Herbalife (NYSE:HLF) remains in the news. Most recently with a downgrade by the Street, and some minor reports of certain investors getting in (deeper), as in the Capital Group, and some smart money getting out partially, as in Perry Capital, or wholly. On the whole, the buyback has amounted to 4.3 million shares, and hedge funds sold some 5 million shares, as reported by the NY Post, so it makes sense we are lower today at $50+ vs. $65 at the end of Q1. Starting on 7/31, we've been watching a slow drip of insider buys, relatively of a token nature considering the circumstances, but ranging from 200 to 10,700 individually, totaling about 40,000 shares within 2 weeks at close to $50, or $2 million, the real significance of which is hard to read, but probably more PR value.
The question is who has got the goods on this situation. Is it Ackman c.s. or is it Icahn c.s.? The dialog on this site frequently gets lost in that controversy. But it's not about the messengers, it's all about the message. Beyond Herbalife, the overarching issue is the shaky legal foundation of "MLM," which would not have existed but for the Amway ruling in '79, which has however been honored in the breach more than the observance, leaving lots of question marks. It should also be noted that the Nutrition Clubs are now the second HLF "business method" that may prove to be more trouble than it is worth, the first being the troubled "lead generation" racket, which it already closed down. The deeper reason being that promoting an opportunity that is always at risk of being found fraudulent and avoiding the limelight is inherently difficult, and Bill Ackman's flashlight is evidently quite powerful.
Above the din of this epic short battle, the loudest "noise" sometimes seems to be the silence of regulators, who are presumably continuing to work on this case. As hard as it is to get a handle on the situation in the interim, it pays to realize that MLM, after forty years of legal and regulatory confusion, is now a problem that has mushroomed to a size that eclipses Enron plus Madoff on a worldwide basis, depending on what numbers you believe, but the estimates go as high as $150bn worldwide. The combination of American case law and regulatory inaction has been the key enabler of this development.
Then, along comes a curve ball like the voice of "Hell on Deals," who showed up in the comments on this site recently and reported some potentially novel regulatory issues, mainly pertaining to the use of "Value Points" in Herbalife's reporting. Her findings could be relevant to the SEC in terms of inconsistencies in reporting, and the US Treasury/FinCEN in terms of potential violations of rules pertaining to virtual currencies, and possibly covering up irregularities, including the Venezuelan arbitrage, that might have unwittingly made the company into an unlicensed Money Service Business - MSB for short. The jury is still out on that one, but any such issues might have a shorter fuse than the FTC and SEC issues.
Bill Ackman's evolving role
Bill Ackman clearly gets the abuses in Herbalife, and since the very extensive research was all commissioned by Pershing Square, to him it has the fresh quality of first-hand information which he has duly publicized. The latest and greatest extravaganza of July 22nd was a bit counter-climactic, and the overload of information evidently short-circuited the public media, let alone that it was digested by the markets, but in his letter to investors, Ackman has made it clear that the presentation was eventually targeted to regulators, and in that sense, the public spectacle served a purpose. The section of his letter pertaining to Herbalife bears close reading, and I note with particular emphasis the fact that he has stated the intention to extend the short position past current expirations. Anyone who truly digests the level of detailed information Pershing Square has produced on Herbalife can understand the conviction behind its position.
As to the Russian Doll system of Herbalife, the ingenious pyramid-within-a-pyramid, aka Nutrition Clubs, one footnote in the Pershing Square letter to investors sums it all up nicely by pointing out that: "Substantially all of these so-called nutrition clubs are in violation of U.S. labor laws, minimum wage requirements, and state sales tax collection requirements as well as state and local food service requirements, in addition to the anti-pyramid statutes of many states and the Federal government." Bill Ackman admitted in the presentation that even Pershing Square were surprised by what it found once it started its research into the nutrition clubs. Analytically, the key issue emerging from the nutrition club expose is that it reclassifies most of HLF's retail sales as promotional sales, not unencumbered retail, and thereby takes away an obvious defense against a potential pyramid-scheme charge. The investor letter further notes that the very tight knit nature of the Latino community that once enabled Herbalife's easy penetration of that market, now may backfire as the nefarious aspects of Herbalife's "opportunity" become better understood, and that news is spreading fast also. I am seeing some of that in the Latino community in my area, with lawmakers getting involved.
