November 19, 2002
A Recommendation for Pre-Paid Legal Services, Inc.
Introduction Gotham Partners is an investment partnership with a value investment approach. Our typical investment is a high-quality business that generates reliable, preferably growing, free cash flow. We generally invest only when we believe that management will direct the business’ free cash flow to maximize value on a per share basis. In many cases, the companies in which we invest are misunderstood by other investors, creating the opportunity to invest at an attractive price. By the above standards, Pre-Paid Legal Services (“Pre-Paid”) is an ideal investment for Gotham and other like-minded investors. We believe that much of the press coverage of Pre-Paid, has been unfair, unbalanced, and in many cases simply wrong. It is our intent in this report to both lay out in detail the bullish case for Pre-Paid and to refute many of the bearish arguments. Gotham’s Position in Pre-Paid The Gotham funds own more than one million shares of Pre-Paid Legal Services (NYSE: PPD), which were purchased in the open market. We have no arrangements to buy, sell, hold or vote our securities, and we have never received compensation of any form from the company. We initially approached a potential investment in Pre-Paid with no prejudgments or preconceptions. We carefully read Pre-Paid’s SEC filings going back many years. We canvassed the public record of news articles, court cases and general information on the industry. We built a financial model to assist us in valuing the business. We have met management several times, as well as a sampling of sales associates and provider law firms, and have visited the company’s headquarters in Oklahoma, in order to judge for ourselves the quality of the people and the product. In analyzing Pre-Paid, we have also read and taken seriously all of the negative commentary we found. While Gotham is primarily a long investor, we occasionally sell stocks short.1 We believe that short sellers often do the best research on Wall Street and are too frequently
Recently, we published three bearish reports on Farmer Mac (NYSE: AGM) which can be found at www.gothampartners.com. Page 1
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maligned by corporate managers. Rather than attack the messenger, it is our intention in this report to rebut the message of those who have been bearish on the company. Based upon our research and analysis, and after giving due weight to the shorts’ arguments, we believe that Pre-Paid is a highly attractive business that is extremely undervalued. Background Pre-Paid Legal Services, Inc. markets a membership plan offering individuals and small businesses access to legal services. Over the past 29 years, the company has built a membership base of 1.39 million members and a nationwide network of law firms that provide legal services to these members. For a modest monthly fee, members receive an array of legal services, which cover basic legal needs like preparing a will, reviewing a lease, or contesting a traffic ticket. The plan provides added services for additional fees, which represent a discount from the provider law firms’ usual rates. Pre-Paid sells memberships through a network of approximately 200,000 independent sales associates who earn commissions on membership fees. In addition to selling memberships, these sales associates are also responsible for recruiting new associates and share in the commissions generated by the associates they recruit. From year-end 1998 through September 2002, Pre-Paid’s membership base grew by 130% from 603,000 to 1,389,000. During the same period, the company’s outstanding share base shrank from 23.6 million to approximately 19 million. Nearly all of the cash needed to grow the business and simultaneously retire approximately 20% of its shares has been internally generated.2 For 2002, we estimate that Pre-Paid will generate after-tax, recurring, free cash flow of approximately $50 million, or $2.63 per share. We emphasize the adjectives: after-tax, recurring, and free. In other words, the $50 million figure has been fully burdened (and in the case of commission advances, more than fully burdened) with all related expenses and outlays, and can be expected to continue for the foreseeable future. Pre-Paid Offers a Valuable Product Unlike businesses, ordinary people do not need an army of $500/hour attorneys at their side every day. Ordinary people do, however, need legal assistance. We live in a world governed by laws and legal relationships – with our family members, with the government, with our employers, with our landlords and mortgage banks, with people from whom we buy and to whom we sell goods and services.
We understand that the company has recently tapped a bank line of credit in order to fund share repurchases. We do not believe that the amount borrowed, $4 million, is material. The company has also announced that it will be incurring mortgage debt to fund the construction of a new headquarters building. Interest expense on the estimated mortgage balance of $20 million will not significantly affect the company’s results. Gotham Partners Management Co., LLC Page 2
Pre-Paid’s value proposition can be described as follows: The average person often needs a lawyer, but may not know one and cannot possibly afford to pay for one on a customary hourly basis. For around $22 per month, Pre-Paid’s legal plan completely covers many basic legal services and will provide other services on a discounted basis. We believe everyone is well advised to have a will, a health-care proxy and a designation of their children’s guardian in case of emergency – rather than live without these basic documents. Everyone is better off having an attorney review correspondence from their mortgage bank or from their landlord – rather than go without this basic advice. Everyone is better off having legal representation when fighting a traffic fine – rather than showing up alone. Everyone should have one phone number to call for whatever legal questions arise unexpectedly – rather than react impetuously to a situation they cannot handle alone. PrePaid provides all of these services and more to its members for $22 per month. The bears seem to treat Pre-Paid’s product – and perhaps all legal service plans – as a worthless hoax. We disagree. Legal service plans provide a valuable service and have growing acceptance. According to the not-for-profit National Resource Center for Consumers of Legal Services (NRCCLS), in 2002, 154 million Americans are covered by some type of legal-service plan. Of those, 87 million people receive coverage as a benefit from being in some other association, 41 million are in employee assistance plans, and 7 million are covered as members of the armed forces. According to the NRCCLS, in 2002, a total of 18.8 million people are covered by pre-paid plans, which are in many ways similar to medical or dental insurance,3 where some services are covered fully, some covered partially and some covered only with additional payments. With Pre-Paid’s plan, the consumer pays a small monthly fee in return for certain services and has access to affiliated law firms for anything beyond the basic package, for additional, but discounted fees. Several products compete with Pre-Paid’s. Among them are offerings from Legal Services Plan of America (part of General Electric), Hyatt Legal Plans (a unit of MetLife), and the American Association of Retired Persons (AARP). The AARP product is free with membership in the AARP and offers the member little more than a referral to a lawyer who charges a fee for services. The GE, Hyatt and Pre-Paid plans are all quite similar in the depth of their offerings. They include basic will preparation, telephone access to attorneys for specific issues, limited readings of contracts and other documents, limited letter writing and discounts on uncovered services. One of the criticisms of Pre-Paid is that it does not pay enough to the provider law-firms (34% of membership fees) for their services to be worth much. On this point, the shorts might want to consider that, to be affiliated with the AARP plan, provider law firms must
In many states, Pre-Paid is regulated as an insurance company. Page 3
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provide a free initial consultation, bill at discounted rates and pay a fee to AARP. The law firms are willing to do this to gain access to AARPs’ members. We believe Pre-Paid members are getting valuable free services, reduced fees, access, and high quality customer service. The law firms, in exchange for the certainty of a large monthly payment from PrePaid, are accepting the challenge that, to profit, they must perform their services efficiently. When a firm is providing wills and health care proxies to tens of thousands of people, it can standardize its legal documents and train attorneys to handle large volumes of work efficiently. The law firms also have the opportunity, by providing excellent basic services, to convince member-clients that the optional legal services are valuable enough for clients to engage them. What differentiates the Pre-Paid plan from its competition is the use of a closed panel – a single law firm in each state is the sole provider of legal services.4 The closed panel means that within specific geographic areas, Pre-Paid offers the exclusive right to serve its members to a single law firm. This relationship is beneficial to Pre-Paid because it allows the company to limit, or capitate, its cost of legal services. Further, it limits the number of law firms Pre-Paid needs to qualify and monitor for customer service. The closed-panel system also benefits the law firms because it maximizes their revenue from Pre-Paid and allows them to participate directly in the development of membership in their region. As the number of members in each state grows, the service becomes more profitable due to scale economies. Furthermore, experience shows that members who actually use the lawyers’ services are more likely to retain their membership, providing added revenue to both PrePaid and the provider law firm. As the exclusive provider in a state, the provider law firms have a strong incentive to reach out quickly to new members in order to get them to take advantage of the services offered under the plan. As a large customer (often the largest customer) of the provider law firms, Pre-Paid and its members are able to receive a level of responsiveness and service that would be difficult, if not impossible, for an individual of modest means to reproduce. Pre-Paid monitors the number of times the law firms’ phones ring before members’ calls for legal assistance are answered and how long the members wait before their calls are returned. Pre-Paid also surveys its members to get service-related feedback on the provider law firms. Firms that do not meet Pre-Paid’s high standards are replaced.
