Peregrine Systems, Inc. Securities Litigation 02-CV-00870-First Amended Consolidated Complaint
Pre-Paid Legal Services, Inc. Securities Litigation 01-CV-00182-Consolidated Amended Complaint
Transcript of Pre-Paid Legal Services, Inc. Securities Litigation 01-CV-00182-Consolidated Amended Complaint
UNITED STATES DISTRICT COURT Ft! mit.P°211" .41WESTERN DISTRICT OF OKLAHOMA
P vr,to Rim
'JUN 4IN RE PRE4A1D SECURITIES, INC., Master DocketW4 Viet ;04 faigtgLITIGATION) CIV-01 -182-C
CONSOLIDATED AMENDED COMPLAINT DOCKETEDf.
Lead Plaintiffs Jon McNamara, Richard Landin and Bricoleur Capital Management
("plaintiffs"), on behalf of themselves and all other persons similarly situated, by their undersigned
attorneys, for their complaint, allege upon personal knowledge as to themselves and their own acts,
and upon the investigation made by and through their attorneys, which investigation included, among
other things, a review and analysis of public filings with the U.S. Securities and Exchange
Commission ("SEC"), public documents, analyst reports, news stories, and press releases, interviews
with individuals or entities with knowledge of defendants' activities during the Class Period and
information available over the Internet, as follows:
Summary And Overview
1. This is a securities class action on behalf of all purchasers of the common stock of
Pre-Paid Legal Services, Inc. ("Pre-Paid" or the "Company") from March 18, 1999 through May 15,
2001 (the "Class Period"), against Pre-Paid and certain of its senior officers and directors for
violations of the Securities Exchange Act of 1934 (the "Exchange Act").
2. During the Class Period, the Company's financial situation was deteriorating, but this
was never publicly disclosed. On the contrary, certain officers and directors of Pre-Paid made false
and misleading public statements in order to overstate Pre-Paid' s earnings and materially falsify the
Company's financial condition in order to artificially inflate the price of Pre-Paid stock. Pre-Paid's
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auditor Deloitte & Touche LLP ("Deloitte") knew or recklessly disregarded Pre-Paid' s true financial
and operating condition and failed to take steps to fully and fairly disclose them to the public.
3. Pre-Paid designs, underwrites and markets legal expense plans. These plans, called
Memberships, provide for a variety of legal services used by Members in a manner similar to
medical reimbursement plans. Memberships sold by the Company allow Members to access legal
services through a network of independent law firms ("provider law firms").
4. The Company markets Memberships through a multi-level marketing program where
salespeople ("associates") are paid commissions both on what they sell personally, as well as
commissions on sales by new associates they recruit. Therefore, associates have as much incentive
to recruit other associates as they do to make sales of Memberships. The Company continuously
touted the high numbers of new associates being recruited, but failed to disclose the extremely high
turnover rate among associates. For example, although almost 200,000 new associates were
recruited in the 1999-2000 time period, the Company had a total of only 200,000 associates at the
end of 2000, thereby reflecting the severe attrition being suffered by the Company.
5. Even though Members can cancel their Memberships at any time, Pre-Paid pays its
associates commission advances, at the time of the sale of a new Membership, in an amount equal
to three years of annual commissions. If Members cancel their polices before three years, associates
are technically obligated to repay the commission advances as follows: The Company can recover
50% of an associate's commission advances from "charge-backs" to that associate's commissions
on future sales, plus interest. Thus, these commission advances are essentially loans. The remaining
50% can be recovered from commissions due on previously sold Memberships, when and if
Members renew after three years.
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6. As Members cancel policies within the first three years, the associates who sell these
policies have a decreasing incentive to sell new Memberships. These new sales yield smaller
commissions, if any, because the Company recovers commission advances for canceled policies by
charging back a portion of the associates' new sales. Therefore, most associates lose interest in
selling Memberships after making a few sales. For example, only 26% of the Company's associates
made a sale in the first nine months of 2000.
7. If an associate stops selling policies, the Company cannot withhold future
commission advances because there are none. Nor can the Company withhold an associate's
commissions on the renewal of Memberships if the associate has not sold any policies that are more
than three years old. Thus, the decline in associate sales makes it more difficult for Pre-Paid to
recover its commission advances. Notwithstanding these undeniable and known facts, throughout
the Class Period, the Company misrepresented its ability to collect "charge-backs".
8. The Company wrote down one-third of the commission advances on its balance sheet
each year that a policy was in force. However, if a policy was cancelled before three years, the
Company stopped writing down the advance. Instead, the Company continued to include the
remaining advances as assets on its balance sheet, despite the fact that defendants knew or recklessly
disregarded that commission advances for cancelled policies would not be recovered in full. If the
associate did not sell new Memberships and did not earn commissions on renewals, the remaining
advances could not be recovered, and the Company's assets, net income and stockholders equity
were overstated by the unrecoverable amounts.
9. Instead of properly including the commission advances in the Company's reported
expenses at the time they were paid, Pre-Paid capitalized the commission advances and reported
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them as assets. This materially reduced the Company's reported expenses and correspondingly
increased the Company's reported income. This practice also increased the Company's reported
assets by tens, and cumulatively, hundreds of millions of dollars. Commission advances ballooned
to almost $100 million by the beginning of fiscal year 2000. In fact, by the end of 2000, associate
commission advances reached approximately $160 million. That amount constituted approximately
half of the Company's reported assets, and almost all of the Company's reported stockholders' equity.
10. Over the past five years, the Company has not written off any of these unrecoverable
commission advances even though the historical average life of a Pre-Paid Membership is less than
three years. Under Generally Accepted Accounting Principles or "accounting principles generally
accepted in the United States of America" ("GAAP"), the commission advances should have been
written off at a faster rate than the one-third per year rate used by the Company given the fact that
the average life of a Membership is less than three years and that there is no way to recover the
commission advances from the associates who have stopped selling policies. Historically, the
Company never attempted to recover these loans if the associates stopped writing new business or
if the associates had no renewals. Even one of the defendants in the case, Pre-Paid' s Controller, has
admitted under oath that the Company has not historically attempted to collect the commission
advances loaned to associates when associates leave the Company. The Pre-Paid Defendants
(defined below) violated GAAP as set forth in '5 101; 102; 103; 107 throughout the Class Period
in order to prop up the price of Pre-Paid stock. These practices were also recklessly approved by the
auditors, defendant Deloitte.
11. On January 17, 2001, an article in The Wall Street Journal revealed some of the
misrepresentations and nondisclosures regarding the improper accounting practices of Pre-Paid.
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However, the Company continued to expressly deny any violations of GAAP and thus, the
Company's stock Price continued to be artificially inflated until the end of the Class Period.
12. On March 16, 2001, Pre-Paid disclosed that the SEC had begun an inquiry and had
requested information relating to the Company's accounting policies. Pre-Paid stated that it would
change the way it accounts for commission payments and restate its financial results for the year
2000. However, once again, Pre-Paid continued to publicly insist that its method of accounting was
correct.
13, On April 16, 2001, an article in The Wall Street Journal revealed that Pre-Paid
intended to restate its previously reported financials for 2000. Based on preliminary estimates, net
income for the year would be reduced by $7.2 million, or $.32 a diluted share. Its soon to be reported
first quarter 2001 net income would be reduced by $600,000 or 5.03 a diluted share. The Company
said it decided to reduce its 2000 earnings "in light of preliminary comments received from the staff
of the SEC." However, Pre-Paid continued to claim that its accounting method was acceptable.
14. On April 27, 2001, Pre-Paid finally filed its 2000 10-K with the SEC, incorporating
the reductions previously announced on April 16, 2001. These reductions dealt only with Pre-Paid' s
methodology for evaluating the recoverability of its commission advances from terminated associates
or associates who have not met certain vesting requirements of the Company. This change did not
deal with the commission advances loans.
15. Within two weeks, the SEC reviewed Pre-Paid' s 2000 10-K and concluded that Pre-
Paid was in violation of GAAP.
16, On May 15, 2001, the last day of the Class Period, the Company disclosed that it had
received a letter from the SEC on May 11, 2001, advising it that its accounting for commission
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advances is not in accordance with GAAP. It was not until that date that the full truth was revealed.
Pre-Paid' s stock price plunged from $19 per share on May 15, 2001 to approximately $14 per share
on the following day.
17. Nevertheless, despite the unequivocal position of the SEC, on May 16, 2001, Pre-
Paid's CFO, defendant Harp, stated that, "rdjespite the position of the SEC's Division of
Corporation Finance, we continue to believe, with the concurrence of our independent auditor,
[Deloitte] that our accounting is in compliance with generally accepted accounting principles and
have begun the appeals process through the SEC's Office of the Chief Accountant." No such appeal
has ever been successful.
18. Defendant Harp also said on May 16, 2001, that based on preliminary estimates under
the proposed SEC accounting, the Company's EPS for fiscal 2000 and fiscal 1999 would have been
approximately $.81 per share and $.57 per share, respectively, compared to reported earnings per
diluted share of $1.92 and $1.67, respectively. The pro-forma EPS for the first quarter of 2001
would have been approximately $.27 per share compared to reported earnings per diluted share of
$.60. These figures represent very material decreases of 66%, 58% and 55% for fiscal 2000, 1999
and first quarter of 2001, respectively.
19. Because of the Pre-Paid Defendants' misrepresentations and omissions, as well as
their violations of GAAP which caused the Company's financial statements issued during the Class
Period to be materially false and misleading along with Deloitte's approval of such financials,
plaintiffs and other investors in Pre-Paid stock during the Class Period have been damaged by
purchasing Pre-Paid common stock at artificially inflated prices. As a result of defendants' false
practices and statements, Pre-Paid' s stock price traded at artificially inflated levels during the Class
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' Period, increasing to as high as $ 48 3/4 in November, 2000. On May 16, 2001, the day that the SEC
ruling was disclosed (and the day after the close of the Class Period), the Company's stock closed
at only $14 3/32. This represented a decline of approximately 70% from its Class Period high.
Jurisdiction And Venue
20. Jurisdiction is conferred by §27 of the Exchange Act, 15 U.S.C. §78aa. Defendants
used the instrumentalities of interstate commerce. The claims asserted herein arise under §§10(b)
and 20(a) of the Exchange Act, 15 U.S.C. §§ 78j(b) and 78t(a), and Rule 10b-5.
21. Venue is proper in this District pursuant to §27 of the Exchange Act. Many of the
false and misleading statements were made in or issued from this District and the Company
maintains offices in this District.
Parties
22. Lead Plaintiffs Jon McNamara, Richard Landin and Bricoleur Capital Management
purchased Pre-Paid common stock as described in the certifications previously filed with the Court
and were damaged thereby. Plaintiffs were appointed as Lead Plaintiffs by Order of the Court dated
May 15, 2001.
23. Defendant Pre-Paid develops, underwrites and markets legal expense plans. The
Company's principal executive offices are in Ada, Oklahoma, where the day-to-day operations of
the Company are directed and managed by the Individual Defendants. Pre-Paid's common stock
currently trades in an efficient market on the New York Stock Exchange ("NYSE"). From the
beginning of the Class Period until May 19, 1999, Pre-Paid' s common stock traded in an efficient
market on the American Stock Exchange ("AMEX"). As of April 6, 2001, Pre-Paid had 21,486,395
shares of common stock outstanding.
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24. Defendant Harland C. Stonecipher ("Stonecipher") is Chief Executive Officer and
Chairman of the Board of Pre-Paid.
25. Defendant Randy Harp ("Harp") is the Chief Operating Officer and a director ofPre-
Paid. Until May 16, 2000 Harp was Pre-Paid' s Chief Financial Officer as well. Harp is a Certified
Public Accountant ("CPA").
26. Defendant Kathleen S. Pinson ("Pinson") is Pre-Paid' s Controller and a director of
Pre-Paid and has been the chief accounting officer since 1982. Pinson is also a CPA.
27. Defendant Peter K. Grunebaum ("Grunebaum") is a director of Pre-Paid and
Chairman of the Audit Committee.
28. Defendant David A. Savula ("Savula") is a director of Pre-Paid and one of its senior
associates.
29. The individuals named as defendants in 24-28 are referred to herein as the
"Individual Defendants." The Individual Defendants and Pre-Paid will be collectively referred to
herein as the "Pre-Paid Defendants."
