For more than a year, the question of the fundamental corporate legitimacy of Herbalife has been overshadowed by rival billionaires fighting over the answer.
Bill Ackman has lost hundreds of millions of dollars belonging to investors in his hedge fund Pershing Square as he has sought to reduce the share price of Herbalife to zero.
On the other side, rival investor Dan Loeb and corporate raider Carl Icahn have made fresh fortunes betting against him. Fellow titans George Soros and Bill Stiritz, another veteran investor and chief executive of cereal company Post Foods, have also thrown their money and reputations behind the company.
Now the US government has launched its own investigation into the underlying question: Is Herbalife, a 34-year-old listed company that reported sales of more than $5bn from operations in more than 90 countries, nothing more than an elaborate pyramid scheme?
That investigation by the Federal Trade Commission into Herbalife, disclosed by the company after the Financial Times asked about it this week, will probably take more than a year.
In the meantime Herbalife’s share price is a referendum on the outcome. It fell 16 per cent in two days after Herbalife’s announcement on Wednesday, but it is still 30 per cent higher than when Mr Ackman said the company was worthless.
The FTC’s ruling, when it comes, will be important for Herbalife’s network of 3.7m direct salespeople across 91 countries. None of those individuals can be expected to care too much about the bruised ego of a billionaire. But there is only one certain outcome of the regulator’s investigation – one hedge fund manager or the other is going to lose big.
Yet the investigation will have other, far-reaching consequences. Herbalife’s corporate brand is splashed across the shirts of sports stars worldwide, including its local football team, LA Galaxy. It is also the “official nutrition sponsor” to the world’s best football player, Cristiano Ronaldo of Real Madrid. Former secretary of state Madeline Albright is a paid spokeswoman.
Similarities between Herbalife and other multilevel marketing companies such as Nu Skin and Amway raise questions over the business model of modern direct selling. Herbalife sells nutritional shakes and supplements through a network of independent salespeople, known in the industry’s jargon as “distributors”. Its branding is designed to promote two related things: Herbalife products and the business opportunity to sell those products.
Distributors sign up to sell the shakes for a profit, but they are also encouraged to build their own team of salespeople beneath them. Those new recruits are encouraged to do the same, and the original distributor at the top takes a cut from all the sales made in that network below them.
Herbalife has said that its business is entirely legitimate and it “welcomes the inquiry given the tremendous amount of misinformation in the marketplace, and will co-operate fully with the FTC. We are confident that Herbalife is in compliance with all applicable laws and regulations.”
In recent pyramid scheme suits brought by the FTC, the commission has applied a legal test that requires a company claiming it has safeguards in place also to show that a majority of revenues are from ‘true’ retail sales to customers, not its own distributors
Mr Ackman alleges that the company is a pyramid scheme hiding in plain sight. He argues that its structure means the only way to make money is through recruitment. Recruits are motivated to buy enough Herbalife products to qualify for commissions from their own recruits, funnelling money up to the top, but the constant need to recruit dooms almost all of them to failure.
The investor has published a series of dossiers on distributors at the top of that pyramid, including a current and former board member, alleging that they have recruited the unwary on promises of easy money, then profited by selling them services such as training and sales support.
The company and its supporters respond that Herbalife is misunderstood, that most people join the company not for the business opportunity but because they are dieters and athletes who join for a discount on its protein shakes.
Soros Fund Management invested after conducting its own consumer polling to find customers, according to people familiar with the fund. Like Nu Skin and Amway, Herbalife says it has rules and safeguards in place that the industry has long used as a defence against prosecution.
Indeed, last year the question debated by most investors was whether the FTC would act at all.
At the heart of the controversy is a question about Herbalife’s customer base. In recent pyramid scheme suits brought by the FTC, the commission has applied a legal test that requires a company claiming it has safeguards in place also to show that a majority of revenues are from “true” retail sales to customers, not its own distributors.
What we have found, and what we know from our own statistical studies and knowledge of industry, is that you can have a perfectly legitimate plan where most of the people, or many of the people, or some of the people, are consuming the product internally as sales people
The principle is that such sales show legitimate economic activity takes place, rather than the product obscuring the transfer of money from new recruits up through a pyramid.
Any case against Herbalife, which argues that sales to distributors for their own personal consumption are legitimate, would probably be a test of that principle across the industry.
Joseph Mariano, president of the Direct Selling Association, told the FT that “what we have found, and what we know from our own statistical studies and knowledge of industry, is that you can have a perfectly legitimate plan where most of the people, or many of the people, or some of the people, are consuming the product internally as sales people.”
But Peter Vander Nat, senior economist at the FTC, recently wrote a paper with William Keep, dean of the business school at The College of New Jersey and a widely consulted expert on direct selling, that expressed concerns about the way the industry has evolved. The two wrote in the paper that “the multi-level marketing model now apparently depends heavily upon selling to itself”.
Without underlying data from the company, which the FTC will seek as part of its investigation, it is impossible to offer a conclusive answer either way. While awaiting its judgment, the fight continues in other forums.
Mr Ackman restructured his $1bn bet last year, using option positions to limit further losses for his funds. He has so far resisted Herbalife’s own campaign, involving contacting Mr Ackman’s investors to argue he was behaving recklessly with their money.
He has redoubled a lobbying and public relations onslaught against the company and promised to go to “the end of the earth” to prove the company a pyramid scheme.
Mr Icahn, who has traded insults with Mr Ackman live on business television, is equally entrenched in opposition. With 17 per cent of the company, he is Herbalife’s largest shareholder and is negotiating to increase his representation on its board from his two seats. On Thursday, the company delayed its annual shareholder meeting to allow additional time for those talks.
Billions will be won and lost before this is over.