-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Lt2+9g5IzGZT3pp3gS941JSWzd5psyI3MFiax8HLo6tQHYCicalHrp1mgYNY6NvN IX5QfLEA/r2HYMmoMEejRg== 0000311657-98-000003.txt : 19980219 0000311657-98-000003.hdr.sgml : 19980219 ACCESSION NUMBER: 0000311657-98-000003 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980218 SROS: AMEX FILER: COMPANY DATA: COMPANY CONFORMED NAME: PRE PAID LEGAL SERVICES INC CENTRAL INDEX KEY: 0000311657 STANDARD INDUSTRIAL CLASSIFICATION: INSURANCE CARRIERS, NEC [6399] IRS NUMBER: 731016728 STATE OF INCORPORATION: OK FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 001-09293 FILM NUMBER: 98544339 BUSINESS ADDRESS: STREET 1: 321 E MAIN ST CITY: ADA STATE: OK ZIP: 74820 BUSINESS PHONE: 4054361234 MAIL ADDRESS: STREET 1: 321 E MAIN CITY: ADA STATE: OK ZIP: 74820 10-K 1 ANNUAL REPORT UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark one) (X) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1997 ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____________ to ____________ Commission File Number: 1-9293 ______________________________________________________________ PRE-PAID LEGAL SERVICES, INC. (Exact name of registrant as specified in its charter) Oklahoma 73-1016728 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 321 East Main Ada, Oklahoma 74820 (Address of principal executive offices) (Zip Code) Registrant's telephone number including area code: (580) 436-1234 Securities registered pursuant to Section 12(b) of the Exchange Act: Name of each exchange on Title of each class which registered Common Stock, $0.01 Par Value American Stock Exchange Securities registered under Section 12 (g) of the Exchange Act: None Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K ( ). State the aggregate market value of the voting stock held by non-affiliates of the registrant. The aggregate market value shall be computed by reference to the price at which the stock was sold, or the average bid and asked prices of such stock, as of a specified date within the past 60 days prior to the date of the filing: As of February 3, 1998 - $843,262,424. Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date: As of February 3, 1998 there were 22,404,853 shares of Common Stock, par value $.01 per share, outstanding. DOCUMENTS INCORPORATED BY REFERENCE. Portions of the Company's definitive proxy statement for its 1998 annual meeting of shareholders are incorporated into Part III of this Form 10-K by reference. PRE-PAID LEGAL SERVICES, INC. FORM 10-K For the year ended December 31, 1997 TABLE OF CONTENTS PART I. ITEM 1. DESCRIPTION OF BUSINESS General Industry Overview Description of Contracts Provider Attorneys Marketing Operations Quality Control Competition Regulation Employees ITEM 2. DESCRIPTION OF PROPERTY ITEM 3. LEGAL PROCEEDINGS ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS PART II. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS ITEM 6. SELECTED FINANCIAL DATA ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General Results of Operations: 1997 compared to 1996 1996 compared to 1995 Liquidity and Capital Resources ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE PART III. ** PART IV. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K SIGNATURES ** Information required by Part III is incorporated by reference from the Company's definitive proxy statement for its 1998 annual meeting of shareholders. PRE-PAID LEGAL SERVICES, INC. FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1997 Forward Looking Statements All statements in this report concerning the Company other than purely historical information, including, but not limited to, statements relating to the Company's future plans and objectives, expected operating results and assumptions relating to future performance constitute "Forward-Looking Statements" within the meaning of Section 21E of the Securities Exchange Act of 1934 and are based on the Company's historical operating trends and financial condition as of December 31, 1997 and other information currently available to management The Company cautions that the Forward-Looking Statements are subject to all the risks and uncertainties incident to its business, including but not limited to risks relating to the marketing of its Contracts, Contract persistency, regulation and competition risks and the risk relating to the continued active participation of its principal executive officer, Harland C. Stonecipher. Moreover, the Company may make acquisitions or dispositions of assets or businesses, enter into new marketing arrangements or enter into financing transactions. None of these can be predicted with certainty and, accordingly, are not taken into consideration in any of the Forward-Looking Statements made herein. For all of the foregoing reasons, actual results may vary materially from the Forward-Looking Statements. PART I. ITEM 1. DESCRIPTION OF BUSINESS - ------------------------------------ General Pre-Paid Legal Services, Inc. (the "Company") was one of the first companies in the United States organized solely to design, underwrite and market legal expense plans. The Company's predecessor commenced business in 1972 and began offering legal expense reimbursement services as a "motor service club" under Oklahoma law. In 1976, the Company was formed and acquired its predecessor in a stock exchange. The Company began offering memberships independent of the motor service club product by adding a legal consultation and advice service, and in 1979 the Company implemented a legal expense benefit which provided for partial payment of legal fees in connection with the defense of certain civil and criminal actions. The Company's legal expense plans (referred to as "Contracts") currently provide for or reimburse a portion of the legal fees associated with a variety of legal services in a manner similar to medical reimbursement plans. At December 31, 1997, the Company had 425,381 Contracts in force with members in all 50 states, and the District of Columbia. Approximately 94% of such Contracts were in 27 states. Industry Overview Legal service plans, while used in Europe for many years, were first developed in the United States in the late 1960s. Since that time, there has been substantial growth in the number of Americans entitled to receive various forms of legal services through legal service plans. According to estimates developed by the National Resource Center for Consumers of Legal Services ("NRC"), there were 105 million Americans entitled to service through at least one legal service plan in 1997, compared to 4 million in 1981, 15 million in 1985, 58 million in 1990 and 98 million in 1996. The legal service plan industry continues to evolve and market acceptance of legal service plans, as indicated by the recent growth in the number of individuals covered by plans, is increasing. Legal service plans are offered through various organizations and marketing methods and contain a wide variety of benefits. The types of plans offered include "free" plans which generally provide limited benefits on an automatic enrollment basis without any direct cost to the individual user. Free plans include those sponsored by labor unions, the American Association of Retired Persons, the National Education Association and military services and, according to NRC estimates, accounted for approximately 50% of covered persons in 1997. The NRC estimates that an additional 29% are covered by employee assistance plans which are also automatic enrollment plans without direct cost to participants designed to provide limited telephonic access to attorneys for members of employee groups. Employer paid plans pursuant to which more comprehensive benefits are offered by the employer as a fringe benefit are estimated by the NRC to account for approximately 6% of covered persons in 1997. According to the NRC, the remaining covered persons in 1997 were covered by individual enrollment plans, other employment based plans, including voluntary payroll deduction plans, and miscellaneous plans. These plans were estimated by the NRC to account for approximately 15% of the market in 1997 and represent the market segment in which the Company primarily competes. According to the NRC, these plans typically have more comprehensive benefits, higher utilization, involve higher costs to participants, and are offered on an individual enrollment or voluntary basis. Of the current work force covered by legal service plans, only 10% was estimated by the NRC to be covered by plans having benefits comparable to those provided by the Company's Contracts. Accordingly, the Company believes that significant opportunities exist for successful marketing of the Company's Contracts to employee groups and other individual consumers. Description of Contracts Legal services have been offered by the Company under two types of Contracts: closed panel and open panel. Since 1987, substantially all of the Contracts sold by the Company have been closed panel Contracts which allow members to access legal services through a network of independent attorneys ("provider attorneys") under contract with the Company. Provider attorneys are paid a fixed fee on a per capita basis to render services to plan members residing within the state in which the provider attorney is licensed to practice. Because the fixed fee payments by the Company to provider attorneys in connection with closed panel plans do not vary based on the type and amount of benefits utilized by the member, the closed panel plans provide significant advantages to the Company in managing claims risk. At December 31, 1997, closed panel Contracts comprised approximately 91% of the Company's active Contracts. Prior to 1987, the Company sold primarily open panel Contracts which allow members to locate their own attorney to provide legal services available under the Contract with the member's attorney being reimbursed for services rendered based on usual, reasonable and customary fees. The family legal plan currently marketed by the Company consists of five basic benefits which provide coverage for a broad range of preventive and litigation-related legal expenses. The family plan accounted for approximately 93% of the outstanding Contracts at December 31, 1997. In addition to the family plan, the Company markets other specialized legal services products specifically related to employment in certain professions. The Commercial Driver Legal Plan, developed in 1986, is designed specifically for the professional truck driver and offers a variety of driving-related benefits, including coverage for moving and non-moving violations. The Law Officers Legal Plan, developed in 1991 and marketed to law enforcement officers, provides 24-hour job-related emergency toll-free access to a provider attorney and provides legal services associated with administrative hearings. The School Teachers Legal Plan, developed in 1993 and marketed to school employees, also provides legal services associated with administrative hearings. The Small Business Owners plan was developed during 1995 and marketed in selected geographical areas. This plan provides business oriented legal service benefits for small businesses with 20 or fewer employees and $2 million or less in gross income per year. In several states, the Company's plans are available in the Spanish language. For the Spanish language plans, the provider law firms have bilingual staff and attorney resources and the Company has bilingual staff for both customer service and marketing service functions. The Company will continue to evaluate making its plans available in additional languages in markets where demand for such a product is expected to be sufficient to justify this additional cost. In exchange for a fixed monthly, semi-annual or annual payment, members are entitled to specified legal services. Each Contract, other than the Small Business Legal Defense Plan, is guaranteed renewable, except in the case of fraud or nonpayment of Contract fees. Contracts are automatically renewed at the end of each membership period unless the member cancels prior to the renewal date or fails to make payment on a timely basis. The basic legal service plan Contract is sold as a package consisting of five separate benefits known as "Titles." Contracts range in cost from $10.00 to $25.00 per month depending in part on the schedule of benefits, which varies from state to state in compliance with regulatory requirements, and on certain other state regulations. Benefits for most corporate and commercial matters are excluded from open panel Contracts. Benefits for domestic matters, bankruptcy and drug and alcohol related matters are limited in all Contracts. Title I: Preventive Legal Services. This benefit offers unlimited toll-free access to a member's provider attorney firm for any legal matter. This Title also offers last will and testament preparation for the member and annual will reviews at no additional cost. Document review benefits and letter writing benefits are also Title I benefits. Title I benefits offered on the open panel plan basis permit half-hour consultations for personal legal matters with the attorney of choice and pay an attorney's reasonable fee for covered consultations. This benefit, however, does not provide for a duplication of services previously billed relating to the same matter per membership in a 90-day period. The member is responsible for any fees incurred as a result of legal work in addition to the half-hour consultation or legal assistance provided under this benefit. Title II: Automobile Legal Protection. This benefit offers legal assistance for matters resulting from the operation of a licensed motor vehicle or boat. Members have assistance available to them at no additional cost for: (a) defense in the court of original jurisdiction of moving traffic violations deemed meritorious, (b) defense in the court of original jurisdiction of any charge of manslaughter, involuntary manslaughter, vehicular homicide or negligent homicide as the result of a licensed motor vehicle or boat accident, (c) up to 2.5 hours of assistance per incident for collection of minor property damages (up to $2,000) sustained by the member's licensed motor vehicle or boat in an accident, (d) up to 2.5 hours of assistance per incident for collection of personal injury damages (up to $2,000) sustained by the member or covered family member while driving, riding or being struck as a pedestrian by a motor vehicle, and (e) up to 2.5 hours of assistance per incident in connection with an action, including an appeal, for the maintenance or reinstatement of a member's driver's license which has been canceled, suspended, or revoked. No coverage under this Title of the basic legal service plan is offered to members for pre-existing conditions, drug or alcohol related matters, or for commercial vehicles over two axles or no valid operators license. Title III: Trial Defense. This Title offers assistance to the member and the member's spouse through an increasing schedule of benefits based on membership year. Up to 60 hours of attorney time are available for the defense of civil or job-related criminal charges in the first membership year. The criminal action must be within the scope and responsibility of employment activities of the member or spouse. Up to 2.5 hours of assistance are available prior to trial, and the balance is available for actual trial services. The schedule of benefits under this Title increases by 60 hours each membership year to: 120 hours in the second membership year, 3 hours of which are available for pre-trial services; 180 hours in the third membership year, 3.5 hours of which are available for pre-trial services; 240 hours in the fourth membership year, 4 hours of which are available for pre-trial services, to the maximum limit of 300 hours in the fifth membership year, 4.5 hours of which are available for pre-trial services. This Title excludes domestic matters, bankruptcy, deliberate criminal acts, alcohol or drug related matters, business matters, and pre-existing conditions. In addition to the pre-trial benefits of the basic legal plan described above, there are additional pre-trial hours available as an option, or add-on, to the basic plan. These optional benefits cost $9.00 per month and add 15 hours of pre-trial services during the first year of the membership incrementing 5 additional hours each membership year to the maximum limit of 35 hours in the fifth membership year. These pre-trial hours are in addition to those hours already provided by the basic plan so that the member, in the first year of the membership, has a combined total of 17.5 pre-trial hours available escalating to a combined total of 39.5 pre-trial hours in the fifth membership year. The Company has experienced increased sales of this option during the last three years. Title IV: IRS Audit Protection Services. This benefit offers up to 50 hours of legal assistance per year in the event the member, spouse or dependent children receive written notification of an Internal Revenue Service ("IRS") audit or are summoned in writing to appear before the IRS concerning a tax return. The 50 hours of assistance are available in the following circumstances: (a) up to 1 hour for initial consultation, (b) up to 2.5 hours for representation in connection with the audit if settlement with the IRS is not reached within 30 days, and (c) the remaining 46.5 hours of actual trial time if settlement is not achieved prior to litigation. Coverage is limited to audit notification received regarding the tax return for years during which the membership is effective. Representation for charges of fraud or income tax evasion, business and corporate tax returns and certain other matters are excluded from this Title. With pre-trial benefits limited to 2.5 hours to 4.5 hours based on the membership year under Title III (without the pre-trial option described) and 3.5 hours under Title IV, these Titles do not ensure complete pre-trial coverage. In order to receive additional Title III or IV benefits, a matter must actually proceed to trial. The costs of pre-trial preparation that exceed the benefits under the Contract are the responsibility of the member. Provider attorneys under the closed panel Contract have agreed to provide to members any legal service beyond those stipulated in the Contract at a 25% discount from the provider's customary and usual hourly rate. Title II, III and IV benefits available on an open panel plan basis provide comparable benefits with limitations based on fees incurred rather than hours of service. Title V: Preferred Member Discount. Provider attorneys