FILED0`0 "IN THE UNITED STATES DISTRICT COURT FOR THE r o~ j~ US 2002
WESTERN DISTRICT OF OKLAHOMA
aiTEF-UDISTOF0J.S. Dl.F C" i
z,!^£PS1T
)In re Pre-Paid Securities , Inc., Litigation Master Docket
No. CIV-O1-0182- C
ORDE R
BACKGROUND
Defendants Pre-Paid Legal Services, Inc . ("Pre-Paid"), Harland C . Stonecipher, Randy
Harp, Kathleen S . Pinson, Peter K . Grunebaum, and David A . Savula (collectively, "the
Pre-Paid defendants") and defendant Deloitte & Touche, LLP ("Deloitte") have submitted
motions to dismiss plaintiffs ' amended class action complaint under Fed. R. Civ. P. 12(b)(6)
and 9(b), and the Private Securities Litigation Reform Act of 1995, 15 U .S .C. 78u-4 (b) (the
"PSLRA") . The Pre-Paid defendants have also filed a Request for Judicial Notice ("RN") .
Finally, the Pre-Paid defendants have filed a motion for oral argument . Plaintiffs have filed
responses to all motions .
On January 17, 2001, The Wall Street Journal published an article entitled "Pre-Paid
Legal Draws Criticism on Accounting for Commissions ." Pre-Paid's stock closed that day
at approximately 20-7/8 . The week following the article, the first of many complaints in thi s
litigation were filed and the Securities Exchange Commission ("SEC") began an informa l
inquiry into Pre-Paid's accounting practices . Defendant Deloitte was not named in the initia l
wave of complaints, but was added to the Amended Complaint on June 14, 2001 . The class
action was brought on behalf of all purchasers of the common stock of Pre-Paid from Marc h
18, 1999, through May 15, 2001 (the "Class Period") .
The suit alleges that Pre-Paid and certain of its senior officers and directors violate d
the Securities Exchange Act of 1934 (the "Exchange Act") . The prolix allegations in the 63-
page complaint allege that the defendants made false and misleading public statements in
order to overstate earnings which materially falsified the company's financial condition ,
resulting in an artificially inflated stock price . Deloitte participated in this scheme, according
to plaintiffs, by knowingly or recklessly disregarding Pre-Paid's true financial operating
condition and failing to fully and fairly disclose it to the public .
Pre-Paid designs, underwrites, and markets legal expense plans . These plans, calle d
memberships, provide for a variety of legal services and are similar to medica l
reimbursement plans. Memberships sold by Pre-Paid allow members to access legal service s
through a network of independent law firms . Pre-Paid utilizes a multi-level marketing
program where sales people ("associates ") are paid commissions both on what they sel l
personally and on sales by new associates they recruit .
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 the expected annual commissions . If new
members cancel their policies before three years' time, associates are obligated to repay th e
commission advances to the company . The company can immediately recover 50% of an
associate's commission advances from "charge-backs" to that associate's commissions on
2
future sales . The remaining 50% can be recovered from commissions due on previously sold
memberships , if existing members renew after three years .
The Wall Street Journal article, subsequent informal SEC inquiry, and this lawsuit
stem from accounting practices on the part of Pre-Paid where the commission advances wer e
counted as assets rather than liabilities on its balance sheet. Pre-Paid's theory was that it wa s
to be reimbursed for the advances as policy premiums came due ; in other words, Pre-Pai d
had the right to receive those amounts back from the sales associates in the future . Pre-Paid
argues that under the accrual method of accounting, this is the proper way to record a
receivable . A major feature of accrual method of accounting is that a future right to receiv e
money is treated as if money were already received ; until events arise which indicate that
actual receipt of payment will be highly unlikely . Lomas & Nettlecon Financial Corp. v.
United States, 486 F . Supp . 652 (N.D. Tex . 1980) ; see also 26 U.S.C . § 446 (2001) ; General
rule for methods of accounting. The plaintiffs maintain that this practice was in violation of
Generally Accepted Accounting Principles (GAAP), an allegation that the Pre-Paid
defendants and Deloitte vigorously dispute .
Therefore, the crux of this lawsuit is a debate over how the commission advance s
should have been recorded on Pre-Paid's balance sheets . Plaintiffs' main contention is that
recording these advances as assets , which they contend was a material misstatement, vastly
overstated Pre-Paid's financial condition, resulting in investors looking more favorably on
Pre-Paid stock than if the material misstatements of Pre-Paid's financial condition had no t
occurred .
