Herbalife Settlement Exposure Could Exceed $1.2 Billion

| About: Herbalife Ltd. (HLF)

Summary

$1.2 Billion is the projected financial harm caused to a small group of U.S. Herbalife Members alone.

Herbalife's use of Average Gross Payments may dramatically increase those damages.

Herbalife Member Agreements could be determined by a Court to be "Contracts for an Illegal Purpose".

Net Winners concept from the Zeek Rewards case becomes a very real possibility.

Bostick case may have an error and Foreign Government Regulators will contact the FTC.

BACKGROUND

In March of 2014, the Federal Trade Commission served Herbalife (NYSE:HLF) with a Civil Investigative Demand. Herbalife disclosed in their SEC filings that the purpose of this CID "as supplemented" was: "to determine whether the Company has complied with federal law in the advertising, marketing, or sale of business opportunities".

Herbalife has additionally disclosed in SEC filings inquiries from the Securities and Exchange Commission and "other governmental authorities". Herbalife has not disclosed the purpose of those inquiries and/or who the "other governmental authorities" are.

LIGHT AT THE END OF THE TUNNEL OR IS THAT A TRAIN?

On May 5th, 2016 at 3:13pm and 3:15pm, Herbalife, its surrogates or parties somehow connected with same leaked information from the unreleased 10Q to CNBC and Charles Gasparino.

CNBC and Charles Gasparino ran the leaked information as "Breaking News", as follows:

The market, on receipt of this "Breaking News", placed great faith in CNBC and Charles Gasparino and Herablife's shares ran up. It turned out that the markets faith in both CNBC and Charles Gasparino was misplaced. CNBC and Gasparino had not confirmed the completeness, accuracy or veracity of said News. When the actual 10Q was released and conference call completed, the truth regarding the $200 Million "settlement" or "payment" was revealed.

That truth was:

  1. The $200 Million was number fabricated by Herbalife.
  2. The $200 Million DID NOT come from the FTC.
  3. Herbalife CFO John DeSimone refused to explain how the $200 Million was derived.
  4. The $200 Million was something the Company noted it might pay under a "Mutual Resolution"
  5. The fabricated $200 Million was the only positive part of a 588 word statement that noted numerous times there was no deal, material open issues still existed and the FTC may file a Civil Complaint

10Q Excerpt:

"The outcome of these matters with the FTC, whether by mutual resolution or through litigation, could have a material adverse impact on the Company's business operations, its results of operations or its financial condition. The Company believes it is reasonably possible that it may have incurred a loss. At the present time, the Company's best estimate of the payment amount that would be made by the Company under a mutual resolution with the FTC is $200 million. The Company has not accrued any amounts with respect to any potential monetary payments relating to this matter. If a resolution is not attained and litigation ensues, the Company is unable to estimate a range of potential loss, if any, relating to these matters."

What this Twitter event showed us all, was that the market (and the Company specifically) are fully aware the fate of Herbalife sits in the hands of the FTC, and possibly the SEC.

With that in mind, I wanted to attempt an analysis at whether the Herbalife $200 Million "mutual resolution" (which is de-facto an offer) is reasonable or sufficient as restitution damages.

Here are some basic facts:

  1. The FTC investigation covers 2009 to present.
  2. Herbalife's offer of $200 Million as a "mutual resolution" is indicia of acceptance of culpability for some bad acts.
  3. Herbalife's offer of $200 Million will be hard to argue later as unreasonable, when they proposed it.
  4. Herbalife's offer of $200 Million represents a 1,233.3% increase over the $15 Million that they agreed to settle the Bostick Class Action for.

Now, let us consider the following two scenarios:

Should the FTC aver Pyramid Scheme practices as present at Herbalife, in whole or part, then all U.S. based contracts Herbalife entered into with its "members" during the FTC investigation period (2009 to present) could, with high probability, be adduced by a Court to be "Contracts for an Illegal Purpose".

Utilizing California law, Herbalife contracts would be specifically unlawful under California Penal Code § 327 Endless Chain Statute, among others, and as such the contracts would be void ab initio per California Civil Code § 1608. This would render all terms and conditions of such contracts void and unenforceable (including the arbitration provision) which would then ostensibly entitle all injured parties to unilateral rescission and give rise to those members not in "Pari Delicto" a claim against any Government restitution funds.

