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Assessing Herbalife's shape

by Paula Schaap  |  Published January 11, 2013 at 3:42 PM
"I don't care what is written about me," Dorothy Parker would say, "as long as it isn't true." Obviously, she was never the target of a short seller.

Companies under the gun of an activist investor such as Pershing Square Capital Management LP's Bill Ackman can't respond with Parkeresque detachment. So it was that Herbalife Ltd. executives spent more than two hours at a specially called analyst conference Thursday, Jan. 10, debunking Ackman's brief against the diet supplement manufacturer. Ackman and Pershing Square analyst Shane Dineen, who claimed he spent a year analyzing the company, have positioned their short thesis on the company that it is nothing more or less than a pyramid scheme.

Most of Ackman's argument, which he delivered Dec. 20, revolves around whether the company sells to retail customers, as opposed to the distributors that multilevel marketing companies bring in with assurances that they will not only make money selling the products, but also from the sales of other distributors that they, in turn, bring in.

If he is correct, then the Federal Trade Commission should sit up and investigate the Los Angeles-based Herbalife as a pyramid scheme, Ackman claims.

The investor has said he feels a "moral obligation" to tell the world about Herbalife's financial shenanigans. That, and a $1 billion bet on the company's stock taking a serious dive.

To which Third Point LLC's Dan Loeb said, in so many words, balderdash, as he revealed an 8.2% stake in the company. Loeb's analysis, like Ackman's, turned on whether the company is a pyramid scheme. Loeb, though, believes it is not.

"The short thesis rests on the notion that the FTC has been asleep at the switch, missed a massive fraud for over three decades, and will shortly awaken (at the behest of hedge fund short seller) to shut down the Company," Loeb wrote in an investor letter on Jan. 9.

But Height Analytics LLC analyst Jarrel Price, who focuses on the effect policymakers and regulators have on public companies, said the FTC might not be the regulator to base a short case on.

While Price voices no opinion on who's right in the Herbalife dispute, he also said, "I think it's fair to say that pyramid schemes have been a low priority for the FTC in recent years. So the question is whether renewed scrutiny on Wall Street is capable of forcing the FTC's hand to act."

However, Loeb may have also missed another big regulator in the room: the Securities and Exchange Commission.

The Wall Street Journal has reported that the SEC had been in touch with the company. A spokesman said the agency doesn't comment on investigations. Herbalife did not return a call seeking comment.

But the SEC has a history of going after these kinds of marketers under the theory that the act of bringing in distributors can form a contract that acts like a security. And, if that security hasn't been registered or -- worse -- if the SEC finds that misrepresentations have been made, that could be a more serious problem for the company.

Essentially, the SEC views situations where money coming in from distributors and going out to others in the distribution chain as akin to a Ponzi scheme.

"Every pyramid scheme is a Ponzi scheme, although not every Ponzi is a pyramid scheme," as someone put it who is familiar with SEC investigators' approach.

Herbalife has hired legendary litigator David Boies and investment bank Moelis & Co. LLC to help it with its campaign against Ackman. Boies was a great choice for the company, given that he engineered a $155 million settlement on behalf of former Amway Corp. distributors -- one of the great MLM companies of all time. Having prosecuted that case, he should know what Herbalife is up against.

But for Ackman and Loeb, the real test will be in the stock price and, so far, investors are equivocating. Herbalife closed at $39.24 per share the day of its presentation, up 44% from the day Ackman delivered his condemnation, but still down 46% from its 52-week high.

Tags: Bill Ackman | Dan Loeb | David Boies | Federal Trade Commission | Herbalife Ltd. | Moelis & Co. LLC | Pershing Square Capital Management LP | Ponzi scheme | SEC | Shane Dineen | Third Point LLC

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Paula Schaap

Assistant Managing Editor: Markets

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