30. Defendant Deloitte served as the independent auditor for Pre-Paid during the Class
Period. Deloitte is an international accounting firm and one of the five largest accounting firms in
the world. During the Class Period, Deloitte issued unqualified opinions on Pre-Paid' s consolidated
financial statements for the fiscal years ended December 31, 1998, 1999 and 2000 (collectively the
"Financials"). Deloitte's opinions inaccurately represented that its audits of the fiscal 1998, fiscal
1999 and fiscal 2000 financial statements were conducted in accordance with generally accepted
auditing standards or "auditing standards generally accepted in the United States" ("GAAS") and that
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Pre-Paid's financial statements fairly presented its financial condition and results of operations in
conformity with GAAP. •
Class Action Allegations
31. Plaintiffs bring this action as a class action pursuant to Rule 23 of the Federal Rules
of Civil Procedure on behalf of all persons who purchased Pre-Paid publicly traded common stock
on the open market during the Class Period (the "Class"). Excluded from the Class are defendants
and the Members of their immediate families, their heirs, successors and assigns, and any entity in
which any defendant has a controlling interest or of which the Company is a parent or subsidiary.
32. The members of the Class are so numerous that joinder of all members is
impracticable. The disposition of their claims in a class action will provide substantial benefits to
the parties and the Court. Throughout the Class Period, Pre-Paid had more than 21,000,000 shares
of stock outstanding, owned by hundreds if not thousands of persons.
33. There is a well-defined community of interest in the questions of law and fact
involved in this case. Questions of law and fact common to the members of the Class which
predominate over questions which may affect individual Class members include:
(a) Whether the Exchange Act was violated by defendants;
(b) Whether defendants omitted and/or misrepresented material facts;
(c) Whether defendants' statements omitted material facts necessary to make the
statements made, in light of the circumstances under which they were made, not misleading;
(d) Whether defendants acted with scienter in making their statements false and
misleading;
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Whether the prices of Pre-Paid's publicly traded common stock were
artificially inflated; and
(I) The extent of damages sustained by Class members and the appropriate
measure of damages.
34. Plaintiffs' claims are typical of those of the Class because plaintiffs and the Class
sustained damages arising out of the defendants wrongful conduct in violation of federal law as
complained of herein.
35. Plaintiffs will fairly and adequately protect the interests of the Class and have retained
counsel competent and experienced in class action securities litigation. Plaintiffs have no interests
antagonistic to or in conflict with those of the Class.
36. A class action is superior to other available methods for the fair and efficient
adjudication of this controversy since joinder of all members of the Class is impracticable.
Furthermore, because the damages suffered by individual Class members may be relatively small,
the expense and burden of individual litigation make it impossible for the Class members
individually to redress the wrongs done to them. There will be no difficulty in the management of
this action as a class action.
37. Plaintiffs and the Class will rely, in part, upon the presumption of reliance established
by the fraud-on-the-market doctrine in that:
(a) defendants misrepresented and failed to disclose material facts during the
Class Period;
(b) the misrepresentations and omissions were material;
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(c) the common stock of the Company traded under the symbol "PPD" initially
on the AMEX, and thereafter on the NYSE, open and efficient markets;
(d) the misrepresentations and omissions alleged would tend to induce a
reasonable investor to misjudge the value of the Company's common stock;
(e) brokerage firms, including Hoak Breedlove Wesneski, followed the Company
and issued recommendations based on the Company's public filings and announcements;
(f) Plaintiffs and members of the Class acquired their Pre-Paid common stock
between the time defendants misrepresented or failed to disclose material facts and the time the true
facts were disclosed, without knowledge of the omitted or misrepresented facts,
38. Based on the foregoing, plaintiffs and the Class are entitled to a presumption of
reliance upon the integrity of the market price for the Company's common stock.
False and Misleading Statements During the Class Period
39. On March 18, 1999, the first day of the Class Period, Pre-Paid filed its Form 10-K
with the SEC for the year ended December 31, 1998. The 1998 10-K was signed by defendants
Stonecipher, Harp, Pinson and Savula. The Company reported net income of $30.2 million with a
43% increase in Membership fees. It also stated that one of the major factors affecting the
Company's profitability and cash flow is its Membership persistency rate. Pre-Paid stated that
persistency represents the ability of the Company to retain a Membership and therefore receive fees,
once the Membership has been written. From 1981 through 1998 the Company reported that the
persistency rate had averaged approximately 75%. According to Pre-Paid, the Company's
Membership persistency rate measures the number of Memberships in force at the end of a year as
a percentage of the total of (i) Memberships in force at the beginning of such year, plus (ii) new
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Memberships sold during such year. The Pre-Paid Defendants represented in the 10-K that the
annual persistency rate for 1998 was 73.8%. This statement was false and misleading in that the
persistency rate did not reflect the ability of the Company to retain a Membership and the Company
failed to disclose that fewer than 54% of members were still paying one year after purchasing a
Membership; fewer than 47% of members were still paying after two years; and fewer than 29% of
members were still paying after three years.
40. In that same Form 10-K, defendant Deloitte issued a "clean" or "unqualified" audit
opinion dated March 3, 1999, stating in relevant part that: "[w]e conducted our audits in accordance
with generally accepted auditing standards," and "[i]Ja our opinion, based on our audits and the
reports of the other auditors, [the] consolidated financial statements present fairly, in all material
respects, the financial position of Pre-Paid Legal Services, Inc. and subsidiaries as of December 31,
1998 and 1997, and the results of their operations and their cash flows for each of the three years in
the period ended December 31, 1998 in conformity with generally accepted accounting principles."
In fact, this information was false and misleading because the audit was not conducted in accordance
with generally accepted auditing standards nor were the financial statements presented in conformity
with generally accepted accounting principles, as set forth below in 117 101; 102; 103; 107; 115; 120;
124-134.
41. On April 19, 1999, Pre-Paid reported record results for the first quarter of 1999 ended
March 31, 1999. According to its press release:
Net income for the first quarter of 1999 rose 67 percent to $8,782,000from $5,266,000 for the same period in 1998. Total revenues rose 18percent to $44,583,000 from $37,877,000 for the 1998 period due todecreased TPN product sales. The Company's membership revenuesincreased 41 percent to $33,767,000 from $23,953,000 for the same
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periods. Earnings per share, diluted, increased 68 percent to 37 centsper share from 22 cents per share for the comparable quarter of 1998.
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Even though membership revenues increased 41% as a result of newmemberships written, cash flow exceeded cost of operations andacquisition of new business and resulted in positive cash flow fromoperations of $1,951,000 for the first quarter of 1999, an increase of824% from the $211,000 for the comparable quarter of 1998,resulting in cash and investment balances of $54,585,000 at March31, 1999.
For the first quarter of 1999, the Company added 118,814 newmembers, 39 percent above the 85,223 new members added duringthe same period of 1998. New sales associates recruited during thefirst quarter of 1999 were 20,442 compared to 14,741 for thecomparable period of 1998, also an increase of 39 percent.
* * *"We are obviously very pleased with our first quarter operatingresults, but more than ever, firmly believe the best is yet to come. Aswe celebrate our 27 th year in business, we are in the best financialcondition in our history with cash and investment balances of morethan $54 million, no long term debt and significant positive cash flowwhile growing our core revenues at better than 40 percent. Ourcontinued growth in new memberships written and new salesassociates recruited coupled with our new recruiting, presentation andcommunication systems all contribute to our belief that the best is stillahead of us," Harland Stonecipher, Chairman, said. "These resultsreflect the increasing market acceptance of our product and theCompany's ability to effectively deliver the services that so manyAmericans need."
42. The information in the April 19, 1999 press release was false and misleading when
made in that Pre-Paid failed to disclose information known to the Pre-Paid Defendants or recklessly
disregarded by them including:
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(a) Pre-Paid' s financial situation was deteriorating rather than improving due to
the large and growing membership commission advances which were classified as "assets" in the
Company's financial statement, but were not, in reality, assets at all;
(b) The Pre-Paid Defendants materially overstated the Company's income
because they failed to take adequate reserves for losses on uncollectible commission advances;
(c) Pre-Paid's reported earnings were materially overstated due to improper
capitalization of current expenses and failure to write off uncollectible receivables in violation of
GAAP as described in in 101; 102;
(d) Pre-Paid' s commission advances were increasing faster than revenue and thus,
without the accounting fraud, the Company could not claim it was in the best financial condition in
its history;
(e) Despite the faster growth of commission advances, Pre-Paid failed to change
the Company's allowance for estimated unrecoverable commission advances which has remained
unchanged at $4.5 million for more than a year;
Cancellation rates on Memberships were increasing, making it more difficult
for Pre-Paid to recoup its commission advances from associates;
(g) Pre-Paid's membership growth rate was slowing and an increasing number
of associates were not making any sales, which would in turn lead to increased defections and
uncollectible commission advances;
(h) As the growth in those completing the Fast Start program, which was
instituted in 1997 to increase productivity and for which each associate paid $249 to participate,
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slowed, a smaller proportion of associates were actually making sales which resulted in a greater
number who were inactive and would not pay back advances;
(i) It was materially false and misleading to trumpet positive cash flow without
disclosure that the Company did not collect "charge-backs" if a customer cancels a policy before
three years. In fact, only 26% of the associates made a sale during the nine months ended September
30, 2000 and thus the Pre-Paid Defendants knew or recklessly disregarded that it is impossible to
dock an associates's renewal commissions if they have not sold any policies. In addition, Pre-Paid
never pursued its legal remedies against the associates.
(j) Pre-Paid's persistency rate which purported to represent the ability of the
Company to retain Memberships did not in fact reflect that information and instead presented an
artificially inflated picture of the Company's ability to retain Memberships. Instead of a persistency
rate of approximately of 75%, the Company actually retained only 53.37% of Members after one
year, 36.97% after two years and 28.66% of Members after three years;
(k) Pre-Paid' s balance sheet combines or "pools" receivables from associates and
commission advances. This prevents investors from determining which portion is being written
down and which portion is not. If these two groups had not been pooled, Pre-Paid's net income
would have been reduced; and
(1) The fact that Pre-Paid has not written off any commission advances as
unrecoverable gives investors the false impression that the Company will be able to recover
commission advances by charge-backs to sales associates.
43. In its Form 10-Q for the first quarter of 1999, filed with the SEC on May 13, 1999,
and signed by defendants Stonecipher, Harp and Pinson, the Company repeated the figures from the
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April 19, 1999 press release and again falsely emphasized that there had been an increase in new
membership sales of 39% over the same period in 1998. This statement was false and misleading
as the Pre-Paid Defendants failed to disclose that the Company's membership growth rate was
slowing and an increasing number of associates were not making any sales, which the Pre-Paid
Defendants knew or recklessly disregarded would in turn lead to increased defections and
uncolleetible commission advances.
44. On May 13, 1999, Pre-Paid began trading on the New York Stock Exchange. Pre-
Paid issued a release in which defendant Stonecipher stated:
The move to the New York Stock Exchange is just one moreillustration of Pre-Paid's effort to maximize shareholder value. Webelieve that listing on the New York Stock Exchange will broadenour investor base and provide greater visibility for our stock.
45. On July 19, 1999, the Pre-Paid Defendants caused Pre-Paid to issue a press release
announcing its results for the second quarter of 1999, which stated in part:
Net income for the second quarter of 1999 rose 54 percent to$9,872,000 from $6,419,000 for the prior year's period, whilerevenues rose 20 percent to $47,959,000 from $39,814,000 for theprior year's period despite planned decreases in TPN product sales.The Company's membership revenues increased 46 percent to$38,557,000 from $26,385,000 for the same period last year.Earnings per share, diluted, increased 56 percent to 42 cents per shareform 27 cents per diluted share for the last year's comparable quarter.Second-quarter 1999 earnings were increased $455,000, or 2 cents perdiluted share, due to gains on the sale of investments.
* * *Even though commission advances increased $10.9 million as a resultof increasing membership revenues during the second quarter of1999, cash flow from operations was $5,710,000, an increase of$2,361,000, or 70 percent, over the cash flow of $3,349,000 for thecomparable quarter of 1998. At June 30, 1999, the Company hadcash and investment balances exceeding $37,000,000 after the
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Company expended $19.8 million to repurchase 750,000 of its sharesduring the second quarter.
For the second quarter of 1999, the Company added 122,885 newmembers, 33 percent above the 92,206 new members added duringthe same period of 1998. New sales associates recruited during thesecond quarter of 1999 were 25,100 compared to15,969 for thecomparable period of 1998, an increase of 57 percent.