The balance of the treatment of Herbalife is in terms of its deteriorating financials, and the fact that it's out of bullets to maintain the stock buyback program does the rest. PS states its intention to maintain its "short stock, and long puts" strategy, made cheaper now by the suspension of dividends. In the end, however, for Pershing Square this is about Herbalife, though it is clear that some of the issues have been surfacing for other industry players as well, including NuSkin (NYSE:NUS) and Usana (NYSE:USNA), in particular the China anti-MLM issues.
E. Robert Smith and the prospect of congressional hearings
Herbalife very likely will be the trigger for a revision of the entire regulatory framework that applies to the industry, and it is the appearance of the book "Downline... an intolerable potential to deceive," which provides the context for that. Clearly Robert Smith, who is a frequent contributor in the comments about Herbalife on this site, is working towards a congressional hearing, and the regulatory mess is bad enough that congressional action should be merited, lest China, India and Italy draft the laws and regulations for us, as is already starting to happen. Since public listings have served to help the con game become international, the SEC should be acutely concerned with the global credibility of the American markets. Ackman does not (yet?) seem to get the overall picture and how much the issues affect the whole industry, including the likes of Legal Shield (formerly PrePaid Legal), Primerica (NYSE:PRI) and every other operation of this type, including potentially even Pampered Chef and Tupperware, even though most of those are owned by "nice people."
Clearly, MLM is such an unusual business format, few people understand it. Wall Street certainly hasn't, they still think these are legitimate businesses and don't ask questions about the unique characteristics of their financial performance, except for cashing the checks - quite in the spirit of John Hempton: they are "scumbags," but they're "my scumbags," for they are sending me checks. Many would-be MLM "leaders" do not seem to grasp that they are basically paid shills for a massive deception, a leveraged version of three-card monte. A few figure it out eventually, and Robert Smith is one of those few, and... blessed with a talent for writing an engaging story about it. His book should be required reading for any legislator, prosecutor, investigator or participant in MLM. It was clearly the Pershing Square short against Herbalife that caused Smith to speed up the publication of the book, and for Pershing Square, this was so much unexpected outside help, a very public whistleblower coming on the scene, with obvious industry experience. In a way, the surprise appearance of this book was a serendipitous help, as much as the completely unexpected Russian Doll effect of the Nutrition Clubs, which wiped out the legitimacy of most of HLF's much vaunted retail sales.
Out of left field
A complex situation such as the Herbalife position almost is a natural setting for surprise developments, and if the sudden publication of Robert Smith's book was one, the emergence of "Hell on Deals" in the comments on this site was another. Even though she made a few moves that damaged her credibility, the material she reported to the FinCEN and the SEC seems to be under consideration, and this potentially brings yet another regulator to the scene. If indeed the FinCEN/Treasury deems the matter worth pursuing, typically their fuse is shorter, because here there seem to be matters of very cut-and-dried violations of rules that allow prompt action, faster than some of the other pending issues involving other agencies. How this evolves remains to be seen. Additionally, she has also indicated she is looking into the McDonald's/NLRB ruling to see if it may apply to HLF, and that ties in with issues PS has already pointed out.
Regulators, self-regulation and the future
The DSA is a joke, it is sort of the Apalachin commission for MLM, and it is a great enabler of the worst scams, all the while pretending to advocate "legal" MLM in a bid to stave off regulatory interference. Its resistance to the FTC's Revised Business Opportunity Rule (aka RBOR) did nothing but protect abuse, for any legitimate business would have no problem with those rules. But MLM resisted, because for the most part, it is not a legitimate business. The central deceit remains in almost all cases the promotion of "unlimited income potential" to an unlimited number of people, with the idea in mind of ultimately creating a feeding frenzy that will garner a company huge market penetration for the price of making a few people very wealthy, while ripping off the rest, who never stand a chance. It never creates a stable business, however, but then we move on to the next scam. The DSA view of legality is rooted in the case law of what is clearly illegal, and maintaining the appearance that such illegality is avoided, and fighting regulation and eviscerating the law when and where they can. The FTC, by indulging the DSA and accepting an exemption for MLM from RBOR, became complicit in perpetuating the fraud, so that we now have regulators who are there to protect the fraudsters from the public and not the public from the fraudsters (thanks to Harry Markopolos for that quip).