3
On May 15, 2001, the last day of the class period , Pre-Paid disclosed that it ha d
received a letter from the SEC stating that, according to the SEC's informal inquiry ,
Pre-Paid ' s accounting for commission advances was not in accordance with GAAP.
Pre-Paid's stock price fell from $19/share on May 15, 2001, to approximately S 14/share o n
May 16 . Pre-Paid appealed the SEC's informal finding and has , since the filing of this
lawsuit, lost its appeal .
Plaintiffs have put forth two claims against the defendants . The first is a violation of
§ IOb of the Securities and Exchange Act, and Rule I Ob-5 promulgated thereunder, agains t
all defendants . The second is a violation of § 20a of the Securities and Exchange Act agains t
the Pre-Paid individual defendants, i.e., Stonecipher, et al.
DISCUSSION
1 . Rule 12(b)(6)
Defendants seek dismissal of the amended class action complaint pursuant to Rul e
12(b)(6) of the Federal Rules of Civil Procedure . A complaint will be dismissed under Rul e
12(b)(6) "only when it appears that the plaintiff can prove no set of facts in support of th e
claims that would entitle the plaintiff to relief." Roman v . Cessna Aircraft Co ., 55 F.3 d 542 ,
543 (10' Cir . 1995) (quotations omitted) . In considering a Rule 12(b)(6) motion the Court
"must accept all the well-pleaded allegations of the complaint as true and must construe them
in the light most favorable to the plaintiff." Id. (quotations omitted) . However, in
considering a Rule 12(b)(6) motion in the securities fraud context, a court may conside r
public disclosure documents filed with the SEC, as well as documents upon which plaintiff
4
has relied in bringing suit . Considering these documents does not require converting th e
motion to one for summary judgment . Mark v. Fleming Companies, Inc., No .
CIV-96-506-M, Order at 3 , n. 6 (W.D . Okla. 2000), citing Cortec Indus., Inc. v. Sum
Holding, L.P., 949 F.2d 42, 47-8 (2d Cir . 1991) .' Thus, in conside ring the present motions
to dismiss, and in accordance with precedential securities fraud case law (as well a s
defendants ' Request for Judicial Notice) the Court has taken judicial notice of numerou s
documents, a list of which is appended to this Order as Appendix "A." Finally, the Court
"accepts as true all well-pleaded facts, as distinguished from conclusory allegations . "
Inlercon, Inc. v. Bell Atlantic Internet Solutions, Inc ., 205 F .3d 1244, 1247 (10th Cir . 2000) .
II. Section 10b/Rule 10b-5 Claims
A. Introduction
Section 10b of the Securities and Exchange Act provides, in pertinent part :
It shall be unlawful for any person, directly or indirectly, by theuse of any means or instrumentality of interstate commerce o r
A finding that plaintiff has had notice of documents used bydefendant in a 12(b)(6) motion is significant since . . . theproblem that arises when a court reviews statements extr aneousto a complaint generally is the lack of notice to the plaintiff thatthey may be so considered ; it is for that reason -- requiringnotice so that the party against whom the motion to dismiss ismade may respond -- that Rule 12(b)(6) motions are ordinarilyconverted into summary judgment motions . Where plaintiff hasactual notice of all the information in the movant's papers andhas relied upon these documents in framing the complaint thenecessity of translating a Rule 12 (b)(6) motion into one underRule 56 is largely dissipated . Cortec, 949 F .2d at 48 .
5
of the mails , or of any facility of any na tional securitiesexchange
(b) to use or employ, in connection with the purchase orsale of any security registered on a national securities exchangeor any security not so registered, any manipulative or deceptivedevice or contrivance in contravention of such rules andregulations as the capital commission may prescribe asnecessary or appropriate in the public interest or for theprotection of investors .
15 U .S.C. § 78j(b) .
Rule 10b-5 provides, in pertinent part :
It shall be unlawful for any perso n
(b) to make any untrue statement of a material fact or toomit to state a material fact necessary in order to make thestatement made, in light of the circumstances under which theywere made, not misleading . . .
in connection with the purchase or sale of any security .