For matters outside the providers’ immediate vicinity, they either send their own lawyers to see the client or to appear in court, or they arrange for an affiliated firm to handle the matter, under the providers’ supervision, at no additional cost to the client. Gotham Partners Management Co., LLC Page 4
Share Buy-Backs Since April 1999, Pre-Paid has engaged in one of the most consistent and aggressive share repurchase programs we have ever seen. As of September 30, 2002, the company had repurchased and retired approximately 5.2 million shares (over 20% of the starting share base) at a cost of approximately $117.3 million, an average price of about $22.50 per share. We applaud the company’s commitment to its core business and agree with management’s conclusion that the best way to enhance shareholder value is for the company to buy back its stock. These repurchases return capital to those shareholders who wish to sell without generating the taxable income of dividends; are accretive to those shareholders who remain because the retired shares are trading at a modest multiple of free cash flow; and avoid the trap into which many companies fall of squandering cash on supposedly ‘synergistic’ acquisitions. How do the Shorts Sleep at Night? As a percentage of shares outstanding, we believe that Pre-Paid is the most heavily shorted of all companies listed on a U.S. exchange. The company has neither convertible debt nor dual share classes, either of which can lead to substantial arbitrage-related short selling as opposed to fundamental short selling. We believe that short sellers often do some of the most thorough research on public companies. In this case, we think the shorts are wrong. With approximately 19 million shares outstanding and 11.5 million shares sold short, the shorts are playing a dangerous game of musical chairs. Currently, there are 30.5 million players in the game and only 19 million chairs. When the music stops, we believe that there will be a furious rush to match players with chairs and the price at which the market clears will be materially higher than it is today. If that were not enough, the game of musical chairs gets more dangerous with each passing week. We estimate that the company currently generates approximately $1 million of free cash flow per week and uses that cash to retire shares. At the current share price, the company is able to remove around 40,000 chairs from the game each week or around 2,000,000 chairs annually. Pre-Paid is an unusual short candidate in that it is missing many of the hallmarks of short ideas. The classic short is highly leveraged, burdened with off-balance sheet liabilities, cash flow negative, dependent on the capital markets to provide debt and/or equity to support its business plan, employs aggressive accounting, trades at an excessive multiple of earnings or cash flow, may have been assembled through a series of acquisitions and is notable by the amount of stock sold by insiders. Not a single one of these attributes can be applied to PrePaid. It has no material debt outstanding. It has a valuable off-balance sheet asset, in the form of its $209 million in commission advances. It is materially cash flow positive. It does not require additional debt or equity capital. In fact, it is returning capital to the market, being a purchaser as opposed to an issuer of securities. It has conservative accounting. It
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trades at a modest multiple of cash flow. It has been built almost entirely through internal growth. Insiders at Pre-Paid have been and still are significant shareholders. We are at a loss to understand what the short sellers are thinking. They must believe that the business is going to implode…and soon. As we will show in this report, even a steep decline in growth is insufficient to justify a short sale at the current valuation. We will also provide our detailed analysis of why we do not think litigation is a serious risk to the company. Time is the friend of the company and its shareholders as Pre-Paid grows its membership base and simultaneously generates free cash flow that it uses to retire shares. Short sales actually benefit the company by depressing the market price and allowing the company to repurchase more shares at a lower price. In the third quarter, the short interest increased by 500,000 shares (to a total of 11.5 million shares), while the company retired an additional 921,600 shares at an average price of $18.77 per share. Valuation As of November 19, 2002, Pre-Paid’s approximately 19 million shares were trading at $25, yielding a market capitalization of approximately $475 million. In the first nine months of 2002, the company generated $39 million of cash from operations and spent $42 million repurchasing shares.5 We project 2002 operating cash flow of approximately $50 million and 2003 cash flow of $60 million implying a cash flow multiple of 9.5 times for 2002 and less than 8 times for 2003. Pre-Paid’s business has consistently grown, is non-capital intensive and deploys its free cash flow to retire shares. We feel that a cash flow yield of 10.5% (1 divided by 9.5) is extraordinarily attractive for a business with these attributes. Our detailed valuation separately values the business as if divided into three parts: (1) the existing book of business (1.39 million current members), (2) the off-balance-sheet pre-paid commission asset, and (3) the potential to add new members in the future. 1) The Existing Book of Business The existing book of business as of December 31, 2001 was comprised of 1.24 million members who initially purchased memberships as long ago as 1975. Tables #1 and #2 below show annual membership sales from 1975 through 2001 and membership retention as a function of length of membership or member “age”.
TheStreet.com, in an article dated July 23, 2002, suggested that Pre-Paid was hiding a deterioration in its cash flow between Q1 and Q2 of 2002. It said: “The company posted cash flow of $23.5 million for the first six months of 2002 – but $18.1 million of that rolled in during the first quarter. At $5.4 million, second-quarter cash flow fell 70% from first-quarter levels.” The ‘mystery’ behind these numbers is dispelled by the Statement of Cash Flows. The difference reflected little more than the timing of estimated tax payments. As is the case for most corporations, Pre-Paid pays estimated taxes on April 15, June 15, September 15 and December 15 of each year. Thus, compared to other quarters, Q2 cash flow is overburdened with two tax payments. Q3 cash flow from operations was $15.5 million. Gotham Partners Management Co., LLC Page 6
Table #1 New Memberships Sales
Year New Membership Sales
Table #2 Annual Retention
Length of Cumulative Membership % Renewal % Retention (years) 1 53.37% 53.4% 2 69.27% 37.0% 3 77.52% 28.7% 4 82.34% 23.6% 5 84.96% 20.0% 6 86.68% 17.4% 7 88.32% 15.3% 8 89.51% 13.7% 9 90.54% 12.4% 10 91.32% 11.4% 11 91.90% 10.4% 12 92.72% 9.68% 13 93.18% 9.02% 14 93.24% 8.41% 15 93.10% 7.83% 16 92.46% 7.24% 17 93.37% 6.76% 18 93.49% 6.32% 19 95.41% 6.03% 20 95.19% 5.74% Source: 1/26/01 8-K and Gotham analysis
1975 6,481 1976 2,689 1977 2,401 1978 7,676 1979 11,951 1980 8,569 1981 12,466 1982 20,718 1983 39,836 1984 49,490 1985 133,816 1986 220,632 1987 104,704 1988 59,474 1989 24,214 1990 7,643 1991 9,437 1992 14,439 1993 34,294 1994 45,893 1995 109,922 1996 194,843 1997 283,723 1998 391,827 1999 525,352 2000 670,118 2001 728,295 Source: Company annual reports
It is important to note that the persistency of members who have been members for several years is much greater than that of new members. This makes sense to us because members who have been with the program for a long time are likely to have used the services of their provider law firm and place higher value on the membership than new members. We used the above data to estimate the “age” of the current membership base. Because memberships are sold throughout the year and we have data only for the year-end periods, we needed to make an assumption about retention within the calendar year. In an effort to simplify our analysis, we averaged the one-year and two-year retention rates to get the percentage of memberships that are retained on December 31st of the year subsequent to the membership sale. Thus, for the first and second years, 53.4% and 37.0% are averaged to 45.2%. For the first December 31st, we took the average of the one-year retention (53.4%) and the percentage in force at the time of initiation (100%) in order to estimate year-end retention of 76.7%.
