Mere Puffery or Misleading Promises: How Much of a Scandal Is Trump University for the New York Public?

This article was written by +Kevin Thompson in collaboration with our stellar intern, Amber Lovelady.

Trump - Schneiderman | MLM law

In August, New York Attorney General Erick Schneiderman filed a $40 million lawsuit against Donald Trump for falsely promising as many as 5,000 students a successful real estate career if they enrolled in the unchartered, unlicensed Trump University. Schneiderman alleges that Trump engaged in “deceptive and unlawful practices,” including falsely representing the legitimacy of the school and false advertising in the newspaper and mail. People attended his one free class off those advertisements which led many of them into attending a $1495 three-day seminar, which enticed them into spending from $10,000 to $35,000 into higher-level Trump University programs. At the end, Schneiderman claims these experiences fell way short of teaching participants everything they needed to know about becoming billionaires. Several students are now mile high in debt, without jobs, and quite mad. According to the AG, dozens of attendees have complained to authorities all over the country about what they believed to be a scam.

 

Personal Responsibility?

But was it really illegal? According to Trump, not everyone who participated in these opportunities is as disgruntled as Schneiderman asserts. Trump declares that more than 10,000 students praise the program and 98% of those students in a survey checked excellent to describe their experience. Further, Trump believes Schneiderman is using this suit as a publicity stunt for public office. “They meet on Thursday evening – I get sued by this AG Schneiderman… Saturday at one o’clock,” Trump said. “Think of it. What government in the history of this country has ever brought a suit on Saturday? I never heard of such a thing.”

He’s got a point on the lawsuit being filed on Saturday. It adds a strange element to an already strange matter.

Marketing Claims

Although there are many things Schneiderman alleges in the lawsuit, I find that this case really hinges on the motivation leading people to attend the classes. What were they hoping to gain? Were their expectations consistent with the marketing message?

How were they convinced? Schneiderman suggests it started with false advertisements. In New York, the test for false advertising is whether representations or omissions are “likely to mislead the reasonable consumer from acting reasonably under the circumstances.” Just for the record, this is pretty consistent with the Federal Trade Commissions definition of “false and misleading.” What was misleading? Some of the false advertisements Schneiderman alleges are:

  • Trump claimed he could “turn anyone into a successful real estate investor” and that students would learn “a systematic method for investing in real estate that anyone could use effective” even though dozens of students were unable to finish one real estate transaction.
  • Trump claimed he would “share [his] techniques, which took [his] entire career to develop” when the President of the University, Michael Sexton, could not describe any Donald Trump techniques taught at the university.

Really?

But really, was this misleading to the average American? When you’re watching a commercial where a bikini model vows that you’ll look just like her after a six week, $10 video series, do you buy it? Most of us don’t because we know it’s part of a sales pitch, mere puffery. And for those who do buy it, they know that it’s their hard work with the content that will bring them success. Of course a $10 investment is significantly less than a $35,000 one, but the principle remains. It’s ill-advised, in my opinion, to judge a program based on how customers leverage the content in their spare time. It’s a problem faced in the network marketing industry. Companies get routinely clobbered based on the low success rate of participants. But is that indicative of a bad program, bad product, bad culture…or could it simply be attributed to laziness? It’s hard to pin-point the root cause of failure.

Reasonable Expectations

A reasonable person understands that success takes effort…and lot’s of it. In this case, it was not unreasonable for a person to believe that Donald Trump and his trusted instructors could provide a foundation for real estate investing. It is completely unreasonable, however, for a person to believe that Trump could transform them into a real estate tycoon.

Conclusion

If you sell any kind of informational product, the odds of litigation go up. Consumers can always say “it’s crap, it never worked for me” and you’re unable to fall back on objective metrics like patents, science, etc. It’s one of the reasons why Amway tightened the screws on its tool systems several years ago. Since many consumers were complaining that the information was poorly crafted for their Amway businesses, Amway got more involved with quality-control.

Network marketing companies that sell informational products have it more difficult because the exposure is two-fold: consumers can say the information was ineffective AND they can say they bought the information JUST TO PARTICIPATE IN THE COMPENSATION PLAN. And the latter reason opens the door up for pyramid scheme allegations.

This lawsuit filed by New York is along the same vein as the lawsuits filed by disgruntled college graduates filed against their universities. They were sold a bill of goods, they graduated, they’re jobless. Who’s to blame? And actually, this lawsuit is of the lesser sort because it’s not the disgruntled consumers filing the lawsuit, it’s the government claiming to protect the little guy incapable of protecting him or herself.

