards typically vest on the date of grant and, accordingly, the expense is recognized on the date of grant. We utilize the Black-Scholes option pricing model for determining the fair value of stock option awards.
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 NASDAQ and over-the-counter markets, 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 period to period. Our revenues include the following:
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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;
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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, (iv) income on the exercise of underwriter warrants, and (v) the unrealized appreciation and depreciation of underwriter warrants held;
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Trading income (loss), which is the gain or loss from trading positions before commissions paid to the representatives in the trading department; and
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Commissions, which represent amounts earned from our retail securities brokerage activities.
The following table sets forth the changes in our operating results in 2013 compared to 2012 (dollars in thousands):
Revenues
The recovery in the global economies, particularly in Europe and the United States, had a positive effect on investor confidence which was reflected in the strong financial markets. For the period from December 31, 2012 to December 31, 2013, the Dow Jones Industrial Average increased by 26.5%, and the NASDAQ Composite Index increased by 38.3%.
Commissions declined 31% in 2013 compared to 2012, primarily due to the sale of substantially all the Company's retail brokerage business to JHS effective April 16, 2012 and the Company's renewed focus on investment banking operations for smaller and emerging companies. As of December 31, 2013, the Company had 24 registered representatives involved in brokerage activities and compensated primarily on a commission basis, which were included in the Company's 38 employees, compared to 4 registered representatives as of December 31, 2012.
Corporate finance income increased by 1,394% as the Company added additional personnel and two new offices to focus on investment banking operations. Corporate finance revenue in 2013 included:
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Participation in 12 private offerings during the year, in which we raised $29.8 million in gross proceeds for 11 different companies, and earned $1.259 million in underwriting fees as well as the Black-Scholes value of $6.523 million of the underwriter warrants received in connection with the offerings.
Corporate finance revenue in 2012 included:
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Underwriting fees earned from the initial public offering of Methes Energies International in the fourth quarter of 2012, in which we raised $2.8 million in gross proceeds, as well as the Black-Scholes value of the underwriter warrants received in connection with the offering.
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Fees earned in relation to an additional private placement of shares in Patron Company, Inc., as well as the value of the underwriter warrants received in connection with the offering.
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Fees earned performing financial advisory services for corporate financial clients.
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Revenue related to our participation in closed-end mutual funds.
Investment loss increased in 2013 by 59% over 2012 and included the following (in thousands):
We exercised one of our underwriter warrant positions, and exercised and sold approximately 10% of another of our underwriter warrant positions in 2013, and did not exercise any underwriter warrants in 2012. Generally, when we exercise a warrant to obtain the underlying common stock, the common stock is subsequently sold in the near term and the related gain is reflected as a component of investment income. During 2013, we incurred significant mark-to-market write-downs in the fair-value estimate of two of our private investments, which more than offset a large realized gain on the sale of another private investment position.
Investment income (loss) is volatile from period to period due to the fact that it is driven by the fair value of the securities and underwriter warrants held. In addition, the performance of the securities in which we have a concentration can significantly affect our investment income from period to period.
Trading income increased by $212,000 in 2013 compared to 2012. Trading income was positively affected by the market value of certain securities in which we made a market. Our focus is on very small capitalization issues, especially those tied to our corporate finance clients.
Expenses
Total expenses increased $4.18 million in 2013 compared to 2012, as described in more detail below.
Commissions and salaries increased $328,000 in 2013 compared to 2012. The Company has added additional personnel and two new offices in 2013 to support its investment banking operations.
Underwriter warrant commissions increased to $3.86 million in 2013 from zero in 2012. During 2013, the Company received warrants as compensation for completing private offerings of securities. A portion of the warrants received are payable to employees as commissions.
Underwriting expenses increased $33,000 in 2013 compared to 2012 as a result of the timing and level of investment banking activity in the respective periods.
Clearing expenses decreased $107,000 in 2013 compared to 2012. The decrease was primarily due to the sale of the Company's retail brokerage operations in April 2012.
Rent expense rose by $28,000 in 2013 compared to 2012 due to the Company adding new offices in New York and California during the year.
Communication and quotation services decreased by $192,000 due to the decline in the number of registered representatives in 2013 compared to 2012.
Professional fees rose by $440,000 in 2013 from 2012 primarily due to costs related to the reorganization of the Company and its PIC subsidiary.
Settlement expense increased $10,000 in 2013 compared to 2012, due to the settlement accruals of additional legal claims in 2013.
Bad debt expense, which is recorded for specific amounts when a receivable becomes impaired, totaled $359,000 in 2013 primarily due to impairment of the final installment due from the sale of one private investment. Bad debt expense in 2012 was $570,000 primarily due to the impairment of one note issued to a former employee, and two notes issued to corporate finance clients.
Licenses, taxes and insurance increased by $18,000 to $607,000 in 2013 from $589,000 in 2012 primarily due to higher insurance costs.
LIQUIDITY AND CAPITAL RESOURCES
Our primary sources of liquidity include our cash and receivables from our clearing organization, offset by payables to our clearing organization.
In addition, our sources of liquidity include, to a certain extent, our trading 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 NASDAQ and over-the-counter securities (which make up most of our trading positions) lead to decreased liquidity in the market for these issues, while rising prices in NASDAQ and over-the-counter issues tend to increase the liquidity of the market for these securities.
We believe our cash and receivables from our clearing organization at December 31, 2013 are sufficient to meet our cash and regulatory net capital needs for at least the next 12-month period from December 31, 2013. 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 December 31, 2013.
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 December 31, 2013, we owned 13 underwriter warrants from 9 issuers, all but 2 of which were exercisable. One of the warrants had an exercise price below the December 31, 2013 market price of the securities receivable upon exercise. 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 their fair value can be expected in the future.
Cash provided by operating activities totaled $2.778 million in 2013, primarily due to the increase in trading and investment securities owned and other changes in our operating assets and liabilities as discussed in more detail below. In 2012, operating activities used cash of $213,000.
Our net receivable from our clearing organization totaled $445,000 at December 31, 2013, compared to $2.3 million at December 31, 2012. Our net receivable from our clearing organization is affected by the results of the activity in our trading and investment accounts, as well as the timing of general corporate expenditures and cash flow requirements.
Notes and other receivables increased by $1.568 million to $1.779 million at December 31, 2013 from $211,000 at December 31, 2012. The increase was primarily due to $1,200,000 in loans issued to the Company’s newest employees.
Other assets in 2013 were $78,000 compared to zero in 2012. These assets represent the capitalized incremental direct costs related to the Proposed Financing.
Cash used by investing activities totaled $130,000 in 2013 compared to cash provided by investing activities of $1.413 million in 2012. In 2013, the Company acquired furniture and equipment for its relocated Portland office and new offices in New York City and Novato, California. In 2012, the cash provided was primarily from the sale of the Company’s retail brokerage operations.
Financing activities provided cash of $3.74 million in 2013. The cash was primarily related to the restructuring of PIC, including $700,000 from a note payable, $1.5 million from an advance from a related party, and $1.5 million from the issuance of preferred stock in PIC. During 2012, financing activities used cash of $1.16 million, with almost the entire amount due to dividends paid to common shareholders as the Company paid two special dividends totaling $0.20 per share to common shareholders during 2012.
Changes in our trading and investment securities owned are dependent on the purchase and sale of securities during the period, as well as changes in their fair values during the period.
A summary of activity related to the fair value of our underwriter warrants was as follows (in thousands):
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. In June 2008, our Board of Directors approved the repurchase of up to a total of an additional 200,000 shares of our common stock. We repurchased a total of 1,000 shares of our common stock during 2012 at an average price of $1.25 per share for a total of $1,250. Through December 31, 2013, 731,989 shares had been repurchased and, as of December 31, 2013, 68,011 shares remained available for repurchase. These repurchase programs do not have an expiration date.
