The unraveling of the Bernie Madoff scandal last year rocked the investment management world. Few expected the chairman of one of the world’s largest stock exchanges, a prominent philanthropist, to be running one of the largest investment frauds in history. At least one financial analyst, however, figured it out and tried to tell the world.
In 1999, when working at Raptor Investment Management Co., Harry Markopolos was told to learn how Raptor could replicate Madoff’s double digit returns. Although colleagues labeled him as a “math whiz,” Markopolos could not figure it out. Eventually he concluded that Madoff was running a Ponzi scheme, or illegally “front-running” orders.
In 2005, Markopolos delivered a 21-page memo to the U.S. Securities and Exchange Commission explaining his theory. He wrote, “Madoff Securities is the world’s largest Ponzi Scheme. In this case there is no SEC reward payment due the whistle-blower so basically I’m turning this case in because it’s the right thing to do.” Despite this report and several previous investigations, the SEC remained oblivious to Madoff’s Ponzi scheme until his sons turned in their father Dec. 10 of last year.
Other fraudulent firms likely exist today, deceiving government regulators and investors. One such example is – I believe – a publicly traded company called Pre-Paid Legal Services Inc. (NYSE: PPD). Pre-Paid Legal uses multi-level marketing – more commonly referred to as pyramid scheme marketing – to sell legal expense plans in the United States and Canada. PPD does not advertise. Instead, it relies on sales associates to market the legal plan to their family and friends as well as recruit new salespeople. The company’s legal plan costs about $312 per year and initially covers 60 hours of phone consultation, but only 2.5 hours for pre-trial work, the point where most legal work gets done. The plan covers civil matters and “job-related” criminal charges, but many additional restrictions and exceptions apply.
Investors tout the stock because of its strong cash flows, low valuation and potential for growth. Yet deeper analysis shows that Pre-Paid Legal is a bogus scheme designed to swindle hundreds of thousands of customers out of money and time to the benefit of executive insiders. These insiders use sophisticated deception and diversion to keep Wall Street analysts focused on short-term indications such as quarterly earnings as opposed to the fundamentals of the business. In reality, Pre-Paid Legal is an endless chain recruitment business whose key metrics show the telltale signs of market saturation and imminent collapse. The company’s ultimate decline will likely be the result of public awareness of the company’s deceptions and manipulations.
The company’s legal plan could not be sold without highly misleading presentation of its services and their value. Once customers realize the extent of the plan, they quickly cancel. More than 50 percent of new customers cancel their legal plan within the first year. Before the end of the third year, 75 percent of customers have canceled their plan. The actual value of the plan can be seen in the cost to the company of providing the service. For each $312 per year policy, the company pays a flat fee to its attorneys of $80 each year, regardless of the legal services used. As Barron’s magazine stated, “$80 doesn’t buy a lot of legal services these days, when lawyers routinely bill at $200 or more per hour. Pre-Paid’s solution is to limit benefits.”
The company attracts new sales associates with prospects of $975/week in income. In reality, an estimated 99 percent of sales associates never earn a net profit. Third quarter results from this year show 80 percent of the company’s sales force fails to make even one sale annually and only 2 percent make 10 or more sales annually.
Almost all of Pre-Paid Legal’s sales force and customer base turns over within 24 months, minus a small group of top recruiters. New recruits are often not told the full extent of the fees required to join. They must pay a $72 enrollment fee, a $50 state license fee and additional fees for training material, in addition to purchasing the company’s legal plan for $36/month. In 2008, the company reported that sales associates paid more than $23 million in training and other certifications, a large amount considering less than 15 percent will ever make one sale.
Pre-Paid Legal executives are no strangers to fraud. In 2001, the company was fined by the SEC for accounting fraud. To lure new recruits, Pre-Paid Legal paid its salespeople a three-year advance commission on sales and then claimed these payments as assets, not expenses. In its restatement, the company slashed 2000 earnings by 42 percent and 1999 earnings by 66 percent.� Numerous key personnel have been involved in high-profile fraud. The company’s top salesperson in 2002, David Draney, was indicted for making millions through the sale of bogus securities. Pre-Paid Legal Director Fran Tarkenton paid a steep settlement to quell charges in 1999 by the SEC for alleged fraud relating to an Internet software company. Tommy Vu, the infomercial star widely sued for his $15,000 real estate ‘boot camp,’ also worked for Pre-Paid Legal.
Executive insider selling is rampant and no insider has purchased the company’s stock within the last two years. Executives are committed to inflating the stock price through the company’s share repurchase program while simultaneously selling their own shares. Between 2004 and 2008, the company repurchased $237 million in shares, while executives sold more than $69 million of their personal holdings. Pre-Paid Legal is borrowing money and using cash generated to repurchase shares at any cost. In 2008, 70 percent of the cash provided by operations was spent on stock repurchases. Meanwhile, the company had $59.7 million in debt outstanding.
Last Tuesday, the SEC announced a fact-finding inquiry into Pre-Paid Legal’s operations. The subpoena requires the company to turn in documents related to its stock repurchase program, marketing practices, membership information and other practices. The stock lost 17 percent the day of the announcement. In conducting its investigation, the SEC has the opportunity to think critically about the company. Let’s hope it doesn’t drop the ball on Pre-Paid Legal as it did with Madoff Securities.
Rahul’s column runs biweekly Thursdays. He can be reached at r.gorawara@cavalierdaily.com.
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