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To illustrate, our analysis for the 133,816 memberships sold in 1985 is detailed below. Table #3 Illustration of Membership Run-off
Percentage of 1985 1985 Sales Memberships Year-end Retained in Force 1985 76.7% 102,617 1986 45.2% 60,445 1987 32.8% 43,912 1988 26.1% 34,966 1989 21.8% 29,205 1990 18.7% 25,044 1991 16.4% 21,899 1992 14.5% 19,464 1993 13.1% 17,517 1994 11.9% 15,924 1995 10.9% 14,586 1996 10.1% 13,462 1997 9.4% 12,512 1998 8.7% 11,662 1999 8.1% 10,866 2000 7.5% 10,083 2001 7.0% 9,367 Source: Company filings and Gotham analysis
For each year’s membership cohort, we did an analysis similar to the one shown in Table #3. In other words, we applied the historical retention statistics shown in Table #2 to the new memberships per year shown in Table #1.6 Summarizing our analysis, we derived the following results as of December 31, 2001: Table #4 Derived Aging Distribution of Membership Base
“Age” of Membership Number of Members 0-1 years 558,493 1-2 years 302,692 2-3 years 172,394 3-5 years 164,307 5-10 years 67,336 10+ years 53,272 Total 1,318,494 Source: Company filings and Gotham analysis Percentage of Total Members 42% 23% 13% 12% 5% 4%
A complete analysis of the existing membership base is attached as an appendix. Page 8
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Note that the calculated membership, 1,318,494, is approximately 5.7% greater than the reported membership of 1,242,908 as of December 31, 2001. The calculated/reported difference has ranged between plus 1% and minus 6% over the past ten years. Given the number of assumptions we have had to make in constructing our model, we feel that this level of agreement confirms the reliability of our approach: that is, whether we look directly at the reported number for members at year-end 2001 or derive that number statistically from prior year-end numbers, the figures correspond closely. If we assume that no new members are added to the year-end 2001 membership base, it will obviously erode over time. Because we know approximately how long the various cohorts of members have been associated with Pre-Paid, we are able to apply the retention data from Table #2. Again, using year-end 2001 data, we arrive at the following membership projections. Table #5 Projected Membership Run-off through 2008
(assumes no new sales) Year-end Remaining Members 2001 1,318,494 2002 934,031 2003 748,516 2004 632,610 2005 550,352 2006 487,686 2007 438,244 2008 398,172 Source: Company filings and Gotham analysis Annual Retention 70.8% 80.1% 84.5% 87.0% 88.6% 89.9% 90.9%
The membership base erodes quickly in the early years of run-off. Nearly 30% of the initial membership base has cancelled by the end of the first year. However, retention quickly rises to 85% and is greater than 90% in the seventh and later years. Based upon the business’ historic operating results, we assumed that each of these members pays $260 per year, subtracted 34% for fees to attorneys, 25% for sales commission and 10% for G&A. We then applied a 37% corporate tax rate and discounted the after-tax cash flows at 10% per annum. Finally, we adjusted for the growth in the membership base from 1,242,908 on December 31, 2001 to 1,389,467 at the end of the third quarter and applied a 5.7% discount for the difference between our calculated and the company’s reported membership to arrive at a value for the existing book of business of $230 million or $12.11 per share. 2) Pre-Paid Commission Asset In the above analysis, we ignored the fact that the company has pre-paid $209 million of commissions to its sales associates that it expects to recover from membership fees on the existing membership base.7 We assumed that the advance is recovered over 10 years as the existing membership base runs off. We applied a 37% tax rate and a 10% discount rate to get
The company’s analysis of commission advance recoverability in its Form 10-K makes the conservative assumption that sales associates produce no additional membership sales. Advances are recovered exclusively from future membership revenue from existing members. Gotham Partners Management Co., LLC Page 9
to a present value of approximately $95 million, or $4.98 per share, for the off-balance sheet advanced commissions. 3) Future Sales We modeled the cash flows from new membership sales with the following assumptions: average membership revenue of $267 per year, 70% first-year commission, 5% renewal commission, 34% attorney fees, a 37% tax rate and a discount rate of 12.5%. The company’s current operating results are the basis for these assumptions. We used a higher discount rate for new sales due to the increased uncertainty involved in sales projections.
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Table #6 Present Value of New Membership Sales
(based on 100 new membership sales) End of Year Members 100.00 53.37 36.97 28.66 23.60 20.05 17.38 15.35 13.74 12.44 11.36 10.44 9.68 9.02 8.41 7.83 7.24 6.76 6.32 6.03 5.74 Average Members 76.7 45.2 32.8 26.1 21.8 18.7 16.4 14.5 13.1 11.9 10.9 10.1 9.3 8.7 8.1 7.5 7.0 6.5 6.2 5.9 Discount Rate Total NPV Per Customer NPV IRR Source: Company filings and Gotham analysis Commission Advance (18,690) After-tax Cash Flow (11,775) 6,579 3,875 2,815 2,241 1,872 1,605 1,404 1,248 1,123 1,021 935 863 802 748 697 646 600 561 530 505 12.5% $5,400 $54.00 26.6%
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Retention 53.37% 69.27% 77.52% 82.34% 84.96% 86.68% 88.32% 89.51% 90.54% 91.32% 91.90% 92.72% 93.18% 93.24% 93.10% 92.46% 93.37% 93.49% 95.41% 95.19%
We conclude that the after-tax present value of a customer is approximately $54. We then made assumptions about future growth in sales. Our assumptions range from negative 2% to positive 8% per year. A negative growth rate means continued sales, but at levels that are smaller in each successive year. We believe that these assumptions are conservative in light of the company’s historic growth (5-year growth in sales has been greater than 30% and growth in 2002 has been 8-9%). We then added the three components of value (ignoring net cash) and divided by 19 million shares to arrive at the implied value per share shown in Table #7.
