Might Other Companies Be Liable If Herbalife Is A Pyramid?

| About: Herbalife Ltd. (HLF)

The legality of Herbalife's (NYSE:HLF) business practices has received much publicity of late. After reviewing the matter, including Bill Ackman's December 20, 2012 detailed presentation and Herbalife's January 10, 2013 rebuttal thereto, I have formed the legal opinion that there is evidence to suggest Herbalife pays more money to its "distributors" for their recruitment of new "distributors" than it does for their sale of Herbalife products. This would satisfy the definition of a pyramid scheme, making the practice illegal. Herbalife could therefore be prosecuted. Herbalife's own CEO admits that "us calling everyone a distributor confuses people." (See Q&A of Jan 10 Rebuttal at 2:07:18.) This is the whole point, Herbalife calls participants in its business "distributors," when their primary function may actually be to recruit more participants. This primacy of recruitment over sales would make the scheme illegal.

Despite this strong evidence that Herbalife may be an illegal pyramid scheme, some argue there is no threat to Herbalife's business unless and until government prosecutors pursue the company for such illegality, an event believed to be unlikely. This manifests a critical mistake, as potentially fraudulent companies can fail long before being criminally pursued. For one, the withdrawal of support from other companies can cripple the supply and distribution networks of such firms. For another, private litigation can cripple the firm by distracting management and draining reserves. Third, negative public perception can cripple such a firm by triggering the occurrence of other crippling events, which themselves cause further negative public perception. Fourth, there is also the risk that shareholders of the firm may themselves be sued, criminally and civilly, for committing fraud, as such can be a basis to pierce the corporate veil. Recent purchasers of HLF shares may be especially exposed to personal liability if they purchased shares after becoming aware of the facts that suggest Herbalife may be a fraud.

For now, I discuss just the first risk, Herbalife's reliance on the support of other businesses and how the withdrawal of that support could cripple Herbalife. Prior to Mr. Ackman's public presentation about Herbalife's potential fraud, those doing business with Herbalife could easily deny any culpability for their own participation in the scheme, but that excuse is no longer available now that evidence suggesting Herbalife's conduct is criminal has been made public. Thus, any company that continues to support Herbalife's business after having notice of its potentially illegal conduct can itself be subject to liability as being party to it. To be sure, intermediaries in criminal schemes can be pursued financially to reimburse the victims of the scheme after it collapses. Just look at the Bernie Madoff case as an example where the banks and other third parties that played roles in his fraud are now being pursued for damages by Madoff's victims. In that case, those intermediaries didn't even have concrete evidence of his acts constituting fraud, as has now been made available regarding Herbalife's acts that potentially constitute fraud.

eBay (NASDAQ:EBAY), FedEx (NYSE:FDX) and NYSE (NYSE:NYX), for example, each play critical roles for Herbalife's business. eBay provides an outlet for participants to sell unwanted products. Without that outlet, one could argue the pyramid would likely collapse sooner because the participants would not be able to liquidate their products in order to put more cash back into the pyramid to keep it alive. FedEx provides delivery support to Herbalife and without the distribution of its products there would be not be the alleged cover for the scheme. NYSE provides Herbalife the opportunity for those who wish to invest in its business without becoming participants a ready means to do so. It could be argued that those investments permit Herbalife to extend the scheme by entering new territories and building favorable brand recognition, which are critical to keeping the scheme from collapsing.

Each of these companies have a duty to investigate any allegations that they are participating in a fraud and ensure that they stop doing so immediately. They must seek the advice of competent legal counsel who must perform a sufficient independent investigation and provide both a conclusion and appropriate recommendations to the company regarding its compliance with the law and its fiduciary duties to shareholders. To ensure eBay, FedEx, and NYSE are aware of the legal risk their continued involvement with Herbalife puts them in, I have sent each of them letters raising the Herbalife issue. Here are copies of my letters:

Prior to sending the letters, I purchased one share in each of eBay, FedEx and NYSE. Thus, in my letters, I ask that they confirm to me as a shareholder that they have investigated Herbalife and ensured that they are no longer involved with or providing any support to any fraudulent pyramid scheme activities. I also ask them to provide me the opinion letter(s) they receive from their attorneys regarding whether Herbalife is a fraud and whether their company's continued dealings with Herbalife may subject them to liability should they choose not to investigate this matter or not to cease involvement with Herbalife. I then remind each company that they have a fiduciary duty to me and other shareholders to ensure they are not involved with any criminal activity.

Beyond the legal liability, as I say in closing my letters, I would hope such upstanding companies would have a public relations reason to avoid dealing with Herbalife. I can't imagine it is so important a customer to such large and well diversified firms that they would be willing to jeopardize their good name and reputation by being involved with an unsavory company. These companies can choose to ignore the legal and reputational risk of continuing to be involved with Herbalife at their own peril. I am confident that after reviewing the matter, these companies may very well cease doing business with Herbalife, or any of the participants in its business, which would in turn cripple Herbalife's ongoing prospects.

If those who allege Herbalife is an illegal pyramid scheme are correct, the day may soon come that Herbalife will collapse. If it does, there will be many injured parties who will seek compensation from anyone who played a role in causing their injury. Herbalife will be gone, so the injured (and their attorneys) would look for others who are still solvent to fill the void. For the sake of my shares in eBay, FedEx and NYSE, I hope those generally upstanding companies will each immediately investigate Herbalife and cease any business relationship with Herbalife that may make them responsible for reimbursing victims of what may be criminal activity. They owe me, other shareholders, and the public at large, at least that much.

While I am an attorney that practices mostly patent and copyright law, I do have experience with corporate and criminal law, and therefore consider myself competent to discuss them, even if I am not an expert in them. I know that Mr. Ackman made his attorney directly available to the public during his December 20 presentation. I am not aware that Herbalife has made its attorney available to the public. At minimum, I wonder why Herbalife has not produced for the public the opinion letter from their attorney that has provided them assurances they are not a criminal enterprise. I assume they must have received such an opinion letter, else they have no basis upon which to competently conclude they are not violating the law, as mistake of law is no excuse. While such attorney opinions are no defense to allegations, the production of such can at least help the public form its own conclusions regarding the issue.

Disclosure: I am short HLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: As disclosed in the article, I own one share of EBAY, FDX and NYX for the purposes of establishing a fiduciary duty between them and me as a shareholder. I currently contemplate pursuing claims against each of those firms for breaching their fiduciary duty to me should they not investigate and cease involvement with HLF if appropriate.

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