Why Short Sellers Want to Crash the Tupperware Party

The New York Times/November 13, 2006
By Charles Duhigg

When the Federal Trade Commission proposed new rules this spring for multilevel marketers — businesses best known for commercials that promise riches selling herbal supplements and beauty supplies — it drew howls of protest. Tupperware party-givers, diet pill vendors and knife salesmen sent the agency more than 15,000 letters complaining that the proposed rules would undo a $30-billion-a-year industry.

Now the regulator has gained an unusual ally: short sellers.

These investors are betting that the stocks of multilevel marketing companies will decline when the new rules, which have received little public attention, go into effect.

For years, companies like Avon Products, Herbalife and Amway have prospered by building armies of part-time sales representatives promoting insurance plans and anti-aging creams. Those representatives, in turn, are encouraged to recruit others and are promised that they will receive a portion of new enlistees’ profits. The companies profit, at least in part, by collecting increased revenue and fees paid by new sales representatives.

In April, citing hundreds of fraud investigations, the F.T.C. proposed new rules for multilevel marketing companies and related businesses. They would require companies to tell potential recruits how many sales representatives have failed to earn more than their start-up costs and how many customers have filed lawsuits for deceptive practices.

The proposal, which may be modified and could take as long as two years before approval, also requires a weeklong waiting period between approaching new sales representatives and sealing the deal.

“These companies provide part-time employment for hundreds of thousands of stay-home moms and people who need to feed their families,” said Doris Wood, an official with the Multi-Level Marketing International Association. “It’s unfair to treat them like criminals.”

Analysts say the companies’ real concern is that the new rules will undermine their ability to attract new sales representatives.

“If companies have to tell recruits that the average income is only $1,400 instead of the $50,000 advertised on their Web site, or that the average salesman only lasts two months, a lot fewer people are going to sign up,” said Mimi Sokolowski, an analyst with Sidoti & Company who follows Tupperware Brands, Nu Skin Enterprises and other publicly traded multilevel marketing companies. She said that if the proposed rules pass without modification, recruitment in the United States could fall by as much as 40 percent.

Which is why short selling investors, who sell borrowed shares of a stock and bet that the price will decline before they must repay the loans, are encouraging the F.T.C. to adopt the new rules.

Since the commission’s proposal, short sales of many publicly traded multilevel marketing companies have increased. Short positions in Avon, Tupperware, Nu Skin, Herbalife, Pre-Paid Legal Service, Mannatech, USNA Health Sciences and Medifast have grown. For instance, the number of Avon shares shorted has increased 44 percent, to 11.3 million, since April. Shorted shares of Tupperware are up 77 percent, to 3.9 million, or roughly 1 in every 15 publicly traded shares.

To understand short sellers’ enthusiasm, consider Pre-Paid Legal, a public company that sells legal insurance through multilevel partnerships.

For about $26 a month, Pre-Paid Legal lets customers consult an affiliate lawyer on legal matters like speeding tickets or writing a will. In 2005, the company’s nearly 500,000 sales representatives brought in revenue exceeding $423 million.

But like many multilevel marketing companies, Pre-Paid Legal suffers from high turnover. In 2005, the company replaced at least 50 percent of its active sales force, according to filings with the Securities and Exchange Commission. Industrywide, multilevel marketing companies typically replace almost all of their sales representatives every year.

Short sellers are betting that the F.T.C.’s proposed rules will make it harder for Pre-Paid Legal to replenish its ranks.

Under the rules, Pre-Paid Legal would have to tell prospects that fewer than a quarter of its sales representatives sold more than one insurance plan in 2005, something it disclosed to investors in a filing with the S.E.C. While Pre-Paid’s Web site tells prospects that if they “market just five memberships per week, you’ll receive $500 per week!” very few representatives have consistently sold five memberships a week.

Pre-Paid Legal’s promotional materials also make little mention of current litigation. But the proposed rules would probably force the company to disclose that in 1997, Pre-Paid Legal acknowledged misleading customers and consented to suspend sales of living trusts after an F.T.C. investigation.

The regulations would also require the company to tell potential sales representatives that last year a Mississippi jury awarded a Pre-Paid customer $9.9 million over claims of deceptive marketing. More than 400 other Mississippi plaintiffs filed suit against Pre-Paid Legal before it reached a settlement this year.

In 2004, over 29 separate lawsuits involving more than 250 plaintiffs were filed against the company in Alabama; all of them were settled or dismissed this year.

In an interview, Pre-Paid Legal’s general counsel, Keri C. Prince, said that as a publicly traded company, it already disclosed all material litigation and average sales representative productivity to the S.E.C.

“Pre-Paid Legal has nothing to hide,” Ms. Prince said. “I think it’s difficult to tell how this proposed rule would impact how many salespeople join our company.”

But Ms. Prince conceded that the proposed rules would have “a big impact on our company and on every other multilevel marketing company within the industry.”

Pre-Paid Legal’s filings to the S.E.C., however, do not mention the risks posed by the F.T.C. proposal.

“We believe any impacts from new rules are 12 to 18 months away, and that Pre-Paid won’t be impacted more than any other multilevel marketing or direct sales company,” Ms. Prince said. “We have determined we don’t have to disclose it.”

Filings by Avon, which had 2005 revenue of $8.1 billion, also make no mention of the proposed rules.

In a statement, an Avon spokesperson said that because the F.T.C.’s rulemaking is in its early stages, the company determined that it was premature to notify investors.

Filings by other multilevel marketing companies, including Tupperware, Herbalife and Nu Skin, disclose the F.T.C.’s proposal, but do not elaborate on potential impacts.

That news heartens short selling investors who have bet that Pre-Paid Legal and other multilevel marketing stocks will decline when investors learn of the proposed rules.

Forty percent of Pre-Paid Legal’s publicly traded shares are currently shorted, according to Bloomberg. Investors believe that the price of those shares, today worth $228 million, will fall over the coming months.

Short sellers were further encouraged on Friday, when Pre-Paid Legal announced that it would use $27.4 million of company funds to repurchase shares owned by top executives.

The company’s stock closed at $43.05 on Friday, up 25 percent in the last six months.

Shares of other multilevel marketing companies have remained relatively constant since the F.T.C. rule was proposed in April, suggesting that average investors are not aware of the proposal, analysts said.

To strengthen their bet, short selling investors have encouraged the agency to adopt the regulations.

In one instance, a lawyer representing an investor who had shorted Pre-Paid Legal’s stock filed documents with the agency urging the rules’ adoption. Without explaining his client’s motivation, the lawyer, Hal Neier, wrote that “Pre-Paid and companies like it provide concrete examples of the very sort of practices that the proposed rule was designed to eradicate.”

Mr. Neier did not return phone calls seeking comment.

The sudden enthusiasm for regulation by some short sellers is an odd reversal of roles. There have been calls for greater regulation of short sellers as companies like Overstock.com and Biovail have sued hedge funds that shorted their stocks. Some prominent short sellers have traveled to Washington to argue against regulation.

“There are some contradictions in short sellers supporting the F.T.C.’s proposal,” Ms. Prince of Pre-Paid Legal said.