under the closed panel Contract have agreed to provide to members any legal services beyond those stipulated in the Contract at a fee discounted 25% from the provider's customary and usual hourly rate. Commercial Driver's Legal Plan The Commercial Driver's Legal Plan provides coverage on a closed panel plan basis for persons who drive a commercial vehicle. The Company has members covered under the Commercial Driver's Legal Plan in 44 states. The Commercial Driver's Legal Plan is underwritten by the Road America Motor Club, an unrelated motor service club. During the years ended December 31, 1997, 1996 and 1995, this plan accounted for approximately 2.2%, 3.5% and 4.7%, respectively, of Contract premiums. The Plan is available at the monthly rate of $35.95 or at a group rate of $32.95. Benefits include Title II, defense of Department of Transportation violations and the 25% discounted rate for services beyond plan scope, such as defense of non-moving violations, bail and arrest bonds, and services for family vehicles. Law Officers Legal Plan The Law Officers Legal Plan was designed in 1991 to meet the legal needs of persons in the law enforcement profession and is currently marketed at the monthly rate of $16.00 or at a group rate of $14.95. The Company has members covered under the Law Officers Legal Plan in 21 states. The Law Officers Legal Plan offers the basic plan benefits of Titles I, III, IV and V. Title II is available in the Law Officers Legal Plan only for defense of criminal charges resulting from the operation of a licensed motor vehicle. Additionally, at no charge to the member, a 24-hour emergency hotline is available to access the services of the provider attorney in situations of job-related urgency. The Law Officers Legal Plan also offers representation at no additional charge for up to ten hours (five hours per occurrence) for two administrative hearings or inquiries per year and one pre-termination hearing per membership year before a review board or arbitrator. Preparation and/or counsel for post-termination hearings is also available to members as a schedule of benefits which increases with each membership year. The schedule of benefits is similar to that offered under Title III, Trial Defense, including the availability of the optional pre-trial hours described above for an additional $9.00 per month. During the years ended December 31, 1997, 1996 and 1995, the Law Officers Legal Plan accounted for approximately 2.2%, 2.4% and 3.4%, respectively, of the Company's Contract premiums. Small Business Legal Defense Plan The Small Business Legal Defense plan was developed during 1995 and test marketed in selected geographical areas and more widely marketed beginning in 1996. During 1997, the coverage offered pursuant to this plan was expanded to include trial defense benefits and membership in the Fran Tarkenton Small Business NETwork(TM) ("FTSBN"). Through the FTSBN, members may receive products, services and information from a group of affinity partners, including certificates valued at over $2,000 in free and discounted services from such affinity partners. This expanded plan is currently marketed at the monthly rate of $69.00 and provides business oriented legal service benefits for any for-profit business with 20 or fewer employees and $2 million or less in gross annual income. This plan is available in 28 states and represented approximately 2.1% and 2.4% of the Company's Contract premiums during 1997 and 1996, respectively. Provider Attorneys The Company currently markets Contracts primarily on a closed panel basis. Closed panel Contracts allow members to access legal services through a network of independent attorneys under contract with the Company generally referred to as "provider attorneys." Provider attorneys are paid a fixed fee on a per capita basis to render services to plan members residing within the state in which the provider attorney is licensed to practice. Because the fixed fee payments by the Company to provider attorneys in connection with closed panel Contracts do not vary based on the type and amount of benefits utilized by the member, the closed panel Contracts provide significant advantages to the Company in managing claims risk. Prior to 1987, the Company sold Contracts on an open panel basis. Open panel Contracts allow members to locate their own attorney to provide legal services available under the membership. Members' attorneys are reimbursed for services rendered according to a payment schedule commonly termed "usual, reasonable, and customary" relevant to the average cost of legal services in their area. At December 31, 1997, closed panel Contracts comprised approximately 91% of the Company's active memberships while open panel Contracts accounted for the remainder. Provider attorney firms are selected to serve closed panel plan members based on a number of factors, including recommendations from provider attorneys and other attorneys in the area in which the candidate provider attorney is located and in neighboring states, investigation by the Company of bar association standing and client references, evaluation of the education, experience and areas of practice of attorneys within the firm, on-site evaluations by Company management, and interviews with attorneys in the firm who would be responsible for providing services. Each member of the provider attorney firm rendering services must have at least two years of experience as an attorney, unless the Company waives this requirement due to special circumstances such as instances when the attorney demonstrates significant legal experience acquired in an academic, judicial or similar capacity other than as an attorney. Agreements with provider attorney firms: (a) generally permit termination of the agreement by either party upon 60 days prior written notice, (b) permit the Company to terminate the Agreement for cause immediately upon written notice, (c) require the firm to maintain a specified minimum amount of malpractice insurance, (d) preclude the Company from interference with the attorney-client relationship, and (e) provide for periodic review of services provided. The Company is precluded from contracting with other law firms to provide the same service in the same geographic area, except in situations where the designated law firm has a conflict of interest, the Company enrolls a group of 500 or more members, or when the agreement is terminated by either party. Provider attorneys are precluded from contracting with other prepaid legal service companies without Company approval. Provider attorneys receive a fixed monthly payment for each closed plan member who are residents in the service area and are responsible for providing the Contract benefits without additional remuneration. If a closed panel Contract provider attorney delivers legal services to an open panel member, the attorney is reimbursed for services rendered according to the open panel membership Contract. The Company has had occasional disputes with provider attorneys, some of which have resulted in litigation. Nonetheless, the Company believes that its relations with provider attorneys are generally good. At the end of 1997, the Company had 35 provider attorney firms compared to 30 provider attorney firms at the end of 1996 and 27 at the end of 1995. During the last three years, the Company's relationships with a total of three provider attorney firms were terminated by the Company or the provider attorney firm for reasons other than the lack of a sufficient number of members in the geographic area to support the use of the provider attorney firm. The Company's agreements with provider attorney firms require the provider attorney firms to indemnify the Company against liabilities resulting from legal services rendered by the provider attorney firm. Marketing Multi-Level Marketing The Company markets Contracts through a multi-level marketing program which encourages individuals to sell Contracts and allows individuals to recruit and develop their own sales organizations. Commissions are paid only when a Contract is sold and are not based solely on recruitment. When a Contract is sold, commissions are paid to the associate making the sale, and to other associates (often as many as 11 others) who are in the line of associates who directly or indirectly recruited the selling associate. Each sales associate is responsible for monitoring the progress and sales practices of the associates recruited by him or her. The Company provides training materials, organizes area training meetings and designates personnel at the home office specially trained to answer questions and inquiries from associates. Multi-level marketing is primarily used for product marketing based on personal sales since it encourages individual or group face-to-face meetings with prospective purchasers of the product and has the potential of attracting a large number of sales personnel within a short period of time. The Company's marketing efforts towards individuals typically target the middle income family or individual and seek to educate potential members concerning the benefits of having ready access to legal counsel for a variety of everyday legal problems. Contracts with individuals or families sold by the multi-level sales force constituted 76% of the Company's Contracts in force at December 31, 1997, compared to 76% and 78% at December 31, 1996 and 1995, respectively. Although other means of payment are available, approximately 57% of premiums on Contracts purchased by individuals or families are paid on a monthly basis by means of automatic bank draft. The Company's marketing efforts towards employee groups, principally on a payroll deduction payment basis, are designed to permit its sales associates to reach more potential members with each sales presentation and strive to capitalize on, among other things, what the Company perceives to be a growing interest among employers in the value of providing legal service plans to their employees. Contracts in force at December 31, 1997 sold through employee groups constituted approximately 24% of total Contracts in force compared to 24% and 22% at December 31, 1996 and 1995, respectively. The majority of employee group Contracts are sold to school systems, governmental entities and businesses. No group accounted for more than 1% of the Company's consolidated revenues from Contracts during 1997, 1996 or 1995. Sales associates under the Company's multi-level marketing system are generally engaged as independent contractors and are provided with training guides and are given the opportunity to participate in Company training programs. Sales associates are required to complete a specified training program prior to marketing the Company's Contracts to employee groups. All advertising and solicitation materials used by sales associates must be approved by the Company prior to use. A substantial number of the Company's sales associates market the Company's Contracts on a part-time basis only. At December 31, 1997, the Company had 123,470 "active" sales associates compared to 110,350 and 78,281 "active" sales associates at December 31, 1996 and 1995, respectively. A sales associate is considered to be "active" if he or she has originated at least three new Contracts per quarter or if he or she retains a personal Contract. During 1997, the Company had 37,404 sales associates who sold at least one Contract, of which 25,909 (69%) made first time sales, compared to 32,290 and 21,116 sales associates producing at least one Contract sale in 1996 and 1995, respectively, of which 24,715 (77%) and 18,313 (87%), respectively, made first time sales. The Company derives revenues from services provided to its multi-level marketing sales force, principally from a one-time enrollment fee of $65 from each new sales associate and the sale of marketing supplies and promotional materials to associates. Effective January 4, 1997, the Company implemented a new self funded combination classroom and field training program, titled Fast Start to Success ("Fast Start"), aimed at increasing the level of new membership sales per associate. The positive impact of the program is reflected in the increase in new memberships written and new sales associates recruited per successful Fast Start associate. Associates successfully completing Fast Start during 1997 produced 6.1 times more new Contracts and recruited 4.0 times more new sales associates than non-Fast Start qualified associates. The Fast Start program provides a direct economic incentive to existing associates to help train new recruits. Associates who successfully complete the program by writing three new Contracts and recruiting one new sales associate within 15 days of the associate's Fast Start training advance through the various commission levels at a faster rate. The program requires a one-time training fee of $184 per new associate, or a total of $249 including the one time enrollment fee of $65 described above, and upon successful completion of the program provides for the payment of certain training bonuses and covers the additional training materials used in the program. Amounts collected from sales associates are intended primarily to offset the Company's direct and indirect costs incurred in recruiting, monitoring and providing materials to sales associates and are not intended to generate material profits from such activities. During July, 1996 the Company promoted 14 of its field leaders to the position of Regional Vice President ("RVP") and has since removed and added RVPs based on their performance. At December 31, 1997, there were 18 RVPs in place. Each RVP is responsible for associate activity in a given geographic region and has the ability to appoint Area Coordinators within the RVP's region. The RVPs have weekly reporting requirements as well as quarterly sales and recruiting goals. This RVP and Area Coordinator program provides a basis to effectively monitor current sales activity, further educate and motivate the sales force and otherwise enhance the relationships between the associates and the Company. New products and initiatives, such as the Company's recently implemented Fast Start program, will be channeled through the RVPs and Area Coordinators. Cooperative Marketing The Company is continuing to develop a cooperative marketing strategy pursuant to which the Company seeks arrangements with insurance and service companies that have established sales forces. Under such arrangements, the agents or sales force of the cooperative marketing partner market the Company's Contracts along with the products already marketed by the partner's agents or sales force. Such arrangements allow the cooperative marketing partner to enhance its existing customer relationships and distribution channels by adding the Company's product to the marketing partner's existing range of products and services, while the Company is able to gain broader Contract distribution and access to established customer bases. During the fourth quarter of 1997, the Company announced cooperative marketing agreements with the Chicago-based insurance company, CNA, one of the 10 largest U.S. insurance groups, and Atlanta-based Primerica Financial Services ("PFS"), a subsidiary of the Travelers Group Inc. PFS is one of the largest financial services marketing organizations in North America with more than 100,000 personal financial analysts across the U.S. and Canada. Neither of these arrangements resulted in membership sales during 1997. The premium and commission structures in connection with Contracts sold under cooperative marketing arrangements are generally similar to the structure found in the Company's multi-level marketing system, although the specific terms of each cooperative marketing arrangement may vary depending on the strength of and the specific marketing, training and administrative responsibilities assumed by the cooperative marketing partner. The Company has had mixed success with cooperative marketing arrangements in the past and is unable to predict with certainty what success it will achieve, if any, under its current cooperative marketing arrangements. Operations The Company's corporate operations involve membership application processing, member-related customer service, various associate-related services including commission payments, receipt of premiums, related general ledger accounting, and managing and processing benefit claims. The Company employs a computerized management information system to control operations costs and monitor benefit utilization. Among other functions, the system evaluates benefit claims, monitors member use of attorneys, calculates average amount of claims incurred, processed and paid by benefit category, and monitors marketing/sales data and financial reporting records. The Company believes its management information system has substantial capacity to accommodate increases in data flow before substantial upgrades will be required. The Company believes this excess capacity may enable it to make significant increases in the volume of its business and the number of members serviced with less than commensurate increases in administrative costs. The Company's operations also include departments specifically responsible for marketing support and regulatory and licensing compliance. Quality Control The Company systematically monitors the delivery of services provided by provider attorneys to members through periodic member surveys and review of member complaints. Additionally, the majority of members are represented by provider attorneys who are connected via high speed digital links to the Company's management information systems, providing additional real time monitoring capability. Problems discovered in connection with member surveys or complaints are evaluated to determine remedial actions which the Company might recommend to provider attorneys and in the most extreme cases may result in the termination of a provider attorney. The Company meets with provider attorneys frequently to encourage dialogue and information sharing relating to the timely and effective delivery of services to members and requires provider attorneys that are not connected to the Company's management information systems to provide various statistical reports to the Company to enable the Company to monitor Contract usage. The Company has an extensive data base of attorneys who have provided services to its members. Attorneys with whom members have experienced service problems are not listed on the Company's referral list for use by members when a designated provider attorney is not available. The Company