In February 2009 Citron Research and Jim Cramer provided a critical assessment of Life Partners’ (NASDAQ:LPHI) business and management. The Citron report focused on LPHI's "egregious fees", the unlikely sustainability of those fees, the CEO’s past accounting indiscretions, and LPHI's tiny auditor and equally-small audit fees. A few days after the critical report from Citron, LPHI's management posted a response on its website. Oddly, management has since removed the response, but a copy can be found under the comments sections here.
The reports peaked my interest and as a result, I conducted additional research on LPHI’s business practices and management. I believe many of Citron’s red flags have merit, and found additional red flags that suggest a business model that revolves around exorbitant fees charged to retail investors and possible forensic accounting issues.
Challenge to Eide Bailly
There is one entity in the position to address many of LPHI's red flags, their new auditor Eide Bailly. Eide Bailly acquired LPHI’s tiny auditor Murrell, Hall, McIntosh in August 2008. Eide Bailly is expected to provide its first audited financial statements on LPHI in mid-May 2009. I believe investors should demand more oversight than what was provided in Murrell's 2008 audit (fees of only $85,881). Eide Bailly has a significant opportunity to standout among the smaller audit firms. IF LPHI is taking advantage of its retail customers in a potentially illegal manner (something I suspect but CANNOT verify), then Eide Bailly is in the best position to expose these issues and protect public investors and clients. They are also in the best position to address potential forensic accounting issues highlighted below.
1) Are LPHI’s Fees the Highest in the World for Any Asset Class?
In management’s response to the Citron report, management stated that their fees are “only” 7% of face and that there is no company with which these fees can be compared. I believe the way management characterizes its fees is highly misleading. In LPHI’s 3Q (the last quarter with a 10q or 10k), LPHI had $28.1 million of “gross” revenue and $14.2 million of “net” revenue.
The difference in gross and net is the fees LPHI pays to its licensees, agents and brokers. While management discloses their fees as a percentage of face value (14.4% gross and 7.3% net of policy face value transacted), they do not disclose the purchase price of the policies. Policies are acquired at a large discount to face value.
According to R. Scott Peden, LPI’s President, on LPHI’s second quarter earnings conference call, “it’s not so much the precision of the life expectancy as it is the discount at which we purchase.” The fees as a percentage of the amount invested are much more relevant to LPHI’s investors than as a percentage of face value.
Based on assumptions laid out in the table below (price paid to policyholder between 15% to 45% of face value), LPHI’s fees would equate to 16% to 49% to the gross price paid to the policyholder. In addition, LPHI’s clients must bear the cost of LPHI’s net fees AND the fees paid to LPHI’s licensees, agents and brokers. This is why “gross” revenue / fees is much more relevant to LPHI’s clients than net fees.
As the table below illustrates, if LPHI acquired a $1 million face policy for 30% or $300,000, LPHI would collect close to $73,000 of fees and LPHI’s brokers and agents would collect close to $71,000. So for a policy that someone was willing to sell for $300,000 (I assume this would be a “market price”), LPHI’s investor would have to pay almost $444,000 for it after accounting for all those fees.
Imagine buying Apple’s (NASDAQ:AAPL) stock for $125 because your financial advisor told you it was going to $250, and having to write a check upfront for $185 ($125 for the stock plus 48% fee or $60). Not only would investors avoid that proposition if they had the appropriate disclosures, but regulators would be outraged.
This appears to be the reality for LPHI clients. Based on the table above, 32% to 96% of the amount invested will be paid in fees assuming a 15% to 45% discount. Said another way, for every $100 invested, $24 to $49 would go to LPHI and LPHI's licensees. At that fee level, I cannot find another example of an asset class or asset management firm that charges fees anywhere close to the levels LPHI charges its clients.
LPHI often mentions that there are no public competitors to measure their fees against. However, Peachtree, a direct competitor to LPHI, was a publicly traded company on London’s AIM market prior to their acquisition by DLJ Merchant Banking. Peachtree’s last earnings release is somewhat dated (6/30/06), but does provide some color on their fees.
In the first half of 2006, Peachtree purchased policies with a face value of US$400 million generating gross revenue of US$24 million.
Peachtree’s “gross revenue” of 6.0% was less than half of LPHI’s gross revenue to face (14.4%). Surely, this cannot go unnoticed forever.
I believe LPHI’s exorbitant fees are susceptible to regulation and competition, along with greater awareness including more disclosure to LPHI’s clients. According to Colorado’s complaint, Life Partners
failed to disclose to investors the method by which life expectancy was determined; the high frequency rate in which viators outlived the life expectancies predicted by Life Partners; and that if the viator outlived the life expectancies, the investor was liable to make the premium payments. It is further alleged that Life Partners failed to disclose the original purchase price of the policy and commissions paid to the sales agents, making it impossible for an investor to determine the true market value of the policy.
(See here - pdf warning.)
State and federal regulators are expected to continue to drive transparency of the life settlements market, which should standardize and collapse fees. For example, New York recently proposed legislation that aims to increase disclosures of the
value of offers and counter-offers, the fees paid to life settlement brokers and the contractual arrangements among the parties involved in a transaction” as a means to regulated an industry that “can be ripe for abuse.
2) Audit and Accounting Issues – How is LPHI Accounting for Repuchases?
The challenge to Edie Bailly LLC as they conduct their first annual audit is, can they answer and address the following questions:
- Are 100% of LPHI's policy acquisitions legitimate?
- How does LPHI generate fees at more than two times the industry averages?
- Has LPHI's historical return figures included in their marketing materials been audited and verified?
