Will The FTC Summon 'The Kraken' To Investigate Herbalife?

Mar.17.14 | About: Herbalife Ltd. (HLF)

Summary

FTC Investigation is underway.

FTC's expert witness in Pyramid scheme cases has often been Dr. Peter Vander Nat.

Longs should beware the good doctor's methodology.

The Herbalife (NYSE:HLF) story continues to unfold. Yesterday and today, we received an 8-K revealing that Mr. Icahn is negotiating for more board seats. This seems like common sense to me. Due to the share buyback, Mr. Icahn's 17 million shares now account for over 20% of the company. 2 out of 13 board seats leaves him under-represented.

To date, we have no evidence from any Amended 13 filings that either Mr. Icahn or Mr. Stiritz have increased or decreased their stakes by more than 1% as the law requires. For now, it is reasonable to conclude that this board matter is a matter of housekeeping.

Mr. Icahn's initial investment thesis was built around the idea that the FTC was unlikely to intervene in the Herbalife business model. He took advice from a senior FTC lawyer. Turns out that advice was wrong. Turns out an FTC investigation is underway.

If you are long and if you are still of the view that the FTC and SEC regulators are large, puffy-white, marshmallowy type creatures who are sympathetic to MLMs and beholden to Senators from MLM friendly states like Utah then I suggest you revisit that assumption.

Why?

The FTC may "summon The Kraken" from the deep to analyze Herbalife's payplan?

What is a "Kraken"?

According to the dictionary.com:

Kraken is a legendary sea monster of giant proportions that is said to dwell off the coasts of Norway and Greenland.

The legend may have grown from sightings of giant squid that are estimated to grow to 13-15 m (40-50 ft) in length, including the tentacles.

Who is "The Kraken"?

I must admit, I am not able to take credit for this delicious metaphor. Instead, I must give kudos to MLM attorney Kevin Thompson who revealed the identity of "The Kraken" in one of his more interesting blog posts. All investors long and short should take the time to read it here.

According to Mr. Thompson, "The Kraken (AN)" is none other than the FTC's resident expert witness on Pyramid Schemes Dr. Peter Vander Nat. Those who have been following along with the Herbalife saga will know very well who Dr. Vander Nat is. He is the co-author of an academic paper written with Mr. William Keep on Marketing Fraud: Differentiating MLMs from Pyramid Schemes, which can be found here.

More importantly he is often the FTC's go to person for analysis of MLM pay plans to determine whether or not they function, in practice, as pyramid schemes.

Make no mistake if you are long or short. The FTC is now on the Herbalife case. Over the coming months they will be delving into the ins and outs of Herbalife and be asked to complete an analysis as to whether or not the Herbalife pay plan is a confidence game.

They will be thorough, objective, law-abiding, and methodical. They will be unswayed by who is long and who is short and who stands to make money and who stands to lose money. Their preoccupation will be a search for truth and justice.

Investors who would like some insight into how FTC expert Dr. Vander Nat approaches this task would do well to read the following document. This document outlines Dr. Vander Nat's expert testimony in the FTC's prosecution of Trek Alliance as a pyramid scheme. Investors can read this document and reach their own conclusions. My own thoughts are simple. If you are long HLF common you should be petrified. Here are three reasons why.

1. Herbalife is a Pyramid Scheme. This seems trite to say but the case law seems quite clear on the matter.

2. "Personal Consumption" does not count as a retail sale for the purposes of FTC analysis. On the contrary, the FTC relies upon the court precedents found in the Koscot case and Webster v. Omnitrition case where "ultimate users" must be non-participants in the pay plan. Herbalife has a major problem on this point.

3. The real data provided to investors by Herbalife itself overwhelmingly demonstrates that most Herbalife distributors make no money, fail, and churn out. Since 2008, over 6 million distributors have resigned from the con.

The FTC is a rational entity that will take the evidence as it collects it and apply the law accordingly. The FTC is not a legislator nor does it have the flexibility to "interpret the law." Rather, it has a duty to uphold the law of the land as it is written and as the case law has unfolded.

It is this clinical methodology that Mr. Ackman is relying upon. His entire short thesis and all of the research his team has conducted has been directed towards building a compelling dossier of evidence against Herbalife that reveals that this company breaks the law and causes harm.

Having reported this evidence to the police, so to speak, he then expects the law to be enforced. Truly, what could seem more rational than that?

If, for example, you saw someone breaking into your neighbor's house wouldn't you expect your local police force to do something about it if you called 9-11? One would think so.

Some of Herbalife's transgressions seem obvious to me when matched-up against the law.

It strikes me as obvious that Herbalifers routinely exaggerate earnings claims violating section 5 of the FTC Act. This is part of the company's culture. New recruits are indoctrinated to learn how to talk the talk, tell the Mark Hughes story, deliver product and earnings testimonials, etc.

It strikes me as obvious the pay plan encourages new participants to strive for SUPERVISOR status by buying an up-front amount of inventory "facially unrelated to retail demand" that lowers their COGS and gives them titular recognition immediately.

It strikes me as obvious that all commissions in the pay plan are tied to wholesale activity not retail activity.

It also strikes me as obvious that upon review, the FTC will be left with no choice but to find the good ship Herbalife a pyramid scheme when it is discovered that the economy is a closed system with most revenues coming from pay plan participants chasing the Herbalife dream that is carefully crafted in its sinister Marketing Plan.

To summarize, if you remain long HLF common you may need to beware of "The Kraken."

Failure to investigate and understand this expert witness methodology may be hazardous to your portfolio.

Investors unconvinced of this threat should delve themselves to find out Dr. Vander Nat's batting average in pyramid scheme prosecutions too. I gather it may exceed both Mr. Ackman's and Mr. Icahn's batting average as professional investors.

Pyramid schemes masquerading as MLMs have had a long run it would seem. However, it's a new regime at the top of the SEC and FTC. Strong, intelligent and compassionate women are at the helm. Justice will be served. Justice will be done. No rational regulator will favor overpaid executives and avaricious investors over the little guy on the street who is getting fleeced. This is not "Batman Justice." Reverse Robin Hoods certainly do not carve a sympathetic swath.

Investment Thesis: Herbalife is a global pyramid scheme that will be shut down by regulators because it causes enormous harm to honest business opportunity seekers around the world.

These victims of information asymmetry misallocate their financial and human capital towards a rigged carnival game known as the Herbalife Marketing Plan.

Don't be surprised, too, if State AGs, Chinese authorities, and/or the SEC also join the party.

I remain convinced that Herbalife common is going to $0. As to how Mr. Stiritz or Mr. Icahn get out from under their positions now escapes me entirely. I can imagine $80 looks like a solid bid with the benefit of hindsight. $58 may look equally juicy by the time 2015 rolls around. Tim Ramey's $100 plus target issued only in January seems increasingly like a pipe dream.

Has the short squeeze now turned into a long squeeze? If you wonder aloud how you might get off of 17 million shares of this toxic stock it becomes entirely possible.

If I were still long I would probably give my head "a shake" and take the company's buyback bid while I could. With more negative newsflow destined to emerge, HLF common could trade much lower than a $5.8 billion market cap.

Perhaps "The Kraken" might swallow it into the deep blue sea entirely?

Caveat Emptor

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.