Predictions

This case will settle on the eve of trial. Contrary to what the AG is saying, it’s not about the consumers. I do think it’s really about PR for him and a little grand-standing. With that in mind, the AG will settle for a reduced amount, take the favorable PR, Trump will claim a moral victory and the parties will go their separate ways.

If you learned something new in this article, please share.

If you’re reading this via email, please click this link to download the lawsuit filed against Trump University.

Update on the Fortune Hi Tech Case – FTC Passes on Scalpel, Goes for Sledgehammer

As a refresher, in early February of 2013, the FTC got an injunction issued against Fortune Hi Tech Marketing. The summary of the lawsuit can be found here: FTC vs. Fortune Hi Tech.

FTC’s Strategy

FTC passes on the scalpel and picks up the sledgehammer.

FTC passes on the scalpel and picks up the sledgehammer.

Since the lawsuit was filed, I’ve had a lot of time to study the FTC’s arguments against FHTM. In particular, I closely studied the FTC’s expert report prepared by Dr. Peter Vander Nat. The FTC’s entire case hinges on the validity of Peter Vander Nat’s report.

In the lawsuit, the FTC passed for the scalpel and picked up the sledgehammer. In summary, they’re no longer relying on Vander Nat’s convoluted math formula, which I discussed in my last article regarding the FTC’s economist. If you’re following the news with Herbalife, I think you’ll find this next point interesting. Currently, there’s a lot of bickering back and forth between MLM proponents and critics alike over the interpretation of Vander Nat’s formula. People are discussing how Herbalife stacks up to the standard. With one word, I can put the entire debate to rest for both sides.

Are you ready for it?

The word is:

IRRELEVANT

The formula is irrelevant. In Vander Nat’s lengthy declaration used against Fortune Hi Tech, the formula is never mentioned. Not once. Why? The answer is obvious. The FTC is distancing itself from it because the formula is too broad and too confusing. The FTC’s case against BurnLounge (sued in 2006) is jeopardized due to the ambiguity of this standard. The case is currently under appeal. The main source of contention: Vander Nat’s qualification as an expert. Vander Nat had never studied an MLM that he concluded was legal. Where’s the fairness in using an objective standard to measure right from wrong when you never find anything right? There’s no wisdom in designing a water-filter if there’s no opportunity for water to pass through.

Sledgehammer

In his declaration, Vander Nat opines and argues that FHTM was operating as an illegal pyramid scheme. Instead of relying on his formula, he bases his finding on a few assumptions. Those assumptions are all addressed in Charles King’s declaration (available below). Dr. King was retained by FHTM as its expert in their effort to dissolve the injunction. Out of Vander Nat’s assumptions, there’s one that should be concerning for all people in the network marketing industry: commissions triggered via internal consumption are “recruitment bonuses.” In other words, rewards triggered via distributor consumption are illegal. This argument represents a dangerous and irresponsible strategy employed by the FTC. In one of the footnotes in his declaration, Vander Nat writes, “…I also understand that the ultimate users of the products – for purposes of the Koscot test – are people who are not participants in the business venture.” With this framework, he pulls out all revenue garnered from distributor consumption. He then compares the money left over (not much) with the money paid out in bonuses. He then concludes that the pay plan is underfunded and relies on “recruitment bonuses” to survive. Charles King sums it nicely when he writes:

Since Vander Nat is not counting commissions generated via internal consumption, it creates the impression that the plan lacks sufficient revenue from product sales to support the commissions. He treats the difference between revenue available for commissions and the amounts paid as recruitment bonuses. Using his own definition of “end user,” he’s able to dramatically shrink the commission pot; thus, creating the false impression that the Commission Plan is insufficient and underfunded.

Optimal Scenario

Vander Nat also relies on an economic theory known as “Optimal Scenario.” Using the Optimal Scenario framework, Vander Nat assumes that if EVERYONE were to hit the high levels in the FHTM business, the plan would be underfunded. The reality: not everyone hits the levels nor does everyone try. While Vander Nat acknowledges that breakage exists (money in the plan from un-earned commissions), he ignores it completely. In network marketing, the participants operate with various goals. There are some that want to earn a few hundred dollars a month, some do it for social reasons, some want to save money on product, some are supporting a friend or relative, etc. They’re not all trying to “max out” the pay plan. This assumption was faulty and led to a faulty conclusion.

