Top 10 Red Flags for Fraud at Pre-Paid Legal Services, Inc. (NYSE:PPD)

1. Pre-Paid Legal press releases and earnings calls consistently tout the “record” numbers that the company has achieved. This leaves the impression that the business is increasing in strength.

TRUTH: Every key metric for Pre-Paid Legal’s business was down in 2008, again demonstrating the weakness of the business. The metrics showing rates of decline include total members (down 1%), new memberships sold (down 10%), total sales associates (down 4%), new associates recruited (down 18%), and associates making at least one sale (down 9%).

2. Pre-Paid Legal executives tout efforts to increase recruiting by current associates. Randy Harp, COO, said during the company’s first quarter 2008 earnings conference call: “And as goes recruiting, so goes membership sales. So we are very focused. I will tell you the theme of our international convention at Oklahoma City was very much recruit, recruit, recruit, and don’t get it out of order.”

TRUTH: Recruitment of new associates, the key metric and lifeblood of the company, has been declining. Third quarter 2008 recruiting was down 13% from the prior year. Fourth quarter 2008 recruiting was down 10% from the prior year. The company has been on a consistent downslide as it relates to recruiting.

The earnings release for the fourth quarter touts: “16th Consecutive Year of Increased Membership Revenues,” yet buries in the text of the release the fact that recruiting is down double digits. As in the past, the press release makes it sound like things are better than ever at Pre-Paid Legal, when the fact is that the company is imploding because recruiting efforts are unsuccessful.

In fact, more associates quit Pre-Paid Legal in 2008 than were recruited. The company began 2008 with 442,361 Associates and recruited another 122,255 during the year for a total of 564,616 sales people. Yet at year end, it reported only 425,018 still enrolled. The result is that 139,598 associates quit during the year, 17,343 more than were recruited.

3. The latest press release on earnings was careful to highlight the numbers that are “up” for Pre-Paid Legal, touting the figures related to membership revenues, net income, and earnings per share.

TRUTH: The numbers are trending in the wrong direction. An increasing percentage of their membership revenue comes from personal memberships maintained by associates. Currently about one-third of total revenues come from the associates who maintain personal memberships and purchase marketing and training materials. Less than 20% of the Pre-Paid Legal associates sell one or more memberships to outside customers. None of these details suggests that Pre-Paid Legal is a growing business.

4. It is all about stock price, not a quality product or service, and not shareholder value. Continuing with the plan of repurchasing as many shares of Pre-Paid Legal stock as possible, management spent $44.7 million repurchasing stock in 2008 alone. As COO Randy Harp said during the most recent earnings conference call: “Again second best use that we’ve identified is to buyback our own shares and we’ve been doing that with a vengeance. As Steve said we’re now well under half of what the shares outstanding were when we began the product and so we certainly expect to continue.”

TRUTH: How desperate is Pre-Paid Legal to hold up a phony stock price for future insider dumping of shares? For the year 2008, $64.3 million in cash was provided by operations, and $44.7 million of that was spent on stock repurchases. At the same time, the company had $59.7 million in debt outstanding. The company is committed to repurchasing shares at any cost.

5. According to Pre-Paid Legal, fourth quarter earnings per share increased 36% from a year prior, and increased 30% for the entire year of 2008.

TRUTH: This time around management did mention in their conference call that the EPS numbers benefited from 9% fewer shares on the market thanks to their stock repurchase program. Without the repurchases, the EPS for the year would have been over 9% lower than reported.

Since 2006, the company has repurchased 4.3 million shares at a total price of $184.6 million. During the same period, company insiders sold share totaling a whopping $59 million. Pre-Paid Legal is borrowing money and using cash generated by associates to repurchase shares, and the company insiders are getting rich while more than 85% of the company’s associates are estimated to be quitting or making no sales. These failed business owners literally fund the repurchases of company insider shares.

6. Pre-Paid legal promises its associates residual compensation on their “personal and organizational membership sales for as long as they stay in effect.”

TRUTH: Unfortunately for those who become associates of Pre-Paid Legal, they can only receive residual commissions if they become “vested” by selling at least three new memberships per quarter (12 per year) or maintaining a personal membership.

By withholding residual commissions from associates who do not become vested in a quarter, Pre-Paid Legal has a potential windfall. According to regulatory reports, unearned advance commission balances totaled $62 million in 2008, $56 million in 2007, and $49 million in 2006. If the associates do not become “vested” to “earn” those commissions in the future, Pre-Paid Legal keeps the funds.

7. Pre-Paid Legal management always makes it appear that the company is looking out for the best interest of the associates.

TRUTH: Pre-Paid Legal has increased the fees to become an associate, raising the cost from $57 to $72 in 2008. This 26% increase in the joining fee netted the company almost $2 million. However it did nothing to increase the likelihood for success for the vested associated. It merely accomplished even further fleecing of the doomed by design business builder.

8. Pre-Paid Legal pretends to offer associates an “opportunity” to move up faster. In the latest conference call, management said, “…new associates can pay $249 and progress through the compensation structure more quickly if they do certain things and so after a slow January we have seen recruiting especially on that, after we implemented that new thing continue to increase and just looking at last year, 2008’s first quarter, February was the best month out of the first quarter of 2008.”

TRUTH: This $249 fee is nothing but a money-maker for Pre-Paid Legal. Paying a higher fee doesn’t mean that associates will actually be able to sell more memberships. Currently less than 20% of associates actually sell one or more membership, and the simple act of charging an associate more to join the company isn’t likely to change that fact. All the increased fee does is give Pre-Paid Legal almost 2.5 times more revenue per new associate.

9. The Pre-Paid Legal “opportunity” for a person to make money as an associate is consistently touted on the website, in earnings releases, and during conference calls. It is promoted as a viable business opportunity for anyone.

TRUTH: The Pre-Paid Legal opportunity is obviously not all it’s cracked up to be, as evidenced by the fact that associates quit selling memberships after five months.

According to the 2008 10-K, “The remaining revenues and related incremental direct and origination costs are deferred and recognized over the estimated average active service period of associates which at December 31, 2008 is estimated to be approximately five months, unchanged from year end 2007. Management estimates the active service period of an associate periodically based on the average number of months an associate produces new Memberships including those associates that fail to write any Memberships.”

10. Management has admitted that recruiting new associates is the lifeblood of the Pre-Paid Legal business. New recruits are vital to the survival of the company.

TRUTH: In classic Bernie Madoff fashion, Pre-Paid Legal continues to recruit new investors into their scheme. Madoff sustained his money transfer system by continuously recruiting new investors. He became a master at this, promising high annual returns and a safe haven against market downturns. He implied membership in his fund was exclusive. He claimed he ran a “hedge fund” that protected investors against downturns.

Pre-Paid Legal in turn, must draw on capital investments of later investors to sustain its own business model. It cannot produce enough retail revenue to remain solvent or to grow to the limits its owners want. So the company takes a lesson from the masters in how to continuously induce and use the capital of new investors.

It uses the MLM method, a proven system for drawing in investors in the disguise of a “direct selling” company. This system incentivizes each investor to recruit other investors and offers rewards for doing so endlessly. Amazing income promises and claims are made and the mirage of the “endless” downline is hawked.