Herbalife Announces FTC Investigation

Herbalife announced that the FTC has initiated an investigation. While it’s not pleasant to deal with a government subpoena, this gives Herbalife an opportunity to put this issue to rest. Watch the video below to get my thoughts. In summary, I believe the FTC will use the data it collects from Herbalife to sharpen its saw in an effort to create better guidelines for network marketing companies. They’re not going to sue Herbalife (though I’m sure they’re thinking about it). If you’re reading this via email, click here to watch the video. The paper referenced in my video can be found embedded below (or here).
)

Senator Markey’s Letter to the FTC: Prediction

Recently, Senator Markey from Massachusetts called upon the FTC to investigate Herbalife.  His full letter is included below. Click here to read if you’re reading via email. It’s worth mentioning that that the letter was likely originated by someone at Pershing Square, as observed by John Hempton. Markey has useful letterhead, being a U.S. Senator and all. I digress…

These are my predictions:

  • The FTC will respond. While Markey’s letter called for a response by February 28, I’m guessing they’ll respond after the deadline but by late April.
  • The FTC is not going to respond specifically about Herbalife. Three points worth mentioning here: (1) The FTC lacks the data to provide any meaningful commentary about Herbalife; (2) If the FTC had a problem with Herbalife, they’re not going to announce same at the behest of a Senator; and most importantly (3) Herbalife is not a pyramid scheme.  Ackman is playing another confidence game, and the market has grown immune to his tricks.
  • The FTC is going to take this as an opportunity to start a broader discussion about the network marketing space.  There’s an ocean of gray that separates legitimate network marketing companies from illegal pyramid schemes.  As a result of this ambiguity, fraudulent programs are flying under the guise of network marketing, claiming legitimacy because they’re “just like Amway.”  In my opinion, this is the underbelly of the space that the FTC needs to address, not companies like Herbalife.  What will these guidelines look like in the future?  That’s a different set of predictions for another time.

The video is a short one. I hope you find it informative. If you’re reading this via email, please click here to view the video.

Update: Herbalife’s CEO, Michael Johnson, personally wrote a response to Senator Markey. It’s also included below.

Herbalife Distributors Continue to Win Despite War on Wall Street

This post is for the unsung heroes carrying the Herbalife organization through this difficult period. Candidly, their distributors are dominating! 2nd Quarter Earnings are in for Herbalife. All of the major metrics are up. Despite the war on Wall Street over the fate of Herbalife between several notable players, the Herbalife distributors continue to produce results. In this video, I explain the importance of their achievement. I also give a few predictions about what this conflict means for the future of the industry.

If you’re interested in the financial elements surrounding Herbalife stock, check out the video below. Robert Chapman does a great job explaining the current and potential value of $HLF. He understands the network marketing model AND the markets, which makes his insight valuable. If you’ll recall, Robert Chapman was literally the first professional on Wall Street to question Bill Ackman’s analysis. His article titled “Herbalife: Why I Made It a 35% Position after the Bill Ackman Bear Raid,” let a lot of air out of Ackman’s proverbial tires. It moved the market. I’m proud to know him.

http://video.cnbc.com/gallery/?play=1&video=3000187031

MLM Income Claims: Basic guidelines for companies and distributors | FTC

MLM income claimsIntroduction

With the recent buzz of Federal Trade Commission v. Fortune Hi-Tech Marketing, Inc. slowly coming to a close, I wanted to write an article to reiterate the importance of proper income claims. Statements regarding a network marketing company’s income opportunity go to the heart of the Federal Trade Commission’s (“FTC”) mission to extinguish deceptive, unfair, or unsubstantiated claims made by a company and its distributors. And let’s be honest here, it’s not the distributors’ fault. The majority of income claims made by a distributor are more likely than not truthful statements, but the FTC is not JUST concerned with the truth. Promises of riches and an opportunity to live the American Dream can cloud even the most reasonable person’s judgment. With this in mind, the FTC wants to ensure that all potential distributors make a fully informed decision before choosing to join an MLM program.

In this article, we discuss the legality of income claims made by MLMs and their distributors while using the recent Fortune Hi-Tech (“FHTM”) case as a framework. In Part 2 of this series, we’ll use what we learn in this article to help develop solutions that meet the FTC’s requirements.

What Was All the Fuss About?

Among other reasons in its case against FHTM, the FTC alleged that FHTM’s distributors misrepresented the income opportunity. Specifically, the FTC argued that FHTM violated Section 5(a) of the FTC Act which prohibits “unfair or deceptive acts or practices in or affecting commerce” by misrepresenting or omitting material facts in its income claims. In my opinion, the FTC’s argument about FHTM operating as a pyramid was weak. There’s not much to be learned there. But there’s a lot that can be learned by analyzing its argument regarding improper income claims. The FTC based its allegations off of recorded video and audio presentations, pictures on social media networks, and Twitter posts uploaded by various distributors. These facts underscore the importance of properly educating distributors on how to make clean product and MLM income claims online.

Examples cited by the FTC include the following:

Recorded Video Presentations

  • The FTC alleged one distributor claimed in a recorded video presentation on her Vimeo website dedicated to her FHTM business that “four months into the business [with FHTM]… I had actually quadrupled what I have ever made as a Registered Nurse.”
  • The FTC alleged a distributor claimed on her Vimeo site that distributors who reach the National or Executive Sales Manager levels “are making thirty-, forty-, sixty-, seventy-thousand a month.”
  • The FTC alleged distributors frequently made lifestyle claims, such as highlighting extended family vacations to exotic locations, driving nice cars, and purchasing large homes with luxurious amenities.

Recorded Audio Presentations

  • The FTC alleged a recorded conference call posted on distributor’s team website stated that another distributor earned over $50,000 in his sixth month with the company alone and that he “earned millions and millions beyond that” in subsequent years.
  • Regarding another conference call, the FTC alleged a distributor posted on his team’s website that another distributor was earning “over $100,000 a month” after three years with the company.

Twitter

  • The FTC alleged a distributor posted on her Twitter account about a recruiting meeting, encouraging people to “Bring ur friends & learn how 2 make $100k aYR.”

Facebook Photos

  • The FTC alleged that at a national convention, 30 top earners were called to the stage to be presented with a mock check for $64 million to represent the amount of money they earned with the company. Several distributors later shared a photo of the presentation on social networking sites.

Sound familiar? No matter how long you have been involved in the network marketing industry, chances are you’ve heard claims similar to the examples above on a regular basis. I’m not trying to point any fingers at distributors. The statements referenced above could potentially all be true. The key is whether those distributors shared legally sufficient income disclosures to the prospects immediately after making the claims. When it comes to these income disclosures, the FTC preferences are confusing and they require a lot from all marketers. In most cases, distributors are simply unaware of how to promote their opportunities appropriately. That’s just the nature of the beast, and it all ties back to compliance training. It’s important to understand the FTC’s top priority is ensuring income claims are adequate. With that being said, the best place to start when learning how to play a game is studying the rules.

The Rules of the Game

The FTC used the following legal argument to make its case against FHTM:

Any income claim that is considered to be deceptive needs a disclosure. The FTC considers an income claim deceptive where information that would affect a reasonable consumer’s judgment is misrepresented or omitted.[1] There is a presumption that all information regarding earning potentials affect consumer’s judgment, even when you do not guarantee they will make any money.[2] Out of those claims, it is also presumed to be reasonable for consumers to rely on statements you expressly make,[3] regardless of whether you tell them making “big money” is a sure thing or not.[4] In other words, all income claims that are atypical need adequate disclosures.