OFF-BALANCE SHEET ARRANGEMENTS
We do not have any off-balance sheet arrangements that have or are reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
NEW ACCOUNTING PRONOUNCEMENTS
See Note 20. of Notes to Consolidated Financial Statements included under Part II, Item 8 of this Annual Report on Form 10-K.
CONTRACTUAL PAYMENT OBLIGATIONS
Tabular disclosure of contractual payment obligations is not required for Smaller Reporting Companies.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As a Smaller Reporting Company, this information is not required.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and notes thereto required by this item begin on page of this document, as listed in Item 15 of Part IV. The Supplementary Data is not included as it is not required for a Smaller Reporting Company.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. 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(e) or Rule 15d-15(e) under 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.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and Rules 15d-15(f). Under the supervision and with the participation of our management, including our President and our Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2013.
This Annual Report on Form 10-K does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting as it is not required for Non-Accelerated Filers, which include Smaller Reporting Companies.
Changes in Internal Control Over Financial Reporting
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.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The following table sets forth the Company's executive officers as of March 18, 2014:
The following table sets forth the Company's directors as of March 18, 2014:
The term of office for each director is until the next Annual Meeting of Shareholders or until his successor is duly elected and qualified.
Trent D. Davis joined Paulson Investment Company, Inc. in 1991 in our Operations Department, in 1992 moved to equity trading and, in 1996, was promoted to Senior Vice President, Syndicate/National Sales Department. In 2005, Mr. Davis was promoted to CEO of Paulson Investment Company, Inc. and became President of Paulson Capital Corp. in 2013. He was elected a Director of Paulson Capital Corp. at the 2013 Annual Meeting of Shareholders held on November 8, 2013. Mr. Davis served as a board member and Chairman of the National Investment Banking Association during 2003. Mr. Davis holds a B.S. in Business and Economics from Linfield College and a Master’s Degree in Business Administration from the University of Portland. FINRA Licenses include: Series 7, 24, 63 and 66.
Kellie M. Davis joined Paulson Investment Company, Inc. in 1990 and was named Secretary and Treasurer of Paulson Capital Corp. in 2014. She has served on the Board of Paulson Investment Company, Inc. since 2001 and is currently the Executive Assistant, Director of Human Resources, and strategic liaison for all departments. Kellie has also held positions of Operations Specialist, Director of Public Relations and Investor Relations, Director of Conference and Event Services. Ms. Davis graduated from Linfield College with a BS in Business. FINRA licenses include: Series 7 and 63.
Lorraine Maxfield joined Paulson Investment Company, Inc. in 1983 as a junior research analyst. In 1993, Ms. Maxfield was promoted to Vice President of Research and, in 1995, was promoted to Senior Vice President of Research. Subsequently, Ms. Maxfield was promoted to Senior Vice President, Corporate Finance. Ms. Maxfield attended the University of Oregon where she earned a B.A. in English and an M.A. in English Education, and later returned to the University of Oregon to earn her Master’s Degree in Business Administration. Ms. Maxfield is also a Chartered Financial Analyst (CFA). FINRA Licenses include: Series 7, 24 and 63.
Murray G. Smith became Chief Financial Officer for Paulson Capital Corp. and Paulson Investment Company, Inc. in 2010. Since 2006, Mr. Smith has managed Paulson Capital Corp.’s Sarbanes-Oxley compliance program. He also consulted on the profit-sharing plan and other compliance and accounting projects. Mr. Smith began his career as an Auditor with Allegheny Teledyne Inc. from 1993 to 1996 and with Arthur Andersen LLP from 1996 to 2000. From 2001 to 2006, Mr. Smith served as the Compensation and Benefits Accounting Controller and Sarbanes-Oxley Compliance Manager for Intel Corporation. In addition, Mr. Smith has worked as Controller of Calypte Biomedical Corp., Sarbanes-Oxley Consultant for AVI BioPharma, Inc., and Chief Financial Officer for Jewett-Cameron Trading Company. Mr. Smith earned a B.A. in Business Administration from the University of Washington. He is a Certified Public Accountant (CPA) and Certified Fraud Examiner (CFE). FINRA Licenses include: Series 7, 27 and 66.
Charles L.F. Paulson was named Chairman of Paulson Investment Company, Inc. in 2010. Mr. Paulson is the eldest son of our Founder and Chairman, Chester L.F. Paulson, and the stepson of Jacqueline M. Paulson. He began his career with Paulson Investment Company in 1974. During this time, he served as the Head Trader and continues to serve as the Senior Vice President of Proprietary Trading. His duties include overseeing trading of the firm’s investment accounts and advising senior management on market dynamics and trends that may affect or impact the value of its holdings. Mr. Paulson has served as a member of Paulson Investment Company, Inc.’s Board of Directors since 1994 and Paulson Capital Corp.’s Board of Directors since 2007. We believe that this experience makes Mr. Paulson a valuable Board member. FINRA Licenses include: Series 7, 24, 55 and 63.
Shannon P. Pratt, D.B.A. has been the Chairman and CEO of Shannon Pratt Valuations, Inc., a business valuation and financial advisory services firm, since January 2004. From 1995 to 2005, Dr. Pratt was Managing Owner of Business Valuation Resources. Dr. Pratt is a Lifetime Member Emeritus of the Business Valuation Committee of the American Society of Appraisers. He is also a Lifetime Member Emeritus of the Valuation Advisory Committee of The ESOP Association. Dr. Pratt has received the prestigious Magna Cum Laude award of the National Association of Certified Valuation Analysts for service to the business valuation profession, and he is also the first life member of the Institute of Business Appraisers. Dr. Pratt is a member and a past President of the Portland Society of Financial Analysts, the recipient of the 2002 Distinguished Achievement Award, a member of the Association for Corporate Growth and a past trustee of The Appraisal Foundation. Dr. Pratt holds a Doctor of Business Administration (D.B.A.) from Indiana University with a major in Finance and is also a Chartered Financial Analyst (CFA). Broadly published, he has either authored or co-authored ten books on the subject of business valuation, as well as many other articles, newsletters and papers. Based on the above, we believe that Dr. Pratt brings valuable experience in business valuations and financial analysis to our Board.
Paul F. Shoen is a private investor and also founded and has served as the Chairman of Pantechnicon Aviation, Ltd., a company that buys and sells aircraft, since 1995. Although he is no longer associated with them, over a 15-year period, Mr. Shoen served as a member of various Boards of Directors at the parent and subsidiary levels of Amerco, Inc., including the operational, real estate and insurance companies. He also served in various executive capacities within Amerco, including President and Vice-President of U-Haul International. Mr. Shoen attended College of the Holy Cross where he earned a B.A. in Psychology. He has also taken graduate-level business courses at the University of Chicago. Mr. Shoen is the Director of the Paul F. Shoen Foundation, a charitable organization. We believe that Mr. Shoen’s experience on other company boards and as a private investor is valuable to our Board.
Alan P. Timmins has served as vice president for financial affairs at the University of Portland since 2011. He is the former president and chief operating officer of AVI BioPharma, Inc., now known as Sarepta Therapeutics, Inc. ("AVI"). Mr. Timmins began working for AVI, a pioneering medical research company, in 1992 and was the company's first chief financial officer and executive vice president before serving as president and chief operating officer from 2000 to 2008. Before his career with AVI, he worked as an auditor with Price Waterhouse, now known as PricewaterhouseCoopers. He earned an MBA from Stanford University, and holds an undergraduate degree from the University of Portland. In 2009, he was named one of the "Significant 75" alumni of the University of Portland's Pamplin School of Business Administration. Mr. Timmins is a Certified Public Accountant (inactive). We believe his experience and financial background make him a valuable Board member.
Family Relationships
There are no family relationships between our officers and directors other than the following:
●
Trent D. Davis and Kellie M. Davis are husband and wife;
●
Charles L.F. Paulson is the son of Chester L.F. Paulson, the Company’s former Chairman, President and Chief Executive Officer, the brother-in-law of Trent D. Davis; and the stepbrother of Kellie M. Davis.