This brings us to a question. Is there equal fault (Pari Delicto)? Here the facts speak.

Herbalife has vehemently asserted it is not a pyramid scheme. It has produced mountains of data to lend what they consider "evidence" to this view. It has used this evidence to market and induce parties into the investment in, or purchase, of its business opportunity and drafted the onerous contracts under which buyers of the business opportunity must operate.

It is obvious, the business opportunity buyer/future member was and remains deprived of important facts. Further, given the entry point cost of this "Business Opportunity" it is not reasonable to have expected Buyers to have engaged Lawyers to review the contract.

Add in direct knowledge of recruiting as the only means to recover the investment and that this was not something explicitly made clear in the contracts (as same is unlawful) by Herbalife and you have your pool of victims all with direct claims against potential restitution funds.

Next, I wonder whether the Judge in the Bostick case may well have had an obligation to have raised the "Doctrine of Illegality" and whether failing to do so may constitute error. See below:

California Court of Appeals in Fellom v. Adams (1969) 274 Cal.App.2d 855, 863, "the court has both the power and duty to ascertain the true facts in order that it may not unwittingly lend its assistance to the consummation or encouragement of what public policy forbids. It is immaterial that the parties, whether by inadvertence or consent, even at the trial do not raise the issue. The court may do so of its own motion when the testimony produces evidence of illegality. It is not too late to raise the issue … even on appeal.

Each of these legal avenues (Contracts for an Illegal Purpose and/or Bostick error) create tangible and material new financial peril for Herbalife and its Shareholders.

Additionally, potential claw back actions against Herbalife's high level members as introduced in "Zeek Rewards" case of Net Winners as a certified defendant class is a real possibility. As noted in Bell v. Disner, "Because ZeekRewards' net winners 'won' (the victims') money in an unlawful Ponzi and pyramid scheme, they are not permitted to keep their winnings and must return the fraudulently transferred winnings back to the Receiver for distribution to Zeek's victims,"

Most importantly, all these scenarios provide the FTC with incredible leverage against Herbalife, utilizing either settlement or litigation paths.

CALCULATING FINANCIAL HARM AND RESTITUTION

IDENTIFYING A DAMAGES COHORT

I believe it a reasonable assumption that the Federal Trade Commission is seeking to secure an equitable and meaningful restitution damages amount against Herbalife, in addition to a "Vemma" consistent injunction and business changes.

With that in mind, I want to attempt to quantify the financial harm Herbalife has caused, if only for one small subset of Herbalife Members.

The group I have selected is U.S. based Business Opportunity buyers referred to as Sales Leaders with a Downline, who did not receive payments from Herbalife sufficient to recover their "Business Opportunity" investment.

We have benefit of statistics on this group, as they are provided by Herbalife for 2012 - 2015. They are the bottom three rung's in the Herbalife Statement of Average Gross Compensation (those with Average Gross Payments in the example below, under $2,202.00)

2015 Example:

Click to enlarge

To buy into (invest in) the "Business Opportunity" by "qualifying" as a Supervisor (Sales Leader with a Downline) you must purchase 4,000 volume points per annum. One volume point in the U.S. equals approximately $1.00.

For purposes of this calculation, I will conservatively estimate the average cost to participate at $3,500.00

Volume Points Required to Qualify

4000

Average Cost per Volume Point

$1.00

Average Cost to Qualify

$4,000.00

Calculation Adjustment to be Conservative

-$500.00

Average Cost to Participate

$3,500.00

Click to enlarge

Next, from Herbalife's statistics 2012 - 2015, I will calculate what number and percentage of the total group of Sales Leaders did not recover their "Business Opportunity" investment from Average Gross Payments from Herbalife.

Herbalife Disclosures from Statements of Average Gross Compensation

Year

Number of Members Receiving Average Gross Payments Lower Than Their Investment

Total Number of Members

Percentage who did not recover amount at least equal to their Investment

2015

61,549

68,768

90%

2014

64,175

71,870

89%

2013

64,152

71,535

90%

2012

75,653

82,464

92%

Click to enlarge

KEY POINT: On average 90.25% of Total Sales Leaders with a Downline did not receive Average Gross Payments sufficient to even recover their "Business Opportunity" investment.