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Table 7 Total Value vs. Projected Sales Growth
Present Value Combined Value of Exisitng Sales of Future Sales and Commission Advances ($ million) ($ million) (2%) 294 325 3% 449 325 8% 948 325 Source: Company filings and Gotham analysis Annual Sales Growth Total Value ($ million) 619 774 1,269 Total Value per Share $33 $41 $67
We conclude that the company is worth $33 per share even if sales decline by 2% per year every year in the future. The shares are worth $67 if the company can maintain its current growth rate of 8% per year. Alternative Valuation Methodology I As we have said earlier in our report, the combination of growth in membership, free cash flow and share repurchases will have a material compound effect on valuation as time progresses. If we assume that for the next four quarters that sales remain at roughly 200,000 per quarter and that retention is stable, we estimate that the Q3 2003 membership base will be approximately 1,530,000. During the twelve-month period the company will have generated net income of approximately $53 million and cash flow from operations that should be greater than $60 million. The company will be able to repurchase approximately 2 million of its 19 million shares even if it has to pay an average price of $30 per share. The compound effect of a 20% increase in cash flow ($60 million versus $50 million) and an 11% decline in shares outstanding (17 million versus 19 million) will produce a 34% increase in cash flow per share from $2.63 to $3.53. At a cash flow multiple of 15 times, the business should be worth $53 per share in one year. We have found few companies at reasonable valuations that can produce these types of returns. Alternative Valuation Methodology II Perhaps the most thoughtful analysis that we have read on Pre-Paid was produced by Off Wall Street Consulting (OWS). OWS has a reputation for insightful and detailed analysis of accounting issues and has, over time, uncovered a number of over-valued public companies. In November 2000, with Pre-Paid’s shares trading at over $40, OWS released a negative report on Pre-Paid and established a target price of $24. The focus of the OWS report was the company’s accounting for commission advances and slowing growth. We have carefully read the OWS report and believe that flaws in the assumptions of the report tend to understate the company’s value. OWS does not provide a quantitative framework for their price target, but if we assume for the moment that the OWS
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valuation is correct, we get an interesting result by using the OWS analysis and current facts about the company. At the time of the OWS report two years ago, the company had 22.6 million shares outstanding implying a target market capitalization of $542 million. Since that time, the company has grown its membership base by 36%, from 1.02 million to 1.39 million, and its quarterly revenue by a greater amount (there have been regular increases in average revenue per member) and the company has reduced its shares outstanding to approximately 19 million. Adjusting the target valuation upward by 36% for growth in members and dividing by the reduced share base equates the OWS original valuation of $24 to over $36 per share today. We are comforted that a bearish report about the company establishes a target price that is approximately 44% above the current share price based on current fundamentals. Final Thoughts on Valuation Our valuation analysis has been based on retention rates from the company’s 8-K filed on January 25, 2001. These retention rates have been generated over the company’s 30-year history when there was little focus on retaining members. Instead, the focus was on adding new members. Growth in membership is driven by both adding new members and by retaining existing members. Because the addition of new members is cash flow negative due to commission advances, growth through increased retention is much more attractive than growth through new member addition. The company’s management understands this fact and has begun to implement a series of programs designed both to motivate the sales force to write higher quality (more persistent) business and to increase the level of customer satisfaction and perceived value among their existing members. The impact of increased retention has a leveraged effect on our estimates of value. With respect to new customers, if the company can drive first year retention from 54% to 60%, the present value of a customer increases by more than 30%. With respect to the current book of business, a similar move in annual retention leads to a 50% increase in the value of the existing membership base. The net effect would be to increase our current valuation range from between $33 and $67 per share to between $43 and $88 per share. The Shorts’ Story While Pre-Paid’s business has grown dramatically in revenue, members and free cash flow, the company has been the target of ardent short sellers. Today, 60% of shares outstanding have been sold short (nearly 11.5 million shares), up from 6.3% in January 1999. Pre-Paid’s detractors have employed a number of arguments for why they are negative on the company. The company’s critics pick out a few numbers from an SEC filing – for example, percentage changes in sales associates or new member contracts – and those data, plus a healthy dose of sarcasm and innuendo, serve as the basis of a thesis for why the company is
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about to implode. As these arguments have proven to be false, others have emerged, but the bears do not concede past errors. Below we address a number of the theses that short-sellers and critics have used to justify their bearish view of Pre-Paid. Argument #1: Accounting Issues Shorts say Pre-Paid has been up to accounting shenanigans. We disagree. Pre-Paid has consistently provided adequate and appropriate disclosure that has allowed any investor to determine how the business is performing. While investors have questioned the company’s GAAP income statement, the company’s cash flow numbers have never been questioned. Over all periods in question, Pre-Paid has generated substantial after-tax free cash flow. The accounting issue has centered on the GAAP treatment of commission advances. First, these accounting issues are not unique to Pre-Paid. All subscription businesses – whether magazines, life insurance or health clubs – face questions about how to treat commission advances or “deferred acquisition costs.” Second, Pre-Paid has a reliable record of collecting the majority of those advances. The specific facts are as follows: Pre-Paid advances future commissions to its sales people upon their writing new contracts. Because the annual revenue from a one-year membership is a small sum (the average is around $267) and because it takes a great deal of effort to make each sale, the company advances a substantial commission to its sales associates immediately upon adding a new member. In the case of Pre-Paid, the company advances approximately 70% of the first year’s membership revenue. This approach is not unusual. For example, if you look at the balance sheet of any life insurer, you are likely to find a large item for “Deferred Acquisition Costs,” which includes large, upfront sales commissions as well as other marketing related expenses. Formerly, Pre-Paid capitalized its commission advances and expensed them over time as membership payments were received. The company’s auditors at Deloitte & Touche approved this treatment. Cash advances, amortization, and the capitalized commission asset were all properly disclosed. In January 2001, the SEC began an informal inquiry into PrePaid’s treatment of its advances. The company tried to convince the regulators that this treatment made sense under GAAP because the capitalized advances lead to reduced commissions payable over time. The regulators did not agree. As a result, Pre-Paid changed its treatment of commission advances, wrote-off its entire capitalized advance balance, and began expensing advances as they are paid. The shorts seem to believe that Pre-Paid’s treatment of commission advances showed that management was inflating earnings in an effort to manipulate the share price. On this issue, we find the federal-court opinion issued March 5, 2002 instructive. The opinion dismissed, with prejudice, shareholder claims based on Pre-Paid’s accounting for advances. Among other things, Chief Judge Robin Cauthron wrote:
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It appears patently absurd for a corporation to fraudulently inflate the price of its stock only to then purchase the stock (during the class [action] period) at such inflated prices without any financial benefits. [Opinion at page 13 (emphasis in original).8] She also noted: “There are diametrically opposed views of the accounting methods in question, but differing views, without more, do not lend credence to a charge of fraud.” Id. at 8. Plus, “the information [in question] was not withheld by Pre-Paid and then disclosed; rather, the information regarding Pre-Paid’s accounting methods had been publicly known for some time.” Id. at 21. The first two observations we quoted should put an end to any claim of fraud. The third quote is critical to appreciating why the accounting shenanigans thesis was not only unfounded, but short-sighted. Throughout the period of alleged overstatement, Pre-Paid was generating substantial cash – regardless of how it was treated under GAAP. As value investors, we generally focus our attention on cash flow. The cash generation was never in question, only its GAAP treatment.9 Today, Pre-Paid expenses commission advances when they are paid, reducing GAAP net income, but having no effect on recurring free cash flow, which has been steadily increasing. In an era of increased attention to accounting issues, we feel that Pre-Paid is an anti-Enron. It has a substantial off-balance sheet asset. Because commissions are fully expensed when paid, they do not appear on the balance sheet. Look closely at the balance sheet and you will find no mention of the approximately $209 million of commissions that the company has advanced to sales associates and is entitled to recover in the future through higher net margins on future membership fees which no longer bear commission expense. We estimate that this asset alone is worth approximately $5 per share. Reasonable people could disagree about the company’s prior accounting for commission advances. No reasonable person, we believe, could conclude that the company’s present accounting is anything but conservative. An article in TheStreet.com dated December 6, 2000 stated: “If Pre-Paid were ultraconservative, some short-sellers argue, it would immediately take a hit against earnings on all commissions.” Today, those short-sellers should acknowledge that Pre-Paid’s accounting for commissions is ultraconservative.