●
Murray G. Smith is the brother of Kellie M. Davis and the brother-in-law of Trent D. Davis.
●
Trent D. Davis is the son-in-law of Chester L.F. Paulson.
●
Kellie M. Davis is the stepdaughter of Chester L.F. Paulson.
Involvement in Certain Legal Proceedings
None of our directors or executive officers has been involved in any of events that are material to an evaluation of their ability or integrity during the past 10 years, including:
1)
Any petition under the Federal bankruptcy laws or any state insolvency law was filed by or against, or a receiver, fiscal agent or similar officer was appointed by a court for the business or property of such person, or any partnership in which he was a general partner at or within two years before the time of such filing, or any corporation or business association of which he was an executive officer at or within two years before the time of such filing;
(2)
Any conviction in a criminal proceeding or is a named subject of a pending criminal proceeding (excluding traffic violations and other minor offenses);
(3)
Subject of any order, judgment, or decree, not subsequently reversed, suspended or vacated, of any court of competent jurisdiction, permanently or temporarily enjoining him from, or otherwise limiting, the following activities:
(i)
Acting as a futures commission merchant, introducing broker, commodity trading advisor, commodity pool operator, floor broker, leverage transaction merchant, any other person regulated by the Commodity Futures Trading Commission, or an associated person of any of the foregoing, or as an investment adviser, underwriter, broker or dealer in securities, or as an affiliated person, director or employee of any investment company, bank, savings and loan association or insurance company, or engaging in or continuing any conduct or practice in connection with such activity;
(ii)
Engaging in any type of business practice; or
(iii)
Engaging in any activity in connection with the purchase or sale of any security or commodity or in connection with any violation of Federal or State securities laws or Federal commodities laws;
(4)
Subject of any order, judgment or decree, not subsequently reversed, suspended or vacated, of any Federal or State authority barring, suspending or otherwise limiting for more than 60 days the right of such person to engage in any activity described in paragraph (f)(3)(i) of this section, or to be associated with persons engaged in any such activity;
(5)
Found by a court of competent jurisdiction in a civil action or by the Commission to have violated any Federal or State securities law, and the judgment in such civil action or finding by the Commission has not been subsequently reversed, suspended, or vacated;
(6)
Found by a court of competent jurisdiction in a civil action or by the Commodity Futures Trading Commission to have violated any Federal commodities law, and the judgment in such civil action or finding by the Commodity Futures Trading Commission has not been subsequently reversed, suspended or vacated;
(7)
Subject of, or a party to, any Federal or State judicial or administrative order, judgment, decree, or finding, not subsequently reversed, suspended or vacated, relating to an alleged violation of:
(i)
Any Federal or State securities or commodities law or regulation; or
(ii)
Any law or regulation respecting financial institutions or insurance companies including, but not limited to, a temporary or permanent injunction, order of disgorgement or restitution, civil money penalty or temporary or permanent cease-and-desist order, or removal or prohibition order; or
(iii)
Any law or regulation prohibiting mail or wire fraud or fraud in connection with any business entity; or
(8)
Subject of, or a party to, any sanction or order, not subsequently reversed, suspended or vacated, of any self-regulatory organization (as defined in Section 3(a)(26) of the Exchange Act (15 U.S.C. 78c(a)(26))), any registered entity (as defined in Section 1(a)(29) of the Commodity Exchange Act (7 U.S.C. 1(a)(29))), or any equivalent exchange, association, entity or organization that has disciplinary authority over its members or persons associated with a member.
Committees of the Board of Directors
The Board of Directors held 8 meetings during the year ended December 31, 2013. During 2013, no director attended fewer than 75% of the meetings of the Board of Directors and any committees of which the director was a member. Although we do not maintain a formal policy regarding director attendance at our annual meeting of shareholders, members of the Board of Directors are encouraged to attend. All of the members of the Board of Directors attended our 2013 annual meeting of shareholders.
The Board of Directors has three standing committees: the Audit Committee, the Compensation Committee and the Nominating and Governance Committee. The Audit Committee was established in accordance with Section 3(a)(58)(A) of the Exchange Act.
Audit Committee. During 2013, our Audit Committee originally consisted of Mr. Steve Kleemann, Dr. Pratt (Chair) and Mr. Shoen. Mr. Kleemann passed away in July 2013. On December 16, 2013, Dr. Denis Burger was named to fill the vacancy on the Audit Committee. Dr. Burger resigned on January 22, 2014, and Alan P. Timmins was named to the Committee.
The Audit Committee reviews and makes recommendations to the Board of Directors concerning our internal accounting procedures, reviews and consults with our independent accountants on the accounting principles and auditing practices used for our financial statements and makes recommendations to the Board of Directors concerning the engagement of independent accountants and the scope of the audit to be undertaken by the accountants. The Board of Directors has determined that all members of our Audit Committee are independent under the rules of the Nasdaq Capital Market. The Audit Committee held one meeting during 2013. The Audit Committee Charter is available on our website at www.paulsoninvestment.com.
Compensation Committee. During 2013, our Compensation Committee originally consisted of Mr. Kleemann, Dr. Pratt (Chair) and Mr. Shoen. Mr. Kleemann passed away in July 2013. On December 16, 2013, Dr. Denis Burger was named to fill the vacancy on the Compensation Committee. Dr. Burger subsequently resigned on January 22, 2014, and Alan P. Timmins was named to the Committee.
The Compensation Committee is primarily responsible for reviewing the compensation of our executive officers, including the Chief Executive Officer, and for administering our stock option plan. The Board of Directors has determined that all members of our Compensation Committee are independent under the rules of the Nasdaq Capital Market. The Compensation Committee held one meeting during 2013. The Compensation Committee does not have a charter.
Nominating and Governance Committee. During 2013, our Nominating and Governance Committee originally consisted of Mr. Kleemann, Dr. Pratt (Chair) and Mr. Shoen. Mr. Kleemann passed away in July 2013 and has not been replaced. The Nominating and Governance Committee is responsible for i) nominating and recommending nominees for the Board of Directors and submitting the names of such nominees to the full Board of Directors for their approval; ii) evaluating the composition, size and governance of the Board of Directors and its committees and making recommendations regarding future planning and appointment of directors to the committees; and iii) establishing a policy for considering shareholder nominees for election to our Board of Directors. The Board of Directors has determined that all members of our Nominating and Governance Committee are independent under the rules of The NASDAQ Capital Market. The Nominating and Governance Committee held two meetings during 2013. The Nominating and Governance Committee Charter is available on our website at www.paulsoninvestment.com.
Audit Committee Financial Expert
Our Board of Directors has determined that Shannon Pratt is the “audit committee financial expert” as defined in Item 401(h) of Regulation S-K. Mr. Pratt is independent as that term is used in Section 240.14a-101 under the Exchange Act and as defined under NASDAQ Rule 4200 9a) (15).
Procedures for Selecting and Nominating Director Candidates
In evaluating the appropriate characteristics of candidates for service as a director, the Nominating and Governance Committee (the “Committee”) takes into account many factors. At a minimum, director candidates must demonstrate high standards of ethics, integrity and professionalism, independence, sound judgment, community leadership and meaningful experience in business, law or finance or other appropriate endeavor. In addition, the candidates must be committed to representing the long-term interests of our shareholders. In addition to these minimum qualifications, the Committee also considers other factors it deems appropriate based on the current needs of the Board of Directors, including specific business and financial expertise currently desired on the Board of Directors and experience as a director of a public company. The Committee does not have a formal policy with respect to diversity; however, the Board of Directors and the Committee believe that it is essential that Board members represent diverse viewpoints. With these factors and characteristics in mind, the Committee will generally begin its search by seeking nominations from existing members of the Board of Directors and management. The Committee will also reassess the qualifications of a director, including the director’s past contributions to the Board of Directors and the director’s attendance and contributions at Board and committee meetings, prior to recommending a director for reelection to another term.
