Pre-Paid Weathers Guilty Verdict

Updated from 1:42 p.m.

Pre-Paid Legal Services ( PPD) is having some issues again.

For one thing, the company faces new questions about its financial reports. For another, Pre-Paid has been found guilty of fraud in one of the many legal battles that has been dogging it for years.

Financial experts found the first matter especially troubling. In a regulatory filing on Tuesday, Pre-Paid disclosed that its independent auditor, Grant Thornton, has found itself unable to sign off on the company's 2004 financial statements due to "material weaknesses" with the company's internal controls. More specifically, Pre-Paid said that Thornton has raised questions about the company's processing of commissions -- which have led to material restatements in the past.

For Massachusetts investment strategist Peter Cohan, the news carried a familiar ring.

"This raises the possibility that the company will again be forced to restate those commissions," said Cohan, who has no position in the stock. "It kind of makes you wonder what is going on. Did the company really comply with what the Securities and Exchange Commission required before?"

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

Deja Vu

In 2001, the SEC forced Pre-Paid to start treating commissions paid to its sales associates as expenses rather than assets. The change cut the company's reported earnings by more than half. Moreover, it marked the second time the company found itself adjusting its treatment of commissions and slashing its reported profits as a result.

For now, however, the company has escaped a so-called qualified opinion from its auditor and the need for additional restatements. Instead, Thornton has simply offered no opinion at all until the company addresses problems with its internal controls.

Shares of Pre-Paid fell 1.1% to $34.81 on the disclosure. Still, one financial expert said the news could have been worse.

"This is less damaging or punitive than a qualified opinion," explained Fredric E. Russell, a Tulsa money manager with no position in the stock. "But Grant Thornton's inability or unwillingness to issue an opinion is at least a serious concern if not a real blow for Pre-Paid."

Cohan, too, voiced concerns about the company's internal controls.

"A lot of companies have poorly documented systems," Cohan acknowledged. "But on the other hand, I haven't heard of a lot of situations where auditors decline to issue an opinion because of this. So maybe Pre-Paid's situation is pretty bad."

The company warned on Tuesday that it may need several months to resolve the problem. In the meantime, investors will have no audited 2004 financial statements on which they can rely.

Guilty Verdict

News of the reporting problems came just days after Pre-Paid weathered a legal setback. A Mississippi jury last week found both the company and its founding CEO, Harland Stonecipher, guilty of fraud and deceptive advertising, according to plaintiffs' attorney Doug Minor.

Still, the company did escape without paying any punitive damages in a state known for its runaway jury awards.

"I think Pre-Paid was lucky," Russell said. "But a finding of fraud is not exactly the greatest news as far as goodwill and reputation are concerned."

Pre-Paid has been accused of overstating the coverage provided by its legal policies. In an earlier trial, the company prevailed. Pre-Paid expects that pattern to continue.

"We are very pleased with the jury's verdict and the impact this verdict may have on other pending litigation," Stonecipher said after the favorable ruling in October. "We hope this verdict, our first jury verdict in Mississippi, sets the tone for future legal developments in Mississippi."

Instead, a second jury has saddled the company with a guilty verdict and ordered that some -- albeit small -- damages be paid to four individual plaintiffs. For its part, the company has insisted that the damages, totaling $45,000, "were not based on the evidence" and has vowed to "seek post-trial relief, as necessary."

Looking ahead, Pre-Paid also has pledged to vigorously defend itself against the many lawsuits it still faces.

"We still have more litigation in front of us," Pre-Paid Chief Operating Officer Randy Harp acknowledged during a conference call in October. "It has been very expensive for us to defend ourselves, but we continue to believe that we have very meritorious defenses."

Still, Pre-Paid has limited resources. Minor said that the company's net worth dropped from $41.5 million last summer to $22.5 million when the first trial started in October. In contrast, he said, Stonecipher saw his own net worth jump -- to nearly twice the company's own -- during that period.

Moreover, the company could still face big damage awards in the future. Minor said that his firm will continue to fight for punitive damages in a number of pending cases involving hundreds of Mississippi plaintiffs "because we believe the conduct the jury found fraudulent is also conduct that should be punished." The company will next defend itself three months from now in Holmes County, a Mississippi region notorious for its "jackpot justice."

Pre-Paid has set aside $3 million to cover any major damages that may result from the lawsuits. The company -- which markets its product as essential -- carries no legal insurance itself.

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