The Herbalife saga continues. Mr. Ackman seems to have rested his case at least publicly that Herbalife (NYSE:HLF) is not a legitimate enterprise. Mr. Stiritz and Mr. Icahn have equally wagered their capital. As Mr. Ackman stated in his Bloomberg interview the other day paraphrasing Mr. Stiritz, "May the best analyst win."
As we sit here today we await the results of PWC's reaudit efforts due by the end of December. The company has advised investors that these results should be disclosed before the end of this fiscal year. Will the audits be a Thanksgiving turkey or a Christmas present? Time will tell.
Meanwhile, the wheels of justice continue to turn behind the scenes. I must admit, if I were an honest, hard working regulator earning an honest wage it would steam my beets to know that the pied piper of Herbalife, CEO Michael Johnson has collected tens of millions of dollars in compensation operating this opaque enterprise for much of the last decade. Schadenfreude should never be motivation for a criminal prosecution but one wouldn't be human if the tingle of morality and justice didn't motivate one to bring Mr. Johnson to account for his hubris.
Unquestionably, it would seem that regulators are "on the clock" at least as far as Mr. Ackman is concerned. Rumours abound that Mr. Stiritz has plans to take the Herbalife pyramid private. In the interim, Mr. Icahn remains "locked-up" in his position until and unless HLF common trades north of $73 for 5 days in a row or the calendar rolls past Feb 28, 2014. Who knows what will happen first?
Is Herbalife legimate or not? That is the question. The final act will Break Bad one way or another. Someone is guaranteed to end-up the tragic hero. Who Heisenberg will ultimately be remains to be seen.
That being said, in this article I would like to offer a review of ten ways that Herbalife appears to break the law. Effectively, consider this a preview of the kinds of charges "Reverse Robin Hood" Mr. Johnson and his "Reverse Band of Merry Men" might face in the not too distant future. In Lettermanesque style, I give you the Top Ten potential legal counts facing Herbalife. Consider these a preview of the contents of any future indictments/injunctions in a range of jurisdictions by any one of many sorts of regulators. For the purpose of SA editorial clearance, let's call them allegations.
Herbalife is operating its business in direct contravention of a court ordered injunction issued by the California Attorney General.
This injunction states clearly that Herbalife must have a system to track and account for retail sales made by its distributors. This data must be made available to the California AG upon request. Specifically, the injunction states the following:
B. defendants shall be in compliance with this Section 5, as long as a verification or documentation system they implement allows them, at any given point in time, to verify or: document to plaintiffs that any and all participants who receive commissions, bonuses, overrides and/or advancement from defendants in defendants marketing program, after entry of this judgment, are based on retail sales made by or through such participant(s) or others introduced directly or indirectly under participant(s). Plaintiffs shall not seek such verification or documentation prior to 90 days after entry of this judgment., and defendants shall be in compliance with this verification or documentation requirement if their records are current and accurate to a point in time which does not precede plaintiffs' request for verification or documentation by more than 90 days. Plaintiffs' request for verification or documentation of retail sales shall be made to defendants counsel of record.
Curiously, in an 8k filed by the company last year, Herbalife freely and readily admits that it has no such documentation system nor does it make any efforts whatsoever to track "retail sales". Surely this admission must be like a red rag to a bull if you are the California AG.
Herbalife's Marketing Plan price discriminates.
Price discrimination is a violation of anti-trust law as well as a violation of the FTC act. Details on anti-trust law can be found here. Specifically, Herbalife charges new distributors higher prices for wholesale inventory than they do their Sales Leaders/Supervisors. This price discrimination has the effect of creating a favored nation class of distributors within the Herbalife business model. Effectively, Supervisors who attempt to engage in legitimate retail selling activity in the marketplace enjoy a specific competitive advantage over the junior members they concurrently recruit.
All empirical evidence suggests that in practice, the market clearing retail price for Herbalife products based upon the laws of supply and demand sit below a Junior distributor's actual wholesale cost of goods sold. This fact makes it 100% impractical for anyone who is not a Supervisor to successfully build a profitable retail business as there is no gross margin to be earned. Price discrimination is illegal. Nuskin, in contrast, does not charge different segments of its distributor base different wholesale prices.
Price discrimination also fuels the following mechanics in the Herbalife Marketing Plan:
- Inventory Loading as participants strive for Supervisor status
- Deceptive Marketing Claims - How do you market a retail opportunity that doesn't exist?
- Guaranteed Failure for anyone who isn't a Supervisor
The FTC and/or DOJ is bound to be concerned.
Herbalife points to its recently modified Statement of Average Gross Compensation as evidence that it does not mislead potential recruits who might be interested in pursuing the business opportunity. This argument is nonsense. Why? Because Herbalife executives, distributors, and their entire choir of evangelicals routinely advance the idea that a Herbalife distributorship is a bountiful opportunity. The clever trick is that this effort is often done verbally, face to face, or in the group-hype environment of an Herbalife recruiting meeting or Extravaganza.
If you don't think Groupthink works, watch this video. Make no mistake, Herbalife's psychological methodology is a central element in its recruiting apparatus.