Our Board of Directors has adopted procedures by which shareholders may recommend nominees to the Board of Directors. The Committee will consider any director candidate recommended by shareholders on the same basis as it considers other director candidates. Shareholders may also submit a letter and relevant information about the candidate to the Secretary at Paulson Capital Corp., 1331 NW Lovejoy Street, Suite 720, Portland, Oregon 97209.
Section 16(a) Compliance
Section 16(a) of the Exchange Act requires our directors, executive officers and persons who own more than 10% of our common stock to file with the SEC initial reports of ownership and reports of changes in ownership of common stock and other of our equity securities. Based solely upon a review of Forms 3 and 4 and amendments thereto furnished to us under Rule 16a-3(e) during the year ended December 31, 2013, Forms 5 and any amendments thereto furnished to us with respect to the year ended December 31, 2013, and the representations made by the reporting persons to us, we believe that during the year ended December 31, 2013, all directors, executive officer and persons who own more than 10% of our common stock complied with the requirements of Section 16(a), except for Forms 4 for the following grants made pursuant to the Company’s 2013 Equity Inventive Plan, which are inadvertently late: Steven H. Kleemann (grant of 45,445 stock options); Charles L.F. Paulson (grant of 46,683 stock options); Paul F. Shoen (grant of 30,445 stock options); Shannon P. Pratt (grant of 30,445 stock options); Trent D. Davis (grant of 33,267 stock options); and Murray G. Smith (grant of 11,089 stock options).
Code of Ethics
We have adopted a code of ethics that applies to our officers (including our principal executive, financial and accounting officers), directors, employees and consultants. The text of our code of ethics is posted at our Internet website, located at www.paulsoninvestment.com. Furthermore, if disclosure of an amendment or waiver to our code of ethics is required by Item 5.05 of Form 8-K, we intend to satisfy such disclosure either by timely filing a Form 8-K or by posting such information at the same Internet website.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The following table provides certain summary information concerning compensation awarded to, earned by or paid to our (i) Principal Executive Officer (“PEO”); (ii) our two next most highly compensated executive officers, other than our PEO, who were serving as executive officers at the end of the last completed fiscal year and whose total compensation was greater than $100,000; (herein referred to as the “named executive officers”).
(1)
Represents commissions earned pursuant to performance-based compensation arrangements.
(2)
Mr. Chester L.F. Paulson received an auto allowance of $2,000 and $12,000 in 2013 and 2012, respectively.
(3)
Mr. Chester L.F. Paulson resigned as a director and from the offices of Chairman, President and Chief Executive Officer on December 16, 2013. Mr. Paulson was replaced as President by Trent D. Davis.
Compensation expense generally follows the increase or decrease in net revenues, reflecting the connection of incentive-based pay to our overall performance.
Our Board of Directors is responsible for establishing our compensation program. The Compensation Committee has been delegated by the Board of Directors to annually review the officer compensation program and approve appropriate modifications to the senior officer compensation packages. The Compensation Committee is responsible for establishing the compensation of the CEO and reviews and approves the recommendations of the CEO regarding compensation and incentive packages of other senior executive officers. The Compensation Committee does not delegate this authority and we do not use compensation consultants.
Director Compensation
The following table provides certain summary information concerning compensation awarded to, earned by or paid to our non-Executive Officer Directors in fiscal 2013 ended December 31, 2013.
(1)
Mr. Chester L.F. Paulson and Mr. Charles L.F. Paulson have never received any additional compensation for their service on the Board of Directors.
(2)
Dr. Pratt received $6,500 during 2013 for his assistance as a “financial expert.”
(3)
The Directors receive $3,750 per quarter for serving as a director.
(4)
Mr. Chester L.F. Paulson resigned from the Board of Directors on December 16, 2013.
(5)
Mr. Kleemann passed away on July 27, 2013.
(6)
Dr. Burger was named a Director on December 16, 2013 and resigned on January 22, 2014.
Employment Agreements
None of the named executive officers are covered by formal employment agreements.
Termination of Employment and Change-In-Control Agreements
None of the named executive officers are covered by formal agreements to provide special compensation or benefits upon termination of employment or a change-in-control.
Equity Awards during Fiscal 2013
The following options were granted to officers, directors and employees during the fiscal year 2013 ended December 31, 2013.
Outstanding Equity Awards at December 31, 2013
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The following table summarizes equity securities authorized for issuance pursuant to compensation plans as of December 31, 2013.
(1) Includes our 1999 Stock Option Plan, which expired in September 2009, and the 2013 Equity Incentive Plan approved by shareholders at the Annual Meeting of Shareholders held on November 8, 2013.
The following table sets forth, as of March 18, 2014, certain information furnished to us with respect to beneficial ownership of our common stock of (i) each director; (ii) the “named executive officers” (as defined under “Executive Compensation”); (iii) all persons known by us to be beneficial owners of more than 5% of our common stock; and (iv) all current executive officers and directors as a group. Except as otherwise noted, the persons listed below have sole investment and voting power with respect to the Common Stock owned by them. Unless otherwise indicated, the address of each holder is 1331 N.W. Lovejoy Street, Suite 720, Portland, OR 97209.
*Less than one percent
(1)
Applicable percentage of ownership is based on 6,593,258 shares of common stock outstanding as of March 18, 2014 together with applicable options for such shareholders. Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission, and includes voting and investment power with respect to shares.
(2)
Includes options exercisable or exercisable within 60 days of March 18, 2014 as follows:
(3)
Includes 1,140,514 shares held by the Paulson Family LLC. Mr. Chester L.F. Paulson resigned as a director and from the offices of Chairman, President and Chief Executive Officer on December 16, 2013.
(4)
Represents shares held directly by Barry Honig and DKR Ventures, LLC of which he is the sole member.
(5)
Represents shares held as a member of the Paulson Family LLC and options as detailed in Note 2.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The Board of Directors has determined that each of Dr. Pratt and Messrs. Shoen and Timmins are “independent directors” under Nasdaq Stock Market Marketplace Rule 5605(b)(1). The Board of Directors has also determined that each member of the three committees of the Board of Directors meets the independence requirements applicable to those committees prescribed by NASDAQ and the Securities and Exchange Commission, including Rule 10A-3(b)(1) under the Exchange Act related to audit committee member independence.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Peterson Sullivan LLP served as our independent registered public accountants for the fiscal years ended December 31, 2013 and December 31, 2012. We utilize the services of Grant Thornton LLP for our tax services.
Principal Accounting Firm Fees
We paid the following fees for services performed by Peterson Sullivan LLP in 2013 and 2012:
(1)
Audit fees represent fees for professional services provided in connection with the audit of our financial statements and review of our quarterly financial statements and audit services provided in connection with other statutory or regulatory filings.
Pre-Approval of Audit and Non-Audit Services
The Audit Committee engages the Independent Registered Public Accountants to audit the financial statements of Paulson Capital Corp. Management approves the tax services that are provided by a separate independent registered public accounting firm. Any audit-related or other services required by an independent registered public accounting firm will be discussed with, and approved by, the Audit Committee as needed. The Audit Committee has determined that this practice is compatible with maintaining the principal accountant’s independence.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
Financial Statements and Schedules
The Consolidated Financial Statements and Schedules, together with the reports thereon of Peterson Sullivan LLP, are included on the pages indicated below:
Exhibits
The following exhibits are filed herewith and this list is intended to constitute the exhibit index. Exhibit numbers marked with an asterisk (*) represent management or compensatory arrangements.
** Filed herewith
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Paulson Capital Corp. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on March 18, 2014:
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 18, 2014.
SIGNATURE
TITLE
President, Director
/s/ Trent D. Davis
(Principal Executive Officer)
Trent D. Davis
/s/ Murray G. Smith
Chief Financial Officer
Murray G. Smith
(Principal Financial Officer)
/s/ Paul F. Shoen
Chairman of the Board, Director
Paul F. Shoen
/s/ Charles L.F. Paulson
Director
Charles L.F. Paulson
/s/ Shannon P. Pratt
Director
Shannon P. Pratt
/s/ Alan P. Timmins
Director
Alan P. Timmins
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
Paulson Capital Corp.