Any sense of business ethics would and should eliminate that foundational fraud from the business altogether. So if it does not work by self-regulation, regulators have to do it. And RBOR may not be enough, but it's a start. It should also be understood that the mechanisms of fraud are now so entrenched that a major re-education effort needs to become part of sanitizing the industry.
Building blocks for a "legal" MLM
There is, of course, a small but vocal group of "MLM-ers" who think MLM is legal, although most could not tell you why - they just assume it. The majority of the population thinks invariably: "Is that one of them pyramid scams?" It is my belief that of the 10% of the adult population who are the card-carrying "MLM-ers," less than 50% do it without much doubt or hesitation, but only 10% are "hard core," because they've made some money at it. The other 50% are on the fence, for they've had bad experience. My own history is that I've dabbled in it, and at one time even developed an MLM business plan for a company, and one that I tend think would have passed legal muster - it was a simple multi-level sales plan without much of the MLM overtones. Most of the time I pulled out of ventures when I became uncomfortable. In one case, a friend and I confronted the owners of a company who I felt were courting regulatory problems, and they made like an ostrich. We pulled out, and six months later they were shut down. In other words, if you've really been in the industry, you know they're always skirting the edges of the law and never in a stable equilibrium.
The core issue that won't go away
MLM business models are evolving, and the Herbalife model is a bit of an antique, all things considered. Some recent changes are mostly cosmetic, and if it wants to re-label 70+% of new recruits "members," it should stop charging them $59, and not have them sign complicated agreements, but simply make them "preferred customers" as many companies do nowadays.
- But the one core issue that will not go away and needs to be confronted is the fraudulent proposition of "unlimited earnings potential" that is offered for "good and valuable consideration" to unlimited numbers of people.
- '"Unlimited Earnings" is the fundamental fraud which is the engine of the endless chain recruiting that drives all MLM. Coupled with "infinity compensation," it focuses the leaders on recruiting ad infinitum, and puts them at cross purposes with the very people they sign up, ultimately setting up a feeding frenzy when these companies hit hyper-growth.
- The corollary to the fraud is the deception that because someone did it, you can too, when in fact, your chances of success are, with mathematical certainty, reduced because someone already did it and large numbers of others are doing it simultaneously. This explains why MLM fears disclosure.
A fraudulent proposition of this nature would not be permitted anywhere, and it is merely an accident of history that it has been tolerated in MLM. Case law has gotten us lost in the trees, so the attention of any new regulatory regime has to be focused on the forest first, on core concepts of MLM, possibly strengthened rule-making about appropriate details.
By way of an example, a reductio ad absurdum: An MLM approach to a career at Pershing Square Capital Management might consist of a paid training program for either a tennis pro, a golf caddy, or a ride-sharer, and the argument would be that because somebody did it, you can too; you'd be paying for it all the way; and on the breaks, you'd get to watch movies of Bill Ackman waving big checks around, implying again that you could do this too, if only you took those trainings seriously enough and applied yourself. Think of all the money you could make! Will that be cash or credit please?
Why is the example absurd? Because everyone understands the impossible odds. Why don't people see it in MLM? Why is it OK to represent a remote probability as a certainty?
The one central fraud of MLM proposes something as a sure thing, when it is not, as a matter of simple math. MLM gets people to spend time, effort and money on a proposition which is a lie, a deliberate misrepresentation designed to get buy-in making that lie true, which will never build a sustainable business, for the minute you stop lying, it starts disintegrating. There is nothing wrong with the concept of multi-level compensation and building sales teams. There is everything wrong with misrepresenting an illegal recruiting operation as a legal sales operation, using lies and deceit to promote the opportunity, which misrepresents itself as a sales opportunity, but really is only about recruiting. False opportunity claims, false product claims have all become common currency in MLM, and should be radically eliminated if any sensible regulation is to be attempted. Focusing only on a few symptoms will allow the abuses to continue.
Herbalife is becoming a showcase for the industry, and whatever the outcome, what is to be hoped for is a regulatory framework that protects consumers, but creates a legal way forward without the unending legal challenges that have resulted from an industry failure to regulate itself and a regulatory failure to-date. Meanwhile, on the way down, we may be entering an interesting long squeeze situation, for there are several large positions that really face a kind of prisoner's dilemma right now, as several smaller players have sold out. Icahn, Capital Group and Fidelity increasingly look like they might be set up for a shoot-out at the OK Corral.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.