17 C.F .R. § 240.1Ob-5 .
B. Pleading Standard for § 10b Claim s
Under the PSLRA, a complaint asserting a violation of § 10b : "shall specify each
statement alleged to have been misleading, the reason or reasons why the statement i s
misleading . . . . "
Moreover, the pleading requirement for scienter, which is an essential element of a
§ IOb claim, is higher yet . Allegations of scienter require a plaintiff to : "with respect to
each act or omission alleged to violate this chapter, state with particularity facts giving ris e
to a strong inference that the defendant acted with the required state of mind ." "[S]cienter
6
has been defined by the Supreme Court of the United States as a `mental state embracing
intent to deceive , manipulate , or defraud . "' City ofPhiladelphia v. Fleming Companies, 264
F.3d 1245 , 1258 (10' Cir. 2001) ; quoting Ernst & Ernst v. Hoch/elder, 425 U .S. 185, 193
n. 12 (1976). Recklessness, defined as "`conduct that is an extreme departure from th e
standards of ordinary care, and which presents a danger of misleading buyers or sellers tha t
is either known to the defendant or is so obvious that the actor must have been aware of it, " '
Anixter v. Home -Stake Prod. Co., 77 F . 3 d 1215 , 1232 ( 10`x' Cir . 1996), quoting Hackbart v .
Holmes, 675 F.2d 1114 (10`x' Cir . 1982), can also satisfy the scienter requirement for Sectio n
10(b). "Simple negligence , however , does not satisfy the scienter requirement ." City of
Philadelphia at 1258 . Further, "[p]laintiffs should not be allowed to proceed with allegation s
of `fraud by hindsight ' . . . a plaintiff must set forth, as part of the circumst ances constituting
fraud, an explanation as to why the disputed statement was untrue or misleading when
made." City of Philadelphia at 1260, quotingGrossman v. Novell, Inc. , 120 F .3 d 1112 (10th
Cir. 1997) (emphasis in original ) . Finally , a complaint that does not meet the requirements
of § 78u-4(b)(1) and (2) shall be dismissed . 15 U.S.C. § 78u-4(b)(3) .
C. Essential Elements of § 10b/Rule 10b-S claims
"To state a claim under [Section lOb/Rule lOb-5], a plaintiff must allege : (1) a
misleading statement or omission of a material fact; (2) made in connection with the
purchase or sale of securities ; (3) with intent to defraud or recklessness ; (4) reliance; and
(5) damages ." Mark Order at 15, citing Grossman, 120 F.3d at 1118 . In the instant motions ,
both the Pre-Paid defendants and Deloi tte challenge the third element, scienter . The Court
7
finds that the plaintiffs have not sufficiently pled scienter as to either the Pre-Paid defendant s
or Deloitte as discussed separately and more fully below .
D. Pre-Paid Defendants
1 . Scienter
In September 2001, the Tenth Circuit ruled definitively on the "strong
inference" of scienter required under § 78u-4(b)(2) . Therefore, this Court relies on the
precedent set in City of Philadelphia., 264 F . 3d at 1262 ("courts must look to the totali of
the pleadings to determine whether the plaintiffs' allegations permit a strong inference o f
fraudulent intent" (emphasis added )) . Under the rule of law in City of Philadelphia, the
Court finds that the pleadings , in their totality , do not raise the strong inference of sciente r
against the defendants necessary to defeat the motion to dismiss . There are diametrically
opposed views of the accounting methods in question , but differing views , without more, d o
not lend credence to a charge of fraud . Rather than prolix and conclusory allegation s
consisting of boilerplate accounting theory ("financial reporting should be reliable, "
Amended Complaint at 40), the plaintiffs are required under the PSLRA to show a court
when , where , and how a fraud was perpetrated . The Court below lists the "meat" of the
allegations in the Amended Complaint :
41 . On April 19, 1999 , [in a press release ] Pre-Paid reported record results for thefirst quarter of 1999 ended March 31, 1999 .
