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Fraud Discovery Institute and its sister website iBusiness Reporting delivered duo salvos against Medifast (NYSE: MED) Wednesday releasing reports questioning the company's financial disclosures about its Take Shape for Life division which is responsible for Medifast's recent growth in revenues and profits. In addition, Medifast announced that it was replacing its auditors who came under fire by Minkow and this blog in June 2009, when we suggested that Medifast replace them because of their poor track record as detailed in reports issued by the Public Company Accounting Oversight Board.

Both Fraud Discovery Institute co-founder Barry Minkow, a convicted felon with a long track record of fraud busting and iBusiness Reporting reporter William Lobdell who is a former LA Times investigative reporter have publicly disclosed holding short positions in Medifast securities. I do research for Fraud Discovery on InterOil and I do not own any securities in InterOil (IOC), Medifast, or Pre-Paid Legal (PPD), long or short. In addition, I researched Medifast's former auditors for Fraud Discovery.

Should Medifast be investigated by the Securities and Exchange Commission?

According to former LA Times investigative reporter and bestselling book author William Lobdell's report in iBusiness Reporting:

Despite being an obvious multi-level marketing operation, as defined by the Federal Trade Commission and others, Medifast and Take Shape for Life officials work hard to avoid the label, perhaps in part because it might tip off investors that the company's recent sales increases would be difficult to maintain over time (and when jobs return to the economy) and also because some multi-level marketing efforts are often labeled pyramid schemes destine to collapse once the pool of new recruits dries up.

Lobdell goes on to suggest that Medifast may be in violation of SEC Rule 10b-5 governing securities fraud:

Whether Medifast needs to disclose it's a multi-level marketing company to prospective independent sales people and investors is a matter of the Securities and Exchange Commission. According to SEC regulations, it's illegal ... "to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading ..."

More details from Lobdell's report can be read here and Fraud Discovery's press release can be read here.

Comparing Medifast to Prepaid Legal, another company under investigation by the SEC

Both Barry Minkow and William Lobdell compare Medifast's compensation plans for its Take Shape for Life division with similar plans at multi-level marketing company Pre-Paid Legal (NYSE: PPD) another company under scrutiny by Minkow. Fraud Discovery Institute has set up two websites detailing its investigative reports on Medifast and Prepaid Legal called "Medifraud.net" and "Ponzi Plus Pyramid Equals Prepaid", respectively.

After Fraud Discovery's released its reports questioning Pre-Paid Legal's financial disclosures, the Securities and Exchange Commission and the Federal Trade Commission started an investigation of the company and the SEC recently expanded its probe. According to Pre-Paid Legal's announcement:

The subpoena requests us to provide documents relating to certain membership information, member complaints about provider law firms, our efforts to achieve compliance with all payment card industry requirements, the resignation of Harland C. Stonecipher as Chief Executive Officer and President and the resignation of Tom Smith as a director.

In its recent press release, Fraud Discovery points out five "similarities" between Medifast and Pre-Paid Legal:

1. Both Medifast and Pre-Paid Legal Services report dismally low earnings for the vast majority of "coaches" and "associates." From July to December 2009, 53 percent of Medifast's "active" health coaches made an average of $97 per month, and this "average" is inflated as it conveniently excludes all coaches who made less than $25 per month. In 2009, Pre-Paid Legal Services reported that only 1.6 percent of vested sales associates personally sold more than 10 memberships. With annual commissions of $16 or $25 per sale of a family plan for associates selling less than 25 memberships, this means that 98.4 percent of vested associates make less than $250 per year.

2. Representatives of Medifast and Pre-Paid Legal Services are incentivized to recruit, rather than to sell the products. The representatives above the salesperson in both companies are collectively paid much more in commission on each sale than the associate who actually made the sale. It is nearly impossible to make a reasonable income simply selling the products or services of Medifast or Pre-Paid Legal Services, pushing the representatives to recruit new members in the hope of earning more.

3. Both Medifast and Pre-Paid Legal Services have 10 levels of commission payouts. For an individual sale, the person making the sale will receive a small commission, while 9 other levels will receive commissions that, collectively, usually exceed the commission the actual salesperson received.

4. What's to hide? Neither Medifast nor Pre-Paid Legal Services disclose their "churn rates." While both companies report the number of "active" coaches or associates at the end of the year - and Pre-Paid Legal Services also reports the number of associates recruited during the year, they deliberately fail to disclose the total number of representatives at the end of the year or the number of people who have quit during the year. Failing to disclose these key figures effectively conceals the failure rate of the recruits.

5. What's to hide, Part II? Neither Medifast nor Pre-Paid Legal Services discloses the real average income for their coaches or associates. Medifast appears to disclose average income but excludes all coaches earning $25 or less in monthly commission from its calculations, effectively making the reported "average" a completely fictional number.

"Multi-level marketing is not direct selling and is nothing more than a money transfer game where the product or service is merely the excuse used to move the money from those at the bottom of the pyramid to the exclusive minority at the top of the pyramid," Minkow said.

Both Minkow and Lobdell suggest that the SEC, like it's investigating Pre-Paid Legal, should also investigate Medifast's financial disclosures.


Medifast replaces its auditors

According to Going Concern blogger Caleb Newquist:

McGladrey & Pullen/RSM McGladrey has been named the new audit/tax firm of Medifast, the company announced in a filing last Friday. The Company dropped Bagell, Josephs, Levine and Company LLP of New Jersey who was purchased by Friedman LLP, citing/blaming Sarbanes-Oxley for reducing the number of accounting firms that have the “extensive resources and experience with public companies on a national and regional basis to better serve Medifast.”

In June 2009, I helped Fraud Discovery research Medifast's auditors and noted that 50% of their audits inspected by the Public Company Accounting Oversight Board were materially deficient.

Not backing down from Medifast lawsuit

Minkow, Lobdell, along with acclaimed forensic accountant Tracy Coenen and pyramid scheme expert Robert L. FitzPatrick were recently sued by Medifast claiming defamation. I criticized that lawsuit saying:

Like your complaints to investors and securities regulators, your lawsuit fails to provide a detailed and credible substantive line-by-line rebuttal of serious allegations of improprieties concerning Medifast's business model, marketing practices, and financial disclosures made in reports issued by Fraud Discovery Institute....

Instead, the lawsuit reads like a cheaply produced late-night infomercial for insomniacs, rambles about the purported "health" benefits of Medifast products, and rants that Fraud Discovery Institute's reports are false. To support your claims of defamation, the lawsuit refers to self-serving claims on Medifast's website and disclosures in SEC filings which certain Defendants allege are false and misleading.

Tracy Coenen's rebuttal of Medifast's allegations can be read here. Barry Minkow's and William Lobdell's response can be found here.

None of them are backing down from continuing to investigate financial reporting irregularities at Medifast despite its frivilous lawsuit and I stand behind my friends, too. Medifast can shove its retaliatory lawsuit up their rear ends.

Recommending Reading:

Fraud Files Blog - Medifast changes auditors: Was Barry Minkow right when he criticized former auditors? by Tracy Coenen

Disclosure: I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes, simply because I could.

If it weren't for the efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

I do research for Fraud Discovery on InterOil and I do not own any securities in InterOil, Medifast, or Pre-Paid Legal, long or short. In addition, I researched Medifast's former auditors for Fraud Discovery.

Source: Should the SEC Be Investigating Medifast Alongside Pre-Paid Legal?