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Short Seller Bill Ackman's Crusade Against Herbalife

Herbalife CEO Michael Johnson (left) and Pershing Square Capital Management’s Bill Ackman

Photo illustration by 731; Photographs by Tiffany Rose/Getty Images (Johnson); Bloomberg (Ackman)

Herbalife CEO Michael Johnson (left) and Pershing Square Capital Management’s Bill Ackman

Bill Ackman’s quest to expose Herbalife (HLF) started 18 months ago with a call from a stock researcher who had written a book about the hedge fund manager. She suggested that the nutrition company Herbalife might make a good target for Ackman, an activist investor who has lobbied for shake-ups at Target (TGT) and Canadian Pacific (CP) railway. The tip sparked a research project that pulled in many employees of Ackman’s fund, Pershing Square Capital Management, along with two law firms and forensic accountants. On Dec. 20, Ackman went public with a three-hour presentation (PDF), accusing Herbalife, which has revenue of $4.5 billion, of using inflated pricing, misleading sales information, and a complicated incentive structure to hide a pyramid scheme. Ackman’s big bet against Herbalife—he’s sold 20 million shares short—has the investment world abuzz.

Ackman’s charges center on the company’s network of 3 million distributors in at least 85 countries who sell vitamins, shake mixes, and skin gels. Those independent contractors earn revenue by hawking products directly to customers and recruiting new distributors, for which they earn a share of those sales and incentives from the company. Classic pyramid schemes attempt to make money by solely recruiting new participants, according to the U.S. Securities and Exchange Commission. The Federal Trade Commission has said a pyramid scheme exists if profits come “primarily” from recruiting. “Once you realize that this is about promoting a business opportunity—you recruit five friends who each recruit five friends who each recruit five friends—it becomes very clear that it’s a pyramid scheme,” Ackman says. “Pyramid schemes are inherently fraudulent.”

Herbalife shares plunged 32 percent in the three days after the December presentation. Amid rebuttals from the company and others, the shares rebounded, closing at $39.95 on Jan. 9. That’s still 6 percent below their price on Dec. 18, the day before Ackman disclosed his short position. “We’re prepared to spend whatever it costs and do whatever is required to make sure that the world understands the facts about this company,” says Ackman. “We can’t imagine how the SEC or the Federal Trade Commission or any other relevant regulator will ignore what we have said.” On Jan. 9, the Wall Street Journal reported that the SEC has opened an inquiry into Herbalife.

Responding to Ackman’s presentation, Herbalife Chief Executive Officer Michael Johnson said, “The allegation that Herbalife is a pyramid scheme is bogus. Make no mistake: Today’s announcement isn’t about Herbalife’s business model. It’s about Ackman’s business model.”

Some investors also have raised questions about Ackman’s charges. Robert Chapman, of Chapman Capital Partners, said on his company’s website that after reading an interview with Ackman, “I decided I had to place a monster long bet” on Herbalife. Chapman, who said he has done research on the stock on and off since 2000, noted that there have been few consumer complaints against the company, which has been in business for 32 years, and that Federal law doesn’t give a clear definition of a pyramid scheme. “Ackman overestimates his ability to reroute rivers,” he says.

Daniel Loeb’s Third Point hedge fund took an 8.2 percent stake in Herbalife, according to a Jan. 9 regulatory filing. John Hempton, chief investment officer of Bronte Capital, wrote on the fund’s website that Herbalife has the resources to resist Ackman by buying back its own stock. He also said he’d reported many frauds to regulators, who rarely acted. “Bill Ackman is shorting a profitable company,” he wrote, and “by implication his argument is that government is going to somehow close them down. That is a really truly awful short thesis.”

Ackman says he hasn’t reduced Pershing’s short position and has no plans to—even though he would likely have a sizable profit if he closed out his bets now. (Short sellers borrow shares and sell them, hoping to buy them back later at a lower price.) He also says he’ll give to charity any personal profit he earns from Pershing’s short position. He says he has a “moral obligation” to tell the world about Herbalife.

Bill Keep, dean of the College of New Jersey School of Business, says he is struck by the intensity of Ackman’s campaign. “We usually don’t expect from investors much of a moral stand on anything,” he says. Ackman’s fervor, says Keep, who has studied multilevel marketing companies for 17 years, brings attention to an area where federal regulators have been too lax. Ackman is counting on watchdogs to come through for him: “We’ve done a lot of the work for the regulators.”

The bottom line: Claiming Herbalife is a pyramid scheme that relies on recruitment, not sales, Ackman has sold 20 million shares of the company short.

Stanford is a reporter for Bloomberg News in Atlanta.

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