The FTC says that any income claim made is regarded as what consumers will “general[ly achieve . . . .”[5] In other words, what you represent as potential money to a prospect is what a reasonable prospect will expect to earn. IF YOU LACK SUBSTANTIATION (aka, you have no proof) that the majority of your distributors earn the amount represented by a few high earners, you must give a clear and conspicuous disclosure indicating exactly the percentage of distributors who earn at least the amount you represented.[6] And you must also disclose the average earnings. If you’re a distributor that’s working with a particular company, if they do not provide adequate income disclosures, DO NOT MAKE INCOME CLAIMS. The pressure is on them to provide the data.

Conclusion

If you are the motivated (or self-burdening) type, I’d like to challenge you with a little homework project. Look at the examples cited by the FTC against FHTM above and determine what type of disclosure is necessary using the rules we discussed in this article. In our next installment, we’ll discuss our own solutions and ideas for the proper ways to make income claims.

Click here to read part 2 of this series.

[1] See FTC v. Bay Area Bus Council, Inc., 423 F.3d 627, 635 (7th Cir. 2005); FTC v. World Media Brokers, 415 F.3d 758, 763 (7th Cir. 2005); Kraft, Inc. v. FTC, 970 F.2d 311, 322 (7th Cir. 1992), cert. denied, 507 U.S. 909 (1993); FTC v. QT, Inc., 448 F. Supp. 2d 908, 957 (N.D. Ill. 2006).
[2] FTC v. Febre, No. 94 C 3625, 1996 WL 396117, at *2 (N.D. Ill. July 3, 1996) (conditional earnings claims would be understood to represent typical or average earnings and are therefore deceptive).
[3] See World Travel Vacation Brokers, 861 F.2d 1020, 1029 (7th Cir. 1988).
[4] FTC v. Five Star Auto Club, Inc., 97 F. Supp. 2d 502, 528 (S.D.N.Y. 2000).
[5] 16 C.F.R. § 255.2(b) (Guides Concerning the Use of Endorsements and Testimonials in Advertising); see also In re Cliffdale Assoc., Inc., 103 F.T.C 110, 173 (1984), 1984 WL 565319 (F.T.C.), at *16 (testimonials presumed to represent typical experiences).
[6] In re Nat’l Dynamics, 85 F.T.C. 1052 (1975).

by +Kevin Thompson

FTC’s Disclosure Guidelines for Online Marketing: How to get it right (Part 2)

This article was written by +Kevin Thompson in collaboration with our stellar summer associate, Jake Perry.

FTC Disclosure GuidelinesIn the last article, FTC’s Disclosure Guidelines for Online Marketing: How to get it right (Part 1), we walked through the Federal Trade Commission’s recently published .com Disclosure Guidelines (fully included below). In this installment, we’re going to walk through five hypothetical examples of common marketing claims made in the MLM industry. The goal of this post is to provide you with practical, easy-to-understand tips on how to make proper claims.

The format is simple: I’m going to give you common fact patterns of how claims are made in the MLM industry. Then I’ll show you what most distributors would WANT to do as far as making disclosures. Then I’ll show what they SHOULD do, as per the .com Disclosure Guidelines. These guidelines apply whether the company is an MLM startup or a well-established company.

Ready? Go time!

UPDATE: This article has been updated after further research.  The .com Disclosure Guidelines are over 50 pages and it never mentions income claims.  The analysis below is based on my interpretation of their guidelines.  

EXAMPLE 1: CHECK WAVING

check

Fact Pattern:

Kyle is very excited about his involvement in a new cosmetics company, Wrinkles-B-Gone. After six months of hard work, he received his first check in the mail for $4,500. Overcome with excitement, Kyle gets an idea. He decides to post a picture on his Facebook profile showing off his check. Kyle figures it’ll be a great way to “flex his muscles” while demonstrating the power of his new company. It is clearly visible in the picture that the check is for $4,500. In his Facebook post, Kyle says, “Boom, playa! Check me out! Want to learn why this company is throwing money at me? Give me a call.”

Kyle does not include a disclosure of the average earnings for Wrinkles-B-Gone distributors. The average is $345 per month per distributor.

What Kyle wants to do:

Kyle, in no attempt to be deceitful, would want to provide a naked link to the company’s income disclosure in the caption. He figures, “Hey, they can click on the link and see all of the numbers at their leisure.”

What the FTC wants to see:

In the caption of the photograph: Please click this link to see our average earnings: www.wrinkles-b-gone.com/earningsdisclaimer

Lesson Learned:

The FTC allows marketers to provide a link to a disclosure IF the disclosure is not integral to the claim being made. “Integral” as defined by meridian is “essential or fundamental.”  Is an income disclosure integral to an income claim?  Sadly, the FTC does not give us any examples that involve income claims.  But they did specify that issues related to health or higher costs would certainly require disclosure near the claim itself (not via a hyperlink).  In an example in the guidelines, there was a refrigerator that was unable to maintain a cold enough temperature to prevent bacteria growth.  In that example, a disclosure by the ad itself is required.  Is the risk associated with an earnings claim on par with food borne illnesses?  I doubt it (but I’m open for a discussion).

The FTC further states that disclosures made via hyperlinks are permissible when the data is too complex to disclose next to the ad itself.  With income disclosures, the data can be very complex.  Plus, the average earnings changes each month; thus, making it nearly impossible to get the entire field to properly disclose the averages immediately after their claims.  It’s only practical, in my opinion, to get the field to provide a link to a full earnings disclosure.  Keep in mind, providing the link by itself is insufficient.  The link must be clearly labeled to adequately inform consumers.  Inserting “Please click this link to see our average earnings” sends a clear signal.

If you allow your distributors to make income claims, it’s imperative that you educate them on the proper ways to make those claims.  Also, it’s a good idea to display the income disclosure form at some point during the enrollment process.  This will help “clean up” in the event your leader fails to provide a disclosure.

EXAMPLE 2: Weight Loss Claim

Weight Loss Example -  | MLM attorneyGronk has been using “Slim-Me-Cave” for the past 30 days. Miraculously, Gronk lost 30 pounds in this short period of time. Incredibly happy with this weight loss product, Gronk decides to post a blog on the Internet. In the article, he writes, “I lose 30 pounds in 30 days with Slim-Me-Cave! It best weight loss product!!” The average customer of Slim-Me-Cave loses about 1 pound per week, so Gronk’s results are certainly above average.

What Gronk wants to do:

*Results Not Typical.

What the FTC wants to see:

Typical loss is 1 pound per week for Slim-Me-Cave customers. Results will vary depending on diet and exercise.

Lesson Learned:

Your disclosures must give a “reasonable customer” sufficient information to make a decision. “Results Not Typical” does not provide enough information. When making a testimonial about a product that’s “above average,” the average needs to be disclosed (as per the FTC guidelines). Back in the old days, “Results Not Typical” used to work. But now since everyone is a potential marketer, the FTC wants disclosures to be more specific. Does “Results Not Typical” mean a customer will lose only 20 pounds in 30 days? 15 pounds in 30 days? What results can the average customer expect? When possible, provide the averages.

EXAMPLE 3: YouTube Income Claim

youtube_logo_635

Fact Pattern:

Stephanie is giving a video testimonial on YouTube about the benefits of her network-marketing company’s pay plan. She states that “In this business, when I recruited just 20 people, I was making over $2,000 per week!” In that particular program, the average distributor earns $235 per month.

What Stephanie wants to do:

Stephanie would probably not want to provide an income disclosure at all. I’m just being candid. Rarely in videos prepared by distributors do you see any kinds of income disclosures.

