Herbalife Forced to Retool After FTC Review Sought by Ackman

Bloomberg News/July 15, 2016

By David McLaughlin and Matthew Townsend

Herbalife Ltd. agreed to pay $200 million and make sweeping changes to its business to settle U.S. claims that the nutrition company deceived consumers with get-rich-quick promises.

The U.S. Federal Trade Commission stopped short of hedge fund manager Bill Ackman’s call to declare Herbalife a pyramid scheme and to shut it down, but it described the company’s business in harshly critical terms and said it must restructure and stop misrepresenting how much money its members are likely to make.

Herbalife claimed that people could quit their jobs and earn thousands of dollars a month by selling its shakes and nutritional supplements even though the vast majority earned little or no money. These practices caused “substantial economic injury,” the agency said in a statement Friday.

‘An Illusion’

At a news conference, FTC Chairwoman Edith Ramirez wouldn’t call Herbalife a pyramid scheme but also wouldn’t say that it wasn’t one. “Our focus isn’t on the label,” she said.

“The company promised people a dream: a chance to change their lives, quit their jobs and gain financial freedom,” Ramirez said. But that dream “was an illusion,” she said.

Investors cheered the settlement, bidding up Herbalife’s shares 9.9 percent to close at $65.25 in New York. But the agreement’s long-term effect on Herbalife’s results and recruiting are unclear. The FTC is forcing changes that could make it more difficult for distributors to make money. Herbalife will have to depend on retail sales, which are to be verified by receipts, instead of bulk purchases by members.

“They will have to demonstrate retail sales,” said Tim Ramey, an analyst for Pivotal Research Group. Ramey is one of the few analysts still covering Herbalife and has defended the company throughout Ackman’s onslaught. “I don’t think Herbalife would have agreed to a deal they couldn’t do. But the proof is in the pudding.”

Herbalife remained confident. “The settlements are an acknowledgment that our business model is sound,” Herbalife’s chairman and chief executive officer, Michael O. Johnson, said in a written statement.

Ackman’s Pershing Square Capital Management spent more than $50 million on a public campaign to expose Herbalife as a pyramid scheme and make good on his $1 billion bet against its shares. The attempted takedown has captivated Wall Street since December 2012 when Ackman presented his thesis at an investor conference. He would later say the company was a fraud on the scale of Enron Corp. All the while, Herbalife defended itself.

Pershing Square said in a statement that the FTC’s “findings constitute a pyramid scheme.”

“We expect that once Herbalife’s business restructuring is fully implemented, these fundamental structural changes will cause the pyramid to collapse” as distributors and their recruits “quit the business,” it said.

The FTC’s statement backed up many of Ackman’s claims. It said that the business was driven by member recruitment more than retail sales; that the company’s distributors misrepresent how much money new members can make; that a large number of its members lose money; and that the company doesn’t adequately disclose the risks of membership.

The agency also said the multi-level marketing company’s compensation structure was “unfair” because it rewards distributors for recruiting others to join and purchase products in order to advance in the marketing program “rather than in response to actual retail demand for the product.”

Herbalife’s Defense

Herbalife has said there is real demand, although it hasn’t provided much proof. The company sells products to its distributors and says that after that it can’t be sure what happens. It has instead pointed to surveys that it paid for showing it had almost 8 million customers in the U.S.

In its complaint, the FTC said that the small minority of distributors who do make a lot of money are compensated for recruiting new distributors, regardless of whether those recruits can sell the products they are encouraged to buy from Herbalife. After realizing they can’t make money, they abandon the business opportunity in large numbers. Nearly half the Herbalife distributor base quits in any given year, the FTC said.

The settlement affects only Herbalife’s practices in the U.S., where 80 percent of sales will have to be from “real sales to real users,” Ramirez said. The $200 million will go to compensate consumers.

Icahn vs. Ackman

As Ackman railed against the company, he squared off against billionaire activist Carl Icahn, who became Herbalife’s biggest shareholder and installed five board members, pitting both his money and inner circle against Ackman’s effort to bring down the nutrition company. Short sellers like Ackman aim to profit from a declining stock by borrowing shares, selling them and then buying them back at a lower price.

Icahn declared victory on Friday. “Simply stated, the shorts have been completely wrong on Herbalife,” he said in a written statement.

Ackman’s campaign continued this week -- Pershing Square released its 18th video on Thursday in a series criticizing the company online. The billionaire, who said early on it was a “certainty” Herbalife was a pyramid scheme, took extraordinary measures to influence the outcome, including hiring investigators to dig into Herbalife’s operations and producing videos of unhappy distributors.

“This is the highest conviction I’ve ever had about any investment I’ve ever made,” Ackman said in 2012.

The dispute boiled down to whether there is legitimate demand for Herbalife’s weight-loss shakes and supplements by actual consumers, which is the FTC’s test for a pyramid scheme. Ackman said there isn’t such demand. He says the company’s revenue is derived from sales goals it sets for independent contractors who must buy products from the company. Few of the contractors achieve those goals, Ackman contends.

Independent Contractors

Herbalife products aren’t sold in traditional stores. They’re distributed by independent contractors who market to family, friends, neighbors and just about any stranger they come across, typically in that order.

The distributors can make money by buying products at a discount and selling them at a markup. The bigger payoff comes when distributors broaden their reach by recruiting, training and coaching a “downline” sales team that sells products to friends, neighbors and strangers and then earn royalties and bonuses from those sales.

Also on Friday, Herbalife said it had appointed Jonathan Leibowitz, a former FTC chairman who is now a partner at the law firm Davis, Polk and Wardell LLP, as an adviser.

(A previous version of this story was corrected to reflect Leibowitz’s role as an adviser.)

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