also closely monitors the performance of its home office personnel, especially those who have telephone contact with members or sales associates. The Company records home office employee telephone calls with its members and sales associates to assure that Company policies are being followed and to gather data about recurring problems which may be avoided through modifications in policies. Competition The Company competes in a variety of market segments in the prepaid legal services industry, including, among others, individual enrollment plans, employee benefit plans and certain specialty segments. An estimated 21% of the total estimated market in the segments in which the Company competes is served by a large number of small companies with regional areas of emphasis. The remaining 79% of such market is served primarily by the Company and five other principal competitors: Hyatt Legal Services, Midwest Legal Services, LawPhone, National Legal Plan and the Signature Group. If a greater number of companies seek to enter the prepaid legal services market, the Company will experience increased competition in the marketing of its Contracts. However, the Company believes its competitive position is enhanced by its actuarial data base, its existing network of provider attorney firms and its ability to tailor products to suit various types of distribution channels or target markets. Serious competition is most likely from companies with significant financial resources and advanced marketing techniques. Regulation The Company is regulated by or required to file with or obtain approval of State Insurance Departments, Secretaries of State, State Bar Associations and State Attorney General offices depending on individual state opinions of regulatory responsibility for legal expense plans. While some states regulate legal expense plans as insurance or specialized legal expense products, others regulate them as services. As of December 31, 1997, the Company or one of its subsidiaries was marketing new Contracts in 30 states which require no special licensing or regulatory compliance. The Company's subsidiaries serve as operating companies in 15 states which regulate Contracts as insurance or specialized legal expense products. The most significant of these wholly-owned subsidiaries are Pre-Paid Legal Casualty, Inc. ("PPLCI") and Pre-Paid Legal Services, Inc. Of Florida ("PPLSIF"). Of the Company's total Contracts in force as of December 31, 1997, 39% were written in jurisdictions which subject the Company or one of its subsidiaries to insurance or specialized legal expense plan regulation. In states with no special licensing or regulatory requirements, the Company commences operations only when advised by the appropriate regulatory authority that proposed operations do not constitute conduct of the business of insurance. There is no assurance that Contracts will be exempt from insurance regulation even in states with no specific regulations. In these situations, the Company or one of its subsidiaries would be required to qualify as an insurance company in order to conduct business. PPLCI serves as the operating company in most states where Contracts are determined to be an insurance product. PPLCI is organized as a casualty insurance company under Oklahoma law and as such is subject to regulation and oversight by various state insurance agencies. These agencies regulate the Company's forms, rates, trade practices, allowable investments and licensing of agents and sales associates. These agencies also prescribe various reports, require regular evaluations by regulatory authorities, and set forth minimum capital and reserve requirements. Dividends paid by PPLCI are restricted under Oklahoma law to available surplus funds derived from realized net profits. The Company is required to register and file reports with the Oklahoma Insurance Commissioner as a member of a holding company system under the Oklahoma Insurance Holding Company System Regulatory Act. Transactions between PPLCI and the Company or any other subsidiary must be at arms-length with consideration for the adequacy of PPLCI's surplus, and must have prior approval of the Oklahoma Insurance Commissioner. Payment of any dividend by PPLCI to the Company from its statutory surplus or net gain from operations requires approval of the Oklahoma Insurance Commissioner. Any change in control of the Company, defined as acquisition by any method of more than 10% of the Company's outstanding voting stock, including rights to acquire such stock by conversion of preferred stock, exercise of warrants or otherwise, requires approval of the Oklahoma Insurance Commissioner. Holding company laws in some states in which PPLCI operates, such as Texas, provide for comparable registration and regulation of the Company. Certain states have enacted special licensing or regulatory requirements designed to apply only to companies offering legal service products. These states most often follow regulations similar to those regulating casualty insurance providers. Thus, the operating company may be expected to comply with specific minimum capitalization and unimpaired surplus requirements; seek approval of forms, Contracts and marketing materials; adhere to required levels of claims reserves, and seek approval of premium rates and agent licensing. These laws may also restrict the amount of dividends paid to the Company by such subsidiaries. PPLSIF is subject to restrictions of this type under the laws of the State of Florida and other jurisdictions in which it conducts business, including restrictions with respect to payment of dividends to the Company. As the legal plan industry matures, the Company anticipates enactment of additional legislation which would affect the Company and its subsidiaries. The Company cannot predict with any accuracy if such legislation would be adopted or its ultimate effect on operations, but expects to continue to work closely with regulatory authorities to attempt to minimize any undesirable impact. The Company's operations are further impacted by the American Bar Association Model Rules of Professional Conduct ("Model Rules") and the American Bar Association Code of Professional Responsibility ("ABA Code") as adopted by various states. Arrangements for payments to an attorney by an entity providing legal services to its members are permissible under both the Model Rules and the ABA Code, so long as the arrangement prohibits the entity from regulating or influencing the attorney's professional judgment. The ABA Code prohibits attorney participation in closed panel legal service programs in certain circumstances. The Company's agreements with provider attorney firms comply with both the Model Rules and the ABA Code. The Company relies on the attorneys serving as the designated attorneys for the closed panel benefits to determine whether their participation would violate any ethical guidelines applicable to them. The Company and its subsidiaries comply with filing requirements of state bar associations or other applicable regulatory authorities. The Company also is required to comply with state and federal laws governing the Company's multi-level marketing approach. These laws generally relate to unfair or deceptive trade practices, lotteries, business opportunities and securities. The Company has experienced no material problems with marketing compliance. In jurisdictions which require associates to be licensed, the Company receives all applications for licenses from the associates and forwards them to the appropriate regulatory authority. The Company maintains records of all associates licensed, including effective and expiration dates of licenses and all states in which an associate is licensed. The Company does not accept new Contract sale applications from any unlicensed associate in such jurisdictions. Employees At December 31, 1997, the Company and its subsidiaries employed 216 individuals on a full-time basis, exclusive of independent agents and sales associates. None of the Company's employees are represented by a union. Management considers its employee relations to be good. ITEM 2. DESCRIPTION OF PROPERTY - ------------------------------------ The executive and administrative offices of the Company and its subsidiaries are located at 321 East Main Street, Ada, Oklahoma. These offices, containing approximately 40,000 square feet of office space, are owned by the Company. Additionally, during 1997, the Company completed construction of its material distribution center located approximately 5 miles from its administrative offices. This new structure contains approximately 8,600 square feet of inventory, package assembly and shipping space. While the Company currently fully utilizes these existing facilities, management believes that it will have no difficulty in securing additional facilities in close proximity to its office building if necessary for future expansion. ITEM 3. LEGAL PROCEEDINGS - ------------------------------ The Company is a named defendant in certain lawsuits arising in the ordinary course of the Company's business. While the outcome of these lawsuits cannot be predicted with certainty, the Company does not expect these matters to have a material adverse effect on the Company's financial condition, liquidity or results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ---------------------------------------------------------------- None. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - ------------------------------------------------------------------------------- At February 3, 1998, there were approximately 5,406 holders of record (including brokerage firms and other nominees) of the Company's Common Stock. The Common Stock is listed on the American Stock Exchange under the symbol "PPD." The following table sets forth, for the periods indicated, the range of high and low sales prices for the Common Stock, as reported by the American Stock Exchange. High Low 1998: 1st Quarter (through February 3).................... $ 41.06 $ 28.50 1997: 4th Quarter......................................... $ 34.63 $ 25.50 3rd Quarter......................................... 30.31 21.13 2nd Quarter......................................... 24.63 14.00 1st Quarter......................................... 19.13 14.50 1996: 4th Quarter......................................... $ 18.38 $ 10.88 3rd Quarter......................................... 19.38 10.00 2nd Quarter......................................... 23.13 13.88 1st Quarter......................................... 15.25 9.13 The Company has never declared a cash dividend on its Common Stock. For the foreseeable future, it is anticipated that any earnings which may be generated from the operations of the Company will be used to finance the Company's growth and that cash dividends will not be paid to holders of the Common Stock. Any decision by the Board of Directors of the Company to pay cash dividends in the future will depend upon, among other factors, the Company's earnings, financial condition and capital requirements. In addition, the Company's ability to pay dividends is dependent in part on its ability to derive dividends from its subsidiaries. The payment of dividends by PPLCI is restricted under the Oklahoma Insurance Code to available surplus funds derived from realized net profits and requires the approval of the Oklahoma Insurance Commissioner. At December 31, 1997, PPLCI did not have funds available for payment of dividends without the prior approval of the Oklahoma Insurance Commissioner. ITEM 6. SELECTED FINANCIAL DATA - ------------------------------------ The following table sets forth selected historical financial and statistical data for the Company as of the dates and for the periods indicated. Certain reclassifications have been made to conform to current year presentation. This information is not necessarily indicative of the Company's future performance. The following information should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto included elsewhere herein.
Year Ended December 31, ------------------------------------------------------------- 1997 1996 1995 1994 1993 -------- -------- -------- -------- -------- Income Statement Data: (In thousands, except ratio, per share and Contract amounts) Revenues: Contract premiums............................................ $76,688 $50,582 $31,290 $22,852 $19,182 Associate services........................................... 12,143 5,646 3,183 912 462 Interest income.............................................. 1,636 1,302 1,308 466 195 Other........................................................ 2,001 1,678 1,255 379 329 ------- ------- ------- ------- ------- Total revenues............................................. 92,468 59,208 37,036 24,609 20,168 ------- ------- ------- ------- ------- Costs and expenses: Contract benefits............................................ 25,132 16,871 10,477 7,990 7,480 Commissions.................................................. 16,717 11,476 7,708 6,788 6,117 General and administrative expenses.......................... 8,711 6,201 4,305 3,940 3,530 Associate services and direct marketing...................... 11,431 4,544 2,573 1,539 1,139 Depreciation................................................. 704 533 477 410 538 Depreciation................................................... Interest..................................................... - 26 10 320 518 Other expenses............................................... 866 372 242 226 709 ------- ------- ------- ------- ------- Total costs and expenses................................... 63,561 40,023 25,792 21,213 20,031 ------- ------- ------- ------- ------- Income before income taxes..................................... 28,907 19,185 11,244 3,396 137 Provision (benefit) for income taxes........................... 10,117 6,715 3,932 (319) 29 ------- ------- ------- ------- ------- Net income..................................................... 18,790 12,470 7,312 3,715 108 Less dividends on preferred shares............................. 13 15 125 465 15 ------- ------- ------- ------- ------- Net income applicable to common shares......................... $18,777 $12,455 $ 7,187 $ 3,250 $ 93 ======= ======= ======= ======= ======= Net income per common share - basic (1)........................ $ .85 $ .58 $ .38 $ .28 $ .01 Net income per common share - diluted (1)...................... .83 .56 .34 .24 .01 Weighted average number of common shares outstanding-basic(1).. 22,127 21,332 18,947 11,603 10,662 Weighted average number of common shares outstanding-diluted(1) 22,575 22,319 21,408 15,566 12,407 Contract Benefit Cost and Statistical Data: Loss ratio (2)................................................. 32.8% 33.4% 33.5% 35.0% 39.0% Expense ratio (2).............................................. 34.3% 35.7% 39.2% 47.9% 54.0% Combined loss and expense ratio................................ 67.1% 69.1% 72.7% 82.9% 93.0% New Contracts sold............................................. 283,723 194,483 109,922 45,893 34,294 Period end Contracts in force.................................. 425,381 294,151 203,535 144,438 133,121 Cash Flow Data: Net cash provided by operating activities...................... $ 7,733 $ 942 $ 624 $ 3,040 $ 1,100 Net cash provided by (used in) investing activities............ (3,978) (2,549) (2,192) 254 (611) Net cash provided by (used in) financing activities............ 3,217 1,949 6,545 3,802 (1,307) Balance Sheet Data: Total assets................................................... $91,912 $57,532 $ 35,629 $ 18,154 $ 11,109 Notes payable, financing transactions and subordinated debentures....................................... - - - - 3,837 Total liabilities.............................................. 21,401 12,058 5,889 2,347 6,656 Stockholders' equity ......................................... 70,511 45,474 29,740 15,807 4,453