We urge you to read the entire opinion. It was filed on March 5, 2002, under the name In re Pre-Paid Securities, Inc., Litigation, Master Docket No. CIV-01-0182-C, in the U.S. District Court for the Western District of Oklahoma. Read also the Chief Judge’s decision and order filed March 20, 2002, denying plaintiffs’ motion to reconsider dismissal of their claims. 9 TheStreet.com, in an article dated March 26, 2002, lambasted Harland Stonecipher for his “pure guts” in quoting Warren Buffett who said: “ It actually makes no difference to us what accounting treatment is used. We’re interested in the economics of the transaction.” TheStreet.com says Buffett was quoted “way out of context.” We’ve researched the context and we disagree. We were able to find the quotation in the June 23, 1994 issue of Outstanding Investor Digest. The context is that Buffett and Munger, at the 1994 Berkshire Annual Meeting, were discussing the limits of accounting and the need for investors and managers to look through to the underlying economics of a business. At Pre-Paid, cash flow is a conservative measure of the underlying economics of the business. The company’s cash flow was never impacted by the GAAP treatment of commission advances. Gotham Partners Management Co., LLC Page 15
Argument #2: Slowing Growth and Poor Retention of Members Shorts argue that Pre-Paid is about to implode because, they say, the business must run to keep in place and, therefore, in light of slowing growth it must collapse, almost immediately. We believe the company’s critics, in making these charges, have not adequately considered the value of the business today, assuming the company never sells another membership. As explained above (“Valuation”), assuming zero new sales, we expect the business will generate a nearly 10% return for the foreseeable future even if it never enlists a single new member. We also believe the critics have failed to consider how Pre-Paid compares to other subscription businesses. Every insurance company, every publisher, every health-club operator faces the challenge of finding new subscriber clients and keeping existing clients. Magazine publishers must scramble for new subscribers every year, as they lose upwards of 60% of their subscribers every year. Pre-Paid’s efforts to recruit and retain members are no different, qualitatively, than the efforts of other subscription businesses. What is also missing from the shorts’ criticism is a careful analysis of Pre-Paid’s 8-K filed on January 25, 2001. To better illuminate these issues, the company provided a wealth of detailed data about retention. We have considered the 8-K carefully and used its data to build the model discussed previously. To us, it shows that the company’s business is solid and has substantial value – even without any new membership sales. The bears can say what they want about the decline in the rate of growth of new sales, but we do not believe that anyone believes that sales are likely to decline from approximately 180,000 new members per quarter to zero and stay there indefinitely. To give you a sense of the quality of the bearish analysis, we offer a critique of what The Street.com said about Pre-Paid’s growth in an article dated October 14, 2002. It begins: “Pre-Paid pratfalls: Pre-Paid Legal announced quarterly recruiting and membership ’production’ numbers this morning. And although the headline numbers are rising, their quality keeps deteriorating. (Not that anybody cares!)” The article notes that while the company’s membership base is up, new membership sales have stalled despite the rapid addition of new sales associates attracted by the reduced sales associate entrance price. All true and all disclosed. The article goes on to argue that rather than declining 4% sequentially and rising 11.5% over the prior year period, sales are down 13% sequentially and up only 1% annually. What The Street.com doesn’t tell you is that it has misinterpreted the data in reaching this conclusion.
Gotham Partners Management Co., LLC
The company reported the following information in its third quarter release:
New Membership Sales New Sales Associates Source: October 14, 2002 press release Q3 2002 197,442 46,653 Q2 2002 206,195 45,962
The absolute number of New Membership sales during the third quarter has declined from the Q2 sales by 1% from 206,195 to 197,442. We would, however, make the arguments that: 206,195 membership sales was a record quarter for the company, 197,442 is the third best production quarter in the company’s history. The article correctly notes that most sales associates carry their own membership and that many were not members prior to becoming associates.10 Therefore, in order to determine the growth in non-sales associate membership sales, TheStreet.com subtracts 40% of new sales associates from new membership sales. Therefore, Q3 new membership sales of 197,442 is reduced by 40% of Q3 new sales associates of 46,653 to get 178,780. So far, so good. The article then compares 178,780 to the unadjusted Q2 number of 206,195, resulting in a supposed 13% decline. In order for this to be a fair comparison however, one must subtract the corresponding figure from both the second and the third quarter. If TheStreet.com had made the corresponding adjustment to the Q2 numbers, the figure of 206,195 would have been reduced to 187,810. The adjusted decline from 187,810 to 178,780 is a much more modest 5%. Because TheStreet.com fails to make the same adjustment to the prior period numbers, it is comparing Q3 apples to Q2 oranges and generating a result that is consistent with its already bearish view of the company but is otherwise inaccurate. Argument #3: Multi-Level Marketing Pre-Paid sells its membership contracts through multi-level marketing (sometimes called MLM). The company's critics act as though they need only mention multi-level marketing to prove that the entire enterprise is illegitimate. We believe the critics have not done their homework on this point. MLM businesses are legitimate. Anyone interested in the topic can start by visiting the web site of the Direct Selling Association, www.dsa.org, which disseminates information about direct sales. Click through to the members' directory and you'll see familiar names like Amway, Avon, Fuller Brush, Kirby Vacuums and World Book Encyclopedia (both owned by Berkshire Hathaway), Mary Kay Cosmetics, Shaklee, and another 134 members. According to the Direct Selling Association, Pre-Paid has applied for membership in the Association and is currently in a mandatory one-year waiting period. We expect it will be granted full membership in March of 2003. We also note that Pre-Paid is a member in good standing of
We have always been sensitive to these facts and track quarterly production in non-associate new members. This figure has averaged over 150,000 per quarter since the beginning of 2000. Gotham Partners Management Co., LLC Page 17
the American Prepaid Legal Services Institute (www.aplsi.org), an affiliate organization to the American Bar Association, that “provides information about how prepaid and other legal service plans work . . . and how they make it easy and affordable to get quality legal services when you need them.” MLM businesses are carefully regulated by the states and the Federal Trade Commission. Without question, some MLM businesses sell worthless products and violate the law. But to gain traction for their bearish views, Pre-Paid's critics must do more than merely smear the company as being a multi-level marketer. To assess this issue, we urge you to visit www.prepaidlegal.com, the company's web site, and to consider the terms on which sales associates join the network. You will notice that the indicia of fraudulent ‘pyramids’ are absent. Sales associates face no excessive initiation fees, paying only $99 to $249 for training and sales materials. By signing up just a few new members, the sales associate makes back the cost of training and begins to earn net profits. Associates are not required to purchase large amounts of over-priced inventory (another frequent sign that something is amiss). Associates are not paid merely for recruiting other associates, something akin to a chain letter; they are paid only for actual sales by themselves and their recruits. Have there been missteps by sales associates? Undoubtedly. You can't have 200,000 independent sales associates selling products without some of them overstepping their instructions. But what strikes us is (a) the seriousness of the company's efforts to set and police its policies and practices, and (b) the lack of any material regulatory attention to the company. For example, TheStreet.com mentioned that Pre-Paid had resolved a regulatory inquiry in Wyoming, suggesting something ominous had happened in that State. What the article did not mention is that the resolution, announced in November 2001, involved only the company’s giving Wyoming an assurance that it would comply with its regulations and paying a total of $7,000. In addition, the company recently answered an inquiry from the attorney general in Mississippi and, as far as we know, nothing further has happened, and in 1999 the company entered into a consent agreement with the Montana Insurance Commissioner, requiring Pre-Paid to modify a few items in its sales materials and to pay $5,000 in expense reimbursements and make a donation of $20,000 to Montana Legal Services. None of these seem cause for alarm for a company generating $50 million (and growing) of annual free cash flow. Finally, we come back to the fact that the product being offered is of substantial value to the prospective customers. There are no outlandish promises of miracle cures (losing weight while you sleep, etc.). Instead, as detailed above, we believe a legal service plan fills an important need in the lives of most middle-income Americans. Yes, this product is being sold door-to-door by commission-hungry sales associates who have to convince their customers to buy something they have probably never had before - legal representation. But that does not make the company a fraud. Think of all the products sold by aggressive sales people - cars, magazines, banking and telephone services, you name it - but these are all valuable products that are being sold in a lawful way.
