There is a question I think all Herbalife (NYSE:HLF) investors need to ask themselves at the moment.
Q. Is US Attorney Preet Bharara smarter than a 5th Grader? Call me crazy, but I am going to go out on a limb here and say "Yes".
Could it be:
- The U.S. Attorney's 79-0 record prosecuting Insider Trading cases?; or
- His magna cum laude degree from Harvard College?; or
- His J.D. from Columbia Law School?
These data points are all evidence that Mr. Bharara is one truly accomplished man. Still, the document that helps me understand how Mr. Bharara thinks about white-collar crime can be found here.
For those new to Mr. Bharara, I encourage you to read through this document which outlines the US Government's indictment of SAC Capital for insider trading.
Why is this important?
Evidently, Herbalife executives may be the only people in the world who think that Mr. Bharara may not be smarter than a 5th grader. In spite of overwhelming evidence to the contrary, the company line remains that they are proud to sell one of the greatest business opportunities in the world. Don't believe me? Just ask Michael Johnson and this gallery of Herbalife recruiters. So great, in fact, that most people quit in less than a year. How do you like them apples?
Seemingly, the DOJ isn't buying this line of baloney, even as Mr. Icahn has wagered hundreds of millions of dollars in support of this company. Mr. Icahn readily admits that there are problems with the marketing tactics used in the past, but states, "that's the distributors, and not the company". Perhaps Mr. Icahn should take a read through Mr. Bharara's indictment of SAC for direction on how the US Attorney thinks about this point of view.
I am going to go out on a limb again and suppose that Herbalife's compliance regime is about as effective as an umbrella in a tornado or a one-legged man in a butt-kicking contest. To say that Herbalife turns a blind eye to compliance is like saying on a bright, sunny day, the sky is typically blue.
Here are at least 5 examples of Herbalife's disastrous compliance regime.
- The company has no system to track retail sales to ultimate users. (audio can be found here)
- The company does little to enforce its 10 customer rule and 70% rule, as it has no retail tracking system.
- The company allows its top recruiters to sell "advanced fee" lead generation and marketing systems. (visit here for the details)
- Distributors exaggerate income claims.
- Distributors exaggerate the health benefits of Herbalife products. (visit here for the ABC Undercover report)
Oh yes, and there is the small point that the company sponsors a marketing plan that is clearly designed to promote an endless chain of competitors seeking an obviously finite set of customers/recruits, while paying commissions to those pursuing Supervisor status in a closed, pyramid, ponzi economy. Last year alone, the company recruited over 2 million new people and then told them to go out and compete against one another to recruit yet another 2 million people. Guess how that is turning out for most of them.
Q. How does Herbalife feel about its ability to get its distributors to comply with its policies? How sharp are the compliance teeth?
A. From the Risk Factors section of Herbalife 10k:
Since we cannot exert the same level of influence or control over our independent Members as we could were they our own employees, our Members could fail to comply with applicable law or our Member policies and procedures, which could result in claims against us that could harm our financial condition and operating results.
Our Members are independent contractors and, accordingly, we are not in a position to directly provide the same direction, motivation and oversight as we would if Members were our own employees. As a result, there can be no assurance that our Members will participate in our marketing strategies or plans, accept our introduction of new products, or comply with our Members policies and procedures.
How's that for washing your hands of compliance?
Q. How did that approach work for SAC Capital?
Here's what Mr. Bharara had to say on the question of compliance in the SAC Indictment.
Ineffective Compliance Programs That Failed To Detect Or Thwart Insider Trading
24. Furthering the scheme, the SAC ENTITY DEFENDANTS employed limited compliance measures designed to detect or prevent insider trading by SAC PMs or SAC RAs.