What does all of this mean?

Change is coming. Stay tuned. In 2004, the FTC said that the amount of internal consumption is inconsequential for pyramid scheme analysis. Based on their recent case against FHTM and various posts on their website, the FTC appears to be back-tracking. It’s going to take strong leadership to steer this conversation in a favorable direction for the industry. And strong leadership requires that we at least acknowledge the areas where we’re weak. Cultures of hype need to stop. Product value matters. Without question, the industry is going to look different within 18 months. How different? We’ll see.

If you’re reading this via email, click this link to review the declaration prepared by Charles King.

CNBC Interview With Herb Greenberg

Kevin Thompson, MLM Attorney, and Herb Greenberg

As most of you know, Herb Greenberg prepared a story about Herbalife for CNBC. The 20 minute documentary was titled Selling the American Dream. Herb worked for a very long time on the story, interviewing several people all throughout the country. I was interviewed by Herb in the CNBC studio in July of 2012. If you blink in the video, you miss me. I was only on for about 10 seconds, right around the 16 minute mark.

While Herb was working on the story for over a year, the catalyst for CNBC airing the story was the saga between Bill Ackman and Herbalife. There’s a great guest post on my site about the impact (or lack thereof) of Ackman’s Bear Raid on Herbalife.

Personal Views on Greenberg

He’s a very pleasant person. And he’s very intelligent, surrounded with a great staff of people. And unlike a lot of MLM critics, he actually gives a little airtime to BOTH sides of the agrement. While he certainly favors the negative side by providing links to MLM critics, he at least tries to inject some pro-industry commentary. I believe he’s spoken with the DSA, he interviewed Herbalife’s CEO and he also interviewed me. He dove deep and did his homework. In his own words, “After 10 months of independently digging into Herbalife and the industry, culminating with the CNBC documentary, “Selling the American Dream,” I can say with a fair degree of certainty: Multi-level marketing, which has been dogged by the same legal questions and controversies for 65 years, needs to be cleaned up.”

While not everyone shares this view with me, particularly leaders in the DSA, I actually agree with Herb on the need for change. I’ve written in the past about the MLM industry’s problem with self deception. Burying our faces in piles of money, pretending there’s not a problem is a sure path to irrelevancy. Paying commissions on internal consumption is fine. But we need to create better standards to alleviate the growing problem of “opportunity driven demand.” Opportunity driven demand exists when people purchase products they never would buy at prices they never would pay with the expectation of recovering their “investment” by recruiting additional participants (to repeat the cycle).

There needs to be legitimate value in the products and services changing hands. The popular sentiment that “all pay plans driven by product volume are legal” falls short of common sense and fails to account for opportunity driven demand. Under the influence of a pay plan, people will literally pay $1,000 for an ounce of lemonade. If you drive a pay plan from such sales, is it legal? Of course not. It’s this distinction that’s leading to so much confusion on Wall Street. We can attack the short sellers for manipulating the market. But really, they’re just exploiting the ambiguity in the law. And until the law is cleaner, it’ll keep happening whether at the hands of short sellers, class action attorneys, regulators, FTC, whoever.

My role in Herb’s story was simple: I was to discuss the laws in place distinguishing legitimate MLMs from illegitimate pyramids. While we discussed a lot of the positives in the industry, there’s none of that content that made the final cut. I’m not complaining. I’ll take the exposure when I can get it. But I’m just letting you know, I tried. The interview was an intense thirty minutes. The questions came at me rapid-fire the moment I hit the seat. It was fun.

Greenberg’s View on MLM

If you’re not able to tell by reading Herb’s stories about Herbalife and the MLM industry in general, he has a bad taste in his mouth. Intellectually, he’s not able to really “feel” and understand the benefits of the distribution channel. In an article Herb Greenberg posted on LinkedIn, he extends his focus away from Herbalife and discusses the potential challenges facing the entire industry. In his view, he predicts some regulatory activity against some of the larger companies. This would, in turn, trickle down and affect the smaller companies. While Herb senses a disturbance in the industry, he’s not able to put his finger on it. In his mind, it makes no sense for people to buy an arguably inferior product via MLM. This rationale assumes that the product is inferior and discounts the benefit of joining a community of people that share a common goal. In Herbalife, that common goal is weight loss and nutrition. Notorious short seller, John Hempton, summarized it well when he said,” Herbalife works in the same way as alcoholics anonymous – by supplying (and in this case selling) a support group to help you kick the ‘fat addiction’.” There’s power (and value) in community.