What the FTC wants to see:

The FTC states that the manner you communicate your claim should also be the manner you communicate your disclosure. Therefore, a YouTube video should contain a disclaimer in both video and audio formats. Where should the disclaimer be? Sadly, there’s no clear answer. But if we look at the FTC’s definition of “Clear and Conspicuous,” I think the safest bet is a text disclosure displayed simultaneously to the claim in question in addition to a more detailed audio and video formatted disclosure at the end of the testimonial. Or Stephanie could provide a “visual cue” during the video to communicate to the viewer that disclosures can be found at the end of the video.

Without question, it’s now required (in my opinion) that distributors end their videos with a properly formatted video segment. At the end of the testimonial video, a separate video disclosure should be included to illustrate the average incomes. The video file should include an image of the company’s income disclaimer (usually in spreadsheet format). While the image is on the screen, there should be audio narration regarding the average earnings. If a company is going to permit distributors to use YouTube to promote their businesses, the company should provide this kind of file freely on its website AND educate distributors on how to use it.

While it sounds complicated, it’s not difficult for companies to provide this sort of video file. However, if the company is unwilling to properly arm the distributors with sufficient tools to make good claims, they should restrict distributors from using YouTube (which is not realistic AT ALL).

There are several questions this kind of hypo raises:

Should companies require leaders to insert a clear and conspicuous textual disclosure to appear on the screen when the claim is being made?

It depends. In a perfect world, yes, it’s a good idea to provide the disclosure during the claim. But in reality, most reps lack the technical skill to do this right. This is what we know: disclosures should be as close as possible to the claim being made. Is it sufficient to provide a video file containing a full disclosure at the end of the video? In my opinion, the answer is yes. But in the abundance of caution, it would be better if there were a text disclosure provided during the video in addition to a video file being used at the end.

Is it a good idea to even allow reps to make these sorts of claims to begin with?

Are you able to produce a quality disclosure for your distributors to use? Do you trust your distributors to “color within the lines” and end their videos with a video? Do you have a solid compliance department to catch and correct the distributors that do this poorly? If the answer to those questions is “yes,” then you’ve got a shot. If, on the other hand, you answered “no” to any of those questions, it might not be worth the risk.

Lesson Learned:

If you are going to allow reps to make videos that contain income claims, be careful! When it comes to videos, it’s difficult to walk the tight rope. When it comes to income claims in videos, there’s not much margin for error. With this in mind, I would advise companies to require tight compliance. At a minimum, companies should provide distributors with a professionally produced video file that all distributors can include at the conclusion of their videos. If you know leaders are going to make claims in YouTube videos, or any other video platform, it’s wise to properly arm them with adequate disclosures. A video file will give the needed audio disclosure as well as additional visual disclosure to the income claim in question.

EXAMPLE 4: YouTube Product Claim

Product Claim Example | MLM attorneyFact Pattern:

“Sports Minded” is a company that sells organic products that improve mental focus during physical activity. Adam is a distributor for Sports Minded and he decides to do a self published a YouTube video to give a testimonial about how he can now focus for 8 hours straight while playing golf without additional supplements. However, studies performed by Sports Minded indicate users can experience an average of 4 hours of improved focus. Adam is being honest regarding his experience with the product. He’s like Mr. Miyagi for 8 hour straight! Since it’s a true statement about his personal experience, is he required to provide substantiation and disclose the average results?

What Adam wants to do:

Adam would likely try to provide a disclosure via a hyperlink in the video description, in text at the end of the video or in a brief audio message at the end of the video.

What the FTC wants to see:

They want a “clear and conspicuous” disclosure that contains the average results. Just like with the income claim example above, the disclosure needs to be in both audio and visual format.

It would be ideal if the distributor had the skill to inject the disclaimer immediately after making the claim i.e. “I know that the company says the average person experiences 4 hours of increased focus, but that was NOT the case for me!” In order for this to happen consistently in the field, the company needs to take compliance education very seriously.

Lesson Learned:

As you can see with all of these disclosures, it’s a lot more art than science. We previously mentioned that the manner you communicate your claim should also be the manner you communicate your disclosure. Technically, the FTC wants to see the disclaimer in both audio and visual formats (even for videos produced by the field). With that being said, it’s unrealistic to expect sales people to get this right when they’re making product testimonials. And I think the FTC understands this (I’m at least hoping they do). With product testimonials, I think a text disclaimer inserted into the video would be a sufficient disclosure. But this approach would NOT be sufficient for income claims. Because money clouds judgment, the FTC is much more strict in that category (and they should be).

EXAMPLE 5: Tumblr Blog

Tumblr - MLM exampleFact Pattern:

Mary publishes an article on Tumblr about “N-ERGY SAVER,” a utility service MLM where customers can save money on their electric bills throughout the year. Mary, a representative, claims that she saved $50 per month by signing up with the company. While Mary’s claim is 100% true, the company’s data shows that the average homeowner saves $15 per month on their electric bill.

What Mary wants to do:

She wants to tell her story! She wants to say “I saved $50 a month with this service and so can you!” Since it’s a true story, Mary sees nothing wrong with her sharing her personal experience.

What the FTC is looking for:

The FTC wants to see a disclosure in close proximity to her claim. So if she has written text about her savings with N-ERGY, she needs to include a disclaimer in the same font and format as the text that triggered the claim. The disclaimer can say “The average homeowner saves between $10 and $20 per month, depending on their energy consumption patterns.”

BONUS EXAMPLE!

bonus

Fact Pattern:

Same as Example #2, except suppose Gronk wants to make the same claim via Twitter.

What Gronk wants to do:

I saved 30 LBS w/ Slim-Me-Cave in 30 days! bit.ly/f56/productinfo [linking to the product page that includes the average results]

What the FTC wants to see:

Twitter allows for 140 characters per tweet. If there’s sufficient space for a disclosure, it’s ok to use to twitter. Otherwise, it should be avoided. With Gronk, providing a link is insufficient. But the FTC provides a little hope in this category: as long as the average results are provided in the tweet, twitter can be used. The FTC provides an example of a permissible weight loss claim below:

Untitled

Should Twitter be allowed for income claims?

No! There’s just not enough real estate to provide an adequate income disclosure. As I mentioned above, providing a hyperlink by itself is insufficient.

Lesson Learned:

Twitter is tricky. If the distributors are properly trained, they can use twitter for good product testimonials. But with respect to income claims, Twitter should not be allowed AT ALL.

Conclusion

It’s going to be tough for network marketing companies to walk this tight rope. On the one hand, they want to give their distributors the freedom and flexibility to aggressively market the products and pay plan. On the other hand, they need to “pump the brakes” to ensure that the distributors are doing things right. In my opinion, the real challenge is going to be with online video. While it’s very easy for anyone to create a video with a webcam, it’s very difficult for people to insert proper disclaimers during and/or after the video. In the future, proper education in the field is going to be absolutely crucial. Companies that commit to field education are going to be the ones that pass the scrutiny. Companies that take their hands off the wheel and expect leaders to get this stuff right are walking on thin ice. The FTC’s expectations are out there. Ignorance is no longer an excuse.

BREAKING NEWS: FTC’s Case Against Fortune Hi Tech Removed to Kentucky

FTC - FHTM case transferred to Kentucky | MLM AttorneyIn February of 2013, the FTC filed a lawsuit against Fortune Hi Tech Marketing. The lawsuit was filed in Federal Court in Chicago. The FTC is alleging that FHTM operates as a pyramid scheme. As mentioned in my last article, the FTC passed on the scalpel and picked up the sledgehammer. Basically, they departed from their traditional, math-based pyramid scheme arguments and went for a more generic approach. This new strategy is even worse than the other one. If it sticks, it represents a significant threat to the industry. Based on the FTC’s argument, rewards triggered via distributor consumption are illegal recruitment bonuses. This is a very important case.