Gotham Partners Management Co., LLC
Argument #4: Credibility of The People and Governance The shorts like to attack personally the people associated with Pre-Paid. We believe these attacks are unwarranted. Harland Stonecipher is the company’s founder and has been its salesman-in-chief and head cheerleader for 29 years. He is certainly not a type-cast Wall Street CEO, but through ups and downs, he has persevered and managed to keep the company growing (spectacularly, in recent years) and to build an enormous nationwide network of sales associates and law firm providers. As far as we know, he has never sold a material amount of his stock, always preferring to bet on the future of the company. He has reached into his pocket and exercised options when they were approaching expiration, something, we have noticed, that very few Wall Street executives would do. On a few occasions recently, he has made small bona fide gifts of stock, but nothing material. We would also urge the short sellers to go meet with COO Randy Harp and CFO Steve Williamson. We have met with them many times and find them to be first-class professionals, with strong, relevant credentials and ample backgrounds in their areas of responsibility. They are exactly the sort of people, we believe, that Wall Street investors should want to have running the operations of a public company. Overall, we find the company’s governance to be wholly legitimate. While we might have done things differently on occasion, we find no grounds to condemn the company for its past conduct, which, as far as we know, has always been legal and fully disclosed. One standard we use to evaluate a company is whether its SEC filings provide all the data a reasonable investor would want to know in order to value the enterprise and judge whether the principals are intelligent, capable and of good character. We find the company has always met that standard. We note, as well, that there is no poison pill, another sign to us that management is perfectly comfortable with what they are doing to serve their shareholders. We find it noteworthy that Pre-Paid is moving promptly to comply with the highest standards and best practices required under the new rules of the New York Stock Exchange and under the Sarbanes-Oxley Act. On August 14, 2002, the company issued a press release on governance and other issues and filed a related 8-K on August 15, 2002. The 8-K stated:
As an initial effort to meet the new corporate governance proposals and requirements set forth by the New York Stock Exchange and the recently enacted Sarbanes-Oxley Act of 2002, effective August 9, 2002, four members of the registrant's Board of Directors that do not meet the new independent director definition resigned from the Board. Those resigning from the Board of Directors were Kathleen S. Pinson, Wilburn L. Smith, David A. Savula and Shirley A. Stonecipher. None of the resigning directors expressed any disagreement on any matter relating to the Registrant's operations, policies or practices.
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The three remaining outside, independent Board members, John A. Addison, President and Co-CEO of Primerica Financial Services; Martin H. Belsky, Dean and Professor of Law at the University of Tulsa College of Law; and Peter K. Grunebaum, Director of Corporate Finance with Fortrend International, will comprise the registrant's Audit Committee and newly formed Compensation and Nominating Committees. These three independent board members together with John W. Hail, Chairman and CEO of Advantage Marketing Systems, Randy Harp, Chief Operating Officer of the registrant and Harland Stonecipher, Chairman and Chief Executive Officer of the registrant will comprise the registrants Board of Directors. The registrant plans to name another independent director to the Board in the coming months.
Besides describing the changes on the board, the press release covered several other points. First, at Mr. Stonecipher’s request, the independent Compensation Committee will review his compensation to tie it “even more clearly” to the company’s operating results. Second, the company would discontinue making loans to executives and independent marketing consultants, while noting that all such loans, totaling $2.9 million, had been repaid or would be repaid or substantially reduced by year-end. Third, the company provided additional detail about its cash position and about the status of its commission advances, which have been expensed but are expected to be recouped in the form of reduced future commission expenses. The outside independent directors, some of whom we have met personally, seem to be well qualified, well experienced and genuinely independent. The impending changes in Mr. Stonecipher’s compensation seem entirely appropriate and a good sign of even greater alignment between the founder’s interests and those of the shareholders. The announcement about executive loans, which were previously disclosed in SEC filings, shows the company’s commitment to recent changes in the law. We emphasize, however, that the loans were never illegal; they always bore a substantial interest rate; they were never material in the context of the company’s finances; and they have never caused the company any financial loss. Finally, the disclosure about commission advances, previously expensed, that should lead to higher reported earnings later, seems completely fair and appropriate given the nature of the company’s business. Now let us consider the use to which TheStreet.com puts the recent 8-K and press release. On August 16, 2002, an article in TheStreet.com states:
Pre-Paid pratfalls: Of all the stories I’ve run across in my years of reporting, PrePaid Legal (PPD: NYSE) . . . is certainly one of the strangest. Two days ago the company announced that, for corporate governance purposes, four directors were leaving the board, include CEO Harland Stonecipher’s wife, Shirley. The company also said it had made loans that, under the new rules, wouldn’t be possible. What’s missing in all the company’s yakking about corporate governance, it didn’t do what so many companies – big and small – have done whether it’s required or not: It didn’t say anything about whether its top execs would be certifying their financials!
Gotham Partners Management Co., LLC
TheStreet.com does not suggest that the company will run afoul of the new NYSE rules and the new securities laws that recently came into effect; or that the independent directors are not indeed qualified, conscientious people; or that aligning executive compensation with operating results is a bad thing; or that future earnings will not be increased in the future as the company recoups previously expensed commissions. Nor does TheStreet.com suggest that the company was out of compliance with previous rules or laws. Rather than give credit where credit is due, the article derides as “corporate yakking” PrePaid’s compliance with NYSE rules and with Sarbanes-Oxley. It then criticizes the company for failing to “say anything about whether its top execs would be certifiying their financials!” Of course, there is nothing in the Sarbanes-Oxley Act, requiring a company to state in advance whether its executives will certify its financials. For decades, Pre-Paid’s executives have signed their financial statements and SEC filings. Those signatures alone, we believe, carry significant legal exposure if the financials and SEC filings are inaccurate. Even before the recent change requiring certification, executives who took lightly their signatures on those documents were acting foolishly. Because Pre-Paid’s second quarter 10Q was filed on July 24, 2002, we do not believe any certification was required for that filing. Now that Pre-Paid has filed its third quarter 10Q – complete with certifications – we hope TheStreet.com will have the courtesy to retract its prior implication that Pre-Paid’s executives were ducking their duties. In light of these facts, we cannot understand what made Pre-Paid’s press release “certainly one of the strangest” stories the reporter has “run across in my years of reporting.” Argument #5: Litigation As various bearish arguments have been proven unfounded, critics of Pre-Paid have proven themselves adept at developing new arguments. The one that is currently getting the most attention is litigation. Pre-Paid faces three types of litigation – by shareholders, associates and members. We address them in that order, explain why we do not believe that litigation is likely to have a material negative impact on the company and finally outline why we have found TheStreet.com’s reporting on this litigation to have been incomplete and lopsided. Shareholder class actions, brought by contingency-fee lawyers, claim that Pre-Paid’s former treatment of commission advances as assets was fraudulent because it inflated reported earnings. These claims have been rejected, for sound reasons. First, because PrePaid has been the biggest buyer of its own shares during the period of allegedly inaccurate accounting reports, it is impossible to infer that Pre-Paid was manipulating the market price upward. We referred earlier to a decision filed March 5, 2002 by Chief Judge Robin J. Cauthron in the U.S. District Court in the Western District of Oklahoma that dismissed all claims against the company, with prejudice on the merits. The dismissal of the class action is on appeal, but we do not see any reasonable basis for its being overturned.11
We note also that one of the lead plaintiffs recently took the unusual step of withdrawing its name from the suit and disavowing any claim against the company. Page 21
Gotham Partners Management Co., LLC