- Does LPHI apply consistent treatment to accounts receivable and revenue recognition with "closed transactions," especially at quarter end?
- Does LPHI's GAAP income statement include all expenses associated with its operations, including the costs associated with its ongoing legal battles?
- Does LPHI’s revenue recognition (gross revenue) conform to GAAP?
- Does LPHI properly account for policy repurchases?
There seems to a major GAAP violation as it related to question #7. As part of its agreement with the State of Colorado, LPHI
offered to repurchase the viatical settlement policy interest from all Colorado residents who purchased viatical settlement since January 1, 2006…The rescission offer will be made by letter by or before January 31, 2009, and will require the purchasers’ acceptance of the offer by or before March 3, 2009…Payment to all Colorado purchasers accepting the rescission offer will occur by or before April 30, 2009. With regard to those individuals who have previously accepted Life Partners, Inc.’s prior repurchase offer, they will receive an additional sum consistent with statutory requirements, in addition to the amounts already received by them.
(See here - pdf warning.)
According to LPHI’s 3Q08 10Q,
during the First Nine Months of this year, we recorded $4,951,832 for purchases of policies for investment purposes.
<Q - John Nobile>: Yes, I know that at least on November 30, you had about $7.5 million in investments in policies. When I looked at the Q, I noticed that I think it's about $5 million in the first nine months of the year was used to purchase policies to settle claims, I was hoping you could shed some light on that $5 million?
<A - Brian Pardo>: That was Colorado, I believe and what Colorado want to do is they claimed that this a security which we just agree with, but to settle the issue we just had to look if anybody wants to sell their policies back to us, at their statutory rate of interest, we'll just – we'll buy it.
<Q - John Nobile>: All right. So that's more or less a one-time item or there still could be a few more policies that might trickle in?
<A - Brian Pardo>: Yes, there could be, but we are buying in anyway.
Back to LPHI’s 10Q:
LPI has made repurchase offers to certain Colorado purchasers, some of whom have accepted the offer. Under the terms of the settlement, the purchasers that accepted the repurchase offer will receive statutory interest on the repurchase amount. We estimate the interest will be approximately $1,549,000, which will increase our basis in Investments in Policies.
Serious questions remain surrounding the method LPHI uses to account for repurchased policies. If LPHI recognized revenue and earnings when they sold the policies to their clients, they should have taken a charge for these earnings related to the $5 million repurchased (in addition to future repurchases and interest payments).
Assuming LPHI charged their investors 40% gross sale amount (or around 15% of face), LPHI would have recognized $2 million of revenue on these transactions. Assuming an operating margin consistent with the 3Q08 of 39%, LPHI recognized $750,000 of pretax or $0.03 per share related to these transactions. If LPHI had to buy the policies back, how are these profits not reversed?
According the Colorado lawsuit, LPHI
collectively have obtained more than $11,500,000 from approximately 114 Colorado investors to purchase viatical settlements.
The same assumptions as above, if LPHI repurchased all $11.5 million, this would equate to $4.6 million of revenue, $1.8 mm of pretax profits or $0.08 per share (16% of 3Q08 earnings). Using a 39% operating margin assumes LPHI would be able to recollect fees paid out to licensees and recollect sunk costs. Assuming that they could not recapture these costs, a 100% of gross revenue charge equals $0.20 per share or 41% of 3Q earnings.
While the charges above are not massive sums, the treatment of LPHI’s repurchases does create another startling red flag regarding LPHI’s accounting and creates additional questions. For example, are there other occasions where management sold policies to clients, recognized revenue and profits, and later repurchased the policies?
3) More Questions Regarding CEO
In LPHI’s “Citron Response”, management stated that Brian Pardo entered into a consent decree relating to the sanctioning by the SEC for revenue recognition reporting issues “in order to resolve the issue amicably.” The South Florida Business Journal suggests that he agreed because the company was already in bankruptcy:
The SEC filed a complaint against Pardo and his company Ask Corp. of Waco, charging him with falsifying financial reports to shareholders. Prado consented to the SEC's charges. By then, Ask Corp., a heating and air-conditioning company, already had filed for bankruptcy.
Another oddity about LPHI's CEO Brian Pardo is the address and location of Pardo's trust.
According to SEC filings, the Pardo Family Trust is located in Gibraltar. A simple google address search shows that the Pardo Family trust shares an address with online gambling websites (allpro.com, eBets.com, allhorseracing.com, etc.). The implications of having his trust in a protected offshore location is unclear. However, it does provide another potential red flag for investors.
In another strange turn of events for Brian Pardo and Life Partners. On April 8th 2009, Pardo and Life Partners filed a $50 million lawsuit against a Yahoo! Message Board poster. While I do not agree with the statements Mr. Kane made on the message board, I do hope he has the resources to find out (in his words) if “lphi=scam rips off INVESTORS!!!”
Public Notice to Eide Bailly
In recent accounting scandals and frauds, the accounting firms have shared significant blame in perpetrating and extending dubious actions by corporate managers. I want this to serve as a Public Notice to Eide Bally. There are significant red flags associated with LPHI’s management and business practices. The auditors at Eide Bally are in a position to verify or refute these concerns. Let this also serve as a Public Record, Eide Bailly is in a position to protect current and future LPHI customers and investors. If some of these concerns and red flags turn out to be verified at a later date, and Eide Bailly missed them, let this provide a record so that customers and investors can hold Eide Bailly accountable. A lot of people were exposed to Madoff after Harry Markopolos first raised his concerns to people in position to protect investors; I hope the same does not occur now that the red flags have been raised for Eide Bailly to observe.
Disclosure: Short LPHI with a borrow