CALCULATION OF AMOUNTS PAID BY THE DAMAGES COHORT TO HERBALIFE

Next, I will calculate the total amount paid to Herbalife by the members who failed to recover their full "Business Opportunity" investment

PROJECTED PAYMENTS TO HERBALIFE - BUSINESS OPPORTUNITY (Non-Recovery Group)

SOURCES: HERBALIFE STATEMENT OF AVERAGE GROSS COMPENSATION

Average Payments Category from Herbalife (USD

Number of Members

Est. Average Amount Paid to Qualify (Business Opportunity)

Est. Total Payments to Herbalife for Business Opportunity

2015

1001-5000

11,627

3,500

40,694,500

1-1000

42,658

3,500

149,303,000

0

7,264

3,500

25,424,000

Total

61,549

215,421,500

2014

1001-5000

12,483

3,500

43,690,500

1-1000

41,393

3,500

144,875,500

0

10,299

3,500

36,046,500

Total

64,175

224,612,500

2013

1001-5000

11,942

3,500

41,797,000

1-1000

40,120

3,500

140,420,000

0

12,090

3,500

42,315,000

Total

64,152

224,532,000

2012

1001-5000

11,307

3,500

39,574,500

1-1000

39,151

3,500

137,028,500

0

25,193

3,500

88,175,500

Total

75,651

264,778,500

2011 *

1001-5000

8,480

3,500

2,968,0875

1-1000

2,9363

3,500

102,771,375

0

18,895

3,500

66,131,625

Total

56,738

198,583,875

2010 *

1001-5000

7,632

3,500

26,712,788

1-1000

26,427

3,500

92,464,238

0

17,005

3,500

59,518,463

Total

51,064

178,725,488

2009 *

1001-5000

6,869

3,500

24,041,509

1-1000

23,784

3,500

83,244,814

0

15,305

3,500

53,566,616

Total

45,958

160,852,939

TOTAL PROJECTED PAYMENTS TO HERBALIFE - (2009 - 2015)

1,467,506,801

* See notes below re: 2009 through 2011 assumptions

Click to enlarge

* Herbalife does not provide clear disclosures for the period 2009 to 2011. Conservative assumptions were made as follows:

  1. 2011 members were estimated at 75% for each row of the 2012 members
  2. 2010 members were assumed at 90% for each row of the 2011 members
  3. 2009 members were assumed at 90% for each row of the 2010 members
  4. Average gross payments assumes the 2012 numbers, as little variance was exhibited between 2012 -2015.

KEY POINT: Total minimum projected payments to Herbalife 2009 - 2015 from Members investing in the "Business Opportunity" who did not recover their Investment in the form of a Herbalife payment totals $1.467 Billion!

CALCULATION OF BASIC DIFFERENTIAL LOSS TO THE DAMAGES COHORT

The basic differential minimum loss is that amount paid by the Member to Herbalife less the amount Herbalife paid them in return.

CALCULATION OF FINANCIAL HARM - NON-RECOVERY OF "Business Opportunity" INVESTMENT

SOURCE DATA: HERBALIFE STATEMENT OF AVERAGE GROSS COMPENSATION

Average Payments from Herbalife (NYSEARCA:USD)

Number of Members

Average Gross Payments

Est. Average Amount Paid to Qualify (Biz Opp)

