Pre-Paid Toll Mounts

Pre-Paid Legal Services (PPD) is learning just how costly a courtroom defeat can be.

The legal-insurance provider has seen a recent punitive award against the company derail its plans to borrow $160 million, intended primarily for stock repurchases. Buying back stock has helped the company fend off the advances of short-sellers, who bet a stock will decline by borrowing the stock, selling it and then seeking to buy it back later at a lower price.

"There has always been this sort of Mexican standoff between Pre-Paid and the shorts," says Peter Cohan, a Massachusetts investment strategist with no position in the stock. "With the company buying back its shares, the shorts have come under pressure to cover their positions. ... But this funding termination could cause that whole cycle to fall apart."

To be sure, news of the failed bank deal caused an immediate hit to the stock. The shares dropped $1.02 to $38.97.

After staging sharp rallies in the summer and again early in the fall, the stock began sliding about a month ago after a $9.9 million damage award against Pre-Paid and founding CEO Harland Stonecipher. The award -- promised to just one of more than 400 plaintiffs who have sued the company -- and a ratings downgrade by Standard & Poor's put the financing in doubt, Pre-Paid said.

"While the amount of damages in this case is at a manageable level for the company, Standard & Poor's is concerned about additional negative outcomes for pending cases, as well as the potential for additional lawsuits to be filed," S&P analyst David Kang wrote in mid-November. "Importantly, Standard & Poor's believes this verdict may potentially affect the company's ability to attract and retain new members and sales associates."

Pre-Paid currently provides limited legal coverage to more than 1.5 million customers. Due to its turnover rate, the company depends on "independent associates" who often own the policies themselves to keep selling policies and to grow the customer base. It relies heavily on multilevel marketing, a controversial selling strategy made famous by Amway.