Portland, Oregon
We have audited the accompanying consolidated balance sheets of Paulson Capital Corp. and Subsidiaries ("the Company") as of December 31, 2013 and 2012, and the related consolidated statements of operations, shareholders' equity, and cash flows for the years then ended. Our audits also included the financial statement schedule of Paulson Capital Corp. and Subsidiaries listed in Item 15. These financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company has determined that it is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Paulson Capital Corp. and Subsidiaries as of December 31, 2013 and 2012, and the results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
/S/ PETERSON SULLIVAN LLP
Seattle, Washington
March 18, 2014
F - 1
Paulson Capital Corp. and Subsidiaries
Consolidated Balance Sheets
See accompanying Notes to Consolidated Financial Statements
F - 2
Paulson Capital Corp. and Subsidiaries
Consolidated Statements of Operations
See accompanying Notes to Consolidated Financial Statements
F - 3
Paulson Capital Corp. and Subsidiaries
Consolidated Statements of Shareholders' Equity
For the Years Ended December 31, 2013 and 2012
See accompanying Notes to Consolidated Financial Statements
F - 4
Paulson Capital Corp. and Subsidiaries
Consolidated Statements of Cash Flows
See accompanying Notes to Consolidated Financial Statements
F - 5
PAULSON CAPITAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization
Paulson Capital Corp. is a holding company whose majority owned subsidiary, Paulson Investment Company, Inc., is a registered broker-dealer in securities under the Securities Exchange Act of 1934, as amended, and is a member of the Financial Industry Regulatory Authority (“FINRA”). We provide broker-dealer services in securities on both an agency and a principal basis to our customers who are introduced to RBC Correspondent Services, a division of RBC Capital Markets Corporation, our clearing organization, on a fully disclosed basis. We also act as the managing underwriter, placement agent or participating selling group member of initial and follow-on public offerings, private investments in public equity (“PIPEs”) and private placements for smaller companies. We conduct business throughout the United States.
We operate under the provision of paragraph (k)(2)(ii) of rule 15c3-3 of the Securities and Exchange Act of 1934 and, accordingly, are exempt from the remaining provisions of that rule. Essentially, the requirements of paragraph (k)(2)(ii) provide that we clear all transactions on behalf of our customers on a fully disclosed basis with a clearing broker-dealer and promptly transmit all customer funds and securities to the clearing broker-dealer. The clearing broker-dealer carries all of the accounts of the customers and maintains and preserves all related books and records as are customarily kept by a clearing broker-dealer.
We also have a 100% owned subsidiary, Paulson Capital Properties, LLC, for the purpose of purchasing, improving and remarketing undervalued real estate. Through December 31, 2013, we had not purchased any real estate.
During the second quarter of fiscal 2012 ended June 30, 2012, we sold substantially all of our retail brokerage business to JHS Capital Advisors, LLC and are focusing operations on boutique investment banking. (See Note 3)
Note 4 describes a transaction that, if completed and approved by FINRA, will impact the organization.
Summary of Significant Accounting Policies
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of Paulson Capital Corp. and its wholly owned subsidiary Paulson Capital Properties, LLC and its majority owned subsidiary, Paulson Investment Company, Inc. All significant intercompany balances and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Our estimates regarding the fair value of underwriter warrants, not readily marketable securities and legal reserves are significant estimates and these estimates could change in the near term. Actual results could differ from those estimates.
Revenue Recognition
Securities transactions and related commissions revenue, including the sale of investment company shares, are recorded on a trade date basis. Underwriter’s fees and other underwriting revenues are recognized at the time the underwriting is completed. Revenue from sales of other securities including tax deferred units and insurance products is recorded when the units are sold. Revenue from the receipt of underwriter warrants is recognized when the underwriting is completed and the warrants are received based on the estimated fair value of the securities received using the Black-Scholes option-pricing model taking into account the exercise price, remaining life of the warrant, the current price of the underlying stock and its expected volatility, expected dividends on the stock and the risk-free interest rate for the remaining term of the warrant.
F - 6
Cash
Cash includes cash on hand and cash on deposit with banks.
Notes and Other Receivables
Receivables are reviewed on a regular and continual basis by our management and, if events or changes in circumstances cause us to doubt the collectability of the contractual payments, a receivable will be assessed for impairment. The Company considers a receivable to be impaired when, based on upon current information and events, it believes it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the receivable agreement. When we determine collection to be doubtful, an allowance for doubtful amounts receivable is recorded and the receivable is placed on a nonperforming (nonaccrual) status. Payments received on nonaccrual receivables are applied first to reduce the outstanding interest, and are then applied to the receivable unless we determine impairment is likely in which case payments are applied to the outstanding receivable balance (cost recovery method).
Interest received on impaired receivables is recorded using the cash receipts method unless management determines further impairment is probable. No impairment loss is recorded if the carrying amount of the receivable (principal and accrued interest) is expected to be fully recovered through borrower payments and enforcement of action against the borrower's collateral, if any.
The conclusion that a receivable may become uncollectible, in whole or in part, is a matter of judgment. We do not have a formal risk rating system. Receivables and the related accrued interest are analyzed on an individual and continuous basis for recoverability.
Delinquencies are determined based upon contractual terms. A provision is made for doubtful accounts to adjust the allowance for doubtful accounts to an amount considered to be adequate, with due consideration to workout agreements, to provide for unrecoverable receivables and receivables, including impaired receivables, other receivables, and accrued interest. Uncollectible receivables and related interest receivable are charged directly to the allowance account once it is determined that the full amount is not collectible.
Fair Value of Trading and Investment Securities Owned
Our trading and investment securities owned consist of both marketable securities and not readily marketable securities and are recorded at fair value. Changes in the value of these securities are reflected currently in our results of operations as a component of investment income. See also Notes 7 and 8.
Fair Value of Underwriter Warrants and Underwriter Warrants Payable to Employees
We are required to estimate the value of all securities that we hold at the date of the financial statements and to include that value, and changes in such value, in the financial statements. Accordingly, the aggregate fair value of our underwriter warrants is recorded as an asset on our balance sheet. When a new warrant is received, its fair value is included in corporate finance revenue on the date on which it is earned. Subsequently, any change in fair value is recorded as investment income or loss in the period incurred. When a warrant is exercised, the fair value is adjusted to reflect the value of the securities purchased, net of the exercise price, and the adjustment amount is recorded as income or loss for the relevant period. If a warrant expires unexercised, the fair value is adjusted to zero and the decrease is recorded as a loss in the relevant period. Underwriter warrants payable to employees represent warrants that are held by PIC, but are distributable to employees as compensation.
Fair Value of Financial Instruments
Substantially all of our financial instruments are carried at fair value or amounts that approximate fair value. The carrying amounts reflected in the financial statements for cash, receivables and payables approximate their respective fair values due to the short-term nature of these items. The fair value of certain long-term notes receivable from employees approximate the carrying value of the receivable due to the employment nature of the receivable. The fair values of securities owned and trading securities sold, not yet purchased, are equal to the carrying value. Changes in the fair value of these securities are reflected currently in our results of operations. The fair value of debt approximates carrying value due to the short term and convertible nature of the obligations. Other than those separately disclosed in Note 7, our remaining financial instruments are generally short-term in nature and their carrying values approximate fair value.
Furniture and Equipment
Depreciation of furniture and equipment is generally computed using the straight-line method over their estimated useful lives (typically 3 or 5 years). Leasehold improvements are amortized over the lesser of their estimated useful life or the remaining lives of their related leases.
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Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in results of operations in the period that includes the enactment date.
We recognize benefits for uncertain tax positions if we determine that they are “more-likely-than-not” to be sustained by the taxing authority. Interest and penalties accrued on unrecognized tax benefits are recognized as tax expense.