As an initial matter, the SAC ENTITY DEFENDANTS automatically purged all instant messages after 36 hours and all e-mails not affirmatively saved after 30 days until adopting a revised document retention policy in September 2008. In addition, prior to approximately late 2009, SAC's compliance department rarely reviewed electronic communications by SAC employees for suspicious terms suggesting potential insider trading, notwithstanding the fact that the head of SAC compliance had recommended such searches to SAC management as early as 2005.
25. Although the SAC compliance department, beginning in approximately 2006, prohibited the use of expert networks to make payments to public company employees for industry information, SAC encouraged direct contact with public company employees at various levels outside of these networks. For example, in or around 2006, when Richard Lee initially interviewed for a job at SAC and told a senior SAC executive that his investment process involved, among other things, consultations through an expert network, the SAC executive responded in substance that most SAC PMs relied on their own personal networks of industry contacts. In fact, as reflected in examples noted elsewhere in this Indictment, SAC PMs and SAC RAs routinely consulted public company employees at various levels and recommended trading ideas to the SAC Owner expressly based on information obtained through contacts at these companies.
26. Moreover, notwithstanding that the SAC compliance department was apparently aware that expert networks presented a risk of insider trading, the SAC compliance department failed to effectively monitor SAC employees' use of expert networking firms. For example, the SAC compliance department failed to detect or prevent Martoma from using an expert network for approximately 42 consultations with a doctor involved in the Drug Trial, even though some of the expert networking firm's scheduling e-mails with Martoma- sent through the SAC e-mail system - expressly stated that (1) the doctor in question had confidential information about the Drug Trial; and (2) the purpose of the consultation was to ask the doctor about the experimental medicine being tested in the Drug Trial. The doctor in question in fact provided Martoma with Inside Information about the Drug Trial during many of these consultations.
27. Also furthering the scheme, on several occasions SAC management failed to refer trading recommendations that appeared to be based on Inside Information to SAC's compliance department for investigation. For example, on or about October 30, 2007, Horvath's trading recommendation emailed to the SAC Owner concerning Sun stated my edge is contacts at the company and their distribution channel." Steinberg, who was copied on the e-mail, forwarded it to the SIGMA CAPITAL Chief Operating Officer (the COO") with the comment: " I suspect the line about contacts at the company may wake up some of our legal eagles." The COO responded: "I think it might precipitate a general inquiry to confirm we are not in possession of non public information. This seems like an investment idea, not a trade and my interpretation of his comment is just that he developed good relationships with mgmt. that enhance his comfort level." The COO arrived at this benign (and unsubstantiated) interpretation without anyone interviewing Horvath about his e-mail. In truth and in fact, Horvath's e-mail was based on confidential information about Sun earnings that Horvath had obtained from his contact at Sun.
28. Also furthering the scheme, the limited number of internal investigations by the SAC compliance department of insider trading were generally weak, with a focus on "confirming" with a SAC PM or SAC RA in an interview that an e-mail implying access to Inside Information was an inartfully drafted e-mail. In fact, despite numerous documented cases of insider trading at SAC - established by, among other things, guilty pleas of six former SAC PMs and RAs who each committed insider trading on numerous occasions and over a substantial period of time while employed at SAC- SAC's compliance department contemporaneously identified only a single instance of suspected insider trading by its employees in its history.
29. SAC's resolution of the one case in which it identified suspected insider trading also reflected a lack of commitment to address the issue. On this occasion, information reviewed by SAC's compliance department demonstrated that CR Intrinsic PM-1 and a second PM ("SAC PM-1") had received and then traded based on an advance tip from an outside health care analyst (the "Health Care Analyst") at a research firm doing business with the SAC ENTITY DEFENDANTS. In particular, evidence reviewed by the SAC compliance department reflected that on the evening of July 27, 2009, the Health Care Analyst communicated to CR Intrinsic PM-1 that his firm would publicly release a negative research report the next day about health care company Medicis, Inc. ("Medicis"). CR Intrinsic PM-1 then told this to the research analyst for SAC PM-1. SAC PM-11 S research analyst then admitted - as corroborated by e-mails and phone records - that he had at SAC PM-11 S direction called the Health Care Analyst and learned that the negative research report would be publicly released in the "pm" of July 28 Both CR Intrinsic PM-1 and SAC PM-1 shorted the stock of Medicis before the report was released that evening. Despite this and despite the fact that it was the SAC Owner who had initially inquired about the trading the consequences were limited. The SAC ENTITY DEFENDANTS imposed monetary fines on the two offenders but allowed them to keep their jobs and failed to report the insider trading to any regulatory or law enforcement personnel.