"We are extremely pleased with our second-quarter results. Wecontinue to benefit from significant positive cash flow while growingour core revenues by more than 46 percent. The positive cash flowtogether with our significant cash and investment balances will allowus to continue our previously announced stock repurchase program.We believe the 57 percent increase in recruiting combined with ourrecent expansion into Canada will supplement our continuinggrowth," Harland Stonecipher, Chairman, said.
46. The information in the July 19, 1999 press release was false and misleading when
made in that Pre-Paid failed to disclose information known to the Pre-Paid Defendants or recklessly
disregarded by them including the information set forth in 42.
47. In its Form 10-Q filed with the SEC on August 12, 1999 for the six months ended
June 30, 1999, signed by defendants Stonecipher, Harp and Pinson, the Pre-Paid Defendants reported
net income of $18,6 million up 59% from the same period in 1998. The increase in net income was
said to be primarily the result of increased Membership premiums. But for the clear violations of
GAAP described herein at 111101; 102 below, this net income figure would have been materially
reduced.
48. On October 19, 1999, the Pre-Paid Defendants caused Pre-Paid to announce its results
for the third quarter of 1999 in a release which stated in part:
Net income for the third quarter of 1999 rose 49 percent to$9,870,000 from $6,6111,000 for the prior year's period, while totalrevenues rose 23 percent to $49,025,000 from $39,809,000 for the
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. -pribt year's period despite planned decreases of $4.8 million in TPN
- product sales. The Company's membership revenues increased 41percent to $39,748,000 from $28,105,000 for the same period lastyear. Earnings per share, diluted, increased 50 percent to 42 cents pershare from 28 cents per diluted share for the last year's comparablequarter.
* * *Even though commission advances increased $9.2 million as a resultof increasing membership sales during the third quarter of 1999, cashflow from operations was $5,119,000, a decrease of $379,000, or 7percent, from the cash flow of $5,498,000 for the comparable quarterof 1998. Cash flow from operations for the first nine months of 1999was $12,9 million compared to $8 8 million for the comparableperiod of 1998, an increase of $4.1 million, or 46 percent. AtSeptember 30, 1999, the Company had cash and investment balancesexceeding $42,500,000.
For the third quarter of 1999, the Company added 134,725 newmembers, 41 percent above the 95,619 new members added duringthe same period of 1998. New sales associates recruited during thethird quarter of 1999 were 22,493 compared to 15,820 for thecomparable period of 1998, an increase of 42 percent.
"We are obviously very pleased with our third quarter operatingresults, but more than ever, firmly believe the best is yet to come. Aswe celebrate our 28 th year in business, we are in the best financialcondition in our history with cash and investment balances of morethan $42.5 million, no long term debt and significant positive cashflow while still continuing to grow our membership revenues at betterthan 40 percent. Our continued revenue growth, financial condition,enhanced Internet presence and increases in recruiting all contributeto our belief that the best is still ahead of us," Harland Stonecipher,Chairman, said.
49. The information in the October 19, 1999 press release was false and misleading when
made in that Pre-Paid failed to disclose information known to defendants or recklessly disregarded
by them including the information set forth in 1142.
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50. In its Form 10-Q filed with the SEC on November 15, 1999 for the third quarter,
signed by defendants Stonecipher, Harp and Pinson, the Pre-Paid Defendants proclaimed that the
Company's net income of $28.5 million for the nine months ended September 30, 1999 had risen
56% over the same period in 1998. But for the clear violations of GAAP described herein atir1101;
102 below, this net income figure would have been materially reduced.
51. On January 10, 2000, the Pre-Paid Defendants caused the Company to issue a press
release announcing record 1999 production:
Pre-Paid Legal Services, Inc. today reported record production andrecruiting results for the fourth quarter and for the year endedDecember 31, 1999. During the last quarter of 1999 newmemberships written increased 38% to 148,928 from 108,039 duringthe 1998 period (net of 10,740 memberships related to the TPNacquisition in October 1998). New sales associates recruited duringthe last quarter of 1999 increased 54% to 24,609 from 15,976 duringthe 1998 period (net of 13,231 associates related to the TPNacquisition in October 1998). For the year, including the TPN relatedmemberships and associates, new membership production rose 34%to 525,352 from 391,827 during 1998 while new sales associatesrecruited increased 22% to 92,644 from 75,737 during 1998.
52. The information in the January 10, 2000 press release was false and misleading when
made in that Pre-Paid failed to disclose information known to defendants Or recklessly disregarded
by them including the information set forth in 42.
53. On February 7, 2000, the Pre-Paid Defendants caused the Company to announced its
fourth quarter 1999 and year-end 1999 results. The release stated:
Pre-Paid Legal Services, Inc. today reported record results for thefourth quarter and for the year ended December 31, 1999. Netincome for the fourth quarter of 1999 rose 24 percent to $10,429,000from $8,414,000 for the prior year's period excluding a 1998 taxbenefit of $3.5 million. Total revenues for the quarter rose 27 percentto $55,074,000 from $42,952,000 for the prior year's period despite
19
planned decreases of $2.9 million in TPN product sales. Mostimportantly, the Company's membership revenues increased 43percent to $45,146,000 from $31,560,000 for the same period lastyear. Diluted earnings per share increased 31 percent to 46 cents pershare from 35 cents per share for last year's comparable quarterexcluding the 1998 fourth quarter tax benefit of 15 cents per share.
* * *For the fourth quarter of 1999, the Company added 148,928 newmembers, an increase of 38 percent from the 108,039 new membersadded during the same period of 1998 period [sic] excluding 10,740memberships resulting from the TPN acquisition in October 1998.New sales associates recruited during the fourth quarter of 1999increased 54 percent to 24,609 compared to 15,976 for thecomparable period of 1998 excluding 13,231 associates resultingfrom the TPN acquisition in October 1998.
"We are very proud of our fourth quarter and annual results," saidPre-Paid Chairman Harland Stonecipher. "After 28 years in business,we continue to enjoy a high percentage of recurring revenues, have allof our major cost categories fixed, have significant positive cash flowand remain debt free with more than $36 million in cash afterrepurchasing almost $30 million of our stock during 1999. Since1993 we have increased our membership base by an average of 35%per year and earnings per share has grown from $0.01 per share to$1.67 per share.
54. The information in the February 7, 2000 press release was false and misleading when
made in that Pre-Paid failed to disclose information known to defendants or recklessly disregarded
by them including the information set forth in 42.
55. In the Form 10-K dated March 21, 2000 for fiscal 1999, which was signed by
defendants Stonecipher, Harp, Pinson and Savula, the Pre-Paid defendants caused the Company to
report net income of $38.9 million with a 43% increase in Membership fees. They also stated that
the Company's Membership persistency rate has averaged 75.1% from 1981 through 1999. The
annual persistency rate for 1999 was reported to be 73.4%. Pre-Paid 's persistency rate measures the
20
, .,
number of Memberships in force at the end of a year as a percentage of the total of (i) Memberships
in force at the beginning of such year, plus (ii) new Memberships sold during such year. This
information was false and misleading in that the persistency rate did not reflect the ability of the
Company to retain a Membership as the Company claimed, and the Company failed to disclose that
fewer than 54% of members were still paying one year after purchasing a membership; fewer than
47% were still paying after two years; and fewer than 29% were still paying after three years.
56. In that same Form 10-K, defendant Deloitte issued a "clean" or "unqualified" audit
opinion dated March 3, 2000, stating in relevant part that: "[w]e conducted our audits in accordance
with auditing standards generally accepted in the United States of America," and Tin our opinion,
based on our audits and the report of the other auditors, Mei consolidated financial statements
present fairly, in all material respects, the financial position of Pre-Paid Legal Services, Inc. and
subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 1999 in conformity with
accounting principles generally accepted in the United States of America."
57. On April 17, 2000, the Pre-Paid Defendants caused the Company to report record
earnings for its first quarter of 2000:
Net income for the first quarter of 2000 rose 30 percent to$11,392,000 from $8,782,000 for the prior year's period. Totalrevenues for the quarter rose 28 percent to $57,270,000 from$44,583,000 for the prior year's period despite planned decreases of$1.4 million in TPN product sales. Most importantly, the Company'smembership revenues increased 39 percent to $46,976,000 from$33,767,000 for the same period last year. Diluted earnings per shareincreased 35 percent to 50 cents per share from 37 cents per share forlast year's comparable quarter.
Defendant Stonecipher stated:
21
"We are extremely pleased with our first quarter results. This is the28th consecutive quarter of increased membership revenues. Wecontinue to grow our membership base by an average of more than35% per year, as we have since 1993, and continue to benefit fromsignificant positive cash flow while growing our core revenues bymore than 39 percent. We also believe our new developing strategicInternet relationships will increase recruiting and training of salesassociates and increase membership revenues. . . . With more than$41 million in cash and investments, a high percentage of recurringrevenues, a fixed-cost business model, significant positive cash flow,no debt and a better trained and more effective sales force coupledwith the size of the market for our legal services, we are more excitedtoday about our future than at any time in our 128 year history."
58. The information in the April 17, 2000 press re lease was false and misleading when
made in that Pre-Paid failed to disclose information known to defendants or recklessly disregarded
by them including the information set forth in 42.
59. In its Form 10-Q filed with the SEC on May 4, 2000 for the first quarter of 2000,
signed by defendants Stonecipher, Harp and Pinson, the Company falsely reiterated the financial
figures in its April 17, 2000 press release and reported net income of $11.4 million and an increase
in Membership premiums of 39% compared to the same period in 1999. But for the clear violations
of GAAP described herein at 11 101; 102 below, this net income figure would have been materially
reduced.
60. On May 16, 2000, Pre-Paid announced that Steve Williamson would succeed Harp
as Chief Financial Officer. Harp remained Chief Operating Officer.
61. On July 17, 2000, the Pre-Paid Defendants caused the Company to issue a press
release announcing its results for the second quarter of 2000:
Pre-Paid Legal Services, Inc. today reported record results for thesecond quarter and for the six months ended June 30, 2000. Netincome for the second quarter of 2000 rose 28 percent to $12,659,000
22
, .,
from $9,872,000 for the prior year's period. The Company'smembership revenues increased 34 percent to $51,624,000 from$38,557,000 for the same period last year. Total revenues for thequarter rose 29 percent to $61,750,000 from $47,959,000 for the prioryear's period. Diluted earnings per share increased 33 percent to 56cents per share from 42 cents per share for the prior year'scomparable quarter.
* * *
For the second quarter of 2000, the Company added 169,314 newmembers, an increase of 38 percent from the 122,885 new membersadded during the same period of 1999. During the second quarter of2000, 25,354 new sales associates were recruited, a one-percentincrease over the 25,100 sales associates recruited during thecomparable period in 1999.
"We are extremely excited about our second quarter results. This isour 28th year in business and 29 th consecutive quarter of increasedmembership revenues. We continue to grow our membership base byan average of more than 35% per year, as we have since 1993. Wealso believe our new developing Internet strategies will increaserecruiting of sales associates and increase membership revenues,"said Pre-Paid Chairman Harland Stonecipher.
62. The information in the July 17, 2000 press release was false and misleading when
made in that Pre-Paid failed to disclose information known to defendants or recklessly disregarded
by them including the information set forth in 1142.
63. In its Form 10-Q filed with the SEC on August 9, 2000 for the second quarter of
2000, signed by defendant Harp, the Company falsely reported net income of $24 million for the six
months ended June 30, 2000, up 29% from the same period of 1999. But for the clear violations of
GAAP described herein at in 101; 102 below, this net income figure would have been materially
reduced.
64. On October 16, 2000, the Pre-Paid Defendants caused the Company to issue a release•
announcing its results for the third quarter of 2000:
23
,
,
Pre-Paid Legal Services, Inc. today reported record results for thethird quarter and for the nine months ended September 30, 2000. Netincome for the third quarter of 2000 rose 45 percent to $14,360,000from $9,870,000 for the prior year's period. The Company'smembership revenues increased 37 percent to $54,581,000 from$39,758,000 for the same period last year. Total revenues for thequarter rose 37 percent to $67,198,000 from $49,025,000 for the prioryear's period. Diluted earnings per share increased 50 percent to 63cents per share from 42 cents per share for the prior year'scomparable quarter.
* * *
For the third quarter of 2000, the Company added 171,753 newmembers, an increase of 27 percent from the 134,725 new membersadded during the same period of 1999. During the third quarter of2000, 27,681 new sales associates were recruited, a 23 percentincrease over the 22,493 sales associates recruited during thecomparable period in 1999.