Time for the Update

FHTM filed a motion to get the case transferred to federal court in Kentucky. Kentucky is the home state for the company and most of the principals. The judge in Chicago punted the file to Kentucky. The factors considered when deciding on such a transfer include:

(1) site of material events relative to the case;
(2) relative ease of access to sources of proof;
(3) convenience of the parties litigating;
(4) convenience for the witnesses.

This is big for two reasons. First, the judge in Chicago thought so little of the case that he sent it south. If he wanted it, he could’ve kept it. Second, the law in Kentucky is clearer with respect to pyramid schemes. It states:

Pyramid distribution plan” means any plan, program, device, scheme, or other process by which a participant gives consideration for the opportunity to receive compensation or things of value in return for inducing other persons to become participants in the program;
(5) “Compensation” means payment of any money, thing of value, or financial benefit conferred in return for inducing others to become participants in the pyramid distribution plan. Compensation does not include payment based on sales of goods or services by the person or by other participants in the plan to anyone, including a participant in the plan, who is purchasing the goods or services for actual use or consumption…..

Again, the FTC was initially arguing that commissions triggered via internal consumption are illegal bonuses. But the statute in Kentucky says the exact opposite. This case is FAR from over. There’s likely going to be a hearing next week in Kentucky regarding the injunction over Fortune Hi Tech. If FHTM wins, they’re back in business. The judge’s reasoning for sending the case to Kentucky is included below.

If you’re reading this via email, please click this link to read the judge’s opinion.

The FTC Is Now Regulating Boxing

FTC Regulating Boxing

See below for the FTC’s latest effort to protect people across the country.

Begin Press Release

The FTC has been commissioned to address the growing belief that shorter men can actually compete at a high level in professional boxing. In fact, after conducting surveys over a period of four years, speaking with numerous experts (none of whom have actually boxed), the FTC has ultimately concluded that the empowering message of the Rocky franchise to be misleading for prospective boxers throughout the country. This report is intended to provide guidance for coaches and trainers going forward when they’re soliciting involvement from young fighters.

As per our newly published guidelines, trainers and coaches are required to obtain separate signatures on a disclosure document from prospective fighters before they begin training. The disclosure document addresses numerous myths associated with the Rocky character as well any false expectations held by prospective fighters. The disclosure document must contain a “purpose statement,” which is included below. The purpose statement must be included in red, 16 pt san serif font, center justified, all caps bold. The purpose statement must also be read aloud in English, Spanish, Mandarin and Russian.

THERE ARE BETTER WAYS OF EARNING A LIVING. WE, THE COACHES AND TRAINERS, STRONGLY ENCOURAGE YOU TO GET REAL JOBS. BUT IF YOU DECIDE TO PROCEED WITH A DREAM OF MAKING IT AS A BOXER, THIS IS A REQUIRED DISCLOSURE BY THE FEDERAL GOVERNMENT

The disclosure must state:

The average annualized income for all active Boxers during this period (before expenses) was $8.37. The average boxer can expect to suffer much and earn little.

Regarding the Rocky franchise: Rocky Balboa is a fictional character. Statistically, a 5’8″ Italian man over the age of 30 has zero shot of winning a heavyweight boxing title. Chasing chickens has not been scientifically proven to make you faster. There has never been a man that could really piss lightning or crap thunder. Pounding frozen meat has not been validated as an effective way to improve hand strength. After our medical advisory board reviewed the original Rocky film, they concluded that Rocky Balboa would have suffered 27 concussions at the hands of Apollo Creed before the final bell.

There are no guarantees of income as a fighter. Boxers that fail are condemned socially, labeled “wishful thinkers.”

End

FTC Shuts Down Fortune Hi-Tech Marketing, Summons the Krakan

Peter Vander Nat

As most of you know, the FTC has filed a lawsuit against Fortune Hi-Tech Marketing, alleging them to be a pyramid scheme. This is the first action taken by the FTC against an MLM since December of 2006. The most informative pleading that shows the FTC’s position is the memorandum supporting the FTC’s motion for an injunction. WARNING: It’s 54 pages…and boring. When describing these cases, I’ve found that it’s always best to give a brief summary of the business model.

Fortune Hi-Tech Marketing (“FHTM”) Business Model

FHTM_logoFHTM is a network marketing company that specializes in selling nutritional supplements and beauty products. It also dabbles in selling cable and telecom services. Participants join FHTM by paying a $250 administrative fee. In order to qualify their positions, these “Managers” are required to move (buy or sell) 1,000 volume points. This usually costs between $100 and $400 per month, totaling at least $1,200 annually in product sales / purchases.

Managers can advance to “Regional Sales Managers” by recruiting six additional Managers. RSMs can advance higher by recruiting additional Managers. RSMs are eligible to earn $100 for each new Manager in their downline. While the new Manager doesn’t generate $100 worth of margin based on his or her product purchase, I doubt FHTM is using money from the $250 enrollment for the $100 bonus (which would obviously be a recruitment bonus). Instead, they’re probably allocating some of the breakage in the plan from unpaid commissions from product sales i.e. the majority of reps do not hit the RSM rank; therefore, there’s plenty of money in the pot for the bonus. Using Vander Nat’s “perfect scenario” theory, assuming everyone were to hit the RSM rank, the plan breaks. The FTC is exploiting this as a weakness in the plan.

FTC’s Thesis

The FTC’s thesis is simple: the FHTM products are merely incidental to the money making opportunity. The FTC makes itself clear: while FHTM talks about “selling product,” the references to sales are cosmetic designed to conceal a money transfer scheme. Additionally, the FTC is arguing that the structure of the pay plan itself is turbo-charged to reward recruitment over legitimate product sales.

FTC’s Purported Expert a/k/a the Kraken

Peter Vander Nat

The FTC’s attack dog throughout the years has consistently been its economist, Dr. Peter Vander Nat. Vander Nat co-wrote an article titled “Marketing Fraud: An Approach for Differentiating Multilevel Marketing from Pyramid Schemes.” In the article, Vander Nat publishes his math formula that he uses when reviewing a multilevel marketing program. Vander Nat is an interesting anomaly in the MLM industry. In my opinion, he’s similar to the the Kraken in Pirates of the Caribbean. In the movie, the Kraken is a large beast residing in the depths of the ocean, only to surface when called upon by its master to destroy a vessel. And when the job is done, it vanishes…

Vander Nat operates in simliar fashion. While the FTC recognizes the legitimacy of the MLM industry, their chosen expert does not share the same sentiment. I suspect they keep him locked behind closed doors for years, only to use his services when they need to sink a ship fast. Can you blame them? Vander Nat has never once found an MLM legal using his math formula. I’m not kidding. In the FTC’s case against BurnLounge, Vander Nat’s credibility as a witness is being contested at the appellate level. In its brief, BurnLounge references Vander Nat’s deposition transcript and writes:

Vander Nat had never studied any MLMs that he concluded were legal. He could not testify that using his analysis, one would ever find an MLM to be legal. . . Nothing was presented to show that his test had gained widespread acceptance. He likewise admitted that he did not know if his test complied with the Koscot/Omnitrition test.”

If you want the full text, check out page 43 of BurnLounge’s Appellate Brief.

I’m not making this up. The FTC’s expert, the man charged with distinguishing good companies from bad companies, has created an impossible standard. And furthermore, if you review his math formula published in his article, it requires a doctorate in quantum physics to truly understand. As if that’s not enough, central to his formula is this definition of “retail sales.” He writes, “We rely on Omnitrition’s findings that for purposes of pyramid analysis, the sale of product to ultimate users means the sale of product to those who are outside the organization.” In other words, for purposes of his formula, commissions triggered via internal consumption are considered “recruitment bonuses.” When you control the terminology, you control the outcome.