One thing is certain, as Herbalife’s stock continues to climb, Ackman will get desperate and start lobbying Congress (if he has not done so already). Will he be able to get the regulation he needs to save him from a stupid bet? It’s unlikely. And even if regulation does come, it’ll likely affect the smaller MLMs significantly more than companies like Herbalife. In my opinion, Ackman’s prayer for a government savior will go unanswered.

Conclusion, Lessons Learned and Special Thanks

I learned a lot from this experience. First, if someone with a platform invites you to participate in a conversation, show up. There seems to be this fear of the media by professionals in the industry. While there’s certainly the potential for bad, the upside outweighs the risk. We need more professionals willing to put their necks out there, communicating the benefits of the model. Second, the critics are becoming more organized. The internet is sticky and their content is spreading. The critics are getting in the ear of hedge fund managers, investment bankers, journalists and politicians. They’re like like Agent Smith in the movie The Matrix. If you’re not a tech nerd like myself, Agent Smith was like a computer virus, hell bent on destroying the very program that gave him life.

I want to extend a special thanks to Len Clements of MarketWave. Len is a great friend, and someone I trust very much. He took the time to help me prepare for the kinds of questions that are common from people skeptical of the model. His insight was key. I also want to thank my partner’s wife and Thompson Burton litigator, Melissa Burton. She literally reviewed my notes beat me up for over an hour on the issues. She has a good mind for poking holes in arguments and was invaluable for my preparation.

I’ve included some pictures below from my trip to New York. It’s such a fun place. My wife and I got a babysitter and left the three kids at home for a few days. I hope you enjoy the pictures.

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.

MonaVie Drops Its Lawsuit Against Licciardi Within a Month

Within days of MonaVie’s embarrassing loss in Utah District Court, MonaVie dismisses its lawsuit against former distributor Joe Licciardi. While it might certainly be embarrassing, I think MonaVie is making a smart decision on this one.

In summary, MonaVie sued its former Black Diamond distributor, Joe Licciardi, for soliciting members in his downline for Momentis, another MLM. Click this link to see MonaVie’s lawsuit against Joe Licciardi. The lawsuit is an easy read. Basically, MonaVie went after Joe for violating the non-solicitation provision in the Policies and Procedures. The lawsuit centered on Joe’s use of his Facebook account to solicit people into his Momentis business. Momentis is an MLM that sells utility services i.e. energy.

MonaVie’s non-solicitation policy, arguably one of the more restrictive non-solicitations in the industry, states:

Nonsolicitation during Agreement. You are free to participate in other direct selling, multilevel, or network marketing business ventures or marketing opportunities (collectively “Network Marketing”). However, . . . during the term of this Agreement, you shall not [solicit] . . . other MonaVie Distributors or Customers to any other Network Marketing business, other than those you have personally sponsored. This includes general solicitations on your social networking site where your “friends” include persons not personally Sponsored by you and who are Distributors. It also includes merely mentioning your participation in another Network Marketing Business.

Emphasis mine.

MonaVie argued that Joe initially created his Facebook account to attract and recruit MonaVie distributors. While he was building MonaVie, he built up a following on Facebook. As expected, Joe’s Facebook following was a mix of personally enrolled reps and non-personals. When he flipped the switch and allegedly started using the same account to promote Momentis, MonaVie sent him a notice to stop. When Joe failed to stop, MonaVie sent him a lawsuit.

MonaVie requested a Temporary Restraining Order (“TRO”). A TRO is a temporary injunction given in extreme cases, usually when the monetary damages can be severe without the injunction.

What’s an injunction? An injunction is a court order that requires a party to do or refrain from doing specific things i.e. “stop soliciting,” or “stop making that product,” etc.

As MonaVie learned in this case, TROs are VERY hard to win. Whenever someone is precluded from doing something BEFORE a full hearing, it’s a big deal. There are several lessons to learn from this case:

Proof

If a company is going to request a TRO, they need more proof than a single email and a few status updates on a freaking Facebook account.

Assess the Harm

Companies really need to assess the harm a distributor poses when he or she leaves. When someone is sued by a large company, their entire livelihood is threatened. It bleeds into their personal lives, impacting their friends and families. If you sue someone, the value needs to exceed the inevitable negative PR backlash. In some cases, it’s absolutely warranted. In this case, was it worth it?