Additional shareholder class actions have been filed, relating to the same accounting issues and asserting claims of breach of fiduciary duty, waste and mismanagement. During the third quarter, according to Pre-Paid’s latest 10Q, the company moved to dismiss these claims in their entirety with prejudice on the merits. Upon seeing the company’s defenses, the plaintiffs withdrew their claims, but, under the pertinent procedural provisions, the plaintiffs were permitted to withdraw the complaint without prejudice, meaning they can re-file it later. The company objected to letting the plaintiffs withdraw, preferring to get a ruling on its motion to dismiss the claims once and for all. It is unusual to see a defendant fighting to keep a plaintiff in court, but that is what happened here. The reasonable inference, we think, is that the plaintiffs believed they were about to be thrown out of court and have their claims dismissed with prejudice. Rather than face this outcome, the plaintiffs, we expect, will try to re-file elsewhere, and perhaps engage in forum shopping (that is, looking for a “friendlier” jurisdiction in which to file their case). In reviewing this complaint, we do not see any greater threat than from the claims already dismissed. The difference between these new cases and the earlier one is that the new cases are based upon state common law, while the recently dismissed case was based upon federal securities law. This shift of legal focus, we believe, will not change the outcome. In choosing how to treat commission advances under GAAP, management relied upon Deloitte & Touche’s expert opinion, which the auditors held so firmly they preferred to quit the assignment rather than change their view. While the SEC pushed the company to change its reports, that disagreement does not prove mismanagement. In any event, if the plaintiffs are able to show liability, it will be very difficult for them to prove and quantify any monetary damages. The exposure from these suits, we believe, is immaterial. Sales associate lawsuits, spearheaded again by contingency-fee lawyers, assert two claims: (1) that commission advances actually constitute ‘consumer loans’ that violate certain requirements under Oklahoma law, therefore barring Pre-Paid’s ability to collect these ‘loans’; and (2) that the sales associates’ contracts, permitting them to sell Pre-Paid’s products, constitute ‘securities’ that should have been registered with the SEC and should have carried a prospectus. We have reviewed the ‘consumer loan’ complaint and the statutes on which it is based and find the case extremely farfetched. The substance of the challenged transaction is that PrePaid made advances against future commissions. These advances were not meant, and cannot be reasonably understood, as ‘consumer loans.’ In addition, the precise conduct attacked in the suit (charging allegedly excessive interest) has not been the company’s practice for several years. Even if the charge were sustained, the number of people seeking to cancel their ‘loans’ and the total amount of ‘loans’ is unlikely to be material. Furthermore, those who seek to cancel their ‘loans’ are probably out of the Pre-Paid system and Pre-Paid has no practical way to recover the commission advances anyway, so Pre-Paid’s additional loss if it is prohibited from collecting its ‘loans’ is unlikely to be material.
Gotham Partners Management Co., LLC
In the securities case, on August 1, 2002, plaintiffs filed an amended complaint, which includes seven claims.12 The first four claims depend on the allegation that associates’ contracts are registrable securities under federal and Oklahoma law and that there were misrepresentations made by the company in connection with the sale of those securities. The fifth and seventh claims assert that, by reason of those misrepresentations, Pre-Paid violates Oklahoma’s consumer-protection and business-opportunity statutes. The sixth claim alleges unjust enrichment. (Liberally sprinkled through the associates’ complaint are claims that Pre-Paid misrepresents the nature and value of members’ contracts. Ironically, if this charge is correct, then the very associates who are now suing were the mouthpieces who misled prospective members and associates.) On September 19, 2002, Pre-Paid filed a motion to dismiss the amended complaint in its entirety.13 First, the motion argues that associates’ contracts do not meet any definition of ‘securities’ under federal or state law. Second, to enforce any claim, the associates must tender back to the company the ‘securities’ that were improperly sold. In this case, there is nothing to return: what the associates paid for and received were training and a membership contract that is already fully performed. Third, if the associates had any claim, it would be barred by the doctrine of in pari delicto, meaning the associates are just as guilty of wrongdoing (if there were any) as anyone else involved in the business. Fourth, the complaint is not specific when claiming inaccuracies in the company’s materials. Precisely to weed out meritless suits, federal law demands that claims of misrepresentation must set forth, in detail, the who-what-when-where-how of any alleged inaccuracies, and the plaintiffs must allege their individual reliance on those inaccuracies. Pre-Paid’s motion argues that the amended complaint does not clear these hurdles. Finally, the motion argues that plaintiff’s claims under Oklahoma law suffer the same infirmities that undermine their claims under federal law. On the strength of its motion to dismiss, we believe Pre-Paid has a high likelihood of knocking out the associates’ claims. Of course, the plaintiffs’ contingency-fee lawyers are very aggressive and experienced, and we expect a spirited defense against Pre-Paid’s motion. If the case is not dismissed on the present motion, the plaintiffs still have a long way to go before they can succeed on their claims at trial. Pre-Paid’s current motion is addressed only to the legal sufficiency of the claims as they are written in the pleading. If the court does not dismiss the claims as written, the plaintiffs must then prove each of their allegations by admissible evidence at trial. This is not easy to do. Once the parties dig into the facts, we expect that the company will have numerous additional defenses, any one of which can knock out the plaintiffs’ claims. Putting this case in context, it is likely to be many years before the company suffers harm, if any, from this suit, and any potential harm is extremely unlikely to be material to the company’s finances. We ask ourselves the following questions: If a court rules that
The case, entitled In re Pre-Paid Securities Litigation II, Master Docket No. Civ-02-0273-C, is pending in the U.S. District Court for the Western District of Oklahoma, assigned, like the shareholder suit, to Chief Judge Cauthron. 13 The company’s motion to dismiss is on file with the court and available to the public. Gotham Partners Management Co., LLC Page 23
associates may seek to rescind their contracts, how many will do so? If they do, what can and will they return to the company? How much value have they sought and accepted from the company in training, membership services and commissions that will have to be deducted from any theoretical recovery? In light of the above, we do not see how any reasonable assessment of the exposure here can be material to Pre-Paid. Members cases, once again instigated by contingency-fee lawyers, this time in Mississippi and Alabama, assert essentially that their memberships were worthless, and they were misled into enrolling because the sales associates told them the membership includes ‘everything.’ The plaintiffs are seeking unspecified compensation and punitive damages for breach of contract and fraud. On the merits, these cases make no sense. The membership contracts spell out precisely what services they do and do not include, and on what terms. Basic services are 100% covered by the member’s monthly fee; other services are available from the same legalservice provider at discounted rates. No reasonable person could believe that, for as little as $16/month ($192/year), they will receive unlimited legal services of every description. An initial – and formidable – impediment to these suits is the fact that Pre-Paid’s plans are regulated by the Insurance Commissioner in Mississippi. By statute, the Commissioner must review Pre-Paid’s contracts, rates and sales brochures to make certain they are fair and not likely to mislead customers. Pre-Paid’s contracts and sales materials have passed that requirement, which seems to us should largely undermine all of these cases. On the facts, in many instances, we expect, the members made use of the service, calling for and accepting substantial value under their supposedly ‘worthless’ contracts. In most cases, we expect, members never asked for any services, thus never testing what is or is not included, or they never asked for anything beyond the basic covered services. Those people cannot legitimately claim that they were defrauded or economically damaged merely because they believed the program included ‘everything’ at no additional charge but it actually covered less than ‘everything.’ That is a wholly hypothetical claim, which should not be actionable. Furthermore, a membership program (whether pre-paid legal services, a gym, a golf club, or any other program) is not ‘worthless’ merely because you have not made full use of it. The member receives the right to use the service, which is itself valuable. Finally, we note that these member suits are brought individually, meaning that each person must show how he or she personally was misled; how the person making the inaccurate statements acted intentionally, in order to mislead the prospective member; how Pre-Paid is responsible for the intentional wrongdoing of its sales associates, who are independent contractors; how and why the members misread or ignored the stated conditions of membership; how the members actually and reasonably relied upon any such misrepresentations; how and when they realized their error and what they did upon discovering it; how much they actually suffered in damages (minus how much they received in value); and why Pre-Paid’s conduct was so egregious as to warrant punitive damages. Each of these standards seems like a high hurdle to us.