Earnings Per Share
The Company presents earnings per share for two classifications of Common Stock. The “Legacy Shareholder” classification includes those shareholders of record on October 11, 2013 (the “Record Date”), and reflects the results for the year-to-date up to and including the Record Date, as well as the results after the Record Date of the Trust Assets (as described below in Note 5), in which the Legacy Shareholders have a beneficial interest. The “Non-Legacy Shareholder” classification includes those who were not shareholders on the Record Date, but purchased shares thereafter, and only reflects the operating results of the Company after the Record Date, excluding the results on the Trust Assets for which they do not have a beneficial interest.
We computed basic earnings per common share using net income (loss) available to common stockholders and the weighted average number of common shares outstanding during the year. We computed diluted earnings per common share using net income available to common stockholders and the weighted average number of common shares outstanding plus potentially dilutive common shares outstanding during the year.
Potentially dilutive common shares from other instruments are determined by applying the treasury stock method to the assumed exercise of outstanding stock options. Potentially dilutive common shares are determined by applying the if-converted method.
Stock-Based Compensation
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). We utilize the Black-Scholes option pricing model for determining the fair value of awards. See also Note 11.
Comprehensive Income (Loss)
We had no comprehensive income (loss) items; accordingly, net income (loss) and comprehensive income (loss) are the same.
NOTE 2 - RECEIVABLE FROM AND PAYABLE TO CLEARING ORGANIZATION
We introduce all customer transactions in securities traded on U.S. securities markets to RBC CS on a fully-disclosed basis. The agreement with our clearing broker provides that we are obligated to assume any exposure related to nonperformance by customers or counterparties. We monitor clearance and settlement of all customer transactions on a daily basis. The exposure to credit risk associated with the nonperformance of customers and counterparties in fulfilling their contractual obligations pursuant to these securities transactions can be directly impacted by volatile trading markets which may impair the customer’s or counterparty’s ability to satisfy their obligations. In the event of nonperformance, we may be required to purchase or sell financial instruments at unfavorable market prices, resulting in a loss. We have not experienced credit losses in the past, and we do not anticipate experiencing credit losses in the future, due to significant nonperformance by our customers and counterparties.
At December 31, 2013 and 2012, the receivable from RBC CS was comprised of $8,000 and $5,000, respectively, in commissions receivable and $437,000 and $2.2 million, respectively, in deposits to facilitate principal trading activity.
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At December 31, 2012, the payable to RBC CS was comprised entirely of amounts used to finance principal trading activity.
NOTE 3 - DIVESTITURE OF BROKERAGE OPERATIONS
In the first quarter of 2012, we reached an agreement with JHS Capital Advisors, LLC (“JHS”) to sell substantially all of our retail brokerage operations, including many of our branch and nonbranch offices as well as registered personnel (employees and independent contractors), to JHS. The sale closed on April 16, 2012. In consideration of the sale, we were to be paid approximately $1,653,247 net of certain deductions for compensation expenses. The final purchase price was subject to recalculation after six months based upon the aggregate gross dealer commissions for the 12-month period ended at that time. The final purchase price was $1,522,841. During the year ended December 31, 2012, we received a total of $1,413,505. During the year ended December 31, 2013, the final installment of $109,336 was received.
NOTE 4 - RESTRUCTURE OF PAULSON INVESTMENT COMPANY, INC.
The Company is in the process of restructuring the business involving the broker-dealer license held by the Company’s subsidiary, Paulson Investment Company, Inc. (“PIC”). The restructuring, which is subject to approval by the Financial Industry Regulatory Authority (FINRA), is contemplated to result in PIC being ultimately owned by management of PIC and outside investors.
During the first quarter of fiscal 2013, PIC received a $1,500,000 loan from a related-party investor pursuant to a convertible promissory note bearing 5% simple interest which is due on January 13, 2016. The note is convertible, subject to FINRA approval, into preferred stock of PIC, representing approximately 35% ownership interest in PIC on a fully diluted basis. The noteholder agreed the note would stop accruing interest after April 30, 2013.
During the second quarter of fiscal 2013, PIC issued 215,438 shares of series B preferred stock for $1,500,000. The series B preferred stock is afforded no conversion or voting rights. Upon a liquidation event, the shareholder would be given a liquidation preference equal to 15.79%.
During the fourth quarter of fiscal 2013, PIC received a $700,000 loan from an outside investor pursuant to a convertible promissory note bearing 5% simple interest which is due on July 1, 2014. The note is convertible into 11.6% of the equity of PIC upon the earlier (i) all necessary FINRA and NASDAQ approvals and (ii) July 1, 2014.
NOTE 5 - PROPOSED CORPORATE REORGANIZATION
a)
Proposed Financing
On July 25, 2013, the Company entered into a series of agreements intended to secure investment in the Company of $5,250,000 (the “Investment Funds”) with DKR Ventures, LLC, a Delaware limited liability company, and Hudson Bay Master Fund Ltd., a Cayman Islands limited partnership (collectively, the “Investors”), in a private placement transaction (the “Proposed Financing”) intended to be exempt from registration under the Securities Act of 1933, as amended (the “Securities Act”), subject to satisfaction of certain conditions.
Under the agreements, the Company will complete the private placement of a Unit consisting of (i) 287,773 shares of Common Stock; (ii) 500,000 shares of Series A Preferred Stock; (iii) a Class A Warrant; and (iv) a Class B Warrant. Each share of Series A Preferred Stock has a stated value of $0.806974 and a conversion ratio of 2.305640603 per share of Common Stock, subject to adjustment. Each share of Series B Preferred Stock will be convertible into one share of Common Stock and have a stated value of $0.35 per share and a conversion ratio equal to one share of Common Stock for each share of Series B Preferred Stock outstanding, equal to a purchase price of $0.35 per share of Common Stock, subject to adjustment. The Class A Warrant is exercisable for up to 7,500,000 shares of Series B Preferred Stock at a per share exercise price of $0.80, subject to adjustment, beginning on the date that is six months following the date of issuance and ending on the date that is five years thereafter. The Class B Warrant is exercisable for up to 13,559,407 shares of Series B Preferred Stock. The purchase price of one share of Common Stock underlying the Class B Warrant is deemed to be $0.35, subject to adjustment, without any payment of consideration by the Holder upon exercise. The Class B Warrant is exercisable beginning on the date that is six months following the date of issuance and ending on the date that is two years thereafter.
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On January 29, 2014, the Company closed the private sale of 500,000 shares of its Common Stock to six accredited investors at a price of $0.50 per share for gross proceeds of $250,000. The shares were sold without registration in reliance upon the private transaction exemption set forth in Section 4(a)(2) of the Securities Act, and/or Rule 506 of Regulation D promulgated under the Securities Act.
b)
Formation of Liquidating Trust
In connection with the Proposed Financing, the Board of Directors of the Company has also approved the formation of a trust (the "Trust") for the benefit of shareholders of the Company as of the record date of October 11, 2013 (the “Record Date”). The Trust, if and when formed, will hold certain non-operating assets of PIC (the “Trust Assets”). Common shareholders of record (the “Legacy Shareholders”) will be given non-transferable beneficial interests in the Trust in proportion to their pro rata ownership interest in our Common Stock as of the Record Date. It is expected the assets in the Trust will be liquidated and distributed to the Legacy Shareholders over time.
c)
Proposed Changes to the Articles of Incorporation
At the 2013 Annual Meeting of Shareholders held on November 8, 2013 (the “2013 Shareholders Meeting”), the shareholders approved a proposal to change the Company’s state of incorporation to Delaware from Oregon (the “Reincorporation”). As of the date of this report, the reincorporation of the Company had not been effected.
