Ackman vs. Herbalife: The Pyramid-Scheme Controversy Continues

Is Herbalife (NYSE:HLF) a “well-managed pyramid scheme” or is it simply a multi-level marketing company? Herbalife has firmly contended that it is the latter, releasing a disclosure statement that was meant to show that its method of compensating employees did not align with the characteristics of a fraud. But hedge fund manager Bill Ackman, who took a $1 billion short position on the supplement-maker, responded with a 40-page rebuttal that argued the first case.

A pyramid scheme is defined by the U.S. Federal Bureau of Investigation as a type of marketing and investment fraud in which the “real profit is earned, not by the sale of the product, but by the sale of new distributorships.” Therefore, the amount of money made by Herbalife’s so-called participants from selling the company’s diet shakes and teas, compared to distributorship sales, will be a key metric for regulators in the case of an investigation. The New York Post reported earlier this week that it had received proof that the Federal Trade Commission was investigating Herbalife via a Freedom of Information Act request, but the agency has not confirmed the probe and Herbalife has denied it.

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“Other than the voluntary dialogue with regulators, which we communicated on our January investor day, we are unaware of any other regulatory interest and/or investigation. We are demanding a correction from the NY Post,” said the company in statement posted to its website.

In the disclosure, first seen exclusively by Reuters, the company asserted that 88 percent of its distributors received no payments in 2012, including 71 percent who did not recruit any other distributors. The company also said that 73 percent of its “distributors” joined the company to receive discounts on products. Herbalife President Des Walsh further explained how the business model operated in an interview with the publication. He said that the company was not a pyramid scheme because its distributors did not get paid for recruiting — rather, they are paid for how their recruits perform, taking a cut of sales…

However, the sales data released by Herbalife did not include actual sales figures for Herbalife products or take into account distributors’ expenses like training or advertising costs.

D.A. Davidson analyst Timothy Ramey told Reuters that this admission by Herbalife will “change the math for Ackman.” He added, “Ackman kept including these people in the denominator, representing them as failed businesses. They’re not failed businesses.”

But Ackman hasn’t backed down. He continues to claim that the company is a pyramid scheme and recently outlined a list of queries for Herbalife executives to answer in a questionnaire published on his website. Back in December, he told CNBC that the company uses inflated pricing, misleading sales information, and a complicated incentive structure to hide the scheme.

As he reiterated in the document released on Thursday, Ackman believes that most of the company’s sales come from recruiting rather than retailing. The new disclosure “confirms the material inadequacy of previous” compensation statements, he wrote, asking whether the company felt it necessary to “refund losses of those distributors who were misled.”

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