by Jonathan Berr | March 12, 2014 4:32 pm
Herbalife (HLF) delivered a dour message Wednesday, revealing that the Federal Trade Commission just opened a probe into the business practices of the multilevel marketer of nutritional supplements and personal care. The announcement prompted trading of HLF stock to be briefly halted Wednesday. After trading restarted, HLF sank and finished the day’s trading down 7%.
The investigation comes on the heels of what many pundits have described a highly unusual lobbying effort by hedge fund tycoon Bill Ackman, who in 202 took a $1 billion short position in the Cayman Islands-based company. Ackman has since tried to convince anyone who would listen that Herbalife is a pyramid scheme and has bet against shares.
Meanwhile, other billionaires including Carl Icahn and George Soros jumped in on the other side of the argument and took long positions in HLF stock.
Spurred by Bill Ackman, Sen. Ed Markey, D-Mass., and a group called the League of United Latin American Citizens had asked the FTC to investigate the company. The billionaire claims Herbalife is violating Chinese laws, which HLF has vehemently denied.
However, the fact that the FTC is conducting a formal investigation into Bill Ackman’s claims indicates that regulators think the hedge fund tycoon’s criticisms of Herbalife might be valid.
Of course, Herbalife has vowed to “cooperate fully” with the FTC’s probe, noting that it “welcomes the inquiry given the tremendous amount of misinformation in the marketplace, and will cooperate fully with the FTC.” HLF has denied wrongdoing.
Multilevel marketing (MLM) groups such as Herbalife operate through independent sales representatives, who earn money both through the sales of product and by recruiting other people to join their team. This business model — which is used by scores of companies, including Pampered Chef, which is owned by Warren Buffett’s Berkshire Hathaway (BRK.B), Tupperware (TUP) and Mary Kay Cosmetics — is legal provided that actual products are sold.
If people are only making money by convincing other people to work with them, however, then the enterprise is a pyramid scheme. And if your company is ruled a pyramid scheme … well, you’re in trouble in the U.S. and a host of other countries, which have deemed these schemes illegal.
“Basically, it’s a business of selling hope,” said white-collar crime expert Sam Antar, the former CFO of Crazy Eddie who is a convicted felon, in a Boom Bust interview. “You (make) a better living flipping burgers at McDonald’s.”
The FTC’s probe has the potential to cast a shadow over HLF stock for months, even years. Even if the FTC finds that Herbalife didn’t break any laws, the agency could tighten rules governing MLMs that could raise their cost of doing business significantly. It casts yet another negative light on the industry, which people have long noted promises easier riches than it delivers.
However, the FTC probe is just the latest chapter in Herbalife’s strange history.
For instance, founder Mark Hughes, who enthusiastically sold the company’s products and exposed a philosophy of healthy living, died suddenly in 2000 following from a toxic combination of alcohol and antidepressants after a four-day binge. His death was ruled accidental. What followed was an ugly battle over Hughes’ estate that pitted his widow and its trustees over his $400 million estate. The legal fallout for that case has stretched all the way through this year.
And allegations that Herbalife is a pyramid scheme aren’t new, either. The company faced a few actions related to pyramid scheme accusations in the early aughts. HLF also has been dogged for years by accusations that it was misleading consumers about the health benefits of its products.
Other companies that use the MLM business model have struggled this year, too.
Earlier this year, Chinese newspapers reported claims that Nu Skin (NUS), which provides personal care products, violated the country’s pyramid scheme losses. Although NUS stock was rallying today, shares still remain down more than 40% this year. NuSkin gets more than half of its revenue from the most populous country. Avon (AVP), which is fighting double-digit declines in representatives, is off about 15%. Tupperware is off similarly.
While shares of other MLM companies aren’t off today, investors should be worried about the eventual fallout from the FTC’s investigation into Herbalife. While HLF stock is the most logical victim in the near-term, any finding that shows Herbalife is in fact a pyramid scheme could give the FTC more courage about other such companies.
As for Herbalife itself, anything but the most speculative money should be kept away from HLF stock until the FTC makes a final decision on its practices. And again, even if Herbalife comes out on top, the world could get a lot tougher for it and other MLMs.
As of this writing, Jonathan Berr did not hold a position in any of the aforementioned securities.
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