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There has been a fascinating breadth of coverage of the current bull fight surrounding Herbalife (NYSE:HLF), and it's only too easy to let the fog of war get in the way of clear judgment. The picture is one of a long string of good earnings reports, and share price gains all year, in spite of mounting noise about the company's business practices. After the 3rd quarter earnings report, the stock has been drifting sideways, in spite of strong financial performance - at $62.30 at the close on 11/4 -- a two month low. And it was slipping a bit after hours, and nudging up again at the open on 11/5. Looking at the numbers below the surface, there are potential signs of trouble in such items as the very substantial distributor churn: loss rates of distributors '10 92%, '11 65%, '12 73% (see Matt Stewart's Herbalife Headscratchers). There seem to be camps of those who believe the numbers at face value, and those who insist on digging deeper.

As to the bull fight, it would seem there is only one bull fighting, if you really watch carefully, and that's Carl Icahn, who seems to take this personally. Even the Soros long position, joining in with Icahn, appears more simply opportunistic. The comportment of Bill Ackman and Pershing Square has been nothing if not professional - cool, calm and collected.

The greatest clarifications on this site have come from Matt Stewart, and his piece on Carl Icahn was priceless: so much for Carl Icahn storming into the arena. Other helpful perspectives have been offered by Quoth the Raven, and his speculation on upcoming news on Herbalife from Pershing Square. Lastly Bruce Craig has been really helpful in providing the legal/regulatory background. Another bright light has been Dan McCrum in his Alphaville blog on FT, in particular, his recent piece on the position the FTC finds itself in now.

I want to suggest here that it is all much simpler than it appears, even though the fog of war is making this a murky picture for now.

Once emotions get tied up in trading, trouble is brewing. And if the "facts" on which people make decisions are not seen in context, fallacy takes over. Mostly the longs on Herbalife are quoting the top-line performance, but the fact is that making money is not proof something is not a pyramid- or a Ponzi scheme. In fact, the money that is being made by some is always used to lure in the rest. The question is, is it sustainable? And recent reports by various authors call that into question, because of the huge churn.

The next thing is that almost the entire MLM industry, with precious few exceptions has been operating in reliance on some historical rule making that was fuzzy at best, so they operate in an obscure environment which is by definition subject to challenge at any time. We have enough trouble when the rules are clear, so this circumstance adds to the risk in this sector.

Most companies in the sector operate in the belief that they can get away scot-free by paying lip service to the perceived rules, which are fuzzy enough, and very much subject to interpretation. If you follow the wider debate, MLM-industry people have tried to score points in the Herbalife argument, but they address appearances, or narrow legalities, not substance. Starting with the Pershing Square disclosures on The Facts about Herbalife, the whole point of the research has been to delve beyond appearances. For example, whether or not something is payment for recruiting, should not primarily be decided based on what the accountants call it, but on what actually takes place, on what the thing IS, not what it's called by the lackeys, regardless if they are employees or contractors, such as accountants.

Therefore, if the sales depend on recruiting more fools who stock up on unsalable (because of absurd retail pricing) inventory, and the commissions on this inventory loading are counted as product sales, but are in fact driven by recruiting, the labels simply don't make sense. And we are now potentially starting to look beyond the labels.

Likewise, if the sales of the "opportunity" rest largely on deception, this calls sustainability in question on one hand, and invites regulatory intervention on the other-for business opportunity fraud. This may or may not rise to the level of a "pyramid scheme," but the deceptive element never builds a lasting business, and is open to challenge on multiple fronts at all times.

And so we arrive at the final question, as a philosophical question aside from all the legal details, of what separates a pyramid scheme or scam from legitimate structures, which also are pyramids - be it the government, or any other organization, or the physical pyramids themselves. The sturdiness is proven! The simple principle is that there is deception and harm, and this renders the pyramid structure into a pyramid scam, and ultimately a house of cards. In other words, if you choose bad building materials, the pyramid structure is worthless, and it predictably collapses in on itself. This happens whether or not there is regulatory action, for eventually you run out of greater fools. Arguably, the harm can be limited if regulators play a constructive role, by not only shutting down pyramid scams after the damage is done, but by preventing them in the first place by means of a long overdue clarification of the rules of the game.

In a Ponzi scheme, the subsequent investors are bamboozled by the outsized returns of the early investors, and are too unsophisticated in business analysis to tell that those returns do not derive from returns on a business, but from the gullibility of those subsequent investors themselves. In a pyramid scheme the test is similar, that the money is made on recruiting people who are tricked into believing they can sell a product or service. In this case, the reason to buy is not the merits of the product, but the merits of the illusory "opportunity," and people become "garage qualified" as the technical term in the industry goes -- loaded up with unsalable goods. That's the stuff Pershing Square found on eBay in the Herbalife case. Inventory loading is not sales, as is clearly understood in any other industry. In short, the symptoms are clear, and the Herbalife developments including the petition to the FTC by an ad-hoc coalition of interested parties, may hopefully lead to clarity at a regulatory level.

There can be no question that a networking approach can work and can produce good business results, even more so in this Internet age, but the fog of an unclear regulatory framework, makes it harder for investors and would-be entrepreneurs and participants alike to tell fake from real. We can only hope for all concerned that the current developments lead to desirable regulatory clarification for the future, along with the cleaning up of past abuses.

Meanwhile, what matters is that as long as the first principles discussed here are understood, it is no longer important if regulators act this time or next. This mess will unavoidably get straightened out at some point, the question is just how much suffering and abuse will be tolerated, but eventually they'll have to, for if these businesses are unsound, they will implode on themselves.

Until then, Carl Icahn looks a bit like Wile E. Coyote in the old comic, where he runs off a cliff, and is hanging in the air above a ravine, still not realizing he has no ground under foot. In Icahn's case, he can't even look down till February, because of his agreement not to sell before then, which might become quite a challenge. If the upcoming news before February does not support the long thesis, it could become quite drafty for him. In the Wile E. Coyote comic, the character does not realize he has no ground underfoot but until he looks down, and then, boy, does he fall...

The Pershing Square short, and the accompanying detailed analysis of why the company was a pyramid scheme were the start of trouble, most likely involving primarily the FTC. Then Carl Icahn's involvement might mean more trouble if it brings the SEC down on himself as well as the company, which could happen if Herbalife is found to be an illegal pyramid. The piece on his involvement by Matt Stewart (cited above) points out this possibility, because as not only an investor, but also a spokesman and promoter of a putative illegal pyramid, Icahn exposes himself to a potentially huge liability if the finding "illegal pyramid" moves from speculation to fact. Time will tell.

Source: Herbalife - The Fog Of War, And Double Trouble