42. The information in the April 19, 1999, press release was false and misleadingwhen made in that Pre-Paid failed to disclose information known to thePre-Paid defendants or recklessly disregarded by them including-
8
(a) Pre-Paid's financial situation was deteriorating rather than improvingdue to the large and growing membership commission advances whichwere classified as "assets" in the company's financial statement, butwere not, in reality, assets at all ;
(b) The Pre-Paid defendants materially overstated the company's incomebecause they failed to take adequate reserves for losses on uncollectiblecommission advances ;
(c) Pre-Paid ' s reported earnings were materially overstated due toimproper capitalization of current expenses and failure to write offuncollectible receivables in violation of GAAP as described in ¶¶ 101,102 ;
(d) Pre-Paid's commission advances were increasing faster than revenueand thus, without the accounting fraud, the company could not claimit was in the best financial condition in its history;
(e) Despite the faster growth of commission advances, Pre-Paid failed tochange the company's allowance for estimated unrecoverablecommission advances which has remained unchanged at $4 .5 millionfor more than a year ;
(f) Cancellation rates on memberships were increasing, making it moredifficult for Pre-Paid to recoup its commission advances fromassociates ;
(g) Pre-Paid's membership growth rate was slowing and an increasingnumber of associates were not making any sales, which would in turnlead to increased defections and uncollectible commission advances;
(h) As the growth in those completing the Fast Start program, which wasinstituted in 1997 to increase productivity and for which each associatepaid $249 to participate, slowed, a smaller proportion of associateswere actually making sales which resulted in a greater number whowere inactive and would not pay back advances ;
(i) It was materially false and misleading to trumpet positive cash flowwithout disclosure that the company did not collect "charge-backs" ifa customer cancels a policy before three years . In fact, only 26% of theassociates made a sale during the nine months ended September 30 ,
9
2000, and thus the Pre-Paid defendants knew or recklessly disregardedthat it is impossible to dock an associate's renewal commissions if theyhave not sold any policies. In addition, Pre-Paid never pursued its legalremedies against the associates ;
O Pre-Paid ' s persistency rate which purpo rted to represent the ability ofthe company to retain memberships did not in fact reflect thatinformation and instead presented an art ificially inflated picture of thecompany ' s ability to retain memberships . Instead of a persistency rateof approximately of 75%, the company actually retained only 53 .37%of members after one year , 36.97% after two years and 28 .66% ofmembers after three years ;
(k) Pre-Paid's balance sheet combines or "pools" receivables fromassociates and commission advances . This prevents investors fromdetermining which portion is being written down and which portion isnot. If these two groups had not been pooled, Pre-Paid's net incomewould have been reduced ;
(1) The fact that Pre-Paid has not written off any commission advances asunrecoverable gives investors the false impression that the companywill be able to recover commission advances by charge-backs to salesassociates .
74 . On January 25, 2001 , Pre-Paid filed an 8-K with the SEC to provide detailsregarding the accounting treatment of the commission advances and expenses .For the first time , Pre-Paid detailed its "membership retention rate ." The chartit provided showed that within one year , membership retention falls to53 .37%; after two years it falls to 36 .97%; and after three years it falls to28 .66% . These percentages are a far cry from the 75 .1% persistency rate thatPre-Paid publicly proclaimed measured the company ' s ability to retainmembers . If the retention rate information provided in the 8-K had been givento sales associates , it is likely that many ofthem would never have signed upsince the chances of being successful are de minimis if high percentages ofmemberships cannot be retained . The result of accurate retention rateinformation would have caused a dramatic downtu rn in the growth of thecompany since a multi-level marketing company requires a steady stream ofnew salespeople to fuel its growth . The misrepresentation of the persistency
I0
rate during the class period was material as was the omission of the trueretention rates for years one, two, and three after a membership is sold .
80 . Pre-Paid filed its Form 10-K for 2000 on April 27, 2001 . In it, Pre-Paidfinally made the distinction between the persistency rate (which it hadpreviously defined as the ability of the company to retain a membership) andthe expected economic life of a new member . In its 2000 10-K, Pre-Paiddefined the persistency rate as the number of memberships in force at the endof a year as a percentage of the total membership in force at the beginning ofsuch year plus new memberships sold during such year. In its 2000 10-K,Pre-Paid no longer asserted that the persistency rate represents the ability ofthe company to retain a membership . The expected economic life of a newmember is defined as the average number of years that a new member isexpected to renew .
101 . Pre-Paid amortized the costs of commission advances over three years eventhough the average life of members was closer to two years . Pursuant toGAAP, as set forth in Accounting Principles Board Opinion ("APB") No . 17,such intangible assets should be amortized over the period expected to bebenefitted by the cost . FASB 60 states that acquisition costs, which includecommissions, shall be capitalized and charged to expense in proportion topremium revenue recognized . Without disclosing the life of the policies, aninvestor cannot determine whether the amortization period is appropriate . Inaddition, once the policy is terminated the associated commission advanceshould be expensed immediately because there is no longer any futureeconomic benefit. In violation of GAAP, Pre-Paid selected an unjustifiablylong period so that Pre-Paid's quarterly amortization expense would beunderstated and its quarterly income materially overstated .