On a side note, his reliance on Omnitrition is misplaced. Omnitrition was never held to be a pyramid scheme. But I digress…

What does the FTC say on the issue of MLM internal consumption? Unlike Vander Nat, the FTC takes a softer stance on the subject when it writes, “In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme.” Clearly, there’s some incompatibility between the FTC’s public statements and their arguments made in litigation. Do they reserve the Kraken for what they perceive to be the most egregious of companies? It appears to be the case.

Why Fortune Hi Tech Marketing

Just to be clear, I’m not defending the Fortune Hi Tech model. I lack adequate information to form an opinion one way or the other. I’ve learned that it’s ill-advised to form an opinion based on the initial complaint. But I do know this: FHTM is isolated. The DSA rolled them under the bus and it only took them 24 hours after the FTC filed its lawsuit. FHTM is not part of the tribe, which means they’re not going to score many sympathy points from industry participants. Will this hurt them? I think so. If they survive the injunction (very high bar there), there’s not going to be enough positive press to keep their sales force engaged. The industry, traveling in a pack, will keep moving in a herd knowing full well that occasionally, some get eaten.

The FTC’s allegations can be summarized in two small sections.

(1) Recruitment Culture.

FHTM heavily emphasizes recruitment over sales. In fact, the FTC commonly places sales in quotes i.e. “sales.” They know that there’s a theoretical opportunity for sales, they just dismiss it as fake. They allege that as a requirement for participation in the plan, Managers must buy (or “sell”) a certain amount of inventory each month. This amount averages over $1,200 per year. Are the prices inflated? The FTC never says one way or the other. The FTC also accuses FHTM of overstating the benefits of their partnerships with nationally known brands i.e. DISH Network, Xoom Energy, etc. The FTC alleges that Managers in FHTM tout these partnerships as validation of the model; however, there’s very little commission to be gained from those sales because those partnerships are just “run-of-the-mill affiliate agreements.”

(2) Income Claims.

FHTM allows its sales force to make inappropriate income claims. The FTC provides a number of crazy claims made by leaders and executives. These statements were taken from all over the place, including company meetings, YouTube videos and, most surprisingly, Twitter. If you’re an executive for an existing MLM, pay attention. Compliance matters. While FHTM has an income disclosure document, the FTC is alleging that FHTM never made it a priority to get it in the hands of prospects. Also, the FTC alleges that the income disclosure document uses fuzzy math to reach its numbers because it excluded a large population of the sales force.

Due Process?

dueprocessDoes it make you nervous knowing that the Federal government can shut down a long-standing business without a judicial hearing? Critic or not, it’s disturbing. If FHTM is a flaming pyramid, it would never have survived a hearing. After being in business for over a decade, where is the imminent threat referenced by the FTC in its motion for an immediate injunction? The Critics, who commonly take a “win at all cost” approach, even if it means heralding a felon as their champion, will say “serves them right!” But be careful…

“And when the last law was down, and the Devil turned ’round on you, where would you hide, sir, the laws all being flat? . . . And if you cut them down, and you’re just the man to do it, do you really think you could stand upright in the winds that would blow then? Yes, I’d give the Devil benefit of law, for my own safety’s sake!” Sir Thomas More, A Man For All Seasons.

If you’re reading this via email, please click this link to view the FTC’s memorandum in support of its motion.

After Six Year Slumber, FTC Wakes Up Big And Goes After Fortune Hi Tech

BREAKING NEWS:

The FTC has sued Fortune Hi Tech marketing, alleging them to be a pyramid scheme.  As of today, an injunction has been issued.  Read below for the FTC’s press release.  Also, a copy of the complaint is provided below.

FHTM Promoted Itself as a Path to Financial Independence, But Most People Made Little or No Money

At the request of the Federal Trade Commission and the states of Illinois, Kentucky, and North Carolina, a federal court has halted an allegedly illegal pyramid scheme pending trial.  The FTC and the state attorneys general seek to stop the allegedly illegal practices of the Fortune Hi-Tech Marketing (FHTM) operation, which claimed consumers would make substantial income by joining the scheme.  The operation affected more than 100,000 consumers throughout the United States, including Puerto Rico, and Canada.  In some areas, including Chicago, the scheme targeted Spanish-speaking consumers.

“Pyramid schemes are more like icebergs,” said C. Steven Baker, Director of the FTC’s Midwest Region.  “At any point most people must and will be underwater financially.  These defendants were promising people that if they worked hard they could make lots of money.  But it was a rigged game, and the vast majority of people lost money.”

According to the complaint filed by the FTC and the state attorneys general, the defendants falsely claimed consumers would earn significant income for selling the products and services of companies such as Dish Network, Frontpoint Home Security, and various cell phone providers, and for selling FHTM’s line of health and beauty products.  Despite FHTM’s claims, nearly all consumers who signed up with the scheme lost more money than they ever made.  To the extent that consumers could make any income, however, it was mainly for recruiting other consumers, and FHTM’s compensation plan ensured that most consumers made little or no money, the complaint alleged.

“This is the beginning of the end for one of the most prolific pyramid schemes operating in North America,” Kentucky Attorney General Jack Conway said.  “This is a classic pyramid scheme in every sense of the word.  The vast majority of people, more than 90 percent, who bought in to FHTM lost their money.”

As alleged in the complaint, FHTM promoted itself as a way for average people to achieve financial independence.  Some FHTM representatives claimed they earned more than 10 times as much as their previous earnings in their second and subsequent years with FHTM.  One person claimed that another representative earned more than $50,000 in his sixth month and millions of dollars in subsequent years.  Another person promoted a recruitment meeting on her Twitter account, stating, “Bring ur friends & learn how 2 make $120K aYR.”  At its 2012 national convention in Dallas, FHTM called its top 30 earners to the stage to present them with a mock-up of a $64 million check, which several of them shared as a photo on social networking websites.

To participate in the scheme, consumers paid annual fees ranging from $100 to $300.  To qualify for sales commissions and recruiting bonuses, they had to pay an extra $130 to $400 per month and agree to a continuity plan that billed them monthly for products unless they canceled the plan.  Those who signed up more consumers and maintained certain sales levels could earn promotions and greater compensation, but contrary to FHTM’s claims, the complaint alleged, its compensation plan ensured that, at any given time, most participants would spend more money than they would earn.

According to the complaint, recruits were told they could earn high commissions by selling products to people outside the operation, but instead only minimal compensation was paid for sales to non-participants, and few products were ever sold to anyone other than participants.  The scheme provided much larger rewards for recruiting people than for selling products, and more than 85 percent of the money consumers made was for recruitment.

In addition to charging the defendants with operating an illegal pyramid scheme and making false earnings claims, the FTC charged them with furnishing consumers with false and misleading materials for recruiting more participants.  The attorneys general offices of Illinois, Kentucky and North Carolina joined the FTC complaint, as well as alleging violations of their respective state laws.

The defendants are Paul C. Orberson, Thomas A. Mills, Fortune Hi-Tech Marketing Inc., FHTM Inc., Alan Clark Holdings LLC, FHTM Canada Inc., and Fortune Network Marketing (UK) Limited.  On January 24, 2013, the court halted the deceptive practices, froze the defendants’ assets, and appointed a temporary receiver over the corporations pending a trial.

The Commission vote, including Commissioner J. Thomas Rosch, authorizing the staff to file the complaint was 5-0.  The complaint was filed in the U.S. District Court for the Northern District of Illinois, Eastern Division.

If you’re reading this via email, please click this review the FTC vs. Fortune Hi Tech lawsuit.

