Herbalife (HLF) can now officially add the Securities and Exchange Commission (SEC) to the list of parties interested in what the company calls "irrelevant information." In documents dated from June 5 to July 27 (all cited below), the SEC asked Herbalife management for clarification regarding two things that are becoming all to familiar to the company's shareholders: the breakdown of its distributor base and information regarding its adherence to the so-called 70% rule.
CNBC stock commentator Herb Greenberg summarized the exchange between the SEC and the company in an article published Friday, but I believe it is worth taking a close look at exactly what was said (and what was predictably not said) in order to gain a bit of fresh insight into how the company goes about ensuring investors that its products are reaching and being consumed by end customers.
First, the SEC reiterates hedge fund manager David Einhorn's question as to why the breakdown of the non-sales leader distributor base was conspicuously missing from the company's latest 10K:
We note your disclosure in your Form 8-K filed May 2, 2012 regarding the percentages of your distributors who are considered discount buyers, small retailers and potential supervisors. Please provide us with an analysis regarding your conclusion that...[this] topic [is] immaterial in the context of your periodic reports.
Predictably, Herbalife's explanation seems largely without substance:
First and foremost, our management does not rely on or otherwise utilize the information in managing the Company's business....In addition, a new method of sales leader qualification introduced globally in October 2009 allows a distributor to achieve sales leader status based on smaller, more frequent orders placed within a twelve-month period as opposed to our previous qualification methods which are based upon larger orders over a shorter period of time. With this change, because sales leader status can now be achieved through either a limited number of large orders or a greater number of small orders, sales order size is no longer a reliable indication of which particular group a non-sales leader distributor should belong to or of an individual non-sales leader distributor's intentions generally. Finally, because the information reflects only the number of sales orders but does not account for either the size or total value of a particular sales order, it has not been proven useful to indicate trends with respect to sales volume or other measures on which we focus. Therefore, as part of our regular ongoing evaluation of our various disclosures, we determined to cease disclosing the information in our Annual Report on Form 10-K for 2011 because the continued disclosure of information that Company management does not believe is valuable and does not in fact use in managing the Company may result in investors placing undue emphasis on such information.
Now, there are a number of things which, in my opinion, should strike investors as odd about this statement. First, it makes clear that management is determined to judge what is relevant and what is not and does not intend to let investors make that judgment for themselves. While this would be understandable if the information in question were universally considered to be unimportant, the fact is that many people who evaluate multi-level marketing firms indeed view the information as relevant, so excluding it because management doesn't want anyone to place "undue emphasis" on it seems a bit specious.
Second, management notes that the new method for qualifying as a 'sales leader' that went into effect in 2009 makes the breakdown less useful. This, of course, begs the question as to why the breakdown was included in both the 10Ks from 2009 and 2010 (on page 5 in both documents).
Third, the company's discussion regarding how the new qualification method for sales leaders affects the relevance of "order size" for the classification of the non-sales leaders is quite convoluted, and seems to contain at least one rather obvious inconsistency regarding whether or not "order size" was part of the company's evaluation and subsequent breakdown of the non-sales leader distributors in the first place. In any case, the description seems littered with attempts at obfuscation.
Herbalife's attempts to talk around the SEC's questions about the 70% rule were so tortured that the agency had to ask for a clarification of the company's first response letter. The rule states that at least 70% of the products the company sells to distributors must be consumed or sold within a month. When asked about the rule by the SEC, the company, after listing the procedures it had created to guard against the accumulation of inventory, initially said the following:
Because we believe our core business model involves several safeguards against product accumulation, we do not view the supplemental policies, such as the 70% Rule, as information that is material to investors.
So again, the company apparently will judge for itself what is important and what is not, right up to and including the exclusion from the realm of relevancy a standard which Herbalife itself acknowledges has historically been "regarded by the Federal Trade Commission as an effective means to defend against a Federal Trade Commission Act Section 5 claim because [it] prevented inventory loading and encourage[d] retail sales."
This was not good enough for the SEC. Obviously, stating that the company believes its own policies are adequate does not exempt it from explaining why established standards are not part of those policies. From the SEC to Herbalife:
...your response does not clarify why the 70% Rule should not be considered a part of your core business model. In particular, your response does not clarify the nature of the 70% Rule or why you have implemented such a policy. For example, it is unclear if the rule is memorialized in your internal policies or controls or what, if any, material consequences arise in the event of non-compliance.
In response, the company simply reiterates the "relevancy" argument, this time accompanied with its own interpretation of Item 101(c) of SEC Regulation S-K, which the company notes only requires a description of matters deemed material to the business or to investors' understanding of the business as a whole.
Of course, once the company has deemed the rule immaterial and irrelevant, it is free to say things that, on their face, sound rather cavalier -- like this: "...consistent with our belief that the '70% rule' is not material, we do not include or otherwise reference it in our standard distributor agreement."
The company does mention the rule in its "Sales & Marketing Plan and Business Rules" however. This is particularly interesting, because although the company says it views the rule as neither relevant nor material, the rule's circumvention is nonetheless cause for the company to refuse payment of many distributor incentives:
In order to qualify for and receive Royalty Overrides, Productions Bonuses, and other bonuses paid by Herbalife, at least 70% of the total value of Herbalife products a Distributor purchases each Volume Month must be sold or consumed that month. (emphasis mine)
Now if I am trying to "understand the business" and there is a rule that may negate my ability to enjoy some of that business's most sought-after perks such as, in this case, royalty overrides and production bonuses, it seems that I would view that rule as both relevant and material.
In short, it is quite a stretch for a multi-level marketing company to claim the rule is not material. Indeed, that contention requires justification, which the company obviously realized because it sought to back-up its claim with a less than convincing four sentence explanation which cites:
Webster v. Omnitrition, 79 F.3d 776 (9th Cir. 1996) [which] cast doubt on the legal effect of the "70% rule" ...as a safe harbor from Section 5 claims [and] the FTC's Staff Advisory Opinion -- Pyramid Scheme Analysis dated January 14, 2004, which...does not reference..the "70% rule," or that [it] defend[s] against a Section 5 claim.
So, because the 70% rule may not have constituted safe harbor in one court case, and because it and the other "Amway Protections" were not mentioned in an advisory opinion, Herbalife concludes the following:
...we understand the Amway Protections, and in particular the "70% rule," are no longer uniformly followed in the multilevel marketing industry.
That seems like a rather bold assertion to make based on the evidence presented.
In summation, it should be noted that the SEC's final letter to the company says that:
We have completed our review of your filing. We remind you that our comments or changes to disclosure in response to our comments do not foreclose the Commission from taking any action with respect to the company or the filing.
So yes, the matter appears closed for now, but the inquiry should serve as an important reminder to shareholders and investors that the questions about the company do not just emanate from naysayers and short sellers. The company would say the questions have been answered. Investors should read the documents cited above and judge for themselves. For my part, I recommend shorting the shares.