Gotham Partners Management Co., LLC
On any fair evaluation, therefore, these cases should not pose a material financial risk to the company. We are mindful that the member claims are pending in Alabama and Mississippi state courts. Mississippi, in particular, has a reputation for excessive jury awards. In addition, the plaintiff’s lawyers, well known locally, must be enticed by Pre-Paid’s having previously settled a small number of member claims for about $15,000 per member. In retrospect, this was a mistake, one we doubt the company will repeat. The company has resolved to fight every case forcefully, through trial if necessary, until the plaintiffs and their lawyers realize they cannot prevail. Since recognizing its strategic error in settling earlier cases, the company has consistently, successfully beaten back every claim that has come to court. We realize this is no guarantee that there will not be an adverse result in the future, but we believe the company should be able to defeat these member suits and, in turn, deflate the contingency-fee lawyers’ commitment to them. If the company cannot defeat these claims in their entirety, nonetheless, the damages should not be material. The total membership fees paid by the current plaintiffs is probably not more than a couple hundred dollars each. If Pre-Paid were caused to pay punitive damages – a far higher burden for the plaintiffs to meet – the punishment must bear a reasonable relationship to the wrongdoing. In a notorious case in Alabama, BMW was hit with compensatory damages of $4,000 and punitive damages of $2 million for failing to disclose that the finish of a new car had been damaged and repaired. The U.S. Supreme Court threw out the punitive damages as excessive and therefore unconstitutional. The Supreme Court ruled that punitive damages must bear a reasonable relationship to the reprehensibility of the wrong and to the amount of compensatory damages and that, as an analogous benchmark, trial courts should consider penalties elsewhere under state law for similar wrongdoing. As an example, penalties for violations of consumer-protection statutes are in the thousands of dollars, not hundreds of thousands or millions of dollars. We recognize that this analysis does not eliminate the risks of the members’ suits. Even the U.S. Supreme Court did not prescribe any bright-line rule for deciding whether punitive damages are reasonable or excessive. The trial courts and juries retain a fair degree of independence in setting damages. But, still, if we assume that Pre-Paid loses all of the pending suits and that it is found liable for punitive damages – a big if – and if we then speculate that punitive damages could be 100 times the amount of compensatory damages, Pre-Paid’s exposure is perhaps a few dollars per share. As unlikely (and outrageous) as we would consider those outcomes, the company nonetheless could absorb them and continue creating substantial value for shareholders.
Gotham Partners Management Co., LLC
Appendix I Membership Aging Analysis
Memberships Sold 6,481 2,689 2,401 7,676 11,951 8,569 12,466 20,718 39,836 49,490 133,816 220,632 104,704 59,474 24,214 7,643 9,437 14,439 34,294 45,893 109,922 194,843 283,723 391,827 525,352 670,118 728,295 Memberships Remaining at Year-end: 1975 1976 1977 1978 1979 4,970 2,927 2,127 1,693 1,414 2,062 1,215 882 703 1,841 1,085 788 5,886 3,467 9,165
Year 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
1980 1,213 587 627 2,519 5,398 6,571
1981 1,061 503 524 2,006 3,922 3,871 9,560
1982 943 440 449 1,675 3,123 2,812 5,631 15,888
1983 848 391 393 1,437 2,608 2,239 4,091 9,358 30,548
1984 771 352 349 1,256 2,237 1,870 3,257 6,799 17,994 37,951
1985 706 320 314 1,116 1,956 1,604 2,721 5,414 13,072 22,355 102,617
1986 652 293 286 1,005 1,738 1,402 2,333 4,522 10,409 16,240 60,445 169,192
1987 606 271 262 913 1,564 1,246 2,040 3,877 8,694 12,932 43,912 99,659 80,292
1988 565 251 242 837 1,422 1,122 1,813 3,391 7,455 10,801 34,966 72,400 47,295 45,608
1989 526 234 224 772 1,303 1,020 1,632 3,013 6,519 9,262 29,205 57,651 34,359 26,864 18,569
1990 488 218 209 718 1,202 934 1,483 2,712 5,794 8,099 25,044 48,153 27,359 19,516 10,937 5,861
1991 454 203 195 669 1,117 862 1,359 2,465 5,215 7,198 21,899 41,291 22,852 15,541 7,946 3,452 7,237
1992 424 188 181 623 1,042 801 1,254 2,258 4,740 6,478 19,464 36,106 19,595 12,980 6,327 2,508 4,263 11,073
1993 400 176 168 578 970 747 1,166 2,084 4,342 5,889 17,517 32,091 17,135 11,131 5,285 1,997 3,097 6,522 26,298
1994 381 166 157 537 901 696 1,086 1,937 4,008 5,394 15,924 28,881 15,229 9,733 4,532 1,668 2,466 4,738 15,491 35,193
1995 363 158 148 502 837 646 1,012 1,806 3,725 4,979 14,586 26,255 13,706 8,650 3,963 1,430 2,060 3,773 11,254 20,730 84,294
1996 345 150 141 474 782 600 939 1,682 3,472 4,627 13,462 24,049 12,460 7,785 3,522 1,251 1,766 3,151 8,961 15,060 49,652 149,415
1997 327 143 134 452 738 560 873 1,561 3,235 4,313 12,512 22,196 11,413 7,077 3,170 1,112 1,544 2,702 7,485 11,992 36,071 88,011 217,573
1998 311 136 128 430 703 529 815 1,450 3,002 4,019 11,662 20,629 10,533 6,483 2,881 1,000 1,373 2,363 6,418 10,016 28,723 63,938 128,158 300,473
1999 295 129 121 408 669 504 770 1,355 2,789 3,729 10,866 19,228 9,790 5,983 2,639 910 1,235 2,100 5,612 8,589 23,990 50,912 93,104 176,988 402,866
2000 281 123 115 388 635 480 734 1,279 2,605 3,464 10,083 17,915 9,125 5,561 2,436 833 1,123 1,890 4,988 7,510 20,572 42,524 74,137 128,578 237,301 513,880
2001 267 116 109 368 604 456 698 1,219 2,460 3,237 9,367 16,625 8,502 5,183 2,264 769 1,029 1,718 4,489 6,675 17,989 36,465 61,923 102,384 172,394 302,692 558,493 1,318,494
December 31, 2001 Total:
Note: The above analysis has been derived from the annual membership sales data taken from the Company’s Annual Reports and Form 10-Ks and retention statistics taken from the company’s Form 8-K filed on January 26, 2001.
Gotham Partners Management Co., L.L.C.