Pre-Paid Suffers Legal Setback

The Street.com/July 25, 2003
By Melissa Davis

Pre-Paid Legal Services (PPD:NYSE) has failed to convince a federal judge that the company is not an illegal pyramid scheme.

The legal services provider, which employs the same controversial marketing strategy made famous by Amway, this week lost a motion to dismiss a class-action lawsuit filed by sales associates who feel they were scammed by the company. The ruling opens the door for a full-blown trial that could prove devastating to the so-called multilevel marketing, or MLM, company.

"It should surprise nobody that has either studied or been the victim of Pre-Paid's MLM business practices that the judge would rule in favor of the associate plaintiffs when the case was presented by a competent law firm," said one hedge fund manager with a large short position in the stock. "This case goes to the heart of their MLM practices, and the judge appears to agree it has merit to proceed."

The lawsuit, filed 17 months ago by legal giant Lieff Cabraser Heimann & Bernstein, accuses Pre-Paid of violating federal securities laws by enticing the public to invest in a business opportunity that almost always fails. Participants pay at least $65, and as much as $249, for the right to sell Pre-Paid legal policies and recruit others to do the same.

But many recruits never even recoup their investment, let alone achieve the financial security Pre-Paid touts. Based on Pre-Paid's own financial reports, experts say, the average associate paycheck -- actually lifted by the handful of millionaires at the top of the chain -- comes in at only $3 a week.

Peter Cohan, a business consultant who recently interviewed Pre-Paid CEO Harland Stonecipher for an upcoming column in Oklahoma City Business, said the company seems to knowingly lure people into a money-losing trap. He said he was struck when Stonecipher quickly dismissed the 80% of his sales force that earns very little or nothing.

"It seems like, if they're stupid enough to go along with his scheme, he has no respect for them," noted Cohan, an investment strategist with no position in the stock. "And I still don't understand what the value of the product is. ... They somehow manage to attract people as customers and associates who have a tragic weakness in their personality that makes them susceptible to predatory, psychological reprogramming."

As a matter of policy, Pre-Paid does not comment for stories published by TheStreet.com. Setback

In her 43-page ruling on Wednesday, Oklahoma federal judge Robin Cauthrin thwarted Pre-Paid's attempts to block a lawsuit that the company has always portrayed as frivolous. Although Cauthrin granted Pre-Paid's motion to dismiss outright fraud charges, she did so "without prejudice," leaving the door open for plaintiffs' attorneys to gather more evidence and reargue the charges. In the meantime, Cauthrin said the 30-year-old company -- which points to its sustained growth as a sign of credibility -- had failed to disprove the central allegation that it is an unlawful pyramid scheme peddling its "business opportunity" as an illegal security to the public.

"Although the inherently fraudulent nature of any pyramid scheme is based on its fundamental instability, growth in and of itself, even over an extended period of time, does not necessarily defeat plaintiffs' allegations that Pre-Paid is an illegal pyramid scheme," she wrote. "The relevant inquiry is not how long an enterprise has sustained itself but whether the market would become saturated if associates were to actually achieve the financial gains promised. ... Thus, the court finds that plaintiffs' allegations that Pre-Paid is a pyramid scheme are not facially defective or clearly refuted by defendants' arguments or evidence."

Interestingly, the ruling was issued by a judge that some observers had viewed as friendly to the company. Last year, the same judge threw out a shareholder lawsuit accusing Pre-Paid of misleading investors about the true profitability of the company even after the Securities and Exchange Commission forced Pre-Paid to adopt more conservative accounting methods that cut reported earnings in half. That lawsuit is currently under appeal.

Pre-Paid also faces another class-action lawsuit from associates, headed for a certification hearing in January, and a slew of multiple-party lawsuits filed by disgruntled customers in Mississippi and Alabama counties known for their runaway jury awards.

Exposure

Although Pre-Paid has estimated its maximum exposure at more than $300 million, the company has reserved only about 1% of that amount for potential legal setbacks. Instead, the company has been using all of its free cash -- and even borrowing more -- to fund a share buyback program that some believe provides critical support for the thinly traded stock.

After slipping 28 cents to $22.36 on Thursday, Pre-Paid shares are sitting smack in the middle of their 52-week trading range.

"It should surprise nobody who has followed Pre-Paid management that they have been aware of this potentially huge legal setback but have failed to disclose it to investors," said one short-seller.

Cohan, who has been researching Pre-Paid extensively, said both Stonecipher and Martin Belsky -- a Pre-Paid director who serves as a law school dean in Tulsa -- dodged his specific questions about the company's legal exposure. He said Stonecipher also shifted gears when asked how Pre-Paid's multilevel marketing system really worked.

"Maybe these are topics they know would get them into big trouble if the truth ever came out," Cohan speculated.

Robert FitzPatrick, founder of the consumer watchdog organization Pyramid Scheme Alert, has declared virtually all MLM companies -- including Pre-Paid -- illegal scams. Even Len Clements, an industry watchdog who actually embraces MLM, says he believes that Pre-Paid has violated illegal pyramid laws and could face serious legal exposure as a result.

Both men have served as expert witnesses in other pyramid scheme trials. Clements testified in several cases against Equinox, a company that was eventually shut down by the federal government in one of the industry's biggest cases.

Clements has since predicted that, should Pre-Paid fail in its defense of pyramid-related lawsuits, the company may someday end as a multilevel marketing opportunity and return to its roots as a direct sales company, peddling legal policies much like regular insurance companies do. But he has also questioned the value of Pre-Paid's product. And Pre-Paid itself continually struggled to survive before adopting the MLM strategy -- heavily focused on recruiting -- that led to its explosive growth.

Cohan, for one, says the company may be doomed altogether.

"If it's a pyramid scheme, then it needs to be shut down," he said. "It seems to me that, if the government really wants to clean up business, then it has to start taking this sort of thing seriously."