Start Over

As I’ve written in the past, when distributors leave their MLM and join something else, they need to nuke their Facebook account and START OVER! If Joe followed this free advice, he could have saved himself a few dollars and a lot of headache. In the article, I wrote:

Delete your facebook profile and create a new fan page. After leaving a company, it’s wise to delete the old profile and create a new facebook fan page. First, deleting your profile publicly communicates your intentions of honoring the agreement, which will be important in the event of a dispute. Second, it eliminates the likelihood of error. Again, one update on your facebook profile can be hazardous. In the future, segment your “friends” in your personal profile, separating friends and family from your MLM promotional efforts. Regarding the fan page, fan pages are one directional….people “Like” the fan page if they desire to receive information from the individual (or brand). They’re “opting-in” to receive information, which undermines any argument that the leader is specifically targeting members from the downline.

Do Not Misinterpret!

This case does NOT mean that distributors can use Facebook and remain in compliance with any non-solicitation obligations. On the contrary, if this case had gone the distance, I would argue that MonaVie had the upper hand. But as I’ve said before, TROs are only awarded in extreme cases. This was not such a case. Just because MonaVie lost the TRO battle does not mean it was set to lose the war.

The Open Door Policy is No More…In Fact, It Never Was

In so many words, Randy Schroeder, President of MonaVie, has indicated that the Open Door Policy is not a sustainable policy. But his recent statement assumes an incorrect fact: that the policy even existed in the first place. If it was sincere, why did MonaVie keep its restrictive covenants in its policies i.e. the noncompete and the non-solicitation clauses? In my opinion, if Dallin could go back in time, he’d delete that silly post. As a MLM lawyer that represents numerous companies, those restrictive covenants are important and valuable for a number of reasons. Leaving them out of the Policies is foolish. Leaving them in while at the same time admonishing them is weird.

See below for a copy of the dismissal. One of two things could have happened: (1) Both parties settled the dispute; or (2) MonaVie realized that it’s not worth it and voluntarily dropped it. If you learned something in this post, please be so kind and hit the +1 button or Like button above.

MLM Sales Tax

In this three minute video, I answer the following questions about MLM sales taxes:

  • When is a company obligated to collect and pay sales taxes? 
  • Why are distributors taxed based off the suggested retail price instead of the price they actually pay (wholesale)? 
  • Are all dot coms exempt from collecting and paying sales taxes?   

I hope you find the video informative.  Also, since I’m not a tax professional, I thought now would be a good opportunity to introduce you all to Joe Craft.  Joe is a MLM Accountant and owns Craft Financial Solutions, LLC.  He’s a CPA that understands the industry very well.  He has also been a speaker at our MLM Startup conference, the Direct Selling Edge. If you have more questions about taxes, he’s the man to contact.

Joe Craft

Good job, Kevin. I think your summary in the video is great. It’s important for all direct selling companies to be aware of their obligations concerning sales taxes. There are nearly 8,000 jurisdictions in the United States that impose a sales tax.  The issues are very complex.  The companies need to determine if they’re “retailers,” they need to be aware of the various registration procedures, they need to determine if their products are exempt from sales taxes in certain states, they certainly need to be familiar with the tax rates and they also need to understand the filing requirements for each jurisdiction. If one of your readers want to schedule a free consultation, they can reach me by email at: [email protected]

Google to Settle with U.S. Government for $500 Million

Google has been ordered to fork over $500 million pursuant to a settlement with U.S. government regulators. As reported in the NY Times: “Regulators announced today that Google will pay $500 million to settle government charges that it has illegally shown ads for pharmacies that operate outside the law…” The U.S. government alleged that Google was complicit in allowing drug companies in Canada sell drugs illegally into the U.S.

This is significant for a few reasons:

1) This represents the largest financial forfeiture penalty in history.

2) Big pharma is incredibly powerful and their weapon of choice is NOT fair competition: it’s the Department of Justice and the Food and Drug Administration.

3) When fighting with the government, it’s never a fair fight. If Google can’t win, you can’t win.

4) The government always shoots first and aims second. As the market evolves and technology changes how we connect and communicate, regulators will always be one step behind operating with intense skepticism. How can they reasonably expect Google to control how its platform gets used? Are they going to regulate AT&T on what gets discussed over the telephones? Where does the line get drawn? Platforms will always be used imperfectly because they’re used by imperfect people.

I obviously have some serious concerns with this news. What are your thoughts?