(1) All share and per share information has been restated to reflect the adoption of Statement of Financial Accounting Standards 128, Earnings Per Share. See Note 9 of Notes to Consolidated Financial Statements of the Company. (2) The loss ratio represents Contract benefit costs as a percentage of Contract premiums. The expense ratio represents the total of commissions, general and administrative expenses and premium taxes as a percentage of Contract premiums. The Company has revised the expense ratio definition for 1997 to provide data it believes more accurately reflects trends in the Company's growth. All prior periods have been conformed to current year presentation. The combined ratio does not measure total profitability because it does not take into account all revenues and expenses. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ----------------------------------------------------------------------------- RESULTS OF OPERATIONS --------------------- General Contract Premiums and Contract Benefit Costs The Company's principal revenues are derived from Contract premiums, most of which are collected on a monthly basis. Contracts are generally guaranteed renewable and non-cancelable except for fraud, non-payment of Contract premiums or upon written request by the member. Contract benefit costs vary depending on the type of Contract. Closed panel plans provide the Contract benefits only through a designated provider attorney with whom the Company has arranged for the services to be provided in a particular geographic area. Provider attorneys receive a fixed monthly payment for each member in their service area and are responsible for providing the Contract benefits without additional remuneration. The fixed cost aspect of closed panel plans provides significant advantages to the Company in managing its claims risk. Under closed panel plans, the Company has the ability to more effectively monitor the quality of legal services provided and, due to the volume of claims that may be directed to particular provider attorney law firms, has access to larger, more diversified law firms. At December 31, 1997, approximately 91% of the Company's Contracts were closed panel plans compared to 88% at December 31, 1996. Contract benefit costs relating to open panel Contracts, which constituted approximately 9% of Contracts in force at December 31, 1997, are based on the usual, reasonable and customary fee for providing the required services. Such costs are generally paid on a current basis as most costs are certain in amount and require only limited investigation. The Company maintains a reserve for estimated incurred but not reported open panel Contract benefit costs as well as costs which are in the payment process. These reserves are reviewed annually by an independent actuary as necessary in conjunction with the preparation and filing of financial statements and other reports with various state insurance regulatory authorities. Underwriting risks associated with the open panel Contracts are managed primarily through contractual benefit limitations and, as a result, underwriting decisions are not necessarily based on individual Contract purchases. Commissions Beginning with new membership Contracts written after March 1, 1995, the Company implemented a level commission schedule which results in the Company incurring commission expense related to the sale of its legal expense plans on a basis more consistent with the collection of the premiums generated by the sale of such Contracts. Prior to March 1, 1995, the Company had incurred much higher commissions (approximately 70%) during the first year of the membership with substantially lower commissions (approximately 16%) in all subsequent years. The level commission structure results in the Company incurring commissions at the rate of approximately 25% per year for all membership years. Prior to January 4, 1997, the Company advanced commissions at the time of sale of all new Contracts. Effective January 4, 1997, the Company implemented a policy whereby the associate receives only earned commissions on the first three sales unless the associate has successfully completed the new training program which was implemented at the same time. For all sales beginning with the fourth membership or all sales made by an associate successfully completing the new training program, the Company currently advances commissions at the time of sale of a new membership Contract. The amount of cash potentially advanced upon the sale of a new membership, prior to the recoupment of any charge-backs (described below), represents an amount equal to three years commission earnings. Although the average number of marketing associates receiving an advance commission payment on a new membership is 12, the overall initial advance may be paid to more than twenty different individuals, each at a different level within the overall commission structure. This commission advance immediately increases an associate's account with the Company and represents prepaid commissions on active memberships. Should a membership lapse before the advances have been recovered for each commission level, the Company immediately generates a "charge-back" to the applicable sales associate to recapture 50% of any unearned advance. This charge-back is immediately deducted from any future advances that would otherwise be payable to the associate for additional new memberships. The Company historically has been able to immediately recover the majority of such charge-backs. Any remaining unrecovered advance on a membership that has lapsed represents a receivable from the associate and is reflected as commission advances and is categorized as current or non-current based on the expected recovery period. Additionally, even though a commission advance may have been fully recovered on a particular membership, no additional commission earnings from any membership will be paid to an associate until all previous advances on all memberships, both active and lapsed, have been recovered. During 1997, 24% of all associates submitting new memberships accounted for 76% of all such new memberships produced thereby further enhancing the recovery of commissions advances. The Company's commission advance policy exposes the Company to the risk of uncollectible commission advances particularly for associates who do not receive commissions on a large number of memberships or who experience below average Contract persistency. The Company closely monitors such commission advances to ensure maximum recoverability and maintains a recoverability reserve which at December 31, 1997 and 1996, was $3.7 million and $3.4 million, respectively. Associates also receive compensation when associates sponsored by them or other associates that they have sponsored in their organization successfully complete the new training program implemented by the Company on January 4, 1997. In order to successfully qualify, the new associate going through the training program must produce 3 new Contracts and recruit 1 new associate within 15 days of receiving the training. Contract Persistency One of the major factors affecting the Company's profitability and cash flow is Contract persistency, which represents the ability of the Company to retain a Contract, and therefore receive premiums, once it has been written. The Company monitors its overall Contract persistency rate, as well as the persistency rates with respect to Contracts sold by individual associates and agents and persistency rates with respect to Contract sales by geographic region and payment method. The Company's Contract persistency rate measures the number of Contracts in force at the end of a year as a percentage of the total of (i) Contracts in force at the beginning of such year, plus (ii) new Contracts sold during such year. From 1981 through the year ended December 31, 1997, the Company's annual Contract persistency rates, using the foregoing method, have averaged approximately 76%. The annual Contract persistency rates were 73.6%, 73.9% and 80.0% for 1997, 1996 and 1995, respectively. The Company's overall Contract persistency rate varies based on, among other factors, the relative age of total Contracts in force. The Company's overall Contract persistency rate could be lower when the Contracts in force include a higher proportion of newer Contracts. The Company has recently experienced significant increases in new Contract sales and, as a result, the percentage of newer Contracts in its total Contracts in force has increased. Unless offset by other factors, this increase could result in a decline in the Company's overall Contract persistency rate as determined by the formula described above, but does not necessarily indicate that the new Contracts written are less persistent, only that the ratio of new Contracts to total Contracts is higher than it was during 1997 and 1996. The Company's financial condition and results of operations may be materially adversely affected if the persistency rates of existing and new Contracts are materially lower than the Company's historical experience. Operating Ratios Two principal operating measures monitored by the Company in addition to Contract persistency are the loss ratio and the expense ratio. The loss ratio represents Contract benefit costs as a percentage of Contract premiums. The expense ratio represents the total of commissions, general and administrative expenses and premium taxes as a percentage of Contract premiums. The Company has revised the expense ratio definition for 1997 to provide data it believes more accurately reflects trends in the Company's growth. All prior periods have been conformed to current year presentation. The Company strives to maintain a combined loss and expense ratio as low as possible. The combined ratio does not measure total profitability because it does not take into account all revenues and expenses. Cash Flow Considerations Relating to Sales of Contracts The Company generally advances significant commissions at the time a Contract is sold. Since approximately 93% of Contract premiums are collected on a monthly basis, a significant cash flow deficit is created at the time a Contract is sold. This deficit is reduced as monthly premiums are remitted and no additional commissions are paid on the Contract until all previous commission advances have been fully recovered. Since the cash advanced at the time of sale of a new membership Contract will be recovered over a three year period, cash flow from operations may be adversely affected depending on the number of new membership Contracts written in relation to the existing active base of Contracts and the composition of new or existing sales associates producing such Contracts. Income Tax Matters-Net Operating Losses At December 31, 1997, the Company had net operating loss carryforwards ("NOLs") for Federal regular and alternative minimum tax purposes of approximately $14.6 million and $14.2 million, respectively, expiring in 2001 through 2012. In addition, the Company had general business and rehabilitation tax credit carryforwards of approximately $325,000 expiring primarily in 1998 to 2001, and an alternative minimum tax ("AMT") credit carryforward of $366,000 which does not expire. A valuation allowance has been established for deferred tax assets representing pre-1996 carryforwards, except as related to the AMT Credit carryforward (which is considered to be fully realizable), as the Company does not believe it is more likely than not that the tax benefits of such carryforwards will be realized. The Company generated a tax loss for the year ended December 31, 1997 of $2.6 million. The Company believes it will realize the approximate $926,000 tax benefit from this tax loss and the approximate $997,000 of tax benefits from the 1996 tax loss of $2.8 million and has appropriately not provided a valuation allowance against these amounts. The Company accrued tax expense for 1997 and 1996 at the applicable statutory rates and expects to continue such accrual for 1998 since it does not expect to be able to utilize available tax benefits from its existing pre-1996 carryforwards. However, if the level of tax deductions for commissions is less than expected in 1998 (as a result of new Contract sales being less than expected or for any other reason), the Company may have taxable income. In such case, the Company's tax expense for 1998 would be reduced to reflect any actual or anticipated future utilization of deferred tax benefits through reduction in the current valuation allowance. The ability of the Company to utilize NOLs and tax credit carryforwards to reduce future federal income taxes of the Company is also subject to various limitations under the Internal Revenue Code of 1986, as amended (the "Code"). One such limitation is contained in Section 382 of the Code which imposes an annual limitation on the amount of a corporation's taxable income that can be offset by those carryforwards in the event of a substantial change in ownership as defined in Section 382 ("Ownership Change"). In general, an Ownership Change occurs if during a specified three-year period there are capital stock transactions which result in an aggregate change of more than 50% in the beneficial ownership of the stock of the Company. The Company is not aware of any pending or contemplated transactions that would result in an Ownership Change under Section 382. However, the Company does not have control over all possible variables which can affect the Ownership Change calculation and, accordingly, it is possible that an Ownership Change could occur in the future. The effect of any such Ownership Change on the Company's financial condition or results of operations cannot be determined because it is dependent upon unknown future facts and circumstances at the time of any such change, including, among others, the amount of the Company's NOLs, the fair market value of the Company's stock and the Company's other tax attributes. Associate Services The Company derives revenues from services provided to its marketing sales force, principally from a one-time enrollment fee of approximately $65 ($49 prior to February 1, 1996 and $55 prior to July 1996) from each new sales associate and the sale of marketing supplies and promotional materials to associates on an ongoing basis. Effective January 4, 1997, the Company implemented a training program which allows an associate who successfully completes the program to advance through the various commission levels at a faster rate. Associates participating in this program pay a one-time fee of $249 instead of the $65 fee. The increased fee covers the additional training and materials used in the training program. The Company enrolled 58,121 new sales associates during 1997 compared to 69,789 during 1996 and 50,464 during 1995, resulting in significant increases in associate services revenues and costs. The Company's direct costs of providing materials and services to associates are reflected as costs of associate services and direct marketing. Amounts collected from sales associates are intended primarily to offset the Company's direct and indirect costs incurred in recruiting, monitoring and providing materials to sales associates and are not intended to generate material profits from such activities. Investment Policy The Company's investment policy is to some degree controlled by certain insurance regulations, which, coupled with management's own investment philosophy, results in a conservative investment portfolio that is not risk oriented. The Company's investments consist principally of short term instruments issued by the United States Treasury, insured bank certificates of deposit, high grade government bonds and similar investments. The Company is required to pledge investments to various state insurance departments as a condition to obtaining authority to do business in certain states. Year 2000 Issues The Company has conducted a comprehensive review of its computer systems to identify the systems that could be affected by the "Year 2000" issue and has developed a plan to resolve the issue. The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's affected programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a major system failure or miscalculations. The Company presently believes that, with modifications to existing software and conversion to new software, the Year 2000 issue will not pose significant operational problems for the Company's computer systems as so modified and converted. Testing and conversion of system applications commenced during 1993 and is expected to be completed during 1998. Costs incurred in prior periods have not been material. The remaining total cost of the Company's remediation efforts is expected to be approximately $240,000, substantially all of which will be incurred during 1998. This amount is not expected to have a material effect on results of operations, liquidity or capital resources during 1998 or future periods. A significant portion of the Company's Year 2000 remediation plan will be accomplished by the Company's internal programming staff and while such efforts will result in the concentration on Year 2000 programming, these costs are not likely to be incremental costs to the Corporation, but rather will represent the redeployment of existing information technology resources. However, if such modifications and conversions are not completed in a timely fashion, the Year 2000 issue may have a material adverse impact on the operations of the Company. Accounting Standards to be Adopted Statement of Financial Accounting Standards 130, "Reporting Comprehensive Income," ("SFAS 130") was issued in June, 1997. This Statement establishes standards for reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. This Statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. SFAS 130, effective for fiscal years beginning after December 15, 1997, requires reclassification of financial statements for earlier periods provided for comparative purposes. The Company currently does not expect adoption of this Statement to have a material effect on financial statement presentation. Statement of Financial Accounting Standards 131, "Disclosures about Segments of an Enterprise and Related Information," ("SFAS 131") was issued in June, 1997. This Statement establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. SFAS 131, effective for fiscal years beginning after December 15, 1997, requires comparative information for previous years to be restated to comply with SFAS 131's reporting requirements. The Company currently does not expect adoption of this Statement to have a material effect on financial statement presentation or related footnote disclosures. Results of Operations Comparison of 1997 to 1996 The Company reported net income applicable to common shares of $18.8 million, or $.83 per diluted common share, for 1997, up 51% from net income applicable to common shares of $12.5 million, or $.56 per diluted common share, for 1996. The increase in the net income applicable to common shares for 1997 is primarily the result of increases in every revenue category for 1997 as compared to 1996. Contract premiums totaled $76.7 million during 1997 compared to $50.6 million for 1996, an increase of 52%. Contract premiums and their impact on total revenues in any period are determined directly by the number of active Contracts in force during any such period. The active Contracts in force are determined by both the number of new Contracts sold in any period together with the persistency, or renewal rate, of existing Contracts. New Contract sales increased 46% during 1997 to 283,723 from 194,483 during 1996. At December 31, 1997, there were 425,381 active Contracts in force compared to 294,151 at December 31, 1996. Additionally, the average annual premium per Contract has increased from $216 for all Contracts in force at December 31, 1996 to $225 for all Contracts in force at December 31, 1997, a 4.0% increase, as a result of a higher portion of active Contracts containing the additional pre-trial hours benefit at an additional cost to the member together with increased sales of the Small Business Legal Defense plan. Associate services revenue increased 115% from $5.6 million for 1996 to $12.1 million during 1997 primarily as a result of Fast Start which resulted in the Company receiving training fees of approximately $5.7 million during 1997. The new combination classroom and field training program, titled Fast Start to Success ("Fast Start"), is aimed at increasing the level of new membership sales per associate. The positive impact of the program is reflected in the increase in new memberships written and new sales associates recruited per Fast Start associate. Fast Start requires a training fee of $184 per new associate and upon successful completion of the program provides for the payment of certain training bonuses. In order to be deemed successful for Fast Start purposes, the new associate must write three new memberships and recruit one new sales associate within 15 days of the associate's Fast Start training. The $5.7 million in training fees was comprised of $184 from each of approximately 28,900 new sales associates who elected to participate in Fast Start and training fees of $25 from each of approximately 14,500 existing