I often ask myself what Mr. Bharara might be thinking about the good ship Herbalife and its management team. My sensibilities lead me to believe that the answer is something like, "How did these guys get away with this conspiracy with the company's top recruiters for so long?"
The answer, of course, is complex and simple, all at the same time.
Frauds are designed deliberately to deceive. That is why they are wrapped in the veneer of legitimacy. That is why data points like Distributor Allowances are passed off in 10k's as evidence of real retail sales, when in all reality, the company has absolutely no way of tracking retail sales.
That is how the company sells a business opportunity promising distributors access to lots and lots of real retail customers, even as it has no tracking system to verify the legitimacy of that kind of statement at all.
That is why the company tells investors that all low-level distributors are just personal consumers trying to get a discount on product, even as every single Opportunity Meeting that is held around the world is trying to convince distributors to strive for SUPERVISOR status. Don't believe me? Just ask Mark Hughes.
That is why the company sponsors Cristiano Ronaldo at the same time it defrauds low-income Latinos with the sale of a fraudulent business opportunity that churns over 1.5 million people per year right now.
How can we fault regulators for failing to spot the fraud? I'll leave that question up to wiser minds than me. Still, I think we can clearly say that regulators have no excuses now. Herbalife has been driven out of the shadows and into the open.
Seems doubtful to me that the party line of "Herbalspeak" is going to overwhelm Mr. Bharara and his obvious credentials and intelligence.
If investors want to know how the DOJ thinks about crime, read through the SAC indictment. I am going to go out on a limb yet again and argue that it is highly unlikely that the DOJ will want to see Mr. Johnson keep his $100 million pay day that has been financed by traveling to Extravaganzas the world over on a private jet in order to bald-faced lie to the masses, while delivering Mark Hughes bonuses to his chief recruiters. I am going to guess that Mr. Bharara isn't going to want a tour of Mr. Andry's beachfront mansion, either.
It also seems unlikely to me that the DOJ will accept the view that Herbalife corporate isn't responsible for the fraudulent conduct of its independent distributors. On the contrary, isn't turning a blind eye done with purpose and intent? What do the Mark Hughes bonus checks tell you?
So, what might the DOJ do next? My guess is as follows.
Job #1 - Regulators will want to put an immediate stop to Herbalife's recruiting activities to prevent future damage to unsuspecting marks;
Job #2 - Regulators are going to want to freeze the company's assets to protect those who have been victimized; and
Job #3 - Regulators are going to go after all of the perpetrators of this global fraud in order to recover damages for victims of the fraud who will be numerous, including shareholders, former distributors, and current distributors just trying to make ends meet.
Q. Is Mr. Bharara smarter than a 5th grader?
As an investor, it strikes me that your options are to either side with the Herbalifers and say "NO", or get with reality and say "YES".
A wager against Mr. Bharara is likely a wager against common sense. Don't believe me?
I will remind you that Mr. Bharara's batting average against insider traders is a cool 1.000.
Don't let today's Q1 results fool you. Herbalife remains a global confidence game, a recruiting scam, a money transfer scheme and a ruse. When Mr. Icahn says "that's not the company it's the distributors" he is totally out to lunch.
Compliance matters to the DOJ when conspiracy is at work. Just ask SAC Capital, if you don't believe me.
Regulators are destined to shut Herbalife down. It is only a question of time.
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.