At the 2013 Shareholders Meeting, shareholders also approved the amendment and restatement of the Company’s Articles of Incorporation to increase the authorized capital stock from 10,000,000 shares of Common Stock, no par value per share, and 500,000 shares of preferred stock, no par value, to 90,000,000 shares of Common Stock, par value $0.0001 per share, and 30,000,000 shares of “Blank Check” Preferred Stock, par value $0.0001 per share. As of the date of this report, the Articles of Incorporation had not been amended and restated to change the authorized capital stock.
d)
Proposed Reverse Stock Split of Common Stock
At the 2013 Shareholders Meeting, shareholders approved the proposal to grant the Board of Directors the authority to effect a reverse stock split of its Common Stock. The proposal permits, but does not require, the Board of Directors to effect a reverse stock split of the issued and outstanding Common Stock at any time prior to 18 months from the date of approval by a ratio of not less than one-for-two and not more than one-for-ten, with the exact ratio to be set within this range at the sole discretion of the Board of Directors. The Board reserves the right to elect to abandon the Reverse Stock Split, including any or all proposed reverse stock split ratios, if it determines, in its sole discretion, that the Reverse Stock Split is no longer in the best interests of the Company and its shareholders. As of the date of this report, the Board of Directors had not acted to effect a reverse stock split of the Common Stock.
NOTE 6 - NOTES AND OTHER RECEIVABLES
Notes and other receivables generally are stated at their outstanding unpaid principal balance. Interest income on receivables is recognized on an accrual basis.
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Notes and other receivables consisted of the following (in thousands):
Employee receivables include several promissory notes issued to new employees totaling approximately $1.2 million that are payable in three years and bear 1% interest. These notes will be forgiven if the employees meet certain performance milestones and are still employed by the Company at the end of the three-year term. Other employee receivables relate to advances and expenses in excess of commission earnings and investment losses charged to our current and former employees and registered representatives. Corporate finance receivables are unsecured and principally relate to bridge loans and other short-term advances to corporate finance clients. Other receivables primarily consist of the final installment due from the sale of one private investment.
Impaired Receivables
The following is a summary of the Company's impaired receivables as of December 31, 2013:
The following is a summary of the Company's impaired receivables as of December 31, 2012:
Allowance for Doubtful Accounts
Allowance for receivables from employees principally consists of uncollectible unsecured forgivable promissory notes to registered representatives that are forgiven over a specific period, typically 5 years, if the borrower remains an employee of the Company and meets certain performance criteria. Any amounts remaining under the note become due immediately when the individual either leaves the Company voluntarily or is terminated. Amounts from corporate finance clients principally consist of bridge loans and other advances to underwriting clients.
The following is a summary of the Company's allowance for doubtful accounts for the years ended December 31, 2012 and 2013:
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NOTE 7 - FAIR VALUE MEASUREMENTS
Various inputs are used in determining the fair value of our financial assets and liabilities and are summarized into three broad categories:
●
Level 1 - unadjusted quoted prices in active markets for identical securities;
●
Level 2 - other significant observable inputs, including quoted prices for similar securities, interest rates, prepayment speeds, credit risk, etc.; and
●
Level 3 - significant unobservable inputs, including our own assumptions in determining fair value.
The inputs or methodology used for valuing securities are not necessarily an indication of the risk associated with investing in those securities.
Following are the disclosures related to our financial assets and (liabilities) (in thousands):
Following is a summary of activity related to our Level 3 financial assets and liabilities (in thousands):
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Valuation of Marketable Trading and Investment Securities Owned
The fair value of our marketable trading and investment securities owned is determined based on quoted market prices. Securities traded on a national exchange are stated at the last reported sales price on the day of valuation; other securities traded in the over-the-counter market and listed securities for which no sale was reported on that date are stated at the last quoted bid price.
Valuation of Not Readily Marketable Investment Securities Owned
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 us. The fair value of not readily marketable securities is estimated by management using available information including the following: quoted market prices of similar securities (i.e., unrestricted shares of the same company); price of recent known trades of the same or similar securities; the cost of the security, if recently purchased, adjusted for changes in the financial condition of the issuer; all other information available from review of available documents related to the issuer or discussions with management of the issuer. Significant unobservable inputs include the discount rate for lack of liquidity, and the volatility index of comparable companies. Changes to these unobservable inputs would cause the fair value to fluctuate substantially.
Valuation of Underwriter Warrants and Underwriter Warrants Payable to Employees
We estimate the fair value of underwriter warrants using the Black-Scholes Option Pricing Model. The warrants generally have a five-year expiration date and vest immediately. The warrants are generally subject to a restriction period of six months to one year in which the warrants cannot be exercised. The Black-Scholes model requires us to use five inputs including: stock price, risk free rate, exercise price, time remaining on the warrant and price volatility. After stock price, the most influential factor in this model is price volatility, which we calculate for each company’s warrants based on each company’s own historical closing stock prices as well as an index of historical prices for comparable companies. When we initially receive a new underwriter warrant from an initial public offering, its calculated volatility factor is entirely based on the volatility of an index of comparable companies, since there is no price history for a new publicly traded company. For publicly traded companies, as each underwriter warrant approaches its expiration date, its volatility factor is derived primarily from the historical prices of its underlying common stock. Private company underwriter warrant valuations use the volatility index of comparable companies. There is no assurance that we will ultimately be able to exercise any of our warrants in a way that will realize the fair value that has been recorded in the financial statements based on this model. Underwriter warrants payable to employees represent warrants that are held by the Company, but are distributable to employees as compensation at December 31, 2013.
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NOTE 8 - TRADING AND INVESTMENT SECURITIES OWNED
Certain information regarding our trading and investment securities owned was as follows (in thousands):
The cost basis for our investment securities was $2,615,000 and $4,811,000 as December 31, 2013 and 2012, respectively.
NOTE 9 - FURNITURE AND EQUIPMENT, NET
Furniture and equipment are stated at cost and consisted of the following (in thousands):
NOTE 10 - INCOME TAXES
Income tax expense (benefit) consisted of the following (in thousands):
Income tax expense (benefit) for each year varies from the amount computed by applying the statutory federal income tax rate to earnings before income taxes as follows (in thousands):
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The deferred income tax asset (liability) consisted of the following (in thousands):
We recorded an increase to our valuation allowance for 2013 and 2012 of $342,170 and $17,188, respectively, based upon management’s assessment that it is more likely than not that no portion of the deferred tax assets will be fully realized. The Company generated taxable income during the 2013 tax year and will utilize available net operating losses carried forward from prior years to offset the amount of income. The Company still has a substantial amount of federal and state net operating loss carryforwards, as well as state capital loss carryforwards. The recognition of taxable income during the period is seen as an outlier due to realized tax gains on sale of investment securities in excess of amounts recorded for financial reporting purposes. The realization of any deferred tax assets is dependent on having future taxable income. If we generate income before income taxes in future periods, our conclusion about the realizability of our deferred tax assets, and therefore the appropriateness of the valuation allowance, could change in a future period and we could record a substantial gain on our statement of operations when that occurs.
Federal net operating loss carryforwards of $5.5 million at December 31, 2013 fully expire in 2033. State net operating loss carryforwards of $15.8 million at December 31, 2013, expire from 2014 through 2033. State net capital losses of $4.1 million at December 31, 2013 expire from 2014 to 2017.
The future utilization of net operating loss carryforwards may be subject to annual limitations if there is a change in control as defined under Internal Revenue Code Section 382.
As of December 31, 2013, we had no uncertain tax positions and as such, did not have any reserves for uncertain tax positions.
We are no longer subject to U.S. federal income tax examinations by tax authorities for years prior to the tax year ended December 31, 2009. Depending on the jurisdiction, we are no longer subject to state examinations by tax authorities for years prior to the December 31, 2009 tax years. The tax years which remain open to examination in the U.S., our only major taxing jurisdiction, are 2009 through 2013.
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NOTE 11 - STOCK-BASED COMPENSATION PLANS
1999 Stock Option Plan
Our 1999 Stock Option Plan (the “1999 Plan”) reserves 1.0 million shares of our common stock for issuance upon exercise of options granted under the 1999 Plan. The 1999 Plan expired in September 2009, and, accordingly, there were no options available for grant at December 31, 2013. At December 31, 2013, 180,000 shares of our common stock were reserved for issuance related to the 1999 Plan.
