Federal Probe is Latest Twist in Herbalife Saga

Edited by Vani Rao

Herbalife being probedby the FTC after millionaire accuses it of being a pyramid scheme

Source Herbalife.com
Source Herbalife.com

The Federal Trade Commission (FTC) will investigate the controversial nutritional products company Herbalife Ltd. (NYSE:HLF), as per the company statement on Wednesday, 12 March 2014, after Senator Edward J. Markey urged in a letter to the FTC in January this year.

Herbalife sells nutritional shakes and supplements through a network of millions of independent distributors in more than 80 countries worldwide. The probe comes after a year during which consumer groups and members of Congress have echoed the call for the FTC to begin investigating Herbalife.

It all started when Bill Ackman, the billionaire hedge fund manager ,accused Herbalife of being a pyramid scheme, following which shares of the company traded as low as $27, but recovered to a high of more than $80 in January, as investors have debated the likelihood of regulatory action. Following the statement, Herbalife shares tumbled as much as 17% but recovered to stabilize 8% lower at $60.24.

Source Bloomberg
Source Bloomberg

Ackman had what is known as a “short” position in Herbalife’s stock, which meant that his firm, Pershing Square Capital Management, will profit handsomely if the stock plummets. For more than a year, Ackman has been in a high-stakes battle with Herbalife, trying to persuade the public and key decision-makers that the company is a pyramid scheme that preys on its sales force.

In the days before Markey’s letters to regulators targeting Herbalife became public, there was a spike in purchases of so-called “put” options of Herbalife’s stock. Those options, which were the subject of a New York Times report in January, are essentially bets against the company’s stock.

Things became awkward when another billionaire, Carl Icahn, took to defending Herbalife, and the animosity even spilled over into a yelling match in the public media. This week, the saga worsened when a story covered by The New York Times implied that Ackman had overstepped the line by lobbying with federal politicians to take a look at the company.

Herbalife, headquartered in the Cayman Islands, has worked to build its name recognition as well. It sponsors sports teams like the L.A. Galaxy soccer team and a women’s basketball team in Israel.

MLM or Pyramid Schemes

The main characteristic of a pyramid scheme is that participants only make money by recruiting more members. However, the problem with most product-based pyramid schemes is that the products themselves don’t sell very well, or have very slim profit margins. Hence,the only way to make money is to find more recruits.

Source www.sec.gov
Source www.sec.gov

It’s mathematically impossible for everyone to make money in a pyramid scheme. For example, if each recruit needs to find 10 more people to recoup the cost of his or her initial investment, the eighth level of the pyramid would have to recruit a billion people to get back their money. And the next level, they would need 10 billion, nearly twice the population of the Earth.

In fact, pyramid schemes don’t work unless somebody loses. Those at the bottom of the pyramid are essentially defrauded by those on top. It’s a mathematical fact that no matter how many people join a pyramid scheme, 88% of the members will be at the bottom level and will lose their money, as per the Pyramid Scheme Alert. Pyramid schemes are illegal because people don’t lose their money due to normal market forces, but because the system requires them to lose so that a few at the top will win.

Multi-level marketing (MLM) or network marketing is an American institution. Companies like Amway, Tupperware, Herbalife, Avon, Mary Kay, and The Pampered Chef support huge networks of distributors and recruits who sell every type of product from dietary supplements to kitchenware and beauty products. Salespeople are called independent business owners (IBOs) and generally work from their homes.

On the surface, it’s hard to tell the difference between a legitimate MLM and a pyramid scheme. That’s because they’re both built on the business model of “multiple levels” of distributors and recruits. Some critics of MLMs claim that all of them, even the supposedly “legitimate” ones, are pyramid schemes in disguise.

In a landmark 1979 ruling, the Federal Trade Commission found that Amway was not a pyramid scheme. That ruling has paved the way for hundreds of MLMs to follow Amway’s business model.

Amway stresses that the main difference between a legitimate MLM business model and a pyramid scheme is that a legitimate MLM is focused on selling products, and not on recruiting more salespeople. In a legitimate MLM, it should be possible to make money by simply selling products directly to customers.

The problem with MLM lies with those who join the scheme at a later date. There is a huge difference between participating in the network as a customer on one hand, and buying products at an inflated price (to pay for commissions of the people who have joined the network earlier). The other category of people, who, participate in the scheme as entrepreneurs, develop a business that directly or indirectly markets the network’s products.

For its part, Herbalife was putting on a brave face. “Herbalife welcomes the inquiry given the tremendous amount of misinformation in the marketplace, and will cooperate fully with the FTC,” the company said in a statement on 12 March 2014. “We are confident that Herbalife is in compliance with all applicable laws and regulations. Herbalife is a financially strong and successful company.”

The news could not have come at a better time for Ackman. Pershing Square Capital Management’s returns were dented significantly last year by the enormous run up of Herbalife’s stock. In recent days, The New York Times published a tough piece on Ackman’s lobbying efforts in Washington. He held a long conference call yesterday to slam Herbalife’s practices in China, but it did not seem to have much effect on investors. News of the FTC investigation certainly had a significant impact on investors on Wednesday. The stock is still holding up since Ackman first announced his short promotion of Herbalife and it is also up since Icahn first disclosed his stake.

While the Herbalife war is raging on in 2014, neither the FTC nor Pershing Square Capital Management has made any comments.

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