associates who participated in the program. New associates enrolled during 1997 were 58,121 compared to 69,789 for 1996, a decrease of 17%. The Company believes that the decline in new associate enrollment during 1997 is primarily attributable to the increased costs associated with the Fast Start program. However, while the number of new associates decreased during 1997, the number of new Contracts sold, at least partially as a result of the Fast Start program, increased significantly. Future revenues from associate services will depend primarily on the number of new associates enrolled and the number who choose to participate in the Company's training program, but the Company expects that such revenues will continue to be largely offset by the direct and indirect cost to the Company of training bonuses paid, providing associate services and other direct marketing expenses. Interest income for 1997 increased 26% to $1.6 million from $1.3 million for 1996. Interest income increased as a result of increases in the average investments outstanding. At December 31, 1997 the Company reported $29.5 million in cash and investments compared to $19.9 million at December 31, 1996. Primarily as a result of the increase in Contract premiums, total revenues increased to $92.5 million for 1997 from $59.2 million during 1996, an increase of 56%. Contract benefits totaled $25.1 million for 1997 compared to $16.9 million for 1996, and represented 33% of Contract premiums for both 1997 and 1996. This loss ratio (Contract benefits as a percentage of Contract premiums) should remain near 35% as the portion of active Contracts which provide for a capitated benefit continues to increase. Commission expense was $16.7 million for 1997 compared to $11.5 million for 1996, and represented 22% and 23% of Contract premiums for 1997 and 1996, respectively. Commission expense, as a percentage of Contract premiums, should remain at or near 25% of Contract premiums in future years. General and administrative expenses during 1997 and 1996 were $8.7 million and $6.2 million, respectively, and represented 11% and 12% of Contract premiums for such years. Although the total amount of general and administrative expenses increased approximately $2.5 million during 1997, these expenses, as a percent of Contract premiums, decreased 1%. This trend of gradual increases in the total dollar amount of these expenses but decreases when expressed as a percentage of Contract premiums should continue as a result of certain economies of scale pertaining to the Company's operating leverage. Associate services and direct marketing expenses increased to $11.4 million for 1997 from $4.5 million for 1996 primarily as a result of approximately $4.4 million in Fast Start training bonuses paid, additional costs of supplies due to increased purchases by associates and higher staffing requirements. These expenses also include the costs of providing associate services and marketing costs other than commissions which are directly associated with new membership sales. Due to property and equipment additions during 1997 of $1.3 million, depreciation increased from $533,000 for 1996 to $704,000 for 1997. The Company's expense ratio, which represents commissions, general and administrative expenses and premium taxes as a percentage of membership premiums, was 34% for 1997 compared to 36% for 1996 resulting in a combined loss and expense ratio of 67% for 1997 compared to 69% for 1996. The combined ratio does not measure total profitability because it does not take into account all revenues and expenses. Provision for income taxes increased significantly during 1997 to $10.1 million compared to $6.7 million for 1996, but remained at 35% of income before income taxes. The Company has established a valuation allowance for the portion of its deferred tax asset that the Company believes more likely than not will not be realized. The Company believes it is unlikely that it will generate sufficient taxable income to realize the benefits from its pre-1996 NOLs and certain other carryforwards before they expire, primarily as a result of future tax deductions attributable to expected levels of commissions to be paid on new Contract sales. Dividends paid on outstanding preferred stock decreased to $13,000 for 1997 from $15,000 during 1996 and is attributable to the conversion of shares of $3.00 Cumulative Convertible Preferred Stock into common stock. Comparison of 1996 to 1995 The Company reported net income applicable to common shares of $12.5 million, or $.56 per diluted common share, for 1996, up 74% from net income applicable to common shares of $7.2 million, or $.35 per diluted common share, for 1995. The increase in the net income applicable to common shares for 1996 is primarily the result of increases in every revenue category except for interest income for 1996 as compared to 1995. Contract premiums totaled $50.6 million during 1996 compared to $31.3 million for 1995, an increase of 62%. The increase in Contract premiums was primarily the result of increased new Contract sales resulting in a higher number of active Contracts in force. New Contract sales during 1996 were 194,483 compared to 109,922 during 1995. At December 31, 1996, there were 294,151 active Contracts in force compared to 203,535 at December 31, 1995. Additionally, the average annual premium per Contract has increased from $200 for all Contracts in force at December 31, 1995 to $216 for all Contracts in force at December 31, 1996, a 8.0% increase, as a result of a higher portion of Contracts written during 1996 including the additional pre-trial hours benefit at an additional cost to the member. Associate services revenue increased from $3.2 million for 1995 to $5.6 million during 1996 as a result of higher new associate enrollments and the increase in the fee paid for associate enrollment. New associates enrolled during 1996 were 69,789 compared to 50,464 for 1995, an increase of 38%. Associate services revenue also increased as a result of increases in sales of marketing materials used by the associates in sales presentations of the Company's Contracts. Associate services revenue for 1996 was comprised of $4.1 million in enrollment fees and $1.5 million in sales of marketing materials. Future revenues from associate services will depend primarily on the number of new associates enrolled, but the Company expects that such revenues will continue to be largely offset by the direct and indirect cost to the Company of providing associate services. Interest income for 1996 equaled interest income for 1995 of $1.3 million. Included in 1995 interest income was $187,000 for prior years interest pertaining to outstanding notes receivable. Such amounts were previously not considered recoverable but were subsequently collected. Interest income would have otherwise increased as a result of increases in the average investments outstanding and higher interest rates on investments. At December 31, 1996 the Company reported $19.9 million in cash and investments compared to $18.3 million at December 31, 1995. Primarily as a result of the increase in Contract premiums, total revenues increased to $59.2 million for 1996 from $37.0 million during 1995, an increase of 60%. Contract benefits totaled $16.9 million for 1996 compared to $10.5 million for 1995, an increase of 61%. However, the loss ratio for the 1996 period of 33% was the same for 1995 and should remain near 35% as the portion of active Contracts which provide for a capitated benefit continues to increase. Commission expense was $11.5 million for 1996 compared to $7.7 million for 1995, and represented 23% and 24% of Contract premiums for 1996 and 1995, respectively. Commission expense, as a percentage of Contract premiums, should remain at or near 25% of Contract premiums in future years. General and administrative expenses during 1996 and 1995 were $6.2 million and $4.3 million, respectively, and represented 12% and 14% of Contract premiums for such years. Although the total amount of general and administrative expenses increased approximately $1.9 million during 1996, these expenses, as a percent of Contract premiums, decreased 2%. This trend of gradual increases in the total dollar amount of these expenses but decreases when expressed as a percentage of Contract premiums should continue as a result of certain economies of scale pertaining to the Company's operating leverage. Associate services and direct marketing costs increased to $4.5 million for 1996 from $2.6 million for 1995 but were generally consistent as a percent of total revenues, 8% for 1996 and 7% for 1995. These costs include the costs of providing associate services and marketing costs other than commissions, which are directly associated with new Contract sales. Due to property and equipment additions during the later part of 1995 and the year ended December 31, 1996, depreciation increased from $477,000 for 1995 to $533,000 for 1996. The Company's expense ratio for 1996 was 36% compared to 39% for 1995. These factors resulted in a combined loss and expense ratio of 69% and 73% for 1996 and 1995, respectively. Provision for income taxes increased significantly during 1996 to $6.7 million compared to $3.9 million for 1995, but remained at 35% of income before income taxes. The Company has established a valuation allowance for the portion of its deferred tax asset that the Company believes more likely than not will not be realized. The Company believes it is unlikely that it will generate sufficient taxable income to realize the benefits from its pre-1996 NOLs and certain other carryforwards before they expire, primarily as a result of tax deductions attributable to expected levels of commission to be paid on new Contract sales. Dividends paid on outstanding preferred stock decreased to $15,000 for 1996 from $125,000 during 1995. This $110,000 decrease is attributable to the automatic conversion of preferred stock to common stock pursuant to its terms during February 1995. Liquidity and Capital Resources General Consolidated net cash provided by operating activities was $7.7 million, $942,000 and $624,000 for 1997, 1996 and 1995, respectively. Cash provided by operating activities increased significantly during 1997 compared to 1996 and 1995 due to the $6.3 million increase in net income, an increase of $3.4 million in deferred income taxes and an increase of $1.2 million in accounts payable and accrued expenses, all of which more than offset the $4.5 million increase in commission advances. During 1997, the Company had net cash provided by financing activities of $3.2 million as a result of the exercise proceeds of options to purchase common stock, an increase of $1.3 million from such proceeds in 1996. In 1995, the Company had net cash provided by financing activities of $6.5 million, after dividends of $125,000, as a result of the exercise proceeds of warrants to purchase common stock during May, 1995. The Company had a consolidated working capital surplus of $39.2 million at December 31, 1997 compared to $23.4 million at December 31, 1996. The $15.8 million increase in working capital during 1997 was primarily the result of increases in the current portion of commission advances of $6.6 million and increases in cash and investments of $10.7 million. The Company generally advances significant commissions at the time a membership is sold. During 1997, the Company advanced commissions of $38.1 million on new membership sales compared to $28.5 million for 1996. Since approximately 93% of membership premiums are collected on a monthly basis, a significant cash flow deficit is created at the time a membership is sold. This deficit is reduced as monthly premiums are remitted and no additional commissions are paid on the membership until all previous commission advances have been fully recovered. Commission advances were subsequently reduced by commission earnings of $14.9 million and $9.3 million for 1997 and 1996, respectively. The Company has recorded an allowance of $3.7 million to provide for estimated uncollectible balances which includes an increase in the allowance of $300,000 during 1997. The Company has no outstanding material financial commitments. The Company believes that it has significant ability to finance expected future growth in Contract sales based on its existing amount of unpledged cash and investments at December 31, 1997 of $26.7 million. Parent Company Funding and Dividends Although the Company is the operating entity in many jurisdictions, the Company's subsidiaries serve as operating companies in various states which regulate Contracts as insurance or specialized legal expense products. The most significant of these wholly-owned subsidiaries are PPLCI and PPLSIF. The ability of PPLCI and PPLSIF to provide funds to the Company is subject to a number of restrictions under various insurance laws in the jurisdictions in which PPLCI and PPLSIF conduct business, including limitations on the amount of dividends and management fees that may be paid and requirements to maintain specified levels of capital and reserves. In addition PPLCI will be required to maintain its stockholders' equity at levels sufficient to satisfy various state regulatory requirements, the most restrictive of which is currently $3 million. Additional capital requirements of either PPLCI or PPLSIF will be funded by the Company in the form of capital contributions or surplus debentures. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA - --------------------------------------------------- PRE-PAID LEGAL SERVICES, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND CONSOLIDATED FINANCIAL STATEMENT SCHEDULE Independent Auditors' Report Consolidated Financial Statements - --------------------------------- Consolidated Balance Sheets - December 31, 1997 and 1996 Consolidated Statements of Income - For the years ended December 31, 1997, 1996 and 1995 Consolidated Statements of Cash Flows - For the years ended December 31, 1997, 1996 and 1995 Consolidated Statements of Changes in Stockholders' Equity - For the years ended December 31, 1997, 1996 and 1995 Notes to Consolidated Financial Statements Consolidated Financial Statement Schedule - ----------------------------------------- Schedule II. Consolidated Valuation and Qualifying Accounts - For the years ended December 31, 1997, 1996 and 1995 INDEPENDENT AUDITORS' REPORT ---------------------------- To the Board of Directors and Stockholders of Pre-Paid Legal Services, Inc. We have audited the accompanying consolidated balance sheets of Pre-Paid Legal Services, Inc. and subsidiaries as of December 31, 1997 and 1996, and the related statements of income, changes in stockholders' equity, and cash flows each of the three years in the period ended December 31, 1997. Our audits also included the financial statement schedule listed at Item 8 herein. These financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Pre-Paid Legal Services, Inc. and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. Deloitte & Touche LLP Tulsa, Oklahoma February 12, 1998 PRE-PAID LEGAL SERVICES, INC. CONSOLIDATED BALANCE SHEETS (Amounts in 000's, except par values) ASSETS December 31, ----------------- 1997 1996 ------ ------ Current assets: Cash and cash equivalents............................... $21,803 $14,831 Held-to-maturity investments - current portion.......... 4,242 500 Accrued Contract income................................. 2,399 1,710 Commission advances - current portion................... 15,705 9,108 ------- ------- Total current assets.................................. 44,149 26,149 Held-to-maturity investments.............................. 650 1,757 Investments pledged....................................... 2,772 2,772 Commission advances, net.................................. 38,038 21,744 Property and equipment, net............................... 3,594 2,955 Other..................................................... 2,709 2,155 ------- ------- Total assets......................................... $91,912 $57,532 ======= ======= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Contract benefits........................................ $ 2,649 $ 1,862 Accounts payable and accrued expenses.................... 2,281 912 ------- ------- Total current liabilities.............................. 4,930 2,774 Deferred income taxes...................................... 16,471 9,284 ------- ------- Total liabilities...................................... 21,401 12,058 ------- ------- Stockholders' equity: Preferred stock, $1 par value; authorized 400 shares; 5 issued and outstanding as follows: $3.00 Cumulative Convertible Preferred Stock, 3 and 5 shares authorized, issued and outstanding at December 31, 1997 and 1996, respectively; liquidation value of $55 and $84 at December 31, 1997 and 1996, respectively................................. 3 5 Special preferred stock, $1 par value; authorized 500 shares, issued and outstanding in one series designated as follows: $1.00 Non-Cumulative Special Preferred Stock, 23 and 32 shares authorized, issued and outstanding at December 31, 1997 and 1996, respectively; liquidation value of $304 and $430 at December 31,1997 and 1996, respectively.......................................... 23 32 Common stock, $.01 par value; 100,000 shares authorized; 23,151 and 22,459 issued at December 31, 1997 and 1996, respectively............................................ 232 225 Capital in excess of par value........................... 47,303 41,039 Retained earnings........................................ 25,127 6,350 Less: Treasury stock at cost; 747 shares................. (2,177) (2,177) ------- ------- Total stockholders' equity.............................. 70,511 45,474 ------- ------- Total liabilities and stockholders' equity............. $91,912 $57,532 ======= ======= The accompanying notes are an integral part of these financial statements. PRE-PAID LEGAL SERVICES, INC. CONSOLIDATED STATEMENTS OF INCOME (Amounts in 000's, except per share amounts) Year Ended December 31, ------------------------- 1997 1996 1995 ------ ------ ------ Revenues: Contract premiums............................ $76,688 $50,582 $31,290 Associate services........................... 12,143 5,646 3,183 Interest income.............................. 1,636 1,302 1,308 Other........................................ 2,001 1,678 1,255 ------- ------- ------- 92,468 59,208 37,036 ------- ------- ------- Costs and expenses: Contract benefits............................ 25,132 16,871 10,477 Commissions.................................. 16,717 11,476 7,708 General and administrative................... 