102 . GAAP, as set forth in SFAS No . 5, requires that a loss be recognized for theuncollectible portion of receivables or groups of receivables where it isprobable that a receivable is uncollectible and the amount of loss c an bereasonably estimated .
1l
112 . Defendants failed to disclose that the average life of a policy is less than threeyears . They have no justification for having advanced three years ofcommissions and then not writing off the remaining balance on an advancewhen a membership was not renewed and the associate who sold the policystopped selling policies .
Taken as true, and not necessarily in their entirety, those paragraphs lend themselve s
to an inference that the Pre-Paid defendants at least violated GAAP . However, "allegations
of GAAP violations or accounting irregularities , standing alone , are insufficient to state a
securities fraud claim ." City of Philadelphia, 264 F . 3d at 1261 ; quoting Novak v. Koasks,
216 F.3d 300, 309 (2nd Cir. 2000). "Only where such allegations are coupled with evidence
that the violations or irregularities were the result of the defendant ' s fraudulent intent to
mislead investors may they be sufficient to state a claim ." City of Philadelphia at 1261 .
"[M]otive and opportunity may be important to that totality, but are typically not sufficien t
in themselves to establish a `strong inference ' of scienter ." City of Philadelphia at 1262.
Thus the Court, inferring that the defendants violated GAAP, next weighs any motive and
opportunity that "would entail concrete benefits that could be realized by one or more of th e
false statements and wrongful non-disclosures alleged ." City of Philadelphia at 1261 ,
quoting Novak at 307 .
2 . Motive
On April 6, 1999, the Company announced a stock repurchase program
authorizing management to reacquire up to 500, 000 shares of the Company's common stock .
The Board of Directors increased such authorization from 500,000 shares to 3,000,00 0
shares during subsequent board meetings . By March 31, 2001, the Company had
12
repurchased 2,456,991 shares under these authorizations for a total considera tion of $56 . 4
million, at an average price of $22.94 per share . The Court notes that this average p rice is
above the 20-7/8 closing price on January 17, 2001 (the date of the Wall Street Journal
article that was the impetus for this lawsuit) . Further, there is no allegation that the
purchased shares were later sold at a profit . It appears patently absurd for a corporation t o
fraudulently inflate the price of its stock only to then purchase the stock (during the clas s
period) at such inflated prices without any financial benefit .
The only allegations of profiteering are "dumping" by two of Pre-Paid's outsid e
directors and a scheme by Pre-Paid's CEO to sell some of his privately-held stock throug h
the employee stock purchase plan . The Court finds the CEO' s scheme to be a misnomer
because the stock purchase plan was begun in 1997, well before the class period . Further,
Mr. Stonecipher only disposed of approximately 28,000 shares during the class period ; a
small percentage of his total Pre-Paid holdings of over one million shares .
As far as the outside directors ' alleged dumping , the Court is guided by City of
Philadelphia at 1270, quoting Phillips v. LCI Intl, Inc., 190 F .3d 609 (4`h Cir . 1999) ("T o
support a claim of motive based on the benefit a defendant derives from an increase in th e
value of his holdings, a plaintiff must demonstrate some sale of `personally-held stock' o r
`insider trading' by the defendant" (citations omitted)) . Here, there was selling of personally
held stock by the outside directors ; however, the Court finds these trades innocuous in ligh t
of the relatively small proportion of shares sold and/or the lack of showing of inflated stock
price .
13
Mr. Savula sold 15,000 shares on one day in the Class Period . The Court finds that
the plaintiffs failed to account for Mr. Savula's stock options when describing the amoun t
of his holdings . In Re Credit Acceptance Corporation Sec. Lit., 50 F . Supp .2d 662, 677 (E .D .
Mich. 1999) ("[t]he ownership of options must be considered in evaluating the Defendant s
[sic] stock sale activities" (citations omitted)) . Divestment of 21% of one's holdings doe s
not lend itself to an inference of unusual trading on the pa rt of Mr . Savula . See Havenick v.
