Innovation Update

Return to Article

Pre-Paid Toll Mounts

Melissa Davis

Pre-Paid Legal Services (PPD Quote) 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.

For years, Pre-Paid has been accused of overselling both its product and its so-called business opportunity. The company has consistently denied any wrongdoing and, until recently, has managed to avoid any major backlash for its alleged misconduct.

As a matter of policy, Pre-Paid refuses to comment for stories by TheStreet.com because it believes the coverage is biased against the company.

In its latest quarterly report, Pre-Paid disclosed one of the first-ever regulatory probes of the company. Specifically, the company said it has fielded a so-called civil investigative demand from the commissioner of consumer protection for Connecticut.

Since then, Connecticut Attorney General Richard Blumenthal has confirmed that his office continues to seek information from Pre-Paid for a sweeping examination of the company.

"We are investigating all aspects of the company's operations, (including) its accounting practices and services," Blumenthal told TheStreet.com on Wednesday. "We're hoping to conclude this as soon as possible."

So far, Pre-Paid has largely escaped government probes. Pre-Paid has instead found itself fighting a slew of unhappy customers who have pursued the company on their own. And it has wound up battling a former federal prosecutor in the process.

After securing last month's big damage award in Mississippi, former U.S. Attorney Brad Pigott said that he simply used the company's own words against it. Pigott explained that he showed the jury a video with Pre-Paid's CEO misrepresenting the company's product and then proclaiming "three cheers for greed!" as he attempted to rally those who sell the policies.

Cohan, who has reviewed some of Pre-Paid's sales pitches, believes that justice is finally being served.

"Pre-Paid sows fear, uncertainty and doubt in the minds of society's weakest to get them to pay for a product of questionable value," Cohan says. But "with Mississippi's recent $9.9 million jury award, America's legal system is slowly catching up with this corporate bully."

Pre-Paid can ill afford future courtroom losses.

S&P made that much clear in its credit downgrade last month. The firm stated that a significant award, or multiple awards, could materially hurt the company's financial condition. Moreover, it warned lenders to expect little or no money back from Pre-Paid if the company did, in fact, wind up facing big damages down the road.

Even now, S&P views Pre-Paid as risky. In addition to pending litigation, the firm points to the company's unique business model -- which relies on direct sales to individuals -- as the reason for its cautious view. Most other legal service providers, operated by big corporations like MetLife (MET Quote) and ARAG, market their products to companies as employee benefits instead.

To be fair, S&P notes that Pre-Paid dominates the "niche" market that it currently serves. However, the firm has warned that legal setbacks could threaten that position and ultimately leave the company's creditors empty-handed. S&P estimates the liquidation value of Pre-Paid -- a company with a market capitalization of nearly $600 million -- at just $38 million in all.

Get Jim Cramer's picks for 2006.