"We are extremely excited about our third quarter results. Wesurpassed one million active memberships during the quarter andwhile this is our 28 th year in business, our goal is to reach two millionactive members during the next 28 months. We have increased ourquarter membership revenues each quarter for 30 consecutivequarters" said Pre-Paid Chairman Harland Stonecipher, "and withmore than $48 million in cash and investments, a high percentage ofrecurring revenues, no debt and a fixed-cost business model coupledwith a tremendous market for our legal service plans, we continue tobelieve very strongly that the best is yet to come. We believe nothingcan stop an idea whose time has come and firmly believe the time forlegal service plans is now."
65. The information in the October 16, 2000 press release was false and misleading when
made in that Pre-Paid failed to disclose information known to defendants or recklessly disregarded
by them including the information set forth in 42.
66. On October 18, 2000, The Daily Oklahoman published an article on Pre-Paid based
on an interview with defendant Stonecipher, which stated in part:
24
,
"We should be growing at 100 percent a year," he said."Everything's in place to do that.
"We're just now getting started. We only have 1 percent of themarket right now. There's another 99 percent out there we stillhaven't touched."
Stonecipher said Pre-Paid has 200,000 sales associates — 60,000 ofthem extremely active — writing business policies.
67. The information in the October 18, 2000 interview was false and misleading in that
defendant Stonecipher failed to disclose, among other things, that cancellation rates of Memberships
were increasing, making it more difficult for Pre-Paid to recover commission advances from
associates and that due to the other factors set forth in 42, everything was not in place for 100 per
cent annual growth.
68. In its Form 10-Q filed with the SEC on November 8, 2000 for the third quarter of
2000, signed by defendant Harp, Pre-Paid reported net income of $38.4 million for the nine months
ended September 30, 2000, up 35% from the same period of 1999.
69. On December 6, 2000, TheStreet.com issued a report on Pre-Paid which stated in part:
. .while commission advances continue to grow, new membershipgrowth is slowing: On an annual basis it leapt by 27% last quarter— impressive until you see that it rose by 40% in the same quarter ayear earlier. More to the point: New membership growth has beenfalling every quarter for the last four, barely budging last quarter at1.4% after peaking at 10.5% in last year's fourth quarter.
* * *
But the company hasn't changed its allowance for doubtful accounts— the amount it reserves against uncollected commissions oncancelled policies — for five quarters despite a rise in commissionadvances. Chief Operating Officer Randy Harp explains that thecompany has seen no need to do so, because 20% of the salesforcedoes 80% of the sales, "and where 80% of the production comes from
25
,
20% of the salesforce," he says, "collectibility becomes better; it's acomponent of not how much business he writes, but who writes it."
* * *
How much is currently at risk? Hard to say. The company merelybreaks the commission advances shown on its balance sheet into twocategories: current and long-term. Current reflects the first of threeyear's worth of commission advances. Long term is the balance. Ifcollections were never a problem, one short-seller argues, the long-term advance should never be more than twice the amount of theshort-term. Pre-Paid' s long-term commission advances, however, aremore like 2.6 times the short-term.
(Emphasis in original).
70. On December 6, 2000, defendant Stonecipher, apparently in response to The
Streetcom article, stated, "[O]ur financial statements are audited by an internationally recognized
firm of independent auditors and they have never taken exception to the accounting principles
followed by the Company." As a result of this denial and the fact that Deloitte appeared by its
silence to be affirming defendant Stonecipher's statements, Pre-Paid's stock price remained
artificially inflated and the undisclosed information regarding the true state of the Company's
business absent the accounting fraud, remained concealed. Although Deloitte did not take exception
does not change the fact that the Company was not utilizing or following GAAP in reporting its
financial results. In fact, Deloitte itself opined that the Company was following GAAP in reporting
Pre-Paid's financial results when clearly the Company was in violation of GAAP.
71. On January 10, 2001, the Pre-Paid Defendants caused the Company to announce its
results for the 4 th quarter 2000:
Pre-Paid Legal Services, Inc. today reported production and recruitingresults for the fourth quarter and for the year ended December 31,2000. The Company's active base of memberships increased 29%during 2000 from 827,979 to 1,064,805. During the last quarter of
26 •
, .
2000, new memberships written increased 11% to 165,710 from148,928 during the 1999 period while new sales associates recruiteddecreased 5% to 23,344 from 24,609 during the 1999 period. For theyear, new membership production rose 28% to 670,118 from 525,352during 1999 while new sales associates recruited increased 5% to97,617 from 92,644 during 1999.
72. The information in the January 10, 2001 press release was false and misleading when
made in that Pre-Paid failed to disclose information known to defendants or recklessly disregarded
by them including the information set forth in 42.
73. On January 17, 2001, an article in the "Heard on the Street" column of The Wall
Street Journal partially disclosed many of the improprieties regarding the accounting practices of
Pre-Paid. The article stated in part:
Regulators long have warned investors to be skeptical of companiesthat record everyday business expenses as assets. In a 1996 speechtitled "Dangerous Ideas," the Securities and Exchange Commission'schief accountant at the time, Michael Sutton, said that "concernsabout the quality of the asset created, and therefore the quality ofearnings, follow" when companies defer customer-acquisition costsnormally associated with ongoing operations. He explained that"there usually is no direct and traceable linkage between currentperiod expenses and a specific future period revenue, even though itmay be possible to associate, at least in part, current period activitieswith future revenue." The SEC declines to comment on Pre-Paid' saccounting practices.
One thing is certain: Pre-Paid' s commission-advance assets areballooning. Over the past four quarters, through Sept. 30,commission-advance assets climbed 43% to $156.2 million, asrevenue made its 31% jump, and now exceed Pre-Paid' s $151.2million in shareholder equity. By contrast, the company's allowancefor estimated unrecoverable commission advances was unchanged at$4.5 million.
Critics also question the way Pre-Paid treats commission advancesassociated with lapsed policies. If a customer cancels a policy beforethree years, the company stops writing down the advances, treating
27
,
them instead as receivables —that is, money owed the company. Thecompany tries to collect the receivables by docking associates' futurepay through two types of "charge-backs." Specifically, Pre-Paidseeks to take half the charge-back out of an associates' futurecommission advances and the other half from the associate'scommissions on renewals of policies that are more than three yearsold.
However, critics note, the company can't dock an associate's renewalcommissions if the associate hasn't sold any policies that are morethan three years old. And if an associate stops selling policies, thecompany can't dock future commission advances because there aren'tany.
Indeed, many associates lose interest after making a few sales; onlyabout 26% of Pre-Paid's 234,000 associates made a sale during thenine months ended Sept. 30, according to the company. Moreover,the company's balance sheet lumps receivables into commission-advance assets, meaning investors can't determine which portion isstill being written down and which portion isn't.
The financials are clear on this point: Over the past five years, Pre-Paid hasn't written off any commission-advance assets asunrecoverable. Mr. Harp acknowledges there are some commissionadvances that the company never will be able to recover throughcharge-backs to associates. But he says that isn't a problem, becausePre-Paid makes up for them in other ways.
As a result of the foregoing article, the price of Pre-Paid stock dropped almost two points from $22
11/16 on January 16 to $20 7/8 on January 17 after the closing of the market. But for the Pre-Paid
Defendants' continued denials, the stock would have dropped even further.
74. On January 25, 2001, Pre-Paid filed an 8-K with the SEC to provide details regarding
the accounting treatment of the commission advances and expenses. For the first time, Pre-Paid
detailed its "Membership retention rate." The chart it provided showed that within one year,
Membership retention falls to 53.37%; after two years it falls to 36,97%; and after three years it falls
to 28.66%. These percentages are a far cry from the 75.1% persistency rate that Pre-Paid publicly
28
•
proclaimed measured the Company's ability to retain Members. If the retention rate information
provided in the 8-K had been given to sales associates, it is likely that many of them would never
have signed up since the chances of being successful are de minimis if high percentages of
Memberships cannot be retained. The result of accurate retention rate information would have
caused a dramatic downturn in the growth of the Company since a multilevel marketing company
requires a steady stream of new salespeople to fuel its growth. The misrepresentation of the
persistency rate during the Class Period was material as was the omission of the true retention rates
for years one, two and three after a Membership is sold.
75. In a January 27, 2001 article in The Saturday Oklahoman, Melanie Lawson, Pre-
Paid's financial analyst, said that the January 25, 2001 8-K "basically laid (its) books completely
open." Defendant Stonecipher stated, "But any reasonable person who understands insurance-type
accounting will be satisfied." However, these statements were materially inaccurate as the Company
was not preparing its financial statements in accordance with GAAP for the reasons set forth in r1 0 1-103.
76. On February 22, 2001, defendant Stonecipher issued a press release to the Pre-Paid
shareholders and said in part:
We are obligated to prepare our financial statements in accordancewith generally accepted accounting principles and to have thosefinancial statements audited by our independent auditors (Deloitte &Touche). We have consistently fulfilled that obligation. We reportassets (including "advanced" commissions) as assets, and we reportexpenses (including "earned" commissions) as expenses, consistentwith the basic concepts of accrual accounting.
Once again, this affirmative denial served to offset the effect of any third party disclosures regarding
the Company's accounting thereby allowing the Company's stock to remain artificially inflated.
29
. .
77. On March 16, 2001, for the first time, Pre-Paid confirmed that it had responded to
an inquiry by the SEC Division of Enforcement and to comments made by the SEC Division of
Corporation Finance regarding the Company's 1999 Form 10-K. [The SEC had actually begun its
inquiry on January 26, 2001.1 The Company also said it would change the way it accounts for
commission payments and restate its previously reported 2000 financial results and that it would no
longer "pool" its commission advances. Defendant Harp stated, in contrast to previous statements
by the Company identifying commission advances as assets, "We believe that we have always
portrayed our commission advances as receivables." To date, the Company has not changed the way
in which it accounts for commission payments nor has it restated its previously reported 2000
financial results except with respect to the effect of the accounting change for no longer "pooling"
its commission advances. However, because Pre-Paid said that it continues to believe that the
accounting treatment it used historically for commission advances is acceptable under GAAP, the
Company's stock still remained inflated.
78. On April 16, 2001, The Wall Street Journal reported that Pre-Paid said it would
change the way it accounts for certain commission payments and that it would restate its previously
reported financial results for 2000. Those changes, based on preliminary estimates would reduce
Pre-Paid's net income by $7.2 million from what was previously reported as $50.8 million, or a
decline of approximately 14 per cent and its first quarter 2001 by $688,000 or three cents a diluted
share. The Company continued to falsely proclaim that "the accounting treatment historically
afforded to commission advances is acceptable under generally accepted accounting principles."
30
. . . •
79. On April 17, 2001, while the filing of the Company's 10-K was delayed, defendant
Stonecipher attempted to manipulate the market price of Pre-Paid stock by saying that it had been
trading at a ridiculously low price and called it a "good buy" at $18 per share.
80. Pre-Paid filed its Form 10-K for 2000 on April 27, 2001. In it, Pre-Paid finally made
the distinction between the persistency rate (which it had previously defined as the ability of the
Company to retain a Membership) and the Expected Economic Life of a new member. In its 2000
10-K, Pre-Paid defined the persistency rate as the number of Memberships in force at the end of a
year as a percentage of the total Membership in force at the beginning of such year plus New
Memberships sold during such year. In the 2000 10-K, Pre-Paid no longer asserted that the
persistency rate represents the ability of the Company to retain a Membership. The Expected
Economic Life of a new Member is defined as the average number of years that a New Member is
expected to renew.
81. In that same Form 10-K, Deloitte stated that "we conducted our audits in accordance
with auditing standards generally accepted in the United States of America," and opined that the
"consolidated financial statements present fairly, in all material respects, the financial position of
Pre-Paid Legal Services, Inc., and subsidiaries as of December 31, 2000 and 1999, and the results
of their operations and their cash flows for each of the three years in the period ended December 31,
2000 in conformity with accounting principles generally accepted in the United States of America."
82. On May 15, 2001, the Company announced that on May 11, 2001, Pre-Paid had
received a warning letter from the SEC Division of Corporate Finance stating that the Company's
treatment of commission advances paid to associates is not in accordance with GAAP. The
Company agreed that if this warning is not overturned on appeal, it could have a material adverse
31
. .
_
effect on Pre-Paid' s financial condition and results of operation. Upon information and belief, no
such SEC ruling issued to any public company has ever been overturned.