Network Express, Inc., 981 F.Supp. 480, 528 (E.D. Mich . 1997) (inference of insider sales
rebutted by the fact that the defendants retained 85%, 81%, 75%, 68%, and 80% of
holdings) .
With regard to Mr . Grunebaum, plaintiffs make no concrete allegations, other than
conclusory, that Grunebaum sold Pre-Paid stock at an inappropriately inflated price . Simply
because the plaintiffs claim that the stock was inflated during the class period does no t
transform stock trades during the class period into insider trading . An examination of Mr .
Grunebaum's Form 4 trading history shows that his trades from April through Novembe r
2000 were not out of the ordinary . He made trades (both selling and purchasing ) ranging
from 1,000 to 6,000 shares going back to November 1998 . The trades by Grunebaum appear
to be normal trading in his privately-held stock .
3. Other Issues
For seven years, the defendants operated under what they considered a prope r
interpretation of GAAP and, in 2001, the SEC disagreed . An informal SEC inquiry resulted
in a change in Pre-Paid's accounting . As a result, Pre-Paid restated its financials for 2000
14
and the first quarter of 2001 . This restatement resulted in a reduction to Pre -Paid' s
cumulative income of $4 .109 million and a reduction of Pre-Paid's after-tax income fro m
$47 .7 million to $43 . 6 million (approximately 8 .5%), hardly a precipitous reduction . The
plaintiffs also cannot ignore that an examination of Pre-Paid's SEC filings made well befor e
and during the class period shows how Pre-Paid treated the advance commissions as asset s
rather than liabilities. Plaintiffs' own Amended Complaint admits as much at paragraph 35 ,
"[m]uch of this "asset" was essentially a questionable receivable at best." Pre-Paid als o
clearly stated in the SEC filings that the commission advances represented a risk should th e
advances not be collected or offset . See RJN, Exhibit R at 16 .
The plaintiffs' issue with the defendants is that when a controversial accountin g
interpretation was found to be an issue by the SEC , Pre-Paid's stock p rice fell . Given that
the crux of the argument is a disagreement in accounting principles, the Court must conclud e
that a strong inference is lacking that, based on the totality of the allegations of the Amende d
Complaint, the Pre-Paid defendants possessed the requisite intent to defraud the market . The
defendants have never denied that they utilized a controversial method of accounting, and
in fact, they continue to stand behind their methods . Even though the market was well awar e
of Pre-Paid ' s accounting practices , at least as far back as 1998 , Pre-Paid was never shown
to file an "incorrect" SEC document until May 11, 2001 .
The Court 's role here is to take the facts of plain tiffs in their best possible light an d
decide whether they should be allowed to present evidence to prove the facts alleged . The
Court finds that examining the totality of the facts pled, the plaintiffs have not sufficientl y
15
pled a cause of action for securities fraud against the Pre-Paid defendants . For the reasons
set out more fully above, the plaintiffs' Amended Complaint is hereby dismissed as agains t
the Pre-Paid defendants .
4. Rule 20(a)
The plaintiffs assert a Rule 20 (a) claim against the Pre-Paid defendants only .
Rule 20(a) states, in relevant part :
Every person who, directly or indirectly, controls any personliable under any provision of this chapter or of any rule orregulation thereunder shall also be liable jointly and severallywith and to the extent as such controlled person is liable .
15 U .S .C. § 78t. "[T]o state a prima facie case of control person liability, the plaintiff mus t
establish (1) a primary violation of the securities laws and (2) `control' over the primar y
violator by the controlling person ." Maher v. Durango Metals, Inc., 144 F.3d 1302, 130 5
(10' Cir . 1998) . Because the Court finds that the primary claims of securities law violation s
are insufficient to support a claim for fraud, the individual Pre-Paid defendants cannot b e
found liable for a cause of action that must necessarily piggy-back on a claim for fraud .
Because the fraud claim is dismissed , so must be the Rule 20(a) claim .
E . Deloitte & Touche
1 . Scienter
There is no dispute that during the class period Deloitte signed off on all o f
Pre-Paid's financials . There is no dispute that a potential Pre-Paid investor might hav e
viewed Deloitte' s imprimatur that Pre-Paid' s financials were in order as a "material" factor
16
in deciding to purchase Pre-Paid stock. But a reading of the allegations in the Amended
Complaint, that Pre-Paid's financials were not proper and Deloitte signed off on th e
financials as proper, does not give rise to a fraud . The facts, as twice pled, do not show that
Deloitte intended to deceive, manipulate, or defraud the market for Pre-Paid stock .