Diff. Minimum Loss

Calculation of Damages

2015

1001-5000

11,627

2,202

3,500

1,298

15,091,846

1-1000

42,658

303

3,500

3,197

136,377,626

0

7,264

0

3,500

3,500

25,424,000

Total

61,549

176,893,472

2014

1001-5000

12,483

2,242

3,500

1,258

15,703,614

1-1000

41,393

299

3,500

3,201

132,498,993

0

10,299

0

3,500

3,500

36,046,500

Total

64,175

184,249,107

2013

1001-5000

11,942

2,244

3,500

1,256

14,999,152

1-1000

40,120

302

3,500

3,198

128,303,760

0

12,090

0

3,500

3,500

42,315,000

Total

64,152

185,617,912

2012

1001-5000

11,307

2,216

3,500

1,284

14,518,188

1-1000

39,151

292

3,500

3,208

12,559,6408

0

25,193

0

3,500

3,500

88,175,500

Total

75,651

228,290,096

2011 *

1001-5000

8,480

2,216

3,500

1,284

10,888,641

1-1000

18,252

292

3,500

3,208

94,197,306

0

18,895

0

3,500

3,500

66,131,625

Total

56,738

171,217,572

2010 *

1001-5000

7,632

2,216

3,500

1,284

9,799,777

1-1000

26,427

292

3,500

3,208

84,777,575

0

17,005

0

3,500

3,500

59,518,463

Total

51,064

154,095,815

2009 *

1001-5000

6869

2,216

3,500

1,284

8,819,799

1-1000

23784

292

3,500

3,208

76,299,818

0

15305

0

3,500

3,500

53,566,616

Total

45958

138,686,233

CALCULATION OF FINANCIAL HARM - POTENTIAL RESTITUTION CLAIM - (2009 - 2015)

1,239,050,207

Click to enlarge

KEY POINT: The total projected basic differential minimum loss for this Damages Cohort totals at least $1.239 Billion!

SUMMARY OF KEY POINTS

On average 90.25% of Total Sales Leaders with a Downline did not receive Average Gross Payments sufficient to even recover their "Business Opportunity" investment.

Total minimum projected payments to Herbalife 2009 - 2015 from Members investing in the "Business Opportunity" who did not recover their Investment in the form of Herbalife payments totals at least $1.467 Billion!

The total projected basic differential minimum loss for this Damages Cohort totals at least $1.239 Billion!

POTENTIAL COUNTER ARGUMENT

Herbalife can argue that the Volume Points purchased represent a tangible product, that the product has value and can be resold. It is always possible that the product represented by the Volume Points was sold at retail, external to Herbalife.

REBUTTAL TO THE COUNTER ARGUMENT

The facts reveal that Business Opportunity Buyers are sold the business opportunity as a way to "earn money" through Herbalife's "7 STREAMS OF INCOME".

  1. Retail Commissions
  2. Wholesale Commissions
  3. Royalties / Royalty Roll-Ups
  4. Production Bonus
  5. Cash Promotions
  6. Paid Vacations
  7. Mark Hughes Bonus

What Herbalife materials fatally do not disclose to the Business Opportunity buyers is, nearly all of those "7 Streams of Income" require the recruiting of new members purposely to recover the Business Opportunity investment payments current members have made (i.e. the participation in a Pyramid Scheme).

Finally, had any material amounts (greater than 50%) of the Volume Point product purchased truly have been sold at retail to real, "non-program" end users, it is reasonable to expect Herbalife would have made this very public, very quickly. Why spend $100 Million on Lawyers fighting the FTC if such an easy answer to prove you are not a Pyramid Scheme was present? The fact Herbalife has the right to Audit their members and requires evidence of Retail Sales, yet does not, presents as a giant red flag.

IMPORTANT FINAL POINTS

Herbalife claims 550,000 Members in the United States this year. The $1.239 Billion I have calculated above applies to only 11% of the members annually over the period 2009 to 2015. What is the quantum of damages for the remaining 89% from 2009 to 2015? How about those from 2016?

Note also, these are only damages from the United States. Herbalife likes to emphasize they are in 90+ Countries. How many of those Countries will contact the FTC looking for full details to pursue Herbalife for damages for their Countries victims? With 4 million members worldwide, this leaves at least 3 million+ in a single year with some degree of damage claims.

Finally, this Author asks, has Herbalife "purposely and deceptively captioned" a number that if corrected could increase the damages as calculated above dramatically?

That number is the "Average Gross Payments" column from the annual Herbalife Statement of Average Gross Compensation.

The correct number to disclose would be "Average Net Payments", not "Average Gross Payments".

If Herbalife is reporting Gross Payments (before multiple Herbalife deductions) these numbers DO NOT reflect what was actually paid to the Members. This is a critical and material misrepresentation of how much Members actually achieve and would substantively increase the 90.25% average loss rate and the damages attaching thereto.

Disclosure: I am/we are 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.

Additional disclosure: The information contained in this article represents the opinion of the Author. This opinion is informed by the materials the Author has compiled and as readily available publicly from various sources some of which include the Corporation and SEC filings. The Authors opinions and views may change materially on subsequent information. All readers are strongly cautioned to conduct their own due diligence.