83. Also on May 15, 2001, Pre-Paid filed its Form 10-Q for the quarter ended March 31,
2001 signed by defendant Harp. The Company reported net income of $13.2 million after an after-
tax charge of $4.1 million relating to the cumulative effect on prior years of changing one aspect of
accounting for commission advances.
84. It was reported on May 16, 2001 that in response to an SEC letter, Pre-Paid finally
conceded that its earnings for the past two years will have to be restated and will be reduced
dramatically using the SEC's accounting methods.
85. On May 16, 2001, defendant Harp admitted:
Based on preliminary estimates, our pro-forma EPS for fiscal 2000and fiscal 1999 under the accounting that the Division of CorporationFinance proposed would have been approximately $.81 per share and$.57 per share, respectively, compared to reported earnings perdiluted share of $1.92 and $1.67, respectively. Our pro-forma EPSfor the first quarter of 2001 would have been approximately $.27 pershare compared to reported earnings per diluted share of $.60.
As a result, it is clear that Pre-Paid's reported figures for 2000, 1999 and first quarter 2001 were
materially incorrect by 66%, 58% and 55%, respectively.
86. By the close of trading on May 15, 2001, Pre-Paid' s shares had plunged 26% from
$19 per share to close at $14.10 per share after the disclosure of the SEC's determination that Pre-
Paid' s accounting for commission advances fails to conform to GAAP. Pre-Paid remains the focus
of a separate informal inquiry by the SEC's enforcement division.
87. On May 25, 2001, defendant Stonecipher stated in an interview on CNBC that Pre-
Paid has no directors and officers insurance.
32
, .
88. In the financial statements, SEC filings, press releases and other positive statements
as set forth in 1rlj 39-87, above, the Pre-Paid Defendants have intentionally, or with reckless
disregard, disseminated materially false and misleading statements to the public during the Class
Period by failing to disclose information known to them or recklessly disregarded by them including
the information set forth in 42.
Pre-Paid's False Financial Reporting During The Class Period
89. Throughout the Class Period, the Pre-Paid Defendants knowingly or recklessly caused
the Company to falsely report its results for at least the quarters ended March 31, 1999, June 30,
1999, September 30, 1999, December 31, 1999, March 31, 2000, June 30, 2000, September 30,
2000, December 31, 2000 and March 31, 2001, through improper recognition of revenues and the
failure to properly report the value of its "assets", including commission advances. This caused Pre-
Paid' s earnings and assets to be materially overstated throughout the Class Period and its expenses
to be materially understated.
90. Pre-Paid reported the following financial results during the Class Period:
3/31/99 6/30/99 9/30/99 12/31/99
Revenues $44.6M $48.0M $49.0M $55.1M
Net Income $ 8.8M $ 9.9M $ 9.9M $10.4M
.EPS $0.37 $0.42 $0.42 $0.46
3/31/00 6/30/00 9/30/00 12/31/00' 3/31/01
'As reported in the 2000 10-K before taking into account the effect of the change inaccounting principle.
33
Revenues $57.3M $61.7M $67.2M $65.9M $70.8M
Net Income $11.4M $12.7M $14.4M $12.4M $13.2M
EPS $0.50 $0.56 $0.63 $0.552 $0.60
91. Pre-Paid includes its interim results in Form 10-Qs, and its annual results in its Forms
10-K for 1998, 1999 and 2000 which were filed with the SEC and signed by the Pre-Paid
Defendants. With regard to the financial information included in the SEC filings, Pre-Paid
represented that the financial information was prepared in accordance with GAAP.
92. These representations were false and misleading when made, as Pre-Paid's financial
results reported during the Class Period did not present fairly Pre-Paid' s results, and their results
were presented in violation of GAAP and SEC rules.
93. GAAP are those principles recognized by the accounting profession as the
conventions, rules and procedures necessary to define accepted accounting practice at a particular
time. SEC Regulation S-X (17 C.F.R. §210.4-01(a)(1)) states that financial statements filed with
the SEC which are not prepared in compliance with GAAP are presumed to be misleading and
inaccurate, despite footnote or other disclosure. Regulation S-X requires that interim financial
statements must also comply with GAAP, with the exception that interim financial statements need
not include disclosure which would be duplicative of disclosures accompanying annual financial
statements. 17 C. R. F . §210.10- 01 (a).
94. The Pre-Paid Defendants caused Pre-Paid to falsify its reported financial results
through its improper accounting for the valuation of its "assets," including commission advances.
'As reported in the 2000 10-K (Basic EPS).
34
Improper Capitalization of Commission Expenses
95. As a result of Pre-Paid' s improper capitalization of expenses, Pre-Paid generated an
"asset" called membership commission advances which grew disproportionately to the Company's
total assets. The account represented 48% of Pre-Paid's total assets at December 31, 1998, but by
September 30, 2000, it represented more than 63% of assets. The effect of this capitalization on Pre-
Paid's income was enormous. The growth in this account (both current and non-current portions)
alone during the Class Period equaled the cumulative net income Pre-Paid reported during the fourth
quarter 1999 and the first three quarters of 2000. Much of this "asset" was essentially a questionable
receivable at best, as commission advances loaned to associates would not be repaid by future
commissions if associates stopped signing up new memberships.
96. In its 1998 and 1999 10-Ks dated March 18, 1999 and March 17, 2000, Pre-Paid
stated that historically it has been able to immediately recover "charge-backs" for 50% of the
unearned advances:
Should a Membership lapse before the advances have been recoveredfor each commission level, the Company immediately generates animmediate "charge-back" to the applicable sales associate torecapture 50% of any unearned advance. This charge- back isdeducted from any future advances that would otherwise be payableto the associate for additional new Memberships. The Companyhistorically has been able to immediately recover the majority of suchcharge-backs. Any remaining unrecovered advance on a Membershipthat has lapsed represents a receivable from the associates and isreflected as commission advances and is categorized as current ornon-current based on the expected recovery period. Additionally,even though a commission advance may have been fully recovered ona particular Membership, no additional commission earnings fromany Membership will be paid to an associate until all previousadvances on all Memberships, both active and lapsed, have beenrecovered. During 1999, 21% of all associates submitting newMemberships accounted for 75% of all such new Memberships
35
,
produced thereby further enhancing the recovery of commissionadvances. (emphasis added)
97. However, on August 9, 2000, in a deposition in the case captioned Pre-Paid Legal
Services, et al. v. Gregg Sturz, et al., Case No. 00-5446 in the Circuit Court of The Thirteenth
Judicial Circuit of the State of Florida, Hillsborough County, defendant Pinson testified as follows:
Q :But as people leave the company you do not collect thoseloans?
A: We have not historically done that.
98. In its 2000 10-K dated April 27, 2001, Pre-Paid stated that it sought to recapture up
to 50% of an unearned advance; and it described the fee or interest it had been collecting on lapsed
Memberships as a "Membership lapse fee" in an effort to disguise that these commission advances
were actually loans:
Should a Membership lapse before the advances have been recoveredfor each commission level, the Company generates an immediate"charge-back" to the applicable sales associate to recapture up to 50%of any unearned advance. This charge-back is deducted from anyfuture advances that would otherwise be payable to the associate foradditional new Memberships. Any remaining commission advancereceivable is recovered by withholding future residual earnedcommissions due an associate on active Memberships. Additionally,even though a commission advance may have been fully recovered ona particular Membership, no additional comm [ssion earnings fromany Membership are paid to an associate until all previous advanceson all Memberships, both active and lapsed, have been recovered.
The Company charges associates a fee on commission advancereceivables relating to lapsed Memberships ("Membership lapsefee"). The fee is determined by applying the prime interest rate to thecommission advance receivable balance pertaining to lapsedMemberships. The Company realizes and recognizes income onlywhen the amount of the calculated fee is collected by withholding• from cash commissions payments due the associate, because theCompany's ability to recover fees in excess of current payments is
36
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• primarily dependent on the associate selling new Memberships whichqualify for cornmission advances. (emphasis added)
99. In its 2000 10-K, the Company stated that Pre-Paid had the contractual right to require
associates to repay commission advances from sources other than earned commissions. However,
this right applies only to associates who signed agreements between July 1992 and August 1998 and
to agencies who signed agreements between October 1989 and July 1992. In addition, the Company
cautioned:
The sources, other than earned commissions, that may be available torecover associate commission advance receivables are potentiallysubject to limitation based on applicable state laws relating tocreditors' rights generally.
The Company had never disclosed this contractual right before, and in its 2000 10-K the Pre-Paid
Defendants admitted that they had not demanded repayments of the commission advances from
associates.
100. Not only did Pre-Paid not demand repayment of its commission advances from
associates, but in some cases it allowed associates to abandon an account with high commission
advances and begin a brand new account with no penalty.
101. Moreover, Pre-Paid amortized the costs of commission advances over three years
even though the average life of members was closer to two years. Pursuant to GAAP, as set forth
in Accounting Principles Board Opinion ("APB") No. 17, such intangible assets should be amortized
over the period expected to be benefitted by the cost. FASB 60 states that acquisition costs, which
include commissions, shall be capitalized and charged to expense in proportion to premium revenue
recognized. Without disclosing the life of the policies, an investor cannot determine whether the
amortization period is appropriate. In addition, once the policy is terminated the associated
37
. .
• commission advance should be expensed immediately because there is no longer any future
economic benefit. In violation of GAAP, Pre-Paid selected an unjustifiably long period so that Pre-
Paid's quarterly amortization expense would be understated and its quarterly income materially
overstated.
Failure to Record Losses for Uncollectible Receivables
102. GAAP, as set forth in SFAS No. 5, requires that a loss be recognized for the
uncollectible portion of receivables or groups of receivables where it is probable that a receivable
is uncollectible and the amount of loss can be reasonably estimated.
103. As reported in The Wall Street Journal article of January 17, 2001:
Mr. Harp says that commissions that would have been paid to thesedropouts — totaling millions of dollars over the years — are groupedinto a pool along with unrecoverable commission advances,something the company hasn't disclosed i a financial reports.Historically, Mr. Harp says, those figures have offset each other,making it unnecessary to write off any commission-advance assets.Mr. Harp says company executives just never have found itnecessary' to disclose this pool's existence before.
Defendant Harp acknowledged that defendants caused or allowed Pre-Paid to offset certain liabilities
for commission payments against receivables from their associates, but failed to disclose the
actuarial details of this pool, and to identify the commission advances that have evolved into
receivables. According to GAAP, specifically APB 10, it is a general principle of accounting that
the offsetting of assets and liabilities in the balance sheet is improper except where a right of setoff
exists.
104. Defendant Harp has acknowledged that the Pre-Paid Defendants and Deloitte have
caused or allowed the Company to pool commissions that have not been paid with unrecoverable
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. . • ,
commission advances during the Class Period. A right of setoff only involves two parties, under
FASB Interpretation 39. Pre-Paid is matching commissions due one associate with commissions that
are receivables to another. This is a violation of GAAP.
105. Under Regulation S-X Rule 5-02, current assets must be stated separately in a balance
sheet or in a note thereto if there are any amounts in excess of five percent of total assets.
Defendants have caused or allowed Pre-Paid to violate this Regulation by including associates'
receivables along with the commission advances.
106. Even as Pre-Paid' s membership commission advances skyrocketed, as described
above, defendants have caused Pre-Paid to avoid making adequate accrual for uncollectible
receivables and to not amortize this account even after Memberships were canceled.
