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

,

• 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

38

. . • ,

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

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, .

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,

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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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