Federal investigators probing Herbalife Ltd. (HLF) are uniquely equipped to answer the question at the heart of Bill Ackman’s $1 billion bet against the company: Do people buy its products for their own use?
Sixteen months after going public with his claim that Herbalife is a pyramid scheme, the hedge-fund manager has failed to force it to disclose receipts crucial to his thesis. The records, which Herbalife’s 550,000 U.S. distributors are required to hold, may prove whether its protein shakes and vitamins are actually bought by consumers seeking healthy products or merely by distributors trying to get rich quickly.
The U.S. Federal Trade Commission, which is investigating the company after Ackman’s aggressive lobbying, can end the stalemate by forcing Herbalife’s distributors to disclose such sales records. While the receipts aren’t automatically submitted to the company, Herbalife routinely audits the records for compliance, and the FTC may seek those results as well.
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“It’s going to be a long, drawn-out investigation,” Joel Winston, a former FTC lawyer now at Hudson Cook LLP in Washington, said in an interview. “They have to get all of these records, and what they often run into in these cases is the company doesn’t have records of retail sales.”
Herbalife, which has denied Ackman’s claims, disclosed in March that the FTC had started a civil probe into its practices following months of lobbying by Ackman and his New York-based Pershing Square Capital Management LP. The FBI is also investigating, and Illinois Attorney General Lisa Madigan is examining consumer complaints against the company.
While Herbalife has said it is cooperating with the FTC probe and welcomes the opportunity to clear up “misinformation in the market,” the Cayman Islands-based company has said it has no knowledge of an FBI investigation.
In an attempt to demonstrate that the company has real customers, Herbalife has turned to researchers to provide an answer.
The company commissioned a Nielsen survey last year that estimated about 7.9 million U.S. adults purchased its products for personal use in the previous three months. The online survey of more than 10,000 people was conducted in April and May. Of the 349 survey respondents who said they had purchased for personal use, 87 percent said they didn’t buy as a distributor themselves. Most bought weight-management products, the company said.
In a 2012 study, also commissioned by Herbalife, Los Angeles-based Lieberman Research Worldwide surveyed 2,000 people intercepted on mainstream websites in a common consumer research technique. About 5 percent of respondents had purchased an Herbalife product within the past three months. Of those, about 78 percent said they weren’t registered distributors.
Ackman isn’t satisfied.
“Herbalife has incurred substantial expense in commissioning surveys while it has avoided collecting contractually available empirical data which would answer questions about the sales of Herbalife products to end consumers,” he said in a June statement.
The FTC has said a hallmark of a pyramid scheme is when participants earn money from recruiting others rather than selling products to consumers. The ensuing transfer of wealth benefits the top of the pyramid while those at the bottom lose money buying products they can’t sell.
Herbalife products aren’t sold in traditional stores, and the company’s distributors instead sell directly to family, friends, neighbors and strangers. They buy products at a discount and sell them at a markup. They earn even more by recruiting, training and coaching a sales team, and then generating royalties and production bonuses based on the total sales by their network.
To qualify for commissions and royalties, distributors must make at least one sale to each of 10 retail customers each month. In addition, at least 70 percent of the retail value of the products a distributor orders must be consumed or sold. Distributors are required to certify that they meet the standards every month. They are asked to keep the names, addresses, phone numbers and receipts of the 10 customers for two years.
The goal is to prevent inventory loading, which can constitute a hidden recruiting fee within an illegal pyramid scheme. Herbalife’s 10-customer and 70 percent rules stem from a 1979 FTC ruling in a pyramid-scheme claim against Amway, one of the most well-known multilevel marketers in the world. The FTC used similar benchmarks to determine that the company wasn’t a pyramid scheme. Herbalife and other direct sellers have since adopted the benchmarks to avoid trouble.
Herbalife hasn’t budged on Ackman’s call for the sales records.
“Whatever we release, it isn’t going to be enough for this guy,” Chief Executive Officer Michael Johnson said in an interview.
The company’s distributors, who operate as independent contractors, value the privacy of their sales records and fear that the company may go around them to sell to their customers directly, Chief Financial Officer John DeSimone said. Also, the receipts alone are meaningless without an audit, he said.
“If you know that you are required to sell product, and if you’re not selling it, you can just as easily fake the receipts as you can the 10-customer rule and the 70 percent rule,” DeSimone said in an interview. “The only way to validate the receipts is through the audit process, and we jump right to the audit process.”
The company performs random audits, as well as selective audits based on what DeSimone called “high-risk” transactions. The routine collection of receipts would be inefficient and ineffective, he said, comparing Herbalife’s approach to that of the Internal Revenue Service. The agency requires taxpayers to hold receipts and make them available for audit even though they aren’t automatically submitted.
As part of its investigation, FTC lawyers may send civil investigative demands, similar to a subpoena, to distributors demanding their sales records, Winston said. They also may send surveys to distributors in an attempt to understand the business, and probably will interview company executives, he said.
The FTC has already met with representatives of Herbalife and Pershing Square. In February 2013, DeSimone and Chief Legal Officer Brett Chapman met with Lois Greisman, the agency’s associate director for the division of marketing practices, according to FTC visitor logs.
The next month, Ackman and Pershing Square’s David Klafter, Shane Dinneen and others met with Greisman. Ackman and other Pershing Square officials met with the FTC again in August, according to the logs.
The U.S. Justice Department and FBI also will want to examine sales records of distributors and interview distributors and alleged victims, Adam Lurie, a former Justice Department lawyer, said in an interview. Working with the FTC or other regulators, prosecutors could bring a criminal fraud case against Herbalife or close the probe without action, he said.
The FBI and Justice Department likely will look at whether Herbalife made any misrepresentations to investors or to its own distributors about how the company generates sales, said Lurie, now a partner at Cadwalader, Wickersham & Taft LLP.
The FTC may negotiate a settlement with Herbalife requiring it to change its practices and pay restitution to consumers, Winston said. The agency could sue the company in federal court where a judge could order changes to the company’s practices.
The agency is unlikely to try to shut Herbalife down, Winston said.
“Whatever you think of Herbalife, it’s not like some of these other cases the FTC has brought where they were just outright frauds and there really was no serious question they were pyramids,” he said. “Here, I’m sure it’s going to be at least debatable.”