Update, from the DOJ press release:

According to Deputy Attorney General James M. Cole; Peter F. Neronha, U.S. Attorney for the District of Rhode Island; and Kathleen Martin-Weis, Acting Director of the U.S. Food and Drug Administration’s Office of Criminal Investigations (FDA/OCI), this forfeiture is one of the largest ever in the United States, and represents “the gross revenue received by Google as a result of Canadian pharmacies advertising through Google’s AdWords program, plus gross revenue made by Canadian pharmacies from their sales to U.S. consumers.”

“The Department of Justice will continue to hold accountable companies who in their bid for profits violate federal law and put at risk the health and safety of American consumers,” said Deputy Attorney General Cole. “This settlement ensures that Google will reform its improper advertising practices with regard to these pharmacies while paying one of the largest financial forfeiture penalties in history.”

U.S. Attorney Neronha, added that this settlement was about taking a significant step forward in limiting the ability of rogue on-line pharmacies from reaching U.S. consumers, by compelling Google to change its behavior,” and that this kind of forfeiture “will not only get Google’s attention, but the attention of all those who contribute to America’s pill problem.”

Edge Conference!

Edge Conference

Get ready for the Direct Selling Edge conference!

It’s official! If you’re someone thinking about launching an MLM and you’re intimidated with the countless details, we’re hosting the Direct Selling Edge conference designed to provide as MUCH information as possible. Professionals from multiple disciplines in the industry are coming together to educate soon-to-be MLM and Party Plan business owners. Attendees are set to receive over 20 hours of education from top notch industry professionals. After adding up the hourly rates, attendees are walking away with well over $5,000 worth of consultation. The cost of a ticket: $199. And if someone feels they were ripped off, they get their money back, no questions asked. There’s too much money at stake to leave anything to chance. If you’re going to do it, do it right. Details are below! And to learn more about our speakers, visit our hub at: www.directsellingedge.com. Spread the word. +1 us, “Like” us, tweet about us, share us, email about us, post this on facebook and, more importantly, get your seat.

Old School Marketing vs. Relationship Marketing

The market rewards people that add value daily, helping others win. As the CEO of Coca Cola recently said at the Chick-Fil-A Leadercast, “Customers are increasingly basing their decisions on a number of factors that never existed five years ago. They want more empowerment and they want to know that the company is socially responsible.” I agree! Marketing is changing to a more relationships-driven environment fueled by permission. The direct sales has been ahead of this curve for decades. The space is growing substantially and it’s only going to get better.

What are your thoughts?

Photo courtesy of @Kathy Sierra

The End of Class Action Litigation in MLM?

This is an enormous Supreme Court decision for MLM companies. In a 5-4 decision, the Supreme Court held that consumers (distributors) can waive their right to participate in a class action lawsuit. The full article can be found here. The lawsuit was a case between AT&T and Concepcion. In the original lawsuit, Concepcion served as a class representative for consumers against AT&T over a nominal sum of money per consumer: $30. Clearly, $30 is not worth suing over; hence, the purpose behind the class action. But in the fine print in AT&T’s agreement there was a clause where the consumers waived their right to participate in a class action lawsuit and instead were required to arbitrate their disputes. Clever. And apparently enforceable.

This is nothing entirely new for MLM companies. However, it bolsters the argument that all disputes should occur in arbitration instead of aggregating mass numbers and filing a class action lawsuit. There’s a little bit of healthy criticism over the fairness of arbitration proceedings. As stated in the article, “Modern arbitration practices have been the target of watchdog group
Public Citizen for several years. Bills to create an Arbitration Fairness Act were filed in Congress in 2007 and 2010. In a release supporting the 2007 bill, organization president Joan Claybrook blasted the “take it or leave it” forced nature of the clause, the lack of oversight of the process, and supposed bias: ‘…(A)rbitration companies are beholden to big corporate players for repeat business, which creates a bias. They do not bite the hand that feeds them. For example, public data show that in the portfolio of one California arbitrator who ruled in 532 cases, 526 were in favor of business – a mere 1.14 percent for the ordinary consumer.’”

Brian Fitzpatrick, law professor from Vanderbilt, said if the ruling went in favor of AT&T, it would “end class-action litigation in America as we know it.” Given this recent ruling, it just got a lot easier for companies to skim a little here and there from consumers without much threat of consequences aside from a PR backlash. There’s not going to be single agreement now where there’s no class action waiver, which really takes power out of the hands of an aggrieved community, also referred to as a “class.” I have mixed thoughts on this one. What are your thoughts?