GAAP Violations
107. Due to these accounting improprieties, defendants caused or allowed the Company
to present its financial results and statements in a manner which violated GAAP, including the
following fundamental accounting principles:
(a) The principle that interim financial reporting should be based upon the same
accounting principles and practices used to prepare annual financial statements was violated (APB
No. 28, ¶10);
(b) The principle that financial reporting should provide information that is useful
to present and potential investors and creditors and other users in making rational investment, credit
and similar decisions was violated (FASB Statement of Concepts No. 1,1134);
(c) The principle that financial reporting should provide information about the
economic resources of an enterprise, the claims to those resources, and effects of transactions, events
39
. • .
and circumstances that change resources and claims to these resources was violated (FASB
Statement of Concepts No. 1, ¶40);
(d) The principle that financial reporting should provide information about how
management of an enterprise has discharged its stewardship responsibility to owners (stockholders)
for the use of enterprise resources entrusted to it was violated. To the extent that management offers
securities of the enterprise to the public, it voluntarily accepts wider responsibilities for
accountability to prospective investors and to the public in general (FASB Statement of Concepts
No. 1,1150);
(e) The principle that financial reporting should provide information about an
enterprise's financial performance during a period was violated. Investors and creditors often use
information about the past to help in assessing the prospects of an enterprise. Thus, although
investment and credit decisions reflect investors' expectations about future enterprise perforniance,
those expectations are commonly based at least partly on evaluations of past enterprise performance
(FASB Statement of Concepts No. 1,1142);
The principle that financial reporting should be reliable in that it represents
what it purports to represent was violated. That information should be reliable as well as relevant
is a notion that is central to accounting (FASB Statement of Concepts No. 2,11158-59);
(g) The principle of completeness, which means that nothing is left out of the
information that may be necessary to insure that it validly represents underlying events and
conditions was violated (FASB Statement of Concepts No. 2179); and
(h) The principle that conservatism be used as a prudent reaction to uncertainty
to try to ensure that uncertainties and risks inherent in business situations are adequately considered
40
•
was violated. The best way to avoid injury to investors is to try to ensure that what is reported
represents what it purports to represent (FASB Statement of Concepts No. 2, 151f95, 97).
108. Further, the undisclosed adverse information concealed by defendants during the
Class Period is the type of information which, because of SEC regulations, regulations of the
national stock exchanges and customary business practice, is expected by investors and securities
analysts to be disclosed and is known by corporate officials and their legal and financial advisors to
be the type of information which is expected to be and must be disclosed.
Fraudulent Scheme And Course Of Business
109. Each Pre-Paid Defendant is liable for (i) making false statements, or (ii) failing to
disclose adverse facts known to him or her about Pre-Paid. The Pre-Paid Defendants fraudulent
scheme and course of business that operated as a fraud or deceit on purchasers of Pre-Paid common
stock was a success, as it (i) deceived the investing public regarding Pre-Paid's prospects and
business; (ii) artificially inflated the prices of Pre-Paid's publicly traded common stock; and (iii)
caused plaintiffs and other members of the Class to purchase Pre-Paid publicly traded common stock
at artificially inflated prices.
110. During the Class Period, the Pre-Paid Defendants materially misled the investing
public, thereby inflating the price of Pre-Paid common stock, by publicly issuing false and
misleading statements and omitting to disclose material facts necessary to make defendants'
statements, as set forth herein, not false and misleading. Said statements and omissions were
materially false and misleading in that they failed to disclose material adverse information and
misrepresented the truth about the Company, its business and operations, including, inter alia:
41
(a) That the Company's financial statements were not prepared in accordance
with GAAP and in accordance with the federal securities laws and SEC regulations concerning fair
reporting;
(b) That the Company's statements as to the Company's earnings and stock value
were lacking in reasonable basis at all relevant times for the reasons set forth in paragraph 107(a)-
(h); and
(c) That Deloitte's audit failed to conform to GAAS.
111. At all relevant times, the material misrepresentations and omissions particularized
in this Complaint directly or proximately caused or were a substantial contributing cause of the
damages sustained by plaintiffs and other members of the Class. As described herein, during the
Class Period, defendants made or caused to be made a series of materially false and misleading
statements about Pre-Paid' s business, prospects and operations. These material misstatements and
omissions had the cause and effect of creating in the market an unrealistically positive assessment
of Pre-Paid and its business, prospects and operations, thus causing the Company's common stock
to be overvalued and artificially inflated at all relevant times. Defendants' materially false and
misleading statements during the Class Period resulted in plaintiffs and other members of the Class
purchasing the Company's common stock at artificially inflated prices, thus causing the damages
complained of herein.
112. Defendants failed to disclose that the average life of a policy is less than three years.
They have no justification for having advanced three years of commissions and then not writing off
the remaining balance on an advance when a Membership was not renewed and the associate who
sold the policy stopped selling policies.
42
Deloitte's Wrongdoing
113. Deloitte issued unqualified audit opinions (the "Audit Opinions") on Pre-Paid's
• financial statements for fiscal 1998, 1999 and 2000 and stated that Deloitte' s audits were performed
in conformity with GAAS and, inter alia, that in Deloitte's opinion the financial statements "present
fairly" Pre-Paid' s financial position, results from operations and cash flows in conformity with
GAAP for the fiscal years ended December 31, 1998, December 31, 1999, and December 31, 2000.
However, as alleged herein, Deloitte's Audit Opinions were false and misleading because the
financial statements upon which Deloitte issued its unqualified opinions concerning, inter alia, the
way in which Pre-Paid accounted for its commission advances, contained numerous and material
violations of GAAP.
114. Deloitte conducted audit examinations and participated in investigations of Pre-Paid's
business, operations, financial, accounting and management control systems. In the course of these
audits and investigations, Deloitte knew its obligations under GAAS, detailed below, but simply
ignored them.
115. Had Deloitte conducted its audits in accordance with GAAS, it would not have
certified Pre-Paid' s financial statements as presented. Deloitte's representations that the audits
conformed to GAAS were false and misleading for, inter alia, the following reasons:
(a) Deloitte violated GAAS General Standard No. 3 that requires that due
professional care must be exercised by the auditor in the performance of the audit and the preparation
of the report. Deloitte failed to exercise due care in performing its audit and preparing its report;
(b) Deloitte violated GAAS Standard ofFielcl WorkNo. 3 that requires sufficient,
competent evidential matter to be obtained through inspection, observation, inquiries and
43
•
• confirmations to afford a reasonable basis for an opinion regarding the financial statements under
audit. Deloitte failed to obtain sufficient, competent evidential materials as to the adequacy of asset
valuations, including reserves, and completeness of recorded expenses;
(c) Deloitte violated GAAS Standard of Reporting No. 1 which requires the
auditor, in preparing the report, to state whether the financial statements are presented in accordance
with GAAP; and
(d) Deloitte violated GAAS Standard of Reporting No. 3 which requires
informative disclosures in the financial statements which are to be regarded as reasonably adequate
unless otherwise stated in the report.
116. In the course of issuing its unqualified audit opinions as to the Financials, and prior
to the Company's public announcement of these results, Deloitte was required to adhere to all of the
standards of GAAS, including the requirement that the financial statements comply in all material
respects with GAAP. in issuing its unqualified opinions on the Financials, Deloitte's audits and
reports therein represented an extreme departure from GAAS., and the manner in which Pre-Paid' s
financial results were reported as part of the Company's financial statements represented an extreme
departure from GAAP.
117. SAS No. 82, adopted by the American Institute of Certified Public Accountants
(AICPA) entitled "Consideration of Fraud in a Financial Statement Audit" contains the following
definition: "Misstatements arising from fraudulent financial reporting are intentional misstatements
or omissions of amounts or disclosures in financial statements to deceive financial statement users.
Fraudulent financial reporting may involve acts such as the following:
44
, .
manipulation, falsification or alteration of accounting records orsupporting documents from which financial statements are prepared;
misrepresentation in, or intentional omission from, the financialstatements of events, transactions, or other significant informationquantifying accounting irregularities. During the investigation certainmisstatements were identified; and
intentional misapplication of accounting principles relating toamounts, classification, manner of presentation, or disclosure."
118. The controlling GAAS standard for examination and reporting of irregularities is SAS
No. 53, entitled "THE AUDITORS RESPONSIBILITY TO DETECT AND REPORT ERRORS
AND IRREGULARITIES," which states in relevant part
[53.03] The term irregularities refers to intentional misstatements oromissions of amounts or disclosures in financial statements.Irregularities include fraudulent financial reporting undertaken torender financial statements misleading, sometimes calledmanagement fraud . . .
[53.05] The auditor should assess the risk that errors and irregularitiesmay cause the financial statements to contain a material misstatement.Based on that assessment, the auditor should design the audit toprovide reasonable assurance of detecting errors and irregularities thatare material to the financial statements. The auditor's responsibilitiesfor detecting misstatements resulting from illegal acts, as defined inSAS No. 54, Illegal Acts by Clients, having a direct and materialeffect on the determination of financial statement amounts is the sameas that for other errors and irregularities.
Effect of Irregularities on the Audit Report. [53.26] If the auditor hasconcluded that the financial statements are materially effected by anirregularity, the auditor should insist that the financial statements berevised and, if they are not, express a qualified or an adverse opinionon the financial statements, disclosing all substantive reasons for hisopinion.
[53.33] Disclosure to the [SEC] may be necessary if, among othermatters, the auditor withdraws because the board of directors has not
45
. .•
taken appropriate remedial action. Such failure may be a reportabledisagreement on Form 8-K.
119. Deloitte was required under SAS No. 53 to (1) have the financial statements revised,
(2) issue a qualified or adverse opinion, or (3) withdraw from the audit and notify the SEC. Deloitte
did none of these, contrary to GAAS.
Deloitte's Conduct Was Reckless Or Intentional
120. Through its knowing or reckless conduct, Deloitte violated GAAS for the
following reasons:
(a) Deloitte failed to perform its work with due care, and to plan and supervise
its audit adequately, as required by GAAS. Under the "Third General Standard" of Statement on
Auditing Standards ("SAS") No. 2, "Ed]ue professional care is to be exercised in the performance
of the audit and the preparation of the report."
(b) Deloitte failed to obtain sufficient competent evidential matter to afford a
reasonable basis for its audit opinion, required by GAAS. Under the "Third Standard of Field Work"
of SAS No. 1, "[s]ufficient competent evidential matter is to be obtained through inspection,
observation, inquiries, and confirmations to afford a reasonable basis for an opinion. When
management omits disclosure required by GAAP from its financial statements, the auditor must
express a qualified or adverse opinion and should provide the disclosure required in its audit report,
Under SAS No. 32, "if management omits from the financial statements, including the
accompanying notes, information that is required by generally accepted accounting principles, the
auditor should express a qualified or an adverse opinion and should provide the information in his
report, if practicable, unless its omission from the auditor's report is recognized as appropriate by
46
, .
a specific Statement on Auditing Standards." Similarly, under SAS No. 58, "Mestrictions on the
scope of his audit, whether imposed by the client or by circumstances, such as . . . the inability to
obtain sufficient competent evidential matter . . . may require him to qualify his opinion or to
disclaim an opinion. In such instances, the reasons for the auditor's qualification of opinion or
disclaimer of opinion should be described in his report."
121. Thus, GAAS required Deloitte to express either a qualified or adverse opinion on Pre-
Paid's financial statements. The failure of Deloitte to do so, in light of the clear warnings raising
red flags about the validity of the Company's financial statements, reflects its knowing or reckless
conduct, making it liable under Section 10(b).
122. Defendant Deloitte, by virtue of its position as independent auditor of Pre-Paid, had
access to key employees of the Company and continual access to and knowledge of Pre-Paid's
confidential corporate, financial, operating, and business infoimation at all relevant times. As a
result of the auditing services it provided to Pre-Paid, Deloitte personnel were frequently present at
Pre-Paid' s corporate headquarters throughout each year. Deloitte knew or recklessly disregarded
Pre-Paid' s true financial and operating condition, and intentionally or recklessly failed to take steps
which, as Pre-Paid' s auditor, it could and should have taken to fully and fairly disclose to the public.
Deloitte falsely represented that its audits of Pre-Paid' s 1998 and 1999 financial statements had been
conducted in accordance with GAAS and wrongfully issued "clean" or unqualified opinions or
certifications that those financial statements fairly presented Pre-Paid' s financial condition and
results of operations in conformity with GAAP.
123. GAAS provides that an audit report state whether a company's financial statements
are presented in conformity with GAAP. The Pre-Paid audit reports issued and signed by Deloitte
47
, .
during the Class Period stated that Pre-Paid's financial statements for each reported period were
presented in conformity with GAAP when such financial statements violated GAAP. Had these
financial statements been prepared in accordance with GAAP, Pre-Paid' s net income, earnings per
share, total assets, and stockholder's equity would have been materially reduced.
124. Deloitte either knew or recklessly disregarded the facts which indicated that Pre-
Paid' s financial statements were materially false and misleading. As a result, Deloitte issued
unqualified opinions on Pre-Paid's fiscal 1998, 1999 and 2000 financial statements when such
financial statements materially overstated the Company's net income, earnings per share, total assets
and stockholders' equity.