8,711 6,227 4,315 Associate services and direct marketing...... 11,431 4,544 2,573 Depreciation................................. 704 533 477 Premium taxes................................ 866 372 242 ------- ------- ------- 63,561 40,023 25,792 ------- ------- ------- Income before income taxes..................... 28,907 19,185 11,244 Provision for income taxes..................... 10,117 6,715 3,932 ------- ------- ------- Net income..................................... 18,790 12,470 7,312 Less dividends on preferred shares............. 13 15 125 ------- ------- ------- Net income applicable to common stockholders... $18,777 $12,455 $ 7,187 ======= ======= ======= Basic earnings per common share................ $ .85 $ .58 $ .38 ======= ======= ======= Diluted earnings per common share.............. $ .83 $ .56 $ .34 ======= ======= ======= The accompanying notes are an integral part of these financial statements. PRE-PAID LEGAL SERVICES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Amounts in 000's) Year Ended December 31, -------------------------- 1997 1996 1995 ------ ------ ------ Cash flows from operating activities: Net income..................................... $18,790 $12,470 $ 7,312 Adjustments to reconcile net income to net cash provided by operating activities: Provision for associate stock options........ 100 318 76 Provision for deferred income taxes.......... 10,117 6,715 3,932 Depreciation and amortization................ 704 533 477 Increase in accrued Contract income.......... (689) (672) (475) Increase in commission advances.............. (22,891) (18,381) (9,938) Increase in other assets..................... (554) (492) (736) Increase in Contract benefits................ 787 315 138 Increase (decrease) in accounts payable and accrued expenses............................ 1,369 136 (162) ------- ------- ------- Net cash provided by operating activities.. 7,733 942 624 ------- ------- ------- Cash flows from investing activities: Additions to property and equipment.......... (1,343) (1,286) (608) Purchases of investments..................... (2,951) (1,663) (1,695) Maturities of investments.................... 316 400 111 ------- ------- ------- Net cash used in investing activities...... (3,978) (2,549) (2,192) ------- ------- ------- Cash flows from financing activities: Proceeds from sale of common and preferred stock........................................ 3,230 1,964 6,670 Dividends paid on preferred stock............ (13) (15) (125) ------- ------ ------- Net cash provided by financing activities.. 3,217 1,949 6,545 ------- ------ ------- Net increase in cash and unpledged cash equivalents.................................. 6,972 342 4,977 Cash and cash equivalents at beginning of year. 14,831 14,489 9,512 ------- ------- ------- Cash and cash equivalents at end of year....... $21,803 $14,831 $14,489 ======= ======= ======= Supplemental disclosure of cash flow information: Cash paid for interest....................... $ 6 $ 26 $ 10 ======= ======= ======= Cash paid for income taxes................... $ - $ - $ 18 ======= ======= ======= The accompanying notes are an integral part of these financial statements. PRE-PAID LEGAL SERVICES, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Amounts and shares in 000's, except dividend rates and par values) Year Ended December 31, ----------------------- 1997 1996 1995 ------ ------ ------ Preferred Stock - $1 par value, 400 shares authorized; issued and outstanding in two series designated as follows: $2.40 Cumulative Convertible Preferred Stock, authorized 391 shares; shares issued and outstanding at beginning of year (299 in 1995)..... $ - $ - $ 299 Shares exchanged for Common Stock (299 in 1995)..... - - (299) ----- ----- ----- Shares issued and outstanding at end of year........ - - - ----- ----- ----- $3.00 Cumulative Convertible Preferred Stock, authorized 5 shares; 5 shares issued and outstanding at beginning of year, liquidation value of $84....................................... 5 5 5 Shares exchanged for Common Stock (2 in 1997)....... (2) - - ----- ----- ----- Shares issued and outstanding at end of year (3 in 1997, 5 in 1996 and 1995), liquidation value of $55 at December 31, 1997........................... 3 5 5 ----- ----- ----- Special Preferred Stock - $1 par value, 500 shares authorized; series of fixed annual dividends $1, non-cumulative, convertible, shares issued and outstanding at beginning of year (32 in 1997, 45 in 1996, and 60 in 1995)............................... 32 45 60 Shares exchanged for Common Stock (9 in 1997, 13 in 1996, and 15 in 1995)............................... (9) (13) (15) ----- ----- ----- Shares issued and outstanding at end of year (23 in 1997, 32 in 1996, and 45 in 1995), liquidation value of $304 at December 31, 1997.................. 23 32 45 ----- ----- ----- Common Stock - $.01 par value, shares authorized 100,000; shares issued and outstanding at beginning of year (22,459 in 1997, 21,513 in 1996, and 14,216 in 1995)............................................ 225 215 142 Shares issued during year: Conversion of Preferred Stock (38 in 1997, 46 in 1996, and 4,245 in 1995)............................ - 1 42 Contributed to Company's employee stock ownership plan (3 in 1997, 5 in 1996, and 20 in 1995)......................... - - - Exercise of stock options and warrants (651 in 1997, 895 in 1996, and 3,032 in 1995) .............. 7 9 31 ----- ----- ----- Shares issued and outstanding at end of year (23,151 in 1997, 22,459 in 1996, and 21,513 in 1995)........ 232 225 215 ----- ----- ----- Capital in Excess of Par Value Balance at beginning of year.......................... 41,039 37,757 30,770 Exercise of stock options and warrants.............. 3,267 2,225 6,567 Income tax benefit related to exercise of stock options............................................. 2,930 997 - Conversion of preferred stock and convertible debentures.......................................... 11 14 272 Stock contribution to employee stock ownership plan. 56 46 39 Other............................................... - - 109 ------ ------ ------ Balance at end of year................................ 47,303 41,039 37,757 ------ ------ ------ PRE-PAID LEGAL SERVICES, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (continued) (Amounts and shares in 000's, except dividend rates and par values) Year Ended December 31, ------------------------- 1997 1996 1995 ------ ------ ------ Retained Earnings (Deficit) Balance at beginning of year...................... $ 6,350 $(6,105) $(13,292) Net Income........................................ 18,790 12,470 7,312 Cash dividends.................................... (13) (15) (125) ------- ------- ------- Balance at end of year............................ 25,127 6,350 (6,105) ------- ------- ------- Treasury stock Balance at beginning and end of year (747 shares). (2,177) (2,177) (2,177) ------- ------- ------- Total Stockholders' Equity........................ $70,511 $45,474 $29,740 ======= ======= ======= The accompanying notes are an integral part of these financial statements. PRE-PAID LEGAL SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar amounts in tables are in thousands unless otherwise indicated) Note 1 - Nature of Operations and Summary of Significant Accounting Policies Nature of Operations Pre-Paid Legal Services, Inc. (the "Company") underwrites and markets legal service plans (referred to as "Contracts") which provide for or reimburse a portion of legal fees incurred by members in connection with specified matters. Contracts are guaranteed renewable and are marketed primarily in 27 states by an independent sales force referred to as "Associates". Contract premiums are principally collected on a monthly basis. Basis of Presentation The consolidated financial statements have been prepared in accordance with generally accepted accounting principles which vary in some respects from statutory accounting principles used when reporting to state insurance regulatory authorities. Certain reclassifications have been made to conform to current year presentation. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, as well as those of PPL Agency, Inc. (See Note 6 for additional information regarding PPL Agency, Inc.) The primary subsidiaries of the Company include Pre-Paid Legal Casualty, Inc. (PPLCI) and Pre-Paid Legal Services, Inc. of Florida (PPLSIF). All significant intercompany accounts and transactions have been eliminated. Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Commissions Effective March 1, 1995, the Company implemented a level commission schedule of approximately 25% of annual premium revenue for all membership years. This commission schedule results in the Company incurring commission expense related to the sale of its legal expense plans on a basis consistent with the collection of the premiums generated by the sale of such Contracts. The Company currently advances the equivalent of three years of commissions on new Contract sales. Effective January 4, 1997, the Company implemented a new policy whereby associates receive only earned commissions on the first three memberships submitted unless the associate successfully completes a training program which includes an intensive one-day training seminar, produces three memberships and recruits one associate within 15 business days from their training date. Prior to March 1, 1995, first year commissions payable on the sale of a Contract, and earned in the first Contract year, were approximately 70% of annual Contract premiums while renewal commissions (payable as earned after the first Contract year) were approximately 16% of annual premiums. Fair Value of Financial Instruments The Company's financial instruments consist primarily of cash, certificates of deposit, other short-term investments, receivables and trade payables. Fair value estimates have been determined by the Company, using available market information and appropriate valuation methodologies. The carrying value of cash, certificates of deposit, other short-term investments, net receivables and trade payables are considered to be representative of their respective fair value, due to the short term nature of these instruments. Investment Securities The Company accounts for its investments in debt and equity securities in accordance with Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115"). Investments classified as trading are accounted for at fair value, available for sale investments are accounted for at fair value with unrealized gains and losses, net of taxes, excluded from earnings and reported as a separate component of stockholders' equity, and held to maturity investments are accounted for at amortized cost. All investment securities are adjusted for amortization of premiums and accretion of discounts. Amortization of premiums and accretion of discounts are recorded to income over the contractual maturity or estimated life of the individual investment on the level yield method. The Company has the ability and intent to hold to maturity its investment securities classified as held to maturity; accordingly, no adjustment has been made for the excess, if any of amortized cost over market. In determining the investment category classifications, management considers its asset/liability strategy, changes in interest rates and prepayment risk, the need to increase capital and other factors. Under certain circumstances (including the deterioration of the issuer's creditworthiness, a change in tax law, or statutory or regulatory requirements), the Company may change the investment security classification. Gain or loss on sale of investments is based upon the specific identification method. Income earned on the Company's investments in state and political subdivisions is not taxable. Property and Equipment Property and equipment is stated at cost less accumulated depreciation and amortization. Depreciation of property and equipment is computed using the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized over the estimated useful lives of the related assets or the period of the lease, whichever is shorter. Maintenance and repairs are expensed as incurred and renewals and betterments are capitalized. Revenue Recognition Contract premiums are recognized in income when due in accordance with Contract terms which generally require the holder of the Contract to remit premiums on a monthly basis. Contracts are canceled for nonpayment of premium after ninety days. Premiums due but not collected at the end of an accounting period are recorded as accrued Contract income; a provision for uncollectible premiums, if any, is recorded currently. Revenues from Associates' training program fees and sales of marketing supplies are recognized as income when cash is received. Commission Advances Commission advances represent the unearned portion of commissions advanced to Associates on sales of memberships. Commissions are earned as premiums are collected, usually on a monthly basis. The Company reduces Commission advances as premiums are paid and commissions earned. Unearned commission advances on lapsed memberships are recovered through collection of premiums on an associate's active memberships. At December 31, 1997, the Company maintains an allowance of $3.7 million to provide for estimated uncollectible balances. Effective November 1, 1993, the Company imposed a charge of 1.5% per month on unearned commission advances made between November 1, 1993 and March 1, 1995. Effective March 1, 1995, and in conjunction with other commission structure changes, the Company reduced the charge from 1.5% to .17% per month for commission advances made after such date. Effective January 4, 1997, the Company implemented a change to the method used in calculating the charge on unearned commission advances to only calculate a charge against unearned commission advances on memberships which canceled subsequent to the advance being made. The charge was also changed to equal the prime rate. Contract Benefit Liability The Contract benefit liability represents claims reported but not paid and actuarially estimated claims incurred but not reported on open panel Contracts and per capita amounts due provider attorneys on closed panel Contracts. The Company calculates the benefit liability costs on open panel Contracts based on completion factors which consider historical claims experience based on the dates that claims are incurred, reported to the Company and subsequently paid. Processing costs related to these claims are accrued based on an estimate of expenses to process such claims. Income Taxes The Company accounts for income taxes in accordance with SFAS 109, which is an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that are recognized in different periods in the Company's financial statements and tax returns. In estimating future tax consequences, SFAS 109 generally considers all future events other than the enactment of changes in the tax law or rates. Deferred taxes are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. The Company records deferred tax assets related to the recognition of future tax benefits of temporary differences and net operating loss and tax credit carryforwards. To the extent that realization of such benefits is not considered more likely than not, the Company establishes a valuation allowance to reduce such assets to estimated realizable value. Cash and Cash Equivalents The Company considers all highly liquid unpledged investments with maturities of three months or less at time of acquisition to be cash equivalents. Long-Lived Assets The Company records impairment losses on long-lived assets used in operations when events or changes in circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amounts of those assets. Stock-Based Compensation Compensation expense is recorded with respect to stock option grants and restricted stock awards to employees using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25 ("APB 25"). This method calculates compensation expense on the measurement date as the excess of the current market price of the underlying Company stock over the amount the employee is required to pay for the shares, if any. The expense is recognized over the vesting period of the grant or award. The Company has elected not to adopt the fair value method of accounting for stock-based compensation which is encouraged, but not required, by Statement of Financial Accounting Standards No 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). The Company has adopted the disclosure requirements of SFAS 123 in preparing its financial statement disclosures. Accounting Standards to be Adopted Statement of Financial Accounting Standards 130, "Reporting Comprehensive Income," ("SFAS 130") was issued in June, 1997. This Statement establishes standards for reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. This Statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. SFAS 130, effective for fiscal years beginning after December 15, 1997, requires reclassification of financial statements for earlier periods provided for comparative purposes. The Company currently does not expect adoption of this Statement to have a material effect on financial statement presentation. Statement of Financial Accounting Standards 131, "Disclosures about Segments of an Enterprise and Related Information," ("SFAS 131") was issued in June, 1997. This Statement establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. SFAS 131, effective for fiscal years beginning after December 15, 1997, requires comparative information for previous years to be restated to comply with SFAS 131's reporting requirements. The Company currently does not expect adoption of this Statement to have a material effect on financial statement presentation or related footnote disclosures. Note 2 - Investment Securities A summary of the amortized cost, unrealized gains and losses and fair values of held to maturity investment securities at December 31, 1997 and 1996 follows: December 31, 1997 ------------------------------------ Amortized Gross Unrealized Fair Cost Gains Losses Value --------- ------- ----------- ------ U.S. Government obligations.. $3,200 $ 3 $ - $3,203 Obligations of state and political subdivisions..... 300 - - 300 ------ ------ ------ ------ Total................... $3,500 $ 3 $ - $3,503 ====== ====== ====== ====== December 31, 1996 ------------------------------------ Amortized Gross Unrealized Fair Cost Gains Losses Value --------- ------- ----------- ------ U.S. Government obligations.. $2,025 $ - $ 3 $2,022 Obligations of state and political subdivisions..... 