The value of shares of Herbalife Ltd. (HLF) lost some weight in Thursday trading after U.S. Senator Edward Markey, a Massachusetts Democrat, reached out to the Federal Trade Commission and Securities and Exchange Commission wishing the agencies would dig into the multi-level marketing company’s business practices. Late in 2012, Herbalife was accused by billionaire hedge fund manager Bill Ackman as being a pyramid scheme. Ackman, head of Pershing Square Capital Management, said at the time that his fund had taken a $1 billion short position in the company, saying the stock was worthless and betting it would collapse as it was exposed.
What is a Pyramid Scheme?
Multi-level marketing has a checkered past fraught with scams that have bilked people worldwide out of their life savings. Understand that in its intended sense, multi-level marketing is completely legal, but people have a way of trying to stretch the law in devising get-rich-quick schemes.
Pyramid schemes, let’s call them an illegal variation of the multi-level marketing business model, can be masked in different fashions, but they all work essentially the same way: recruitment. In a naked pyramid scheme, nothing is bought or sold. One person recruits 10 people and collects an “investment” (we’ll use $100) from each of them for a “guaranteed investment opportunity.” Those 10 people are tasked to recruit 10 more people, collecting $100 from each of them, getting them back their initial investment, plus $900 more (generally speaking, the initial person collects some of the proceeds too). Anyway, those next 100 recruits are each tasked to get 10 more people, and so on, effectively building a stair-stepped pyramid. The problem is that there is only a finite number of people in the world, so the pyramid is doomed to collapse as the bottom rows start getting smaller and the people at the bottom lose all of their “guaranteed” investment because there is no one left to recruit.
In the product-based pyramid scheme, the process is similar. A recruiter gets 10 people to buy a “starter sales kit” (let’s say for $100 each). The recruiter then keeps a 10% commission for each starter kit sold and gets a cut of every product sold by his recruits going forward (and all of their recruits too). The 10 new recruits are tasked to do the same thing, incentivized by the fact that they get to keep a 10% commission from each starter kit sold and a commission from sales by people that they recruit. Get the picture? What happens is that the goal easily becomes to recruit more people into buying starter kits, not sell more products, because the higher up a person is in the chain, the less that they have to do; other than keep recruiting people and collecting commission checks from everyone down their line. Worse yet, the products being sold are often times of poor quality or overpriced, leaving people with recruiting as the only way to get their money back.
The common denominator in either pyramid scheme model is that it is mathematically impossible for everyone to make money based solely on recruitment. The plan simply runs out of people.
In contrast, legitimate multi-level marketing systems incentivize team members by collecting commissions from selling genuine, quality products. Obviously, though, that’s where the gray area comes in, veiled by greed and a gallimaufry of rules and products that makes a scam hard to distinguish.
From the Federal Trade Commission website (the regulatory agency governing multi-level marketers):
“Not all multilevel marketing plans are legitimate. If the money you make is based on your sales to the public, it may be a legitimate multilevel marketing plan. If the money you make is based on the number of people you recruit and your sales to them, it's not. It's a pyramid scheme. Pyramid schemes are illegal, and the vast majority of participants lose money.”
Back to Ackman and Herbalife
2013 was not a good year for Ackman’s massive short position of Herbalife. Other hotshot investors, such as Carl Icahn, Dan Loeb and George Soros, placed large bets on the other side of Herbalife. With rising profits, a clean bill of health from auditors and additional investor support, shares of Herbalife rose about 140 percent last year. Pundits estimated that Ackman was down as much as $700 million on his bet at Christmas time.
Ackman said in the fall that he restructured his position (swapped 40% of his equity short position for put options) to make his firm less vulnerable to the possibility of a short squeeze or continued stock price appreciation, but that he was not removing his bet or ending his campaign against the company being a pyramid scheme.
Late in December, Ackman wrote a note to investors saying that Herbalife was still engaging in improper recruiting practices and violating multi-level marketing guidelines in China. Ackman let investors know that he has been conducting an investigation of his own and that he was only sharing his findings with regulators for the time being. Again, he did not back down on the company being a sham, although he noted that the stock price may likely continue to climb until a federal probe is launched.
It’s a New Year
So far in 2014, things are looking better for HLF shorts as the stock is down almost 17 percent in January. On a different front, Ackman’s Pershing Square is also the largest shareholder of Beam, Inc. (BEAM) , a company that just agreed to be acquired by Suntory for $16 billion. Considering the buyout is an all-time high price for Beam, the hedge fund should profit nicely on that investment.
Herbalife shares took a hit last week when the Chinese government launched an investigation of Utah-based NuSkin Enterprises (NUS) , a multi-level marketing company selling health products in China. A Communist Party newspaper, the People’s Daily, broke the story that Nu Skin was suspected of running an illegal pyramid scheme and being investigated. Nu Skin admitted that their initial review showed that some of its sales force, dubbed “Nu Stars,” were not following corporate recruiting regulations and policy, although the company said that the news report was exaggerated and not reflective of its business in China. At one point, shares of NUS were halved, falling from $135 to $67.51, but have since pared some of the losses to around $80.
The mention of “pyramid scheme” made HLF shares guilty by business model association as investors speculated that the Chinese government might next delve into Herbalife, who also sells in China. HLF shares doffed-off about 10 percent, their biggest one-day loss since Ackman first made announced his short position on December 21, 2012.
Herbalife, who sells weight loss and nutritional products, took another shot to the chin on Thursday when Senator Markey has requested federal regulators harken his message and start an investigation of Herbalife. Markey also addressed Herbalifevia mail, seeking a response to questions by February 28. Markey noted that a catalyst for his call to action was a Massachusetts constituent saying that she lost her life savings because of Herbalife. The Senator also noted complaints from other constituents who said that they were pressured to buy more Herbalife products to move up the ranks and stay in the system when they wanted out, and to recruit more people by approaching family members.
“There is nothing nutritional about possible pyramid schemes that promise financial benefit but result in economic ruin for vulnerable families,” said Senator Markey, a member of the Commerce, Science and Transportation Committee. “Herbalife may be a purveyor of health and wellness products, but some of its distributors are suffering serious economic ill-health as a result of their involvement in the company. I have serious questions about the business practices of Herbalife and their impact on my constituents, and I look forward to receiving responses to my inquiries.”
A copy of Senator Markey’s letters to the FTC, SEC and Herbalife are available at: http://www.markey.senate.gov/news/press-releases/markey-calls-for-investigation-into-herbalife-business-practices
The question now certainly seems to be: Was Ackman right all along? If Herbalife is indeed a pyramid scheme, it will eventually collapse. They always do.
Shares of HLF closed the day down by 10.4 percent at $65.92.