Deloitte Failed To Plan and Supervise Its Audit Adequately
125. GAAS provides that an audit is to be adequately planned, and any assistants are to
be properly supervised. Audit planning involves developing an overall strategy for the expected
conduct and the scope of the audit. In planning an audit, the auditor must obtain knowledge of the
matters which relate to the nature of the entity's business, its organization, and operating
characteristics. The auditor must also design the audit to provide reasonable assurance of detecting
errors and irregularities — intentional misstatements — that are material to the financial statements.
In addition, an auditor is required to apply analytical procedures in planning an audit. Analytical
procedures involve comparisons of recorded amounts or ratios developed from recorded amounts.
126. Supervision involves directly the efforts of assistants involved in accomplishing the
objectives of the audit and determining whether those objectives were accomplished. The work
performed by each assistant must be reviewed for adequacy and evaluated to determine whether the
audit results are consistent with the conclusions expressed in the auditor's reports.
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• •
127. In connection with its audit of Pre-Paid' s financial statements for each relevant period
during the Class Period, Deloitte was required by GAAS to obtain knowledge of Pre-Paid' s business,
and apply analytical procedures in planning for its audit. In the course of performing such
procedures, Deloitte knew, or recklessly disregarded, the facts referenced in 113-126, above,
which indicated that it should perform an extensive audit of Pre-Paid's assets, net income, and
expenses.
128. Accordingly, Deloitte either knew or was recklessly indifferent to the fact that Pre-
Paid did not properly amortize and/or write off capitalized commission expenses in violation of
GAAP. Despite this obvious issue, Deloitte failed to develop an adequate strategy for the conduct
and scope of the audit of Pre-Paid' s assets, net income and expenses. Further, Deloitte failed to
supervise and evaluate the work of its assistants in order to determine whether they adequately
audited Pre-Paid's reported assets, net income and expenses. In addition, Deloitte failed to
adequately plan its audit and properly supervise the work of its assistants so as to establish and carry
out procedures reasonably designed to detect the existence of irregularities which materially affected
Pre-Paid' s financial statements.
Deloitte Failed To Obtain Sufficient Competent Evidential Matter
129. GAAS requires that an independent auditor obtain sufficient competent evidential
matter to afford a reasonable basis for an opinion regarding the audited financial statements. Most
of an auditor's work in forming an opinion of a financial statement consists of obtaining and
evaluating evidential matter concerning the assertions contained in the financial statements.
Management's representations are not a valid substitute for the application of audit procedures to
form a reasonable basis for an auditor's opinion of financial statements.
49
130. In the course of auditing Pre-Paid's financial statements during the Class Period,
Deloitte either knew or recklessly disregarded facts which indicated that it had failed to obtain
sufficient competent evidential matter to afford a reasonable basis in opining on Pre-Paid' s financial
statements. Deloitte's staff was frequently present at Pre-Paid corporate headquarters and had access
to Pre-Paid' s private and confidential financial and business information. Despite the availability
of such records and information, Deloitte failed to obtain, through inspection, observations,
inquiries, confirmations and other audit procedures, sufficient competent evidential matter to afford
a reasonable basis for its opinion on Pre-Paid' s financial statements. As a result, Deloitte issued
unqualified opinions on Pre-Paid' s financial statements for 1998, 1999 and 2000 when such financial
statements materially overstated the Company's assets, net income, earnings per share, and
stockholder's equity.
Deloitte Improperly Issued Unqualified Audit Reports
131. GAAS requires that an auditor's inability to obtain sufficient competent evidential
matter constitutes a restriction on the scope of the audit that may require the auditor to qualify or
disclaim an opinion. Informative disclosures in financial statements — financial statement footnotes
— are regarded as reasonably adequate unless otherwise stated in the auditor's report. When
management omits disclosure required by GAAP from its financial statements, the auditor must
express a qualified or adverse opinion and should provide the disclosure required in its audit report.
132. Deloitte failed to issue a qualified or adverse opinion when Pre-Paid's financial
statements omitted disclosures required by GAAP. As alleged above, the disclosures in Pre-Paid' s
financial statements of its assets, net income, earnings per share, and shareholder's equity did not
conform with GAAP. The Company's disclosures in the notes to Pre-Paid' s financial statements
50
,
relating to its policy of accounting for commission expenses were false and misleading.
Nonetheless, Deloitte's audit report — in violation of GAAS — failed to disclose these material
misrepresentations and, as a result, Pre-Paid's financial statements and Deloitte's audit opinions
were false and misleading.
133. GAAS requires that an auditor must exercise due professional care in performing an
audit and in preparing the audit report. GAAS also requires that each audit be planned and
performed with an attitude of professional skepticism.
134. Deloitte failed to exercise due professional care in the performance ofits audit of Pre-
Paid' s financial statements during the Class Period. Deloitte failed to adhere to professional
standards by opining that Pre-Paid' s financial statements were presented in conformity with GAAP
when they were not, inadequately planning and supervising its audit, failing to obtain sufficient
competent evidential matter, and improperly issuing unqualified audit reports.
Additional Scienter Allegations
135. As alleged herein, defendants acted with scienter in that defendants knew or
recklessly disregarded that the public documents and statements issued or disseminated in the name
of the Company were materially false and misleading; knew that such statements or documents
would be issued or disseminated to the investing public, and knowingly and substantially participated
or recklessly acquiesced in the issuance or dissemination of such statements or documents as primary
violations of the federal securities laws.
136. Defendants knew that the SEC, in or about 1994, had challenged one of the very
practices complained of herein, in connection with its review of Pre-Paid's initial public offering
("IPO"). In May 1994, after this SEC challenge, Pre-Paid purportedly began expensing the costs,
51
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, including first year commissions, of acquiring its customers as incurred. Before that, the Company
had amortized them over time. Pre-Paid restated its December 31, 1993, balance sheet, eliminating
90 percent of the Company's net worth. Therefore, all defendants, including Deloitte, were well
aware of the SEC's position and knew that the Company's method of accounting for commissions
created a highly material and misleading effect on the Company's reported worth.
137. However, rather than actually expensing advances as incurred, as Pre-Paid agreed to
do in 1994 after the SEC's review, the Pre-Paid Defendants took substantial liberties with their
interpretation of the word "incurred." Instead of treating the commission advances as being
"incurred" in year. one, the Company took the position that they were now being "incurred" over
three years, despite the fact that the cash amount being advanced to the associates in year one had
not materially changed. This was a change in form, but not substance.
138. Pre-Paid' s then auditor, Price Waterhouse, faced with a recalcitrant client, "resigned"
from the account in August of 1994, and was replaced by Deloitte. At that time, Deloitte was privy
to information regarding any disagreement between Pre-Paid' s management and Price Waterhouse.
139. Since the SEC's challenge in 1993-94, Pre-Paid has not filed a registration statement
for a new stock offering. Thus, the SEC may not have had any occasion to review the matter again
until its recent investigation which was presumably prompted by The Wall Street Journal article of
January 2001 and this lawsuit.
140. Nevertheless, Deloitte was well aware of the SEC' s current investigation with respect
to commission advances when it issued its unqualified audit opinion for Year 2000 on April 27,
2001. Deloitte was reckless in issuing its opinion. Deloitte's recklessness is obvious due to the
magnitude of the impact on the balance sheet and the income statement. The $160 million in
52
commission advances constituted approximately half of the Company's reported assets, and almost
all of the Company's reported stockholders' equity. The pro forma EPS for fiscal 1999 and fiscal
2000 would have been $.57 per share and $.81 per share compared to reported earnings per diluted
share of $1.67 and $1.92 respectively, a material decrease of 58% and 66%. The first quarter, 2001
EPS would have been $.27 as compared to $.60, a material decrease of 55%.
141. As set forth elsewhere herein in detail, the Pre-Paid Defendants, by virtue of their
receipt of information reflecting the true facts regarding Pre-Paid, their control over, and/or receipt
and/or modification of Pre-Paid's allegedly materially misleading misstatements and/or their
associations with the Company which made them privy to confidential proprietary information
concerning Pre-Paid, knew or recklessly disregarded the materially adverse, undisclosed information
throughout the Class Period, as alleged herein. Each Individual Defendant sought to demonstrate
that he or she could lead the Company successfully and generate the growth expected by the market.
The intention of these defendants was to create an impression of growth and to hide a ticking time
bomb of declining growth. These defendants understood the economic reality of the Company's
situation and did everything in their power to prevent the truth from emerging.
142. The Pre-Paid Defendants constantly monitored each of the key factors affecting Pre-
Paid's business. Due to their top executive positions with Pre-Paid and involvement in the day-to-
day management of its business, each Individual Defendant actually knew from internal corporate
documents and conversations with other corporate officers and employees and their attendance at
management and/or Board meetings, the adverse non-public information about the deteriorating
financial condition of Pre-Paid, the problems in growing Pre-Paid's memberships and associates, and
Pre-Paid' s worsening earnings prospects. Each Pre-Paid Defendant actually knew or recklessly
53
disregarded that the public statements about Pre-Paid were false or misleading when made, including
statements about its retention rate, Membership growth and other factors affecting the growth of the
Company.
143. The Pre-Paid Defendants closely monitored the performance of Pre-Paid' s business
via reports which Pre-Paid's Finance Department generated on a weekly and monthly basis. The
Finance Department also distributed monthly financial reports comparing Pre-Paid ' s actual financial
results to projected results. Thus, each Pre-Paid Defendant was apprised of the status of sales, costs,
profitability, new associates, new Memberships, collectibility of advances and cancellations, so that
they knew where Pre-Paid stood in terms of growth as well as Pre-Paid' s actual results compared to
budget. As a result, the Pre-Paid Defendants were constantly aware of the current growth rate for
Pre-Paid, knew that Pre-Paid' s financial condition was deteriorating and learned that Pre-Paid 'S 2001
earnings forecasts could not and would not be achieved.
144. The Company, through the Individual Defendants, other Company employees and
members of the Company's Audit Committee, had knowledge of the Company's true financial
condition and improper accouriting policies.
145. According to a Pre-Paid Proxy Statement dated April 6, 2001, "the Audit Committee
of the Board assists the Board in fulfilling its responsibility for oversight of the quality and integrity
of the accounting, auditing and financial reporting practices of the Company. During fiscal 2000,
the Committee met four times, and the Committee chair, as representative of the Committee,
discussed the interim financial information contained in each quarterly earnings announcement with
the CFO and independent auditors prior to public release."
54
146. Defendant Harp as Chief Financial Officer and Chief Operating Officer had
responsibility for the formulation of the Company's accounting policies and financial reporting.
Moreover, defendant Harp's cash compensation was tied directly to the Company's achievement of
certain earnings per share goals. For fiscal 1999, Harp received a total of approximately $160,000,
of which $40,000 or 25% was a bonus for the Company meeting certain earnings per share criteria.
For fiscal 2000, Harp received a total of approximately $185,000, of which $40,000 or 22% was a
bonus for the Company meeting certain earnings per share criteria. Thus, defendant Harp had a
motive for inflating the Company's earnings and therefore earnings per share.
147. Defendant Pinson, as Controller and chief accounting officer, by virtue of her
positions, had intimate knowledge of the Company's accounting policies and treatment of
commission advances. Pinson also receives a performance bonus based upon certain earnings per
share goals set by the Company.
148. Similarly, defendant Stonecipher had knowledge ofthe Company's commission sales
practices as he was, according to the Company's most recent proxy statement, instrumental in the
conception and development of the sales and commission program. Stonecipher regularly
participated in the recruitment of new associates, and hosted a monthly recruiting conference call
on the second Monday of each month at 10:00 a.m. (CST). In addition, defendant Stonecipher
receives special cash compensation for each new associate who participates in the Company's Fast
Start sales program at a rate of $10 per associate. Stonecipher received $1,230,297, $947,720 and
$654,835 during 2000, 1999, and 1998 respectively under this special compensation plan. In fiscal
2000 alone Stonecipher received approximately $1.4 million in cash compensation, of which more
than $1.2 million was bonus compensation for enticing new associates to sign up for the Company's
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sales program. In fiscal 1999 Stonecipher received approximately $1.1 million in cash
compensation, of which $687,760 was bonus compensation for enticing new associates to sign up
for the Company's sales program. Thus, defendant Stonecipher had an intimate knowledge of the
Company's commission sales practice.
149. Also, according to a Form S-3 dated November 21, 1997, Pre-Paid then established
its Associate Investment Club Stock Purchase Plan (the "Plan"). The Plan was designed to induce
the Company's associates to purchase Pre-Paid stock on a monthly basis, at market prices, via a
monthly bank draft from either a checking or savings account of at least $25. The Company acquired
shares to distribute to its associates through purchases from Stonecipher's personal holdings. Thus,
Stonecipher established an outlet to regularly dispose of his shares at market prices, and thereby
manipulate the price of the stock. He was motivated at all times to maintain an artificially inflated
price for Pre-Paid common stock.