Herbalife: Why I Made It a 35% Position after the Bill Ackman Bear Raid

This is a guest post prepared by Robert Chapman. Chapman is the founder of Chapman Capital LLC, which is a Los Angeles based investment company specializing in takeovers and turnarounds. In 2000, Chapman Capital was an activist versus Herbalife following the death of Herbalife’s founder Mark Hughes. This is an amazing article. It’s well-researched and easy to understand.  If you’re remotely curious about the future of Herbalife after Ackman’s attack, the mechanics of short selling and the potential value of Herbalife’s stock, this is a MUST read. If you find this article informative, hit the +1 or Like buttons above. Sincerely, +Kevin Thompson

Note: Note: Below is the opinion of Chapman Capital LLC and is not a recommendation or an indication of Chapman Capital’s current or future intent to buy, sell or otherwise transact in Herbalife common shares.

Update: Robert Chapman made some slight revisions to the article. His points are the same; however, he made a few stylistic changes.

As anyone even remotely connected to the world of multi level marketing is surely aware, the perpetually sanctimonious Bill Ackman and his extremely successful investment advisory firm Pershing Square formally launched a massive bear raid on Herbalife (HLF) on 12/20/2012, conducting a 3+ hour, media-packed, web-streamed 300+ PowerPoint slide deck presentation in New York after first selling short 20MM HLF shares for as estimated $1 billion plus in proceeds.   In his presentation and numerous interviews with the business media that day, Ackman declared a target price of zero for HLF’s shares.  In other words, he claims to be so convinced that Herbalife operates an illegal pyramid scheme, he is certain that government authorities and/or HLF’s distributors/salespeople/customers will shortly put the company out of business.

SUMMARY INVESTMENT THESIS: Despite beguiling and specious reasoning, Ackman will fail to influence/cause a material regulatory response or a HLF distributor exodus. Consequently, he will suffer a merciless short squeeze, catalyzed and augmented by a fast and furious combination of HLF share count shrinkage (buyback) and excellent operating performance (beat and raise dynamic).

REGUATORY SUMMARY: FTC has been there, done that.

The Ackman Tell. Many poker games are won and lost upon that infamous turning point when a player properly reads his opponent’s “tell.” To wit, I am confident that during an interview with CNBC’s Andrew Ross Sorkin on “D-Day” (12/20/2012), Bill Ackman slipped his “tell”, confirming my suspicion that he already realized the FTC wasn’t going to make his day by shutting down HLF. I strongly recommend all HLF traders/investors read the transcript of this interview, as Sorkin does a masterful job of fighting the media urge to genuflect before Ackman’s drawn down zipper, otherwise known as “The Whitney Tilson”. Specifically, Sorkin, after hammering Ackman, asked toward the end of this interview, “This is somewhat dependent on the FTC taking action. If they don’t, what happens?” Now, remember that Ackman’s entire thesis rests on his certitude (so he claims) that HLF is an illegal pyramid scheme, which the FTC has a mandate to shut down. If you were 100% certain (with 20% of HLF shorted in your funds alone) of this claim, wouldn’t your answer be, “There is no way the FTC doesn’t take action to shut down the illegal pyramid scheme run by Herbalife.” Instead, Ackman diffidently responds, “I think the FTC is going to take a very hard look. But I think most importantly the new distributor someone is trying to suck into the scheme will be better informed …”

The moment I read this response, after having researched HLF on/off since 2000 (when Chapman Capital had been an activist in HERBA/HERBB shares during Mark Hughes’ LBO efforts), I decided I had to place a monster long bet on HLF. I believe Ackman already had concluded the FTC wasn’t going to assist his crusade. Instead, he realized that he had to focus on existing and prospective HLF distributors, praying the media attention would have a materially deleterious impact on any decision to join or to continue with the HLF team. Indeed, without the FTC taking injunctive actions against HLF, Ackman’s crusade toward “zero” is doomed.

Here are key bullet points on the lack of real regulatory risk to HLF shares:

Internal Consumption Issue Already Clarified/Resolved by FTC in 2004: “the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme” is a quote from an FTC letter dated 01/14/2004. Essentially, the letter states that if a product is marketable, the FTC is OK with the MLM, making Einhorn’s 05/01/2012 call focusing questions on this internal consumption issue far less relevant than was (mis)understood.

FTC Material Adverse Actions Near Zero Probability:  during my due diligence, I spoke with the country’s top lawyer specializing in MLM/regulatory dynamics. During our conversation, he offered his legal opinion, pointedly stating that there won’t be any FTC injunction, much less any regulatory action to put HLF out of business (“hell freezes over before this happens”). If there is regulatory action of any kind, it simply will be some type of consent order/settlement addressing better disclosure.

Few Consumer Complaints:  the FTC has not received many consumer complaints on HLF products – only 37 in 2010, 36 in 2009, and YTD 05/2012 was only 18 (again around 40 annually).

HLF is Big, Time Tested Veteran:  the FTC can and will shut down companies violating MLM rules, just as it did BurnLounge (online music retailer) in 03/2012 and Equinox in 2000. While such action is rare, the FTC will act aggressively to shut down companies when it sees the need. During the 32 years of HLF’s existence, the FTC has yet to see the need to pursue Herbalife.

Ackman Relied Greatly on Old Cases, Leaving Out Material Facts – Ackman failed point out that the FTC has already commented about the relevance (or lack thereof) of the cases he referenced in his presentation. In fact, most of the post Einhorn reporting has been misleading information;

No Federal Clarity – lots of Grey:  No “bright line” federal statute against pyramid schemes; even the guy with jihad against MLM’s, Pyramid Scheme Alert’s Robert FitzPatrick, conceded that FTC decided too complex to regulate MLM’s in 09/2011 and other anti-MLM consumer protectors have as well; this MLM lawyer thinks DSA should fight for bright line federal standards to eliminate opportunity for short sellers to exploit the grey;

Vast Preponderance of Sales and Growth are International (i.e., Outside Ackman/FTC): 80% of HLF’s business overseas.

The DSA is an Effective Lobby: The DSA serves as a lobbying entity designed to protect the MLM industry from burdensome government regulations. It led a campaign in 2006 where 17,000 comments were submitted to the FTC, all requesting an exemption from the restrictive requirements in the Business Opportunity rule. The DSA was successful. The DSA is more powerful that Ackman’s ally, Pyramid Scheme Alert’s Robert FitzPatrick

DISTRIBUTOR SUMMARY:  “Bill who?”

Chapman Capital’s distributor surveys show no meaningful percentage of distributors had even heard about Ackman’s circus show. Moreover, their evangelical commitment to HLF and confusion as to what 300+ pages of PowerPoint means seem to be causing an acceleration of business growth. Ackman’s payment for Google Ads (pegged to “Herbalife” search) exhibits his desperation to influence distributors, efforts which appear to have negligible effect.

TAILWINDS — FAT TAILS AND BUSINESS BAILS  HLF has two secular tailwinds in its favor: lots of fat people (fat “tails”) and no shortage of structurally un/underemployed humans. In fact, one thought for a short in HLF to consider is the following: net/net, does the U.S. government benefit from fewer overweight Americans (lower insurance costs) and fewer people standing in unemployment lines (ever hear of a fiscal cliff problem with U.S. budget?)? If the U.S. government benefits from HLF’s impact on the country’s physical and fiscal health, while enduring only 40 complaints/year about HLF, why shut down HLF? Ponder that for a moment.

