Maximizing Shareholder Value when the FBI Raids Your Office

by Travis Johnson, Stock Gumshoe | May 6, 2013 8:13 pm

SPECIAL VALUE INVESTING CONGRESS NOTES FOR THE IRREGULARS

Phillip Goldstein of Bulldog Investors talked this afternoon about his experience with Imperial Holdings (IFT), which is in the life settlements business. The business is and was pretty compelling — lending money to wealthy senior citizens against their life insurance — even as it’s been very controversial.

Bulldog invested in them by buying debt with a 15% coupon several years ago, and later IFT went public to get cheaper funding in February 2011. All was fine and dandy for a short while, but then the FBI went in and raided the company about seven months later in 2011 — as a result, the bank canceled their credit line and the company almost shut down and had a cash crisis. The book value was reported in September 2011 at almost $10, but the stock fell below $2 and they also had tons of shareholder lawsuits. But the Bulldog Investors folks had enough confidence in the CEO and the actual operations of the company to buy the stock based on their judgement of his character and the business model.

It seems like the President of the company may have been the target, he resigned and the lawsuit complaint seems to be that IFT was inducing their potential clients to lie on their applications, but there have been no indictments. They had plenty of cash on the books, with death benefits of over a billion dollars, but they had to pay the premiums until “cash flow becomes positive” and people start dying, so the balance sheet looked good but they were in a cash crisis. The company was being drained by legal fees and getting to the point that they would have trouble paying the premiums on the life insurance policies.

The SEC followed the FBI, and then Imperial paid a fine in April 2012 for a non-prosecution agreement (in which they admitted doing nothing wrong), which drove the stock higher … but they were still bleeding cash and the Directors were not protecting the shareholders. Bulldog and other hedge fund investors settled with the Board and put three hedge fund guys on the board — in what they described as a very atypical proxy fight that had them fighting to oust independent directors and back the CEO. After that went through, with effective board control, they finally got their reporting current, and investors backed the company with a $45 million loan to provide the cash they needed to get a long-term solution to the cash flow crisis.

There are still some issues about collectability from the secondary market, still lawsuits pending, and regulatory risks. But the financing part seems to be fixed — last Wednesday, Imperial announced a $300 million credit facility for 15 years to provide permanent financing and fix most of the underlying cash flow problem. That announcement drove the stock up 40% last week, so clearly the financing was a big deal. Goldstein thinks that making sure they get collectability on the 600 policies they now hold is the biggest deal — insurance companies are likely going to fight them hard on that. The speculation is that book value many run up to eight or nine dollars a share because of their recent deals and the newly expanded number of policies in their portfolio, but the question remains how to “risk” the fact that insurance companies hate the firm that now owns these policies.

The reason the insurance companies are fighting, according to Goldstein, is that if everyone paid their premium forever, life insurance companies would lose money — its not like property and casualty insurance where you have to assess the risk of an occurrence, we know that every single person who has life insurance will die. So the secret, apparently, is that most life insurance doesn’t have to be paid even though all people eventually die — Goldstein said that about 80% of life insurance policies lapse, and once you stop paying the premiums you no longer have life insurance.

Life insurance companies, then, naturally hate the secondary market and the life settlement companies, because they depend on the large number of lapsed life insurance policies from customers who stop paying their premiums and give up the covverage. According to Phillip Goldstein it was one of these life insurers, Lincoln National, that sicced the US Attorney on Imperial.

There are, understandably, strict rules about STOLI (STranger Originated Life Insurance) which mean you can’t take out insurance on someone in whom you have no personal interest … we don’t want to incentive you to end someone’s life prematurely. But once you have an insurance policy, it’s your asset and you have the right to sell it to someone else — the idea that you might consider selling someone the right to profit from your death, and to profit more if you die more quickly, is worrisome but apparently not illegal. The life insurance company really doesn’t want you to sell it, and life insurance companies are far more powerful than the few life settlement companies and investors, so I’d guess that there’s some risk of changes to the marketplace — especially because no one wants to defend companies like this that seem a bit sleazy (even if the insurance companies might be sleazier).

So this company looks like it’s still trading at a significant discount to what their book value will probably end up being — but the regulatory risk makes me want to shy away. The other company in the same sort of business, Life Partners, got in trouble because they weren’t holding these insurance policies but were re-selling the policies to retail investors and overestimating the value, which is a very different problem.


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