414 1 $ 2 $ 413 ------ ------ ------ ------ Total................... $2,439 $ 1 $ 5 $2,435 ====== ====== ====== ====== A comparison of the amortized cost and fair value of the Company's held to maturity investment securities at December 31, 1997 by maturity date follows: Amortized Cost Fair Value --------- ---------- One year or less............... $2,850 $2,853 Two years through five years... 650 650 ------ ------ Total.......................... $3,500 $3,503 ====== ====== The Company's investment securities are included in the accompanying consolidated balance sheets at December 31, 1997 and 1996 as follows. December 31, --------------- 1997 1996 ------ ------ Held-to-maturity investments -current portion................ $1,875 $ 500 Held-to-maturity investments.... 650 989 Investments pledged............... 975 950 ------ ------ Total........................... $3,500 $2,439 ====== ====== Remaining amounts included in these balance sheet captions represent certificates of deposit. The Company is required to pledge investments to various state insurance departments as a condition to obtaining authority to do business in certain states. The Company has investments pledged to state regulatory agencies as follows: December 31, ---------------- 1997 1996 ------ ------ Certificates of deposit.......... $1,797 $1,822 Obligation of state and political subdivisions.......... 300 300 U. S. Government obligations.... 675 650 ------ ------ Total $2,772 $2,772 ====== ====== Note 3 - Property and Equipment Property and equipment is comprised of the following: December 31, Estimated ---------------- Useful Life 1997 1996 ------------ ------ ------ Equipment, furniture and fixtures................... 3-10 years $6,186 $5,283 Computer software.............. 5 years 2,324 2,087 Building and improvements...... 20 years 1,834 1,653 Automotive..................... 3 years 231 213 Land........................... 110 110 ------ ------ 10,685 9,346 Accumulated depreciation...... (7,091) (6,391) ------ ------ Property and equipment, net... $3,594 $2,955 ====== ====== Note 4 - Income Taxes The provision for income taxes consists of the following: Year Ended December 31, ------------------------- 1997 1996 1995 ------- ------- ------- Current........................... $ - $ - $ - Deferred.......................... 10,117 6,715 3,932 ------- ------- ------- Total provision for income taxes.. $10,117 $ 6,715 $ 3,932 ======= ======= ======= A reconciliation of the statutory Federal income tax rate to the effective income tax rate is as follows: Year Ended December 31, ----------------------- 1997 1996 1995 ------ ------ ------ Statutory Federal income tax rate............................ 34.0% 34.0% 34.0% Tax exempt interest.............. (.2) (.2) (.2) State income taxes and other..... 1.2 1.2 1.2 ---- ---- ---- Effective income tax rate........ 35.0% 35.0% 35.0% ==== ==== ==== Deferred tax liabilities and assets at December 31, 1997 and 1996 are comprised of the following: December 31, --------------------- 1997 1996 -------- -------- Deferred tax liabilities: Commissions advanced .............................. $ 18,784 $ 10,772 Depreciation ...................................... - 175 -------- -------- Total deferred tax liabilities.................... 18,784 10,947 -------- -------- Deferred tax assets: Expenses not yet deducted for tax purposes........ 445 340 Depreciation ..................................... 14 - Net operating loss carryforward................... 5,099 4,198 Capital loss carryforward ........................ - 654 General Business Credit carryforward.............. 325 325 AMT Credit carryforward .......................... 366 366 ------- ------ Total deferred tax assets ........................ 6,249 5,883 Valuation allowance for deferred tax assets....... (3,936) (4,220) ------- ------ Total net deferred tax assets..................... 2,313 1,663 ------- ------ Net deferred liability ........................... $(16,471) $(9,284) ======== ======= A valuation allowance has been established for deferred tax assets representing the estimated tax benefit of the General Business Credit carryforward and pre-1996 net operating loss carryforwards as the Company does not believe it is more likely than not that the tax benefits of such carryforwards will be realized. The valuation allowance decreased $284,000 during the year ended December 31, 1997 and increased $147,000 for the year ended December 31, 1996. The Company generated tax losses of $2.6 million and $2.8 million for the years ended December 31, 1997 and 1996, respectively. The Company believes it will realize the approximate $1.9 million future tax benefits from these tax losses and has appropriately not provided a valuation allowance against this amount. The exercise of stock options which have been granted under the Company's various stock option plans give rise to compensation which is includable in the taxable income of the option grantee and deductible by the Company for federal and state income tax purposes. Such compensation results from increases in the fair market value of the Company's common stock subsequent to the date of grant of the applicable exercised stock options, and in accordance with Accounting Principles Board Opinion No. 25, such compensation is not recognized as an expense for financial accounting purposes and the related tax benefits, including the $1.9 million of future tax benefits of net operating loss carryforwards, are recorded in capital in excess of par value. At December 31, 1997, the Company has net operating loss carryforwards for Federal regular tax and alternative minimum tax purposes of approximately $14.6 million and $14.2 million, respectively, expiring in 2001 through 2012. In addition, the Company has general business and rehabilitation tax credit carryforwards of approximately $325,000, expiring primarily in 1998 to 2001, and an alternative minimum tax credit carryforward of $366,000 which does not expire. The ability of the Company to utilize NOLs and tax credit carryforwards to reduce future Federal income taxes of the Company is subject to various limitations under the Internal Revenue Code of 1986, as amended (the "Code"). The utilization of such carryforwards may be further limited upon the occurrence of certain capital stock transactions, including the issuance or exercise of rights to acquire stock, the purchase or sale of stock by 5% stockholders, as defined in Temporary Treasury Regulations, and the offering of stock by the Company during any three-year period resulting in an aggregate change of more than 50% ("Ownership Change") in the beneficial ownership of the Company. In the event of an Ownership Change, Section 382 of the Code imposes an annual limitation on the amount of a corporation's taxable income that can be offset by those carryforwards. Note 5 - Stockholders' Equity On February 27, 1995, all of the Company's remaining outstanding $2.40 Cumulative Convertible Preferred Stock automatically converted into Common Stock pursuant to its terms. Approximately 3.9 million shares of Common Stock were issued as a result of this conversion. Each share of $3.00 Cumulative Convertible Preferred Stock is entitled to receive cumulative cash dividends at the annual rate of $3 per share, payable quarterly, is convertible into 2.5 shares of Common Stock and is redeemable at the option of the Company at $25 per share. The $3.00 Cumulative Convertible Preferred Stock had a liquidation value of $55,000 at December 31, 1997. During 1997 and 1996, $3.00 Cumulative Convertible Preferred Stock consisting of 1,714 and 40 shares, respectively, were converted into 4,385 shares of Common Stock. Each share of the Special Preferred Stock is entitled to a non-cumulative annual dividend of $1.00 per share, is convertible into 3.5 shares of Common Stock and is redeemable at the option of the Company at $13.34 per share, plus all accumulated and unpaid dividends. The Special Preferred Stock had a liquidation value of $304,000 at December 31, 1997. During 1997, 1996 and 1995, Special Preferred Stock consisting of 9,767, 12,812 and 14,841 shares, respectively, were converted into 130,970 shares of Common Stock. The Company's ability to pay dividends is dependent in part on its ability to derive dividends from its subsidiaries. The payment of dividends by PPLCI is restricted under the Oklahoma Insurance Code to available surplus funds derived from realized net profits. At December 31, 1997, PPLCI did not have funds available for payment of dividends without the approval of the Oklahoma Insurance Commissioner. At December 31, 1997, the Company had outstanding options to purchase a total of 560,100 shares of the Company's Common Stock at an average price of $15.89 per share expiring at various periods through July, 2003. Note 6 - Related Party Transactions The Company's Chairman is the owner of PPL Agency, Inc. ("Agency"). The Company has agreed to indemnify and hold harmless the Chairman for any personal losses incurred as a result of his ownership of this corporation and any income earned by Agency accrues to the Company. The Company provides management and administrative services for Agency, for which it receives specified management fees and expense reimbursements. Agency's financial position and results of operations are included in the Company's financial statements on a combined basis. Agency earned commissions, net of amounts paid directly to its agents by the underwriter, during 1997, 1996 and 1995 of $110,000, $130,000 and $120,000, respectively, through its sales of insurance products of an unaffiliated company. Agency had a net loss for the year ended December 31, 1997 of $12,500 and net income for the year ended December 31, 1996 and 1995 of $6,700 and $599, respectively, after incurring commissions earned by the Chairman of $50,000, $49,000 and $45,000 respectively, and annual management fees of $72,000 paid to the Company. The Chairman and his wife own Stonecipher Aviation LLC ("SA"). The Company has agreed to reimburse SA for certain expenses pertaining to trips made by Company personnel for Company business purposes using aircraft owned by SA. Such reimbursement represents the pro rata portion of direct operating expenses, such as fuel, maintenance, pilot fees and landing fees, incurred in connection with such aircraft based on the relative number of flights taken for Company business purposes versus the number of other flights during the applicable period. No reimbursement is made for depreciation, capital expenditures or improvements relating to such aircraft. During 1997, the Company paid $192,000 to SA as reimbursement for such transportation expenses. An executive officer (President) and director of the Company has loans from the Company made in December 1992 and December 1996. The largest aggregate balance of these loans during the year ended December 31, 1997 was $296,000. The outstanding balance of these loans as of December 31, 1997 was $296,000. These loans bear annual interest at the rate of 3% in excess of the prime rate, adjusted on January 1 of each year, and are secured by commissions due from the Company. This individual also owns interests ranging from 10% to 67% in corporations or partnerships not affiliated with the Company but engaged in the marketing of the Company's Contracts and which earn commissions from sales of Contracts. These entities earned commissions, net of amounts passed through as commissions to their sales agents, during 1997, 1996 and 1995 of $49,000, $54,000 and $55,000, respectively. Note 7 - Commitments and Contingencies Aggregate rental expense under all operating leases was $17,000, $27,000 and $28,000 in 1997, 1996 and 1995, respectively. There are no significant operating lease commitments in effect at December 31, 1997. The Company is a named defendant in certain lawsuits arising in the ordinary course of the Company's business. While the outcome of these lawsuits cannot be predicted with certainty, the Company does not expect these matters to have a material adverse effect on the Company's financial condition, liquidity or results of operations. Note 8 - Stock Options and Purchase Plan The Company has a stock option plan ("Plan") under which the Board of Directors ("Board") or its Stock Option Committee ("Committee") may grant options to purchase shares of the Company's common stock. The Plan permits the granting of options to directors, officers and employees of the Company to purchase the Company's common stock at not less than the fair value at the time the options are granted. The Plan provides for option grants to acquire up to 1,000,000 shares and permits the granting of incentive stock options as defined under Section 422 of the Internal Revenue Code at an exercise price for each option equal to the market price of the Company's common stock on the date of the grant and a maximum term of 10 years. Options not qualifying as incentive stock options under the Plan will have a maximum term of 15 years. Vesting of options granted under the Plan is determined by the Board or Committee. No options may be granted under the Plan after December 12, 2005. The Plan provides for automatic grants of options to non-employee directors of the Company. Under the Plan, each incumbent non-employee director and any new non-employee director will receive options to purchase 10,000 shares of common stock on March 1 of each year commencing March 1, 1996. The options to be granted on March 1 of each year will be immediately exercisable as to 2,500 shares and will vest in additional increments of 2,500 shares on the following June 1st, September 1st, and December 1st in the year of grant, subject to continued service by the non-employee director during such periods. Options granted to non-employee directors under the Plan have an exercise price equal to the closing price of the common stock on the date of grant. A summary of the status of the Company's Plan as of December 31, 1997, 1996 and 1995 and changes during the years ending on those dates is presented below:
1997 1996 1995 -------------------- -------------------- -------------------- Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price Outstanding at beginning of year..... 410,000 $ 6.78 405,000 $ 5.40 150,000 $ .58 Granted.............................. 185,000 14.49 45,000 13.50 315,000 6.84 Exercised............................ (285,000) 5.55 (40,000) .38 (60,000) .90 Terminated........................... (10,000) 16.00 - - - - ------- -------- ------- ------- ------- ------- Outstanding at end of year........... 300,000 $ 12.39 410,000 $ 6.78 405,000 $ 5.40 ======= ======== ======= ======= ======= ======= Options exercisable at year end...... 290,000 $ 12.27 385,000 $ 6.18 405,000 $ 5.40 ======= ======== ======= ======= ======= =======
The following table summarizes information about stock options outstanding at December 31, 1997 issued pursuant to the Plan: Weighted Average Range of Exercise Number Remaining Weighted Average Prices Outstanding Contractual Life Exercise Price - ------------------------------------------------------------------------------- $.38 15,000 2.72 $ .38 $8.13 - $10.38 85,000 3.02 9.32 $14.25 -$16.00 200,000 4.25 14.60 ------- ---- ------ 300,000 3.82 $12.39 ======= ==== ====== The Company, effective July 3, 1995 and July 22, 1997, adopted stock option plans for its marketing associates whereby the associates could earn stock options based upon their production and recruiting efforts. These options were issued to qualifying associates at each month end from July 1995 through March 1996 and for the month of July 1997 based on the month's production and recruiting results. The exercise price is equal to the closing stock price on the last trading day of each respective month for all grants from July 1995 through March 1996 and the exercise price for the July 1997 grants was $27.00 (which exceeded market). The options granted from July 1995 through March 1996 expired pursuant to their terms on July 31, 1997 and the options granted for production during July 1997 expire on July 31, 1998. Activity related to these plans is as follows:
1997 1996 1995 --------------------- --------------------- ----------------------- Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price --------- ---------- ---------------------- ---------- ---------- Outstanding at beginning of year........ 350,092 $ 10.00 298,225 $ 8.02 - $ - Granted................................. 100,000 27.00 177,133 12.50 299,785 8.02 Exercised............................... (135,125) 10.26 (70,516) 8.95 (1,560) 7.03 Terminated.............................. (213,617) 10.01 (54,750) 8.63 - - -------- -------- ------- -------- ------- ------- Outstanding at end of year.............. 101,350 $ 26.54 350,092 $ 10.00 298,225 $ 8.02 ======== ======== ======= ======== ======= ======= Options exercisable at year end......... 101,350 $ 26.54 350,092 $ 10.00 298,225 $ 8.02 ======== ======== ======= ======== ======= =======
Weighted Average Range of Exercise Number Remaining Weighted Average Prices Outstanding Contractual Life Exercise Price ----------------- -------------- -------------------- ------------------- $8.25 2,500 2.96 $ 8.25 $27.00 98,850 .58 27.00 ------- ----- ------ 101,350 .64 $26.54 ======= ===== ====== In addition to those options issued pursuant to the Plan and those options issued to marketing associates in the two preceding tables, the Company has other options outstanding. A summary of the status of such options as of December 31, 1997, 1996 and 1995 and changes during the years ending on those dates is presented below:
1997 1996 1995 -------------------- ----------------------- ---------------------- Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price --------- ---------- --------- ---------- ----------- ---------- Outstanding at beginning of year..... 245,050 $ 1.00 1,029,656 $ 1.47 3,995,781 $ 2.01 Granted.............................. 144,000 17.12 - - 5,000 2.69 Exercised............................ (230,300) .96 (784,606) 1.62 (2,971,125) 2.20 Terminated........................... - - - - - - ------- -------- --------- ------- --------- ------- Outstanding at end of year........... 158,750 $ 15.69 245,050 $ 1.00 1,029,656 $ 1.47 ======= ======== ======== ======= ========= ======= Options exercisable at year end...... 158,750 $ 15.69 245,050 $ 1.00 1,029,656 $ 1.47 ======= ======== ========= ======= ========= =======
