Bernie Madoff operated one of the largest Ponzi schemes in financial history. However, the betrayal ran far deeper than people's wallets. Specifically, Mr. Madoff assaulted people emotionally. Why? For years Mr. Madoff operated with the veneer of legitimacy. Investors never saw it coming that Madoff was a fraud.
When I worked for a brokerage firm in Toronto, there was an individual Investment Advisor who was caught by the firm's compliance department raiding the individual accounts of his clients to siphon funds into his personal name. The firm terminated this criminal. As part of the firm's restitution, the firm called each of the clients who had been defrauded. I recall a story of an elderly woman who was called so that she could be advised that her Advisor had been stealing from her account. But not to worry, the firm would make her whole. What I recall about this story was the following. The woman's response was as follows:
"My Advisor would never do that to me. He is a sweet man. How dare you accuse him of being a criminal."
The advisor in question was so good at being a fraud that he had actually deluded his victims into standing up for his honesty even in the face of direct evidence to the contrary.
The argument I would like to advance in this article is that the Veneer of Legitimacy is central to any fraud. In practice, the more sophisticated the fraud the more legitimate it looks on the surface. On this basis, Herbalife (NYSE:HLF) is a very sophisticated and well capitalized fraud.
Some of the arguments we hear from longs as to why Herbalife couldn't be a fraud are as follows:
- the company has been around for 30 years
- Carl Icahn couldn't be wrong
- Bill Stiritz has gravitas
- the company sponsors the LA Galaxy
- Michael Johnson used to work for Disney
- Lou Ignarro won the Nobel Prize
- UCLA has a science lab
- Casa Herbalife does good works
- the company is still growing
- the company trades publicly
- the company is a member of the DSA
The list could go on. What this list does, of course, is give Herbalife a veneer of legitimacy. How could a company with such illustrious connections/attributes be a confidence game?
The answer, of course, lies in the company's Marketing Plan. Some of the greatest frauds in history had the veneer of legitimacy.
Ben Johnson won the Gold medal in the Seoul Olympics in 1988 with a world record time. We were lead to believe his training regimen was the key to his success. The next day he tested positive for steroids.
Sammy Sosa and Mark McGwire had a tremendous Home Run battle a number of years ago. Both players took performance enhancing drugs as it turned out.
Bernie Madoff was Chairman of the NASDAQ. Turned out he was a total fraud. I could go on.
The reason why fraud works and often works for a long period of time is because many frauds are not obvious. In many cases, the fraudsters perfect their narratives to such a degree that the veneer of legitimacy becomes widely accepted.
Fortunately, in this free society we live in the USA we also have room for investigative journalism, whistle blowing, and freedom of speech. Short sellers also play a vital role in capital markets to help penetrate the veneer of legitimacy when the evidence is apparent.
Jim Chanos spotted accounting fraud at Enron. Bill Ackman figured out MBIA's counter-party risk, etc. It would be a fallacy to suggest that if a company appears legitimate that it is not legitimate. It would also be a fallacy to suggest that if a company appears legitimate that it must be legitimate.
To determine whether or not an enterprise is a fraud or not one must look beyond the veneer. Like shopping for a used car, we don't rely on a shiny paint job to determine whether or not the car is a lemon.
Ostensibly, anyone who is short Herbalife stock can concede the point that this company has the veneer of legitimacy. What strikes me as odd, however, is the company's response to Mr. Ackman's allegations.
Mr. Ackman has stated that the company is a pyramid scheme. The simplest way for the company to discredit this thesis is to produce legitimate evidence that recruiting rewards are financed by legitimate retail sales. However, this is not the response we see from the company.
Rather, it is obvious that the company's PR strategy in response to Mr. Ackman's allegations is to add additional layers of laquer to its veneer of legitimacy. Rather than produce evidence of retail sales, instead what we have is the addition of the former Surgeon General to the Board of Directors. Rather than finance a management reporting system to measure retail sales instead we have the hiring of the former Mayor of LA as an advisor. Lobbying firms have been retained to patrol the halls in Washington. These capital allocation decisions are downright strange.
Also, not a single, material change has been made to the mechanics of the Herbalife Marketing Plan. Don't be fooled by Herbalife's shine.
Herbalife's veneer of legitimacy is, in practice, a central ingredient in its fraudulent operations. The gravitas advanced in the company's communications allows unwitting new recruits to look past the rigged game that is presented in the Marketing Plan. It is the starting point for sowing the seeds of delusion that gets new recruits to part with their hard-earned money.
How could a publicly traded company that has been around for 30 years and competes in 89 countries be a fraud? The answer is that its veneer of legitimacy has allowed it to live in the shadows for far too long.
Herbalife's Marketing Plan recruits new participants into saturated end-markets every single day. These recruits risk their human, intellectual, and financial capital in pursuit of a retail business opportunity that cannot exist due to over-saturation. Most fail due to over-saturation.
The pyramid scheme transfers the cashflow these recruits risk up the line all the way to Wall St. All of the scheme's upline sponsors take their pound of flesh along the way. The result is mathematically preordained. The game is rigged.
In Herbalife's case, its veneer of legitimacy is not evidence of its credibility. On the contrary, it is a central ingredient in its fraud.
Think of it this way. If Herbalife didn't seem credible, how could it sign-up so many new recruits every year? And, how could so many leave feeling as though the reason they failed was their fault and not because of a rigged confidence game?
Herbalife's veneer of legitimacy has fooled millions. It continues to fool longs. Don't let it fool you.
Like the Wizard of Oz, the man behind the curtain is singularly unimpressive. Anyone who studies the intricate details of Herbalife's Marketing Plan can see how it functions as a pyramid scheme.
If Herbalife were a legitimate direct seller by now they would have produced a retail tracking system like Tupperware (NYSE:TUP). Instead, the company is spending its time and money "Swimming to Cambodia"
If somebody accused you of weighing 250 pounds, wouldn't the easiest way to discredit the allegation be to step on a scale? Or would you hire a PR firm to tell the world that rumors of your obesity are false?
Herbalife is a short. The sooner the SEC shuts it down the better.
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.