"Plaintiffs merely recite a specific standard, and then assert, generally without muc h
elaboration, that [Deloitte] knowingly violated that standard. And when Plaintiffs do
augment their assertions , they do so based on [Deloi tte's] assumed `knowledge' of the
additional conclusory allegations discussed immediately above ." Queen Uno Ltd.
Partnership v. Coeur D'Alene Mines Corp ., 2 F.Supp .2d 1345 , 1361 (D . Colo. 1998). "The
mere misapplication of accounting principles by an independent auditor does not establis h
scienter ." Id. The same is true here . The SEC 's le tter in no way lends itself to the finding
that Deloitte was engaged in a fraud against the investors of Pre-Paid Legal Services .
Construing the pleaded facts in favor of the plaintiffs, there is simply no cause of actio n
stated against Deloitte & Touche .
2. Statute of Limitation s
Deloitte has also moved for dismissal on statute of limitations grounds .
Deloitte correctly states that, to be timely, suit "must be commenced within one year afte r
the discovery of the facts constituting the violation and within three years after suc h
violation." Lampf, Pleva, Lipkind, Prupis & Petigrow v . Gilbertson, 501 U.S . 350, 364
(1991). Deloitte also correctly notes that the one-year limitations period "begins to run eve n
when a plaintiff is placed on `inquiry notice' of possible misrepresentations ."' Anixter v.
17
Home-Stake Prod. Co., 939 F .2d 1420, 1437 (citations omitted), amended on rehearing 94 7
F .2d 897 (10t" Cir . 1991). The Anixter court stated that inquiry notice facts consist o f
"sufficient storm warnings to alert a reasonable person to the possibility that there [are] eithe r
misleading statements or significant omissions involved in the sale ." Id. (citations omitted) .
In this case, the very article cited by plaintiffs in the Amended Complaint begins ,
"[f]or the better part of two years , this column has, in one form or another, pointed out
accounting and growth related issues with Pre-Paid Legal Services ." "Why Short-Sellers are
Still Courting Pre-Paid Legal Services" TheStreet. com, December 6, 2000 . Thus, the Court
finds that the plaintiffs were on inquiry notice of Pre-Paid ' s accounting methods as early as
1998 - three years prior to the filing of this lawsuit . But the Court's inquiry does not end
there. The Tenth Circuit has stated, "the article put Plaintiff[s] on inquiry notice, triggering
the duty to exercise reasonable diligence ." Sterlin v. Biomune Systems, 154 F. 3d 1191, 1204
(10`x' Cir . 1998 ) ("Sterlin I") . Thus , the Court must next examine when, in the exercise of
reasonable diligence, plaintiffs should have discovered the facts underlying the allege d
fraudulent activity .
The plaintiffs argue that though the knowledge in the marketplace may have bee n
sufficient for inquiry notice , an "investor could not have deduced . . . violat[ions of] GAAP ,
or that the efforts to collect charge-backs on commission advances were a sham, or that [the]
reserve against uncollectability was totally inadequate ." Response at 25-26. However, the
Court finds that a reasonably diligent investor could have investigated the allegations agains t
Pre-Paid using the information in the public SEC documents alone . As stated above, an
18
examination of the SEC filings made well before and during the class period shows that th e
advance commissions were treated as assets rather than liabilities . Again, the Complain t
itself states, "[m]uch of this "asset" was essentially a questionable receivable at best . "
Amended Complaint ¶ 35 . Pre-Paid also clearly stated in the SEC filings that the
commission advances represented a risk should the advances not be collected or offset an d
listed the amount of its rese rve funds . See RJN, Exhibit R at 16.
The Court finds that a clear controversy in the accounting methods, as publicized i n
the media, put a reasonably diligent investor on inquiry notice of the controversy at leas t
three years prior to the filing of this action . Further, the accounting methods were
concurrently stated in the SEC filings, albeit in a manner disagreeable to the plaintiffs, and
thus discoverable by a reasonably diligent investor . Thus, because a failure to meet the
statute of limitations is a non-remedial jurisdictional bar to suit, Deloitte & Touche i s
dismissed from this case with prejudice .