BACKGROUND: Short seller roadkill HLF shares were trading as high as $45/share on 12/14/2012, and had been over $70/share (a high teens P/E multiple) earlier this year before the highly respected investor David Einhorn of Greenlight Capital asked some leading questions on an earnings call that implied he was skeptical that Herbalife was operating within the Amway safe harbor guidelines for multi-level marketers. Fear of Einhorn’s excellent record of identifying overvalued short sale targets sent HLF shares into the $40’s in the spring. In contrast, Ackman has been somewhat vague as to when he built the preponderance of his short position (i.e., did he start before Einhorn’s 05/01/2012 questions or was he an unoriginal shadow to Einhorn’s trailblazing?), but I am guessing $50-55/share is his average short cost basis. There is no evidence Einhorn went short at that time or since, but I would be shocked if Greenlight would maintain HLF short positions anywhere near $30/share based on HLF’s international value alone.

Open interest on HLF puts accelerated and the stock’s relative weakness worsened in the fall of 2012 as, I suspect – No evidence here. I’ve just been around the block a few times – people “around” Ackman shorted HLF or bought HLF puts ahead of 12/20/2012 presentation. In fact, I have a pet theory that Ackman’s interest in going massively public was heightened (if not driven) by the HLF stock’s reasonably strong response (into mid-$50/share) attendant with impressive late July and October 2012 financial results. Essentially, my hypothesis is that Ackman, with overall 2012 performance impaired by JCP’s descent into the teens, came to conclude he needed a big winner before year-end 2012.

As word leaked into the market of Ackman’s intention to present publicly the bear case on Herbalife, the stock began a gradual decline, then fell suddenly from ~$41/share to $36/share in the closing market hours of 12/19/2012, when a CNBC reporter with big hair reported that market rumors were true. The next morning, as the PT Barnum of the hedge fund industry delivered his presentation in a New York hotel ballroom on 12/20/2012, and especially through the early trading hours of 12/21/2012 (a very illiquid trading day), the shares went into free fall, reaching a nadir of $24.40/share. My funds made their last purchases at $25.30/share in a brief but painful period of negative marks. HLF shares have since rebounded to ~$30/share as traders/investors have taken a closer look at whether the emperor is running around New York denuded (figuratively speaking . . . fortunately).

ACKMAN’S TIMING OF “INTEREST” Ackman’s end-of-same-year-that-Einhorn-showed-up timing was masterful – when it comes to the power of influence, only top hypnotists can compete. A classic bear raid involves creating abject panic in the market. Concurrently using the proximity to Christmas, the December option expiration, and the depth of his presentation, the Ackman impact on the shares was maximized. The last ten days of December are as quiet as it gets on Wall Street, with most decision makers leaving for vacation, drying up market depth and liquidity. Also, at the peak of the panic not many institutional investors felt the urge to have HLF show up in their 12/31/2012 Form 13-F filing. December is also the final month of HLF’s fiscal year, which puts them in a “blackout period,” prohibiting the company and insiders from repurchasing shares under the $950mm authorized buyback. Moreover, due to the extensive audit period that attends year-end, it will be several months before year-end 2012 results were reported. This blackout removes HLF’s most effective defense to the bear raid: executing a nearly $1 billion share repurchase authorization. Again, if timing is everything, Ackman is every woman (with a nod to Whitney Houston).

PERSHING SQUARE/ACKMAN RESUME:  Let’s review some history on Bill Ackman and Pershing Square, some color on the mechanics of short selling, and Herbalife’s response to the bear raid to date.

Bill Ackman manages a New York based hedge fund called Pershing Square with exceptionally good long-term results. Ackman is not known as a short seller. His fund is generally a long-biased fund. He achieved some notoriety for predicting that muni-bond insurer MBIA was undercapitalized, which eventually proved true during the financial crisis of 2007-2009. His enormous investment in General Growth Properties (GGP) at less than $1/share remains one of the most impressive brains/balls combinations I have ever seen. All the while, however, his ego seems boundless.

He is somewhat unusual among usually media averse hedge fund managers in that his strategy involves publicly trumpeting the merits (and genius) of his investments, which he generally holds for a long time. He manages a concentrated portfolio comprised of very few, very large investments. He also is considered an activist investor. He frequently badgers the board and management of the companies in which he invests with what start as suggestions and frequently escalate to demands as to how they should conduct their business, what their capital structure should be, and the composition of its board.

Though he will rarely, if ever, publicly concede, Ackman makes mistakes just like the rest of us, even catastrophic financial ones (e.g., call options on Target). Indeed, Ackman closed down a previous hedge fund advisory entity called Gotham Partners after he reportedly marooned his investment funds in an illiquid and devastating combination of a closely held REIT (First Union Real Estate) and a portfolio of golf courses (Gotham Golf) for which no exit was possible. So while Ackman is quite good at what he does for a living, his hubris makes him vulnerable to spectacular failure. He has a high financial IQ, but it may be the delusional and narcissistically 15 surplus IQ points he awards himself that have been, and may again be, his undoing. Think of him as the Reggie Jackson (I’m dating myself here) of Wall Street: he swings for the fences, but can cause a lot of pain and break a lot of hearts – or the bank – when he whiffs.

SHORT SELLING PRIMER: A bit more on short selling for those inexperienced in the sport. Short selling is a vital component of the markets. The ability of investors to sell short shares of overvalued companies keeps market valuations in check, and permits investors to hold hedged portfolios that are not dependent on constantly rising indices to make a positive return. There are risks, however, of going short that do not exist on the long side. For instance, if one purchases the shares of Acme Widget at $10/share, and Acme fails, you know precisely how much you will lose – your $10/share, and no more. If you were to short Acme Widget at $10/share and Acme were to discover a vast plutonium mine under their headquarters, those shares that were shorted at $10/share may have to be repurchased in the market at $100/share, $500/share, or even $1,000/share. The potential loss on a short sale is unlimited. For this reason, most professional long/short investors keep the size of their short positions much smaller than their long positions. For instance, if a core long position is 5% of capital, a core short may be 2%. Last week in Barron’s, famed short seller Jim Chanos discussed his lessons learned from the 1999-2000 internet bubble when he saw his AOL short go up eight times in value in his face. The lesson he drew was to keep individual shorts small relative to capital. Ackman’s $1 billion short in Herbalife is almost 10% of his reported $11 billion fund. If he is wrong, he may very well be putting his firm at risk due to the enormity of his short position relative to both Pershing Square’s and HLF’s size, and the potential difficulty of covering a short position of that magnitude in a “short squeeze”. Google the notorious Volkswagen/Porsche trade to see how dramatically these events can play out at the extremes.

To go short a company’s stock, one must borrow the shares to sell from a broker. Shorting without a proper borrow is called “naked shorting”, and is illegal. Holders of stock give their broker the right to lend out their shares in exchange for the flexibility of keeping margin accounts, and to participate in a portion of the fees short sellers incur for access to those shares. Short selling is conducted by the investor calling his broker, securing a borrow, and then executing the sale. Most companies have ample shares available to borrow, and this process yields little drama. However, in the case of controversial stocks, the demand to borrow shares may exceed the supply in the brokers “box”. If long holders sell shares brokers had out on loan to short sellers, the short seller must replace those borrowed shares he has lost access to with newly sourced shares. Should none be found, he will be forced to cover that portion of his position, and if unwilling to cover, the broker will involuntarily “buy him in”. This dynamic is what leads to short squeezes, where heavily shorted issues rapidly appreciate in the absence of any fundamental reason. Just look back to 2008 when the US government suddenly prohibited the shorting of financial stocks to see how painful that result can be for short sellers.

One effective defense for the short seller would be to have his broker contract on his behalf with a lender of shares to provide a quantity of shares for a specific term, at a negotiated payment. This insulates the short seller from buy-in risk for the duration of the contract. However, these contracts are individually negotiated, and somewhat rare. Also, they frequently permit the long holder to regain access to his shares if the company were to, for instance, conduct a self-tender offer for its shares. It is not known if Ackman has such an arrangement.