These verbal interactions and deliberate manipulation make the compensation document totally irrelevant. YouTube alone is littered with videos of Herbalife distributors exaggerating earnings claims, misleading recruits as to their business prospects, selling the dream, etc. Here is but one video example promoted by none other than Mr. Michael Johnson. It is illegal to deceive people with fraudulent representations and deliberate misstatements.
Again, the FTC Act covers this territory.
Selling Unregistered Securities.
Under numerous State and Federal laws it appears that Herbalife distributorships are, in fact, securities. Herbalife may market these securities in violation of the law. Securities should be offered by registration with a prospectus and sold by a licensed representative. Herbalife makes no such effort to market its securities legitimately to the investing public. For all who are wonkish, enjoy the following read.
No doubt the SEC is paying attention.
Deceiving Investors as per Rule 10b-5.
Herbalife executives have made a number of material misstatements to investors and/or have ommitted material facts from the company's disclosures over the years. Specifically, Herbalife has delivered a cornucopia of responses to "the retail question" in its 10Qs and 10ks dating back to the time Mr. Johnson started as CEO. The range of responses Herbalife has given to the question "What % of retail sales occur outside the salesforce?" runs from "in excess of 90%" to the more recent "we don't track this data because we don't think it is material to investors".
Herbalife also used to segment its junior distributors into 3 buckets in its 10k based upon an unsubstantiated assumption. As recently as 2011 less than 20% of junior distributors were considered personal consumers. Today, that number is in excess of 70%. Go figure.
In the interim, the true answer to the question "How much product is sold to ultimate users"? remains a mystery. As Winston Churchill said, the answer to the "retail question" remains, like Russia..."...a riddle, wrapped in a mystery, inside an enigma."
Is it likely the SEC turns a blind eye to rule 10b-5 violations? Doubtful
What probability should we assign to the idea that an audit partner capable of insider trading might also be capable of turning a blind eye to certain FASB guidelines? We'll see. For its part, Pershing Square alleges that Herbalife has misstated its accounting records in order to hide the amount of recruiting rewards it actually pays to its distributors from investors and regulators alike. In the event Herbalife has to restate these historical results to treat the accounting of Royalty Overrides and Commissions the same way (for starters), one should anticipate a series of class action initiatives to unfold from securities lawyers across the country. Herbalife knowingly overstates distributor allowances and understates its expenses and has done so for a long period of time. Michelle Celarier of the NY Post provides a summary here.
I am sure the SEC is watching as is PWC's Executive Committee with some degree of trepidation.
Forgive the pun but as we sit here today, Herbalife is appealing a ruling made by a European court that the company operates an illegal pyramid scheme. Consumer Watchdog Test Ankoop took the good ship HLF to task in much the same way as Mr. Ackman is taking it to task here in the USA. The end result? Once Belgium stops waffling there will be clarity at least in one jurisdiction on Herbalife's legitimacy. Herbalife takes the following position. We'll see how it turns out.
Class Action pursues Endless Chain.
Herbalife was not successful in having a class action lawsuit that asserts that Herbalife's marketing plan violates California's Endless Chain legislation thrown out of court. The court's ruling also provides investors the most recent interpretation of the correct legal answer to the "retail question".
Sorry folks, sales to "Members" don't count as a retail sale.
Executives and Investors alike potentially committing fraud.
According to attorney Dan Ravicher, it is illegal for anyone to aid in the proliferation of a fraud. Mr. Ravicher's argument can be found here. Is it any coincidence that we have not seen Tim Ramey nor Mr. Icahn interviewed recently on Herbalife on TV? One must tread carefully in the face of criminal allegations.
And finally, the #1 Legal count facing Herbalife?
Herbalife is a Pyramid Scheme.
For those who remain unclear as to what a product based Pyramid Scheme actually is, I defer to Dr. Peter Van Der Nat of the FTC as he can explain it much better than I. Longs who fail to heed Mr. Van Der Nat's arguments do so at their own risk.
In the end, you can be the judge.
As to whether or not Mr. Johnson and his cabal of executives end-up doing the perp walk?
I am sure the stakes are higher for them than they are for either you, me, Mr. Icahn or Mr. Stiritz. As to which one might jump ship to join the contingency of insider whistle blowers already revealed by Mr. Ackman?
Your guess is as good as mine.
Quite the Prisoner's Dilemma.
This author concludes that Herbalife is a product based pyramid scheme, an endless chain, a deceptive enterprise run by a group of shameless promoters.
It may be okay to concede that Herbalife has some real "ultimate users" who purchase its shakes to lose weight. It may also be reasonable to concede that many of Herbalife's distributors strive to be honest and decent people.
Regrettably, all of these people are enveloped in the eye of a Marketing Plan that, like a Cat 5 Hurricane, victimizes marginal business opportunity seekers as it churns its way around the globe.
Specifically, the Marketing Plan victimizes its most junior participants with a rigged game of perennial recruitment.
Evidence of legitimate retail sales to "ultimate users" is scant. certainly the company doesn't provide any data on this point. Evidence of market saturation, relentless churn, ad nauseum recruiting, and affinity group exploitation is apparent and abundant.
The sooner Herbalife is shut down and the perpetrators of the scheme are brought to justice the better off society will be the world over.
If you remain long, ignore these legal risks at your own peril.