F. Fraud on the Market
Though the Court finds the lack of scienter on the part of the defendants sufficient t o
dismiss this action, the Amended Complaint also fails as a matter of law because the marke t
was aware of Pre-Paid's accounting practices and there can be no securities fraud liabilit y
for failing to disclose that which is in fact disclosed or known to the market . See Heliotrope
Gen. Inc. v. Ford Motor Co., 189 F.3d 971, 975 (9t'' Cir . 1999) ("an omission is actionabl e
`only if the information has not already entered the market"') (cita tion omi tted)) .
Therefore, an examination of the parties ' dispute regarding the fraud-on-the-market theory
19
and the truth-on-the-market defense is relevant to a complete analysis of the issues before
the Court .
"Under the fraud- on-the -market theory, the market incorporates into a stock's p rice
all publicly available information ." Id. at 976-77, citing Basic, Inc . v. Levinson, 485 U.S .
224, 246 (1988 ) . Plaintiffs have chosen to bring this ac tion under the fraud-on-the-market
theory and the Supreme Court has spoken specifically to the issue of publicly available
information. "[T]he market price of shares traded on well-developed markets reflects al l
publicly available information ." Basic at 246 . Plaintiffs' own pleadings show that, at least
as early as 1998, the market was aware of Pre-Paid's controversial accounting practices .
Finally, the very article cited by plaintiffs begins, "For the better part of two years, this
column has, in one form or another, pointed out accounting and growth related issues wit h
Pre-Paid Legal Services ." "Why Short-Sellers are Still Courting Pre-Paid Legal Services, "
TheStreet. com, December 6, 2000. Thus, the author of the article cited by plaintiffs ha d
"pointed out accounting . . . issues" since 1998 - even before the start of the class period .
The Court finds the plaintiffs ' claim that the 2001 SEC ruling was a "wake-up call" to a
controversy is belied by the existence of the art icle mentioned above. Further, as the above
article states, Pre-Paid's stock price had already precipitously fallen off of its Novembe r
2000 high of 48-7/5 .
This information in the marketplace during the class period also belies plaintiffs '
reliance on In re Resource America Securities Litigation, No. CIV. 98-5446, 2000 W L
1053861 (E.D . Pa . July 26, 2000). In that case the court found that "before the truth on th e
20
market defense can be applied, the defendants must prove that the information that wa s
allegedly withheld or misrepresented was `transmitted to the public with a degree of intensity
and credibility sufficient to effectively counterbalance any misleading impression created by
defendant 's statements ." Id at *3 (cita tions omi tted). Here , Plaintiffs have proved this fo r
the defendants by citing the Street. com article. Further, the information was not withheld
by Pre-Paid and then disclosed ; rather, the information regarding Pre-Paid's accounting
methods had been publicly known for some time . The evident purpose of the article was t o
continue to enlighten investors about Pre-Paid's questionable practice of bookin g
commission advances as receivables. It is clear that the publicized information was
sufficiently controversial and is to be presumed to have been re flected in the market pric e
of the stock under Basic. Finally, the Resource America court found that when Off Wall
Street Reports discussed accounting improprieties of that comp any, the "stock decline d
markedly." Resource America at * 15 . Here, the stock price actually rose the day after the
Street. com article. This leads to an inference that the information in the December 6 articl e
was not new to the market .
CONCLUSIO N
The Court finds plaintiffs have failed to allege facts sufficient to state a claim against
any named defendant for the reasons stated here . Because it does not appear that any
amendment would be successful in overcoming the pleading deficiencies, this action i s
dismissed with prejudice, and a judgment will enter . The Motion for Oral Argument is moot .
21
IT IS SO ORDERED this )day of March, 2002 .
ROBIN J . CA THRONCHIEF UNITED STATES DISTRICT JUDG E
22
APPENDIX A
2)
3)
4)
5)
Wall Street Journal article, "Pre-Paid Legal Draws Criticism on Accounting forCommissions" January 17, 2001 .
TheStreet . com article , "Why Short-Sellers Are Still Courting Pre-Paid LegalServices" December 6, 2000 .
Pre-Paid 10-Ks for 200019991998
Pre-Paid 8-K filed August 1, 200 1
Pre-Paid 10-Qs for
6) Press Relase s
7) Pre-Paid Form 4s
2Q-20011 Q-20013Q-20002Q-20001 Q-20003Q-19992Q-1999IQ-1999
July 30, 2001May 16, 200 1
Harland StonecipherRandall HarpKathleen PinsonDave SavulaPeter Grunebaurn