2013 Equity Incentive Plan
Our 2013 Equity Incentive Plan (the “2013 Plan”) reserves 1.5 million shares of our common stock for issuance of equity and cash and equity-linked awards to certain management, consultants and others. On June 19, 2013, the Board of Directors granted 300,000 stock options to purchase shares of common stock at a purchase price equal to the closing price of stock on that date.
Activity under the 1999 Plan and 2013 Plan for the two most recent fiscal years was as follows:
The following table summarizes information about stock options outstanding under all of our option plans at December 31, 2013.
We did not record any income tax benefits for stock-based compensation arrangements for the year ended December 31, 2013 or 2012, as we have cumulative operating losses and have established full valuation allowances for our income tax benefits.
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. Our options are fully vested upon the date of grant. Accordingly, we recognize the related stock-based compensation expense on the grant date as a component of commissions and salaries on our consolidated statements of operations. Stock-based compensation totaled $131,000 and $0 in 2013 and 2012, respectively.
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The following weighted average assumptions were utilized in determining fair value pursuant to the Black-Scholes option pricing model:
No options were granted during 2012.
The risk-free rate used is based on the U.S. Treasury yield over the expected life of the options granted. Expected lives were estimated using the simplified method, which considers the vesting term and original contract term. The expected volatility is calculated based on the historical volatility of our common stock.
Shares to be issued upon the exercise of stock options will come from newly issued shares.
Certain information regarding our stock-based compensation plan was as follows (in thousands, except per share amounts):
As of December 31, 2013, there was no unrecognized stock-based compensation.
NOTE 12 - EARNINGS (LOSS) PER SHARE
Legacy Shareholder basic earnings per share is the same as diluted earnings per share for the years ended December 31, 2013 and 2012 since we were in a loss position in both years.
Non-Legacy Shareholder earnings per share after the Record Date included 16,477,003 contingently issuable common shares in the calculation of diluted earnings per common share that were held in escrow pending the subsequent closing of a financing transaction. The contingently issuable common shares are described in Note 5. Following is a reconciliation of our shares used for our basic net income (loss) per share and our diluted net income (loss) per share:
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NOTE 13 - COMMITMENTS, CONTINGENCIES AND GUARANTEES
Leases
We lease office space under the terms of various non-cancellable operating leases. The Company signed an 18-month sublease for office space in Portland, Oregon commencing in April 2013; a five-year lease for New York City office space commencing in June 2013; and a two-year lease for office space in Novato, California commencing in October 2013.
The future minimum payments for each of the next five years required for leases were as follows:
Legal
We have been named by individuals in certain legal actions, some of which claim state and federal securities law violations and claim principal and punitive damages. Included in the financial statements is an accrual of $52,500 for pending settlements near and subsequent to our year-end. As preliminary hearings and discovery in the remaining cases are not complete, it is not possible to assess the degree of liability, the probability of an unfavorable outcome or the impact on our financial statements, if any. Our management denies the charges in the remaining legal actions and is vigorously defending against them. No provision for any liability that may result from the remaining contingencies has been made in the financial statements.
Guarantees
There are no guarantees made by the Company that may result in a loss or future obligations as of December 31, 2013.
NOTE 14 - NET CAPITAL REQUIREMENT
We are subject to the Securities and Exchange Commission Uniform Net Capital Rule (Rule 15c3-1), which requires the maintenance of minimum net capital (as defined) of 6 2/3% of total aggregate indebtedness or $100,000, whichever is greater. At December 31, 2013, the required minimum net capital was $464,011. At December 31, 2013, we had net capital of $6,584,250, which was $6,120,239 in excess of our required net capital of $464,011. In addition, we are not allowed to have a ratio of aggregate indebtedness to net capital in excess of 15 to 1. The Rule also provides that equity capital may not be withdrawn or cash dividends paid if the resulting net capital ratio would exceed 10 to 1. Our net capital ratio was 1.06 to 1 at December 31, 2013.
NOTE 15 - SHARE REPURCHASE PLAN
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. In addition, in June 2008, our Board of Directors approved the repurchase of up to a total of an additional 200,000 shares of our common stock. During 2013 and 2012, we repurchased a total of 0 and 1000 shares for $1,250, respectively, and, at December 31, 2013, 68,011 shares remained available for repurchase. These repurchase programs do not have an expiration date.
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NOTE 16 - CONCENTRATION OF RISK AND GEOGRAPHIC INFORMATION
Our trading and investment securities owned include investments in the common stock and warrants of the following companies, which represent more than 10% of trading and investment securities owned at December 31, 2013 and 2012 (dollars in thousands):
Warrants from one company represented 87.1% of the total underwriting warrants owned as of December 31, 2013.
We received 80.2% of our commissions revenue from three investment banking clients, and 89.4% of our revenue from underwriting, including warrants received, from one investment banking client during 2013.
We are also exposed to concentrations of credit risk related to our cash deposits. We maintain cash at a financial institution where the total cash balance is insured by the Federal Deposit Insurance Corporation (“FDIC”) up to its limit. At any given time, our cash balance may exceed the balance insured by the FDIC. We monitor such credit risk at the financial institution and have not experienced any losses related to such risks to date.
In addition, we are engaged in trading and brokerage activities with RBC CS. In the event RBC CS does not fulfill its obligations, we may be exposed to risk. The risk of default depends on the creditworthiness of RBC CS. It is our policy to review, as necessary, the credit standing of RBC CS.
NOTE 17 - RELATED PARTY TRANSACTIONS
During the years ended December 31, 2013 and 2012, we paid approximately $127,000 and $57,000, respectively, of legal costs on behalf of our officers, employees and independent contractors.
In January 2013, PIC received a $1,500,000 loan from a related party investor pursuant to a convertible promissory note bearing 5% simple interest which is due on January 13, 2016. The note is convertible, subject to FINRA approval, into preferred stock of PIC, representing approximately 35% ownership interest in PIC on a fully diluted basis. The noteholder agreed the note would stop accruing interest after April 30, 2013.
NOTE 18 - DEFERRED REVENUE
Deferred revenue consists of amounts received related to our clearing firm agreement. Other income in both 2013 and 2012 included $60,000 and $170,000, respectively, in amortization of deferred revenue.
NOTE 19 - DIVIDENDS
During 2012, we paid two special cash dividends to our common shareholders. In March 2012, the Board of Directors approved a special cash dividend of $0.05 per common share payable April 16, 2012 to shareholders of record April 4, 2012. In December 2012, the Board approved a special cash dividend of $0.15 per share payable December 28, 2012 to shareholders of record December 14, 2012.
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In connection with the Proposed Financing described in Note 5, the Board approved the formation of the Trust (as defined in Note 5) for the benefit of shareholders as of the Record Date (as defined in Note 5). The Trust, if and when formed, will hold certain Trust Assets (as defined in Note 5) which are expected to be liquidated and distributed to the Legacy Shareholders (as defined in Note 5) over time. As of March 18, 2014, the Trust had not yet been formed, nor had any distributions been made.
NOTE 20 - NEW ACCOUNTING GUIDANCE
Management has reviewed the new accounting guidance and determined that there is not a material impact on our financial statements.
NOTE 21 - SUBSEQUENT EVENTS
On January 29, 2014, the Company closed the private sale of 500,000 shares of its Common Stock to six accredited investors at a price of $0.50 per share for gross proceeds of $250,000. The shares were sold without registration in reliance upon the private transaction exemption set forth in Section 4(a)(2) of the Securities Act, and/or Rule 506 of Regulation D promulgated under the Securities Act.
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Paulson Capital Corp. and Subsidiaries
SUPPLEMENTARY SCHEDULE OF WARRANTS OWNED
As of December 31, 2013