Ackman’s self-reported short position of 20 million HLF shares is over 75% of the reported short interest in Herbalife. At this point, the “borrow is tight” – there appears to be a near zero supply of shares available to sell short. The few brokers that will supply a borrow are charging as much as 20% of the value of the short annually for that access. This is a monster number – between the 20% negative-borrow and HLF’s dividend, it would cost nearly 25% each year to stay short HLF, all things remaining constant on those two variables.

HLF’s DEFENSE IS COMING:  Given the holiday timing, the best defense HLF has been able to muster has been to put a video of CEO Mike Johnson on its IR webpage defending the company broadly, and to schedule an investors’ day two weeks later, for 01/10/2013 in New York to address Ackman’s accusations in detail. The company has hired an impressive team of advisors. While most would have expected Bank of America/Merrill Lynch to get the assignment given their execution of last spring’s $400mm share repurchase, the task has been given to Moelis & Company, a well regarded, Los Angeles-based boutique investment banking firm. The firm’s namesake, Ken Moelis, is a disciple of Mike Milken from the height of Drexel Burnham’s power in the mid-1980’s. Moelis went on to a successful career at DLJ and UBS, where he became the premier investment banker to the casino gaming world, before launching his own shop.

Additionally, Herbalife has reportedly hired Boies, Shiller & Flexner the law firm founded by famed litigator David Boies. Consider Boies’ HLF team to be the Navy Seals Team 6 of litigation – you really don’t want them on the other side of your war. Note, I have no evidence that Bill Ackman is related to Osama bin Laden, and thus worthy of being targeted by DEVGRU (figuratively speaking, of course).

HLF promises a detailed rebuttal of the Ackman allegations on 01/10/2013, and I expect it will blow away the skeptics with a point-by-point dissection of Ackman’s claims. I presume Boies was brought on to bring suit against Ackman for some combination of libel, slander, defamation, tortuous interference and other imaginative causes of action. No matter how this turns out, the discovery, depositions and testimony should be highly enlightening and probably quite entertaining.

HLF’s DIRT CHEAP VALUATION:  So now, how might one value the shares of HLF in the bull case where Ackman is convincingly discredited by HLF CEO Johnson (a singular American bad-ass, according to my sources who know him personally here in L.A.) on 01/10/2013, and the market no longer ascribes risk to the feared FTC intervention (if I hear “headline risk” one more time …). EBITDA is a preferred valuation metric for a company like HLF that doesn’t have heavy capital expenditure requirements, and converts much of its reported earnings to cash that can be distributed as dividends or used to repurchase shares. Herbalife will produce over $725mm of earnings before interest, depreciation, and amortization (EBITDA) this year, a growth-stock worthy increase from $634mm in 2011 and $480mm in 2010. The few analysts that cover the stock project $800mm in 2013. Think of HLF’s gushing cash flow this way – HLF is printing EBITDA of over $2mm/day. That’s a heck of a lotta cheese with which to fight Ackman, who has and will be spending his own and his investors’ money on litigation and other matters (which won’t bother his limited partners until the stock is going up on a daily basis). HLF is lightly leveraged, with $500mm of bank debt, and quite liquid with $700mm of unused borrowing capacity and $300mm of cash. HLF currently pays $1.20/share in dividends annually on its ~108 million shares outstanding.

In the absence of controversy, the market would typically accord a fast growing, capital efficient company such as HLF a premium multiple. Let’s just assume the S&P 500 index current multiple of 8x EBITDA. This would yield a total enterprise value of 8x $725 of EBITDA = $5.8B. Deducting ~$500 million of debt, but giving credit for $150 of the cash (that is excess to the operating needs of the business), would yield a total equity value of $5.45B, which divided by the 108mm shares works out to $50.46/share. The current price of ~$30/share implies an EBITDA multiple of 4.7x. Tupperware, which is a MLM free from controversy, trades at 9.3x EBITDA, and Avon trades slightly higher. At $50/share, the share still would sport a dividend yield of 2.4%. Herbalife should report net income of about $4 per share this year and $4.50 in 2013 (ignoring the massive buyback I see coming). $30/share implies a 2012 P/E multiple of around 7x. The current S&P multiple is about 13x. For a company growing 15%+, you would expect to see a premium multiple, which is why brokerage firm analysts who cover the stock have target prices from $65 to $101. My valuation is lower, but should the Ackman-induced cloud be lifted, I can’t say those targets are absurd.

In fact, between the technical short squeeze that is in the making, the massively accretive impact of a $1B buyback, and the FTC risk fading away, I can’t say that I’d be surprised to see HLF trade back to its old highs of $70/share. If HLF has $500mm of 2013 net income, and buys back 30mm of around 110mm shares, the ultra-low interest rate environment makes the net income impact from interest expense miniscule (the HLF 13% EPS yield is 3-4x borrowing costs). Getting over $6/share in EPS is really not that hard to financially engineer, and between the short squeeze, comparable valuations, a below-market 11-12 P/E multiple would take HLF back into the $70s. Indeed, it could turn out even more financially salubrious than even these scenarios.

Ackman’s essentially fired nuclear missiles at HLF’s business model and its legality. When (and not “if”) HLF’s regulators and distributors essentially blow off Ackman’s claims as either old or no news, HLF will for all intents/purposes become bulletproof and battle tested. This may/should garner it a higher valuation than before Einhorn or Ackman ever showed up. That “what if” scenario gets you a $100/share stock price potential (again, only 15x $6-7/share in EPS gets you there; I’m not talking about a NFLX-level valuation here).

This hypothetical rally toward triple digits is not farfetched. In the event of a self-tender by HLF, or even without one, should the large institutional shareholders proactively remove their shares from the stock loan supply, there is great potential for short sellers being forced to cover as the borrow dries up. A panic to the upside could occur as the shorts are forced to buy in 25 million shares in a market unable to induce that many sellers. I am sure HLF and its capable teams of advisors are looking at the myriad of options to create value out of the chaos caused by this spectacular bear raid. Indeed, it does not take great imagination to see what could make these numbers dance.

In addition, Ackman has no shortage of enemies from my own polling of the audience. The odds favor Herbalife in this aspect of the battle. Ackman truly went all-in telling the world he has shorted ~20% of a relatively unlevered company trading at ~4x EBITDA.

BUT WHAT IF ACKMAN IS RIGHT?  His target price of zero implies the company is shut down globally, not just here in the US, which comprises only 20% of HLF’s global revenue. Is it possible? I guess so, but in my view no more than a very slim probability. More probable, in the unlikely case the FTC responds to Ackman’s presentation and reopens the same issues they have been policing for 32 years in the case of HLF, it is possible that the company could be forced to change some elements of how it conducts business in the US, and maybe elsewhere, leading to lower sales and margins. No doubt this would spook the market with fears that there was even more scrutiny to come, leading the market to value Herbalife at a discounted multiple on reduced earnings.
So let’s take a cut at that. Let’s say the FTC somehow compels business practice changes that reduce sales by 20% and lead to current pre-tax margins contracting by 25%. This would yield EBITDA of approximately $450mm, which at 5x would yield a share price of $17. Personally, I think there is about a 10% chance of this outcome. So weighting a 10% chance of $17/share, and a 90% chance of $50/share, I come up with a fair value of $47/share, which is why I own a boatload of shares purchased into the panic created by the bear raid. In fact, there is far more likelihood of another LBO of HLF (Golden Gate/Whitney stole it the first time around) than any other “headline risk.”

Ackman took his shot; now it is HLF’s turn.