150. Defendant Grunebaum, as a Director and Chairman of the Audit Committee, had
intimate knowledge of the Company's accounting policies, treatment of commission advances, and
true financial condition. From April 24, 2000 through November 28, 2000, Grunebaum dumped
23,700 shares of Pre-Paid stock on the market, reducing his total holdings to only 4000 shares.
151. Defendant Savula, a Director and the Company's most senior sales associate, received
commissions for his own sales, as well as the sales of associates below him in the pyramid. He
received regular commission reports for innumerable associates in his downline, and was intimately
familiar with the Company's policies with respect to commission advances, the accounting therefor,
and the attrition of associates and Members. On October 23, 2000 Savula dumped 15,000 shares,
or approximately 37% of his total holdings on the market, netting proceeds of over $500,000. Savula
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also purportedly makes over $40,000 a day from commissions on his own as well as other associates'
sales of Memberships.
Controlling Persons
152. The Individual Defendants, by virtue of their executive positions at Pre-Paid and
ownership of Pre-Paid stock, were controlling persons of Pre-Paid pursuant to §20(a) of the
Exchange Act. Because of the Individual Defendants' positions with the Company, they had access
to the adverse undisclosed information about its business, operations, products, operational trends,
financial statements, markets and present and future business prospects via access to internal
corporate documents (including the Company's operating plans, budgets and forecasts and reports
of actual operations compared thereto), conversations and connections with other corporate officers
and employees, attendance at management and Board of Directors meetings and committees thereof
and via reports and other information provided to them in connection therewith.
153. It is appropriate to treat the Individual Defendants as a group for pleading purposes
and to presume that the false, misleading and incomplete information conveyed in the Company's
public filings, press releases and other publications as alleged herein are the collective actions of the
narrowly defined group of defendants identified above. Each of the Individual Defendants, by virtue
of his or her high-level positions with the Company, directly participated in the management of the
Company, was directly involved in the day-to-day operations of the Company at the highest levels
and was privy to confidential proprietary information concerning the Company and its business,
operations, products, growth, financial statements and financial condition, as alleged herein. Said
defendants were involved in drafting, producing, reviewing and/or disseminating the false and
misleading statements and information alleged herein, were aware or recklessly disregarded, that the
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• false and misleading statements were being issued regarding the Company, and approved or ratified
these statements, in violation of the federal securities laws.
154. As officers and controlling persons of a publicly-held company whose common stock
was, and is, registered with the SEC pursuant to the Exchange Act, was traded initially on the AMEX
and is currently traded on the NYSE, and governed by the provisions of the federal securities laws,
the Individual Defendants each had a duty to disseminate promptly, accurate and truthful information
with respect to the Company's financial condition and performance, growth, operations, financial
statements, business, products, markets, management, earnings and present and future business
prospects, and to correct any previously-issued statements that had become materially misleading
or untrue, so that the market price of the Company's common stock would be based upon truthful
and accurate information. The Individual Defendants' misrepresentations and omissions during the
Class Period violated these specific requirements and obligations.
155. The Individual Defendants, because of their positions of control and authority as
officers and/or directors of the Company, were able to and did control the content of the various SEC
filings which were signed by them, press releases and other public statements pertaining to the
Company during the Class Period. Each Individual Defendant was provided with copies of the
documents alleged herein to be misleading prior to or shortly after their issuance and/or had_ the
ability and/or opportunity to prevent their issuance or cause them to be corrected. Accordingly, each
of the Individual Defendants is responsible for the accuracy of the public reports and releases
detailed herein and is therefore primarily liable for the representations contained therein.
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No Statutory Safe Harbor
156. The statutory safe harbor provided for forward-looking statements under certain
circumstances does not apply to any of the allegedly false forward-looking statements pleaded in this
Complaint. The safe harbor does not apply to Pre-Paid' s allegedly false financial statements. None
of the written forward-looking statements made were identified as forward-looking statements, nor
was it stated that actual results "could differ materially from those projected." Nor did meaningful
cautionary statements identifying important factors that could cause actual results to differ materially
from those in the forward-looking statements accompany those forward-looking statements. Each
of the forward-looking statements alleged herein to be false was authorized by an executive officer
of Pre-Paid and was actually known by each of the Individual Defendants to be false when made.
FIRST CLAIM
Violation of Section 10(b) Of The Exchange Act AndRule I0b-5 Promulgated Thereunder Against AD Defendants
157. Plaintiffs repeat and reallege each and every allegation contained above as if fully set
forth herein.
158. During the Class Period, Pre-Paid, Deloitte, and the Individual Defendants, and each
of them, carried out a plan, scheme and course of conduct which was intended to and, throughout
the Class Period, did: (i)deceive the investing public, including plaintiffs and other Class members,
as alleged herein; (ii) artificially inflate and maintain the market price of Pre-Paid's common stock;
and (iii) cause plaintiffs and other members of the Class to purchase Pre-Paid's common stock at
artificially inflated prices. In furtherance of this unlawful scheme, plan and course of conduct,
defendants and each of them, took the actions set forth herein.
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159. Defendants (a) employed devices, schemes and artifices to defraud; (b) made untrue
statements of material fact and/or omitted to state material facts necessary to make the statements
not misleading; and (c) engaged in acts, practices, and a course of business which operated as a fraud
and deceit upon the purchasers of the Company's common stock in an effort to maintain artificially
high market prices for Pre-Paid' s common stock in violation of Section 10(b) of the Exchange Act
and Rule I Ob-5. All defendants are sued as primary participants in the wrongful and illegal conduct
charged herein and as controlling persons.
160. In addition to the duties of full disclosure imposed on defendants as a result of their
making of affirmative statements and reports, or participation in the making of affirmative
statements and reports to the investing public, defendants had a duty to promptly disseminate truthful
information that would be material to investors in compliance with the integrated disclosure
provisions of the SEC as embodied in SEC Regulation S-X ( 1 7 C.F.R. Sections 210.01 et seq.) and
Regulation S-K (17 C.F.R. Sections 229.10 et seq.) and other SEC regulations, including accurate
and truthful information with respect to the Company's operations, financial condition and earnings
so that the market price of the Company's common stock would be based on truthful, complete and
accurate information. Deloitte was able to and did control the contents of its own audit opinions.
161. Pre-Paid, Deloitte, and the Individual Defendants, individually and in concert, directly
and indirectly, by the use, means or instrumentalities of interstate commerce and/or of the mails,
engaged and participated in a continuous course of conduct to conceal adverse material information
about the business, operations and future prospects of Pre-Paid as specified herein,
162. These defendants employed devices, schemes and artifices to defraud, while in
possession of material adverse non-public information and engaged in acts, practices, and a course
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of conduct as alleged herein in an effort to assure investors of Pre-Paid' s value and perfounance and
continued substantial growth, which included the making of, or the participation in the making of,
untrue statements of material facts and omitting to state material facts necessary in order to make the
statements made about Pre-Paid and its business operations and future prospects in the light of the
circumstances under which they were made, not misleading, as set forth more particularly herein,
and engaged in transactions, practices and a course of business which operated as a fraud and deceit
upon the purchasers of Pre-Paid's common stock during the Class Period.
163. Each of the Individual Defendants' primary liability, and controlling person liability,
arises from the following facts: (i) the Individual Defendants were high-level executives and
directors at the Company during the class Period and members of the Company's management team
or had control thereof; (ii) each of these defendants, by virtue of his or her responsibilities and
activities as a senior officer and director of the Company was privy to and participated in the
creation, development and reporting of the Company's internal budgets, plans, projections and/or
reports; and (iii) each of these defendants was aware of the Company's dissemination of information
to the investing public which they knew or recklessly disregarded was materially false and
misleading.
164. The defendants had actual knowledge of the misrepresentations and omissions of
material facts set forth herein, or acted with reckless disregard for the truth in that they failed to
ascertain and to disclose such facts, even though such facts were available to them. Such defendants'
material misrepresentations and/or omissions were done knowingly or recklessly and for the purpose
and effect of concealing Pre-Paid's operations, condition and future business prospects from the
investing public and supporting the artificially inflated price of its common stock. As demonstrated
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by defendants' overstatements and misstatements of the Company's business, operations and
earnings throughout the Class Period, defendants, if they did not have actual knowledge of the
misrepresentations and omissions alleged, were reckless in failing to obtain such knowledge by
deliberately refraining from taking those steps necessary to discover whether those statements were
false or misleading.
SECOND CLAIM
Violation of Section 20(a) Of The Exchange ActAgainst Individual Defendants
165. Plaintiffs repeat and reallege each and every allegation contained above as if fully set
forth herein.
166. The Individual Defendants acted as controlling persons of Pre-Paid within the
meaning of Section 20(a) of the Exchange Act as alleged herein. By virtue of their high-level
positions, and their ownership and contractual rights, participation in and/or awareness of the
Company's operations and/or intimate knowledge of the false financial statements filed by the
Company with the SEC and disseminated to the investing public, the Individual Defendants had the
power to influence and control and did influence and control, directly or indirectly, the decision-
making of the Company, including the content and dissemination of the various statements which
plaintiffs contend are false and misleading. The Individual Defendants were provided with or had
unlimited access to copies of the Company's reports, press releases, public filings and other
statements alleged by plaintiffs to be misleading prior to and/or shortly after these statements were
issued and had the ability to prevent the issuance of the statements or cause the statement to be
corrected.
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167. In particular, each of these defendants had direct and supervisory involvement in the
day-to-day operations of the Company and, therefore, is presumed to have had the power to control
or influence the particular transactions giving rise to the securities violations as alleged herein, and
exercised the same.
168. As set forth above, Pre-Paid and the Individual Defendants each violated Section
10(b) and rule 10b-.5 by their acts and omissions as alleged in this Complaint. By virtue of their
positions as controlling persons, the Individual Defendants are liable pursuant to Section 20(a) of
the Exchange Act. As a direct and proximate result of defendants' wrongful conduct, plaintiffs and
other members of the Class suffered damages in connection with their purchases of the Company's
securities during the Class Period.
Prayer For Relief
WHEREFORE, plaintiffs pray for judgment as follows:
A. Declaring this action to be a proper class action pursuant to Rule 23;
B. Awarding plaintiffs and the members of the Class damages, interest and costs;
and
C. Awarding such equitable/injunctive or other relief as the Court may deem just
and proper.
Jury Demand
Plaintiffs demand a trial by jury.
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• DATED this day of June, 2001
Respectfully submitted,
A4 - 400-v r
I/William r... ederman, OBA #2853
Stuart W. Emmons, OBA #12281DREIER BARITZ & FEDERMAN120 N. Robinson, Suite 2720Oklahoma City, OK 73102(405) 235-1560/FAX: (405) 239-2112Plaintiffs' Liaison Counsel
SCHIFFRIN & BARRO WAY, LLPAndrew L. BarrowayDavid KesslerFadia EliaThree Bala Plaza East, Suite 400Bala Cynwyd, PA 19004Tel: (610) 667-7706Fax: (610) 667-7056
WOLF HALDENSTEIN ADLERFREEMAN & HERZ LLP
Daniel W. KrasnerFred T. IsquithNikki MontgomeryGustavo Bruckner270 Madison AvenueNew York, NY 10016Tel: (212) 545-4600Fax: (212) 545-4653Plaintiffs' Co-Lead Counsel
334228
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CERTIFICATE OF SERVICE
i(15>I certify that on the f day of June, 2001, the foregoing document was served on thefollowing by First Class Mail, postage pre-paid:
Robert P. Varian, Esq.Margaret M. Snyder, Esq.BROBECK, PHLEGER & HARRISON, LLPSpear Street TowerOne MarketSan Francisco, CA 94105Tel: (415) 442-0900Fax: (415) 442-1010
James L. Kincaid, Esq.Jeffrey T. Hills, Esq.CROWE & DUNLEVY500 Kennedy Building321 S. BostonTulsa, OK 74103Tel: (918) 592-9800Fax: (918) 592-9801
Brooke S. Murphy, Esq.CROWE & DUNLEVY1800 Mid-America Tower20 North BroadwayOklahoma City, OK 73102-8273Tel: (405) 235-7700Fax: (405) 239-6651
William
1 /
; . Federman
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