The following table summarizes information about stock options other than those included in the Plan or issued to marketing associates outstanding at December 31, 1997: Weighted Average Range of Exercise Number Remaining Weighted Average Prices Outstanding Contractual Life Exercise Price $.50 - $2.69 14,750 1.55 $ 1.73 $16.75 - $19.00 144,000 4.55 17.13 ------- ----- ------- 158,750 4.28 $ 15.69 ======= ===== ======= Statement of Financial Accounting Standards No. 123, "Accounting for Stock Based Compensation" ("SFAS 123") establishes a fair value method and disclosure standards for stock-based employee compensation arrangements, such as stock purchase plans and stock options. It also applies to transactions in which an entity issues its equity instruments to acquire goods or services from nonemployees, requiring that such transactions be accounted for based on fair value. As allowed by SFAS 123, the Company will continue to follow the provisions of Accounting Principles Board Opinion No. 25 and related interpretations for its employee compensation arrangements, and disclose the pro forma effects of applying SFAS 123. Had compensation cost for the Company's employee related stock option plans been determined based on the fair value at the grant dates for awards under the Plan consistent with the method of SFAS 123, the Company's net income and earnings per share for 1997 and 1996 would have been reduced to the pro forma amounts indicated below: 1997 1996 ------ ------ Net income applicable to common stockholders: As reported.................. $18,790 $12,455 Pro forma.................... $17,667 $12,227 Basic earnings per common share: As reported.................. $ .85 $ .58 Pro forma.................... $ .80 $ .57 Diluted earnings per common share: As reported.................. $ .83 $ .56 Pro forma.................... $ .78 $ .55 The estimated fair value of options granted to employees was estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used: no dividend yield; risk-free interest rate of 5.00%; expected life of 5 years; and expected volatility of 30%. In accordance with SFAS 123, the Company recorded compensation expense related to the issuance of stock options to marketing associates of $100,000, $318,000 and $76,000 during 1997, 1996 and 1995, respectively. The weighted average fair value of options granted that met the minimum exercise criteria during 1997 was $1.07 per share. The fair value of each stock option grant to marketing associates was measured on the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions used: no dividend yield; risk-free interest rate of 5.00%; expected life of 1 year; and expected volatility of 30%. During 1988, the Company adopted an employee stock ownership plan. Under the plan, employees may elect to defer a portion of their compensation by making contributions to the plan. Up to seventy-five percent of the contributions made by employees may be used to purchase Company common stock. The Company, at its option, may make matching contributions to the plan, and recorded expense during 1997, 1996 and 1995 of $55,785, $46,176 and $39,150 based on contributions of Company stock of 3,000 shares, 5,100 shares and 20,000 shares, respectively. Note 9 - Earnings Per Share The Company has adopted Statement of Financial Accounting Standards No. 128, "Earnings Per Share," and has restated earnings per share for all periods presented in accordance with that Statement. Basic earnings per common share are computed by dividing net income applicable to common stockholders by the weighted average number of shares of Common Stock outstanding during the year. Diluted earnings per common share are computed by dividing net income applicable to common stockholders by the weighted average number of shares of common stock and common stock equivalents outstanding during the year. The $3.00 Cumulative Convertible Preferred stock is not included in the weighted average number of common shares outstanding since such shares are considered antidilutive and therefore ignored in the computation of diluted earnings per share. Special Preferred Stock is considered to be a dilutive common stock equivalent and the number of shares issuable on conversion of the Special Preferred Stock is added to the weighted average number of common shares. The weighted average number of common shares is also increased by the number of shares issuable on the exercise of warrants and options less the number of common shares assumed to have been purchased with the proceeds from the exercise of the options and warrants pursuant to the treasury stock method; those purchases are assumed to have been made at the average price of the common stock during the respective period. Additionally, the $2.40 Cumulative Convertible Preferred Stock, which was actually converted during 1995, is assumed to have been converted at the beginning of 1995 and the respective dividends are included in determining net income applicable to common stockholders. Year Ended December 31, ------------------------- 1997 1996 1995 ------ ------ ------- Basic Earnings Per Share: Earnings: - --------- Net income applicable to common stockholders......... $18,777 $12,455 $ 7,187 ======= ======= ======= Shares: - ------- Weighted average shares outstanding.................. 22,127 21,332 18,947 ======= ======= ======= Basic earnings per common share...................... $ .85 $ .58 $ .38 ======= ======= ======= Diluted Earnings Per Share: Earnings: - --------- Net income applicable to common stockholders......... $18,777 $12,455 $7,187 Add: Dividends on assumed conversion of preferred stock.............................................. - - 110 ------- ------- ------ Income available to common stockholders and assumed conversions........................................ $18,777 $12,455 $7,297 ======= ======= ====== Shares: - ------- Weighted average shares outstanding.................. 22,127 21,332 18,947 Assumed conversion of preferred stock................ 109 142 827 Assumed exercise of options and warrants............. 339 845 1,634 ------- ------- ------- Weighted average number of shares, as adjusted....... 22,575 22,319 21,408 ======= ======= ======= Diluted earnings per common share.................... $ .83 $ .56 $ .34 ======= ======= ======= Note 10 - Selected Quarterly Financial Data (Unaudited) Following is a summary of the unaudited interim results of operations for the years ended December 31, 1997 and 1996. Selected Quarterly Data (In thousands except per share amounts) Income before Basic earnings Diluted income Net per common earnings per Revenues taxes Income share common share -------- -------- -------- ------------- ------------ 1997 ---- First quarter.... $19,725 $6,124 $3,981 $.18 $.18 Second quarter... 22,199 6,700 4,355 .20 .19 Third quarter.... 24,199 7,667 4,983 .22 .22 Fourth quarter... 26,345 8,416 5,471 .24 .24 1996 ---- First quarter.... $12,354 $3,954 $2,566 $.12 $.12 Second quarter... 14,796 4,862 3,156 .15 .14 Third quarter.... 15,760 5,006 3,251 .15 .15 Fourth quarter... 17,036 5,363 3,482 .16 .16 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING - ---------------------------------------------------------------------- AND FINANCIAL DISCLOSURE ------------------------ None. PART III In accordance with the provisions of General Instruction G(3), information required by Items 10, 11, 12 and 13 of Form 10-K are incorporated herein by reference to the Company's Proxy Statement for the Annual Meeting of Shareholders to be filed prior to April 30, 1998. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - ----------------------------------------------------------------------------- (a) The following documents are filed as part of this report: (1) Financial Statements: See Index to Consolidated Financial Statements and Consolidated Financial Statement Schedule set forth on page 20 of this report. (2) Financial Statement Schedule: See Index to Consolidated Financial Statements and Consolidated Financial Statement Schedule set forth on page 20 of this report. (3) Exhibits: For a list of the documents files as exhibits to this report, see the Exhibit Index following the signatures to this report. (b) Reports on Form 8-K: The Company filed no reports on Form 8-K during the quarter ended December 31, 1997. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PRE-PAID LEGAL SERVICES, INC. Date: February 13, 1998 By: /s/ Randy Harp ------------------------------------ Randy Harp Chief Financial Officer and Chief Operating Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Name Position Date /s/ Harland C. Stonecipher Chairman of the Board of February 13, 1998 - ----------------------------- Directors (Principal Harland C. Stonecipher Executive Officer) /s/ Wilburn L. Smith President and Director February 13, 1998 - ----------------------------- Wilburn L. Smith /s/ Kathleen S. Pinson Vice President, Controller February 13, 1998 - ----------------------------- and Director, (Principal Kathleen S. Pinson Accounting Officer) /s/ Randy Harp Chief Operating Officer, February 13, 1998 - ----------------------------- Chief Financial Officer Randy Harp and Director (Principal Financial Officer) /s/ Peter K. Grunebaum Director February 13, 1998 - ----------------------------- Peter K. Grunebaum /s/ Francis A. Tarkenton Director February 13, 1998 - ----------------------------- Francis A. Tarkenton SCHEDULE II PRE-PAID LEGAL SERVICES, INC. Consolidated Valuation And Qualifying Accounts Years ended December 31, 1997 (Amounts in 000's) Additions Balance Charged at to Cost Balance Beginning and at End Description of Year Expenses Deductions of Year ------------------------------------------------------------------------------- Allowance for unrecoverable commission advances - (non-current): December 31, 1997 $3,444 $ 300 - $3,744 ====== ===== ===== ====== December 31, 1996 $2,669 $ 775 - $3,444 ====== ===== ===== ====== December 31, 1995 $2,469 $ 200 - $2,669 ====== ===== ===== ====== INDEX TO EXHIBITS Exhibit No. Description - ----------- ------------- 3.1 Amended and Restated Certificate of Incorporation of the Company, as amended (Incorporated by reference to Exhibit 4.1 of the Company's Report on Form 8-K dated January 10, 1997) 3.2 Amended and Restated Bylaws of the Company (Incorporated by reference to Exhibit 3.1 of the Company's Report on Form 10-Q for the period ended September 30, 1996) *10.1 Employment Agreement effective January 1, 1993 between the Company and Harland C. Stonecipher (Incorporated by reference to Exhibit 10.1 of the Company's Annual Report on Form 10-KSB for the year ended December 31, 1992) *10.2 Agreements between Shirley Stonecipher, New York Life Insurance Company and the Company regarding life insurance policy covering Harland C. Stonecipher (Incorporated by reference to Exhibit 10.21 of the Company's Annual Report on Form 10-K for the year ended December 31, 1985) *10.3 Amendment dated January 1, 1993 to Split Dollar Agreement between Shirley Stonecipher and the Company regarding life insurance policy covering Harland C. Stonecipher (Incorporated by reference to Exhibit 10.3 of the Company's Annual Report on Form 10-KSB for the year ended December 31, 1992) *10.4 Form of New Business Generation Agreement Between the Company and Harland C. Stonecipher (Incorporated by reference to Exhibit 10.22 of the Company's Annual Report on Form 10-K for the year ended December 31, 1986) *10.5 Amendment to New Business Generation Agreement between the Company and Harland C. Stonecipher effective January, 1990 (Incorporated by reference to Exhibit 10.12 of the Company's Annual Report on Form 10-KSB for the year ended December 31, 1992) *10.6 Stock Option Plan, as amended and restated effective December 12, 1995 (Incorporated by reference to Exhibit 10.6 of the Company's Annual Report on Form 10-KSB for the year ended December 31, 1995) *10.7 Demand Note of Wilburn L. Smith and Carol Smith dated December 11, 1992 in favor of the Company (Incorporated by reference to Exhibit 10.15 of the Company's Form SB-2 filed February 8, 1994) *10.8 Demand Note of Wilburn L. Smith and Carol Smith dated December 31, 1996 in favor of the Company *10.9 Security Agreement between the Company, Wilburn L. Smith and Carol Smith dated December 11, 1992 (Incorporated by reference to Exhibit 10.16 of the Company's Form SB-2 filed February 8, 1994) *10.10 Letter Agreements dated July 8, 1993 and March 7, 1994 between the Company and Wilburn L. Smith (Incorporated by reference to Exhibit 10.17 of the Company's Form 10-KSB filed for the year ending December 31, 1993) *10.11 Stock Option Agreement dated May 13, 1997 between the Company and Francis A. Tarkenton (Incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997) 11.1 Statement of Computation of Per Share Earnings 21.1 List of Subsidiaries of the Company 23.1 Consent of Deloitte & Touche LLP 27.1 Financial Data Schedule ____________________ * ....Constitutes a management contract or compensatory plan or arrangement required to be filed as an exhibit to this report. EX-10.8 2 PROMISSORY NOTE EXHIBIT 10.8 PROMISSORY NOTE $224,700.00 Date: December 31, 1996 FOR VALUE RECEIVED, I, waiving grace and protest, promise to pay to the order of Pre-Paid Legal Services, Inc., an Oklahoma corporation (the "Payee"), at 321 East Main Street, Ada, Oklahoma, (or at such other place as the Payee may designate in writing) the principal sum of Two Hundred Twenty Four Thousand Seven Hundred dollars ($224,700.00) together with interest from December 31, 1996, on the unpaid principal at the rate of eleven and one-half percent (11.5%) annually. The unpaid principal and accrued interest shall be payable in full on December 31, 1998 (the "Due Date"). All payments on this Note shall be applied first in payment of accrued interest and any remainder in payment of principal. The undersigned agrees that if, and as often as, this Note is placed in the hands of an attorney for collection or to defend or enforce any of the holder's rights hereunder, the undersigned will pay to the holder its reasonable attorney's fees, together with all court costs and other expenses of collection paid by such holder. The Promisor reserves the right to prepay this Note (in whole or in part) prior to the Due Date with no prepayment penalty. No renewal or extension of this Note, delay in enforcing any right of the Payee under this Note, or assignment by Payee of this Note shall affect the liability of the Promisor(s). All rights of the Payee under this Note are cumulative and may be exercised concurrently or consecutively at the Payee's option. This Note shall be construed in accordance with the laws of the State of Oklahoma. If any one or more of the provisions of this Note are determined to be unenforceable, in whole or in part, for any reason, the remaining provisions shall remain fully operative. All payments of principal and interest on this Note shall be paid in the legal currency of the United States. Effective the 31st day of December, 1996, By: /s/ Wilburn L. Smith ----------------------------------------- Wilburn L. Smith ("Promisor") EX-11.1 3 EARNING PER SHARE STATEMENT EXHIBIT 11.1 EXHIBIT 11.1 PRE-PAID LEGAL SERVICES, INC. Statement re Computation of Per Share Earnings (In 000's except per share amounts)
Year Ended December 31, ----------------------- 1997 1996 1995 ---- ---- ---- BASIC EARNINGS PER SHARE: Computation for Statement of Income - ----------------------------------- Earnings: Net income applicable to common stockholders (a)......... $18,777 $12,455 $7,187 ======= ======= ====== Shares: - ------- Weighted average shares outstanding, (net of 747 shares of treasury stock) disregarding exercise of options or conversion of preferred stock.......................... 22,127 21,332 18,947 ======= ======= ======= Earnings per common share (a)............................ $ .85 $ .58 $ .38 ======= ======= ======= DILUTED EARNINGS PER SHARE: Computation for Statement of Income Earnings: - --------------------------------------------- Net income applicable to common stockholders (a)............ $18,777 $12,455 $7,187 Add: Dividends on assumed conversion of preferred stock..... - - 110 ------- ------- ------ Net income, as adjusted..................................... $18,777 $12,455 $7,297 ======= ======= ====== Shares: Weighted average shares outstanding, (net of 747 shares of treasury stock) disregarding exercise of options or conversion of preferred stock........................................... 22,127 21,332 18,947 Assumed dilutive conversion of preferred stock.............. 109 142 827 Assumed exercise of options and warrants based on the treasury stock method using average market price.......... 339 845 1,634 ------ ------ ------ Weighted average number of shares, as adjusted.............. 22,575 22,319 21,408 ====== ====== ====== Earnings per share - assuming dilution (a).................. $ .83 $ .56 $ .34 ====== ====== ======
(a) These amounts agree with the related amounts in the statements of income. EX-21.1 4 LIST OF SUBSIDIARIES OF THE COMPANY EXHIBIT 21.1 EXHIBIT 21.1 PRE-PAID LEGAL SERVICES, INC. Subsidiaries of Registrant Percentage of State of Ownership by Name of Subsidiary Incorporation Registrant -------------------- --------------- --------------- Pre-Paid Legal Casualty, Inc. Oklahoma 100% American Legal Services, Inc. Oklahoma 100% Pre-Paid Legal Services, Inc. of Florida Oklahoma 100% C & A Investments, Inc. Oklahoma 100% Pre-Paid Legal Administrators, Inc. Oklahoma 100% Justice 900, Inc. Oklahoma 100% Legal Service Plans of Virginia, Inc. Virginia 100% National Pre-Paid Legal Services of Georgia 100% owned by Mississippi, Inc. Pre-Paid Legal Services, Inc. of Florida Pre-Paid Legal Services of Tennessee, Inc. Tennessee 100% owned by Pre-Paid Legal Casualty, Inc. EX-23 5 AUDITORS CONSENT EXHIBIT 23.1 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statements No. 33-82144 and No. 33-62663 on Form S-8 and Registration Statements No. 33-62661, No. 333-15047, No. 333-31069 and No. 333-40723 on Form S-3 of Pre-Paid Legal Services, Inc. of our report dated February 12, 1998 appearing in this Annual Report on Form 10-K of Pre-Paid Legal Services, Inc. for the year ended December 31, 1997. Deloitte & Touche LLP Tulsa, Oklahoma February 17, 1998 EX-27 6 ARTICLE 5 FDS FOR ANNUAL 10-K
5 The schedule contains summary financial information extracted from the December 31, 1997 financial statements contained in Form 10-K and is qualified in its entirety by reference to such financial statements. 0000311657 Pre-Paid Legal Services, Inc. 1,000 U.S. Dollars YEAR DEC-31-1997 JAN-01-1997 DEC-31-1997 1 21,803 4,242 2,399 0 0 44,149 3,594 0 91,902 4,903 0 0 26 232 70253 91,912 76,688 92,468 0 63,561 0 0 0 28,907 10,117 18,790 0 0 0 18,777 .85 .83
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