The fate of the stock of the nutritional supplements company Herbalife may lie not in the hands of two warring hedge fund managers but rather in the purview of various government agencies.
The hedge funds managers, William A. Ackman and Daniel S. Loeb, have recently proclaimed diametrically opposite positions about the propriety of Herbalife’s operations. Mr. Ackman accused Herbalife of being “the best-managed pyramid scheme in the history of the world.” In a detailed presentation assailing the company last month, he even referenced a more powerful image in assailing how Herbalife operates by invoking one of the most dreaded terms around – Ponzi scheme.
Unfortunately, “Ponzi scheme” is not subject to any clear definition, and has been used to describe a variety of programs, including Social Security. Herbalife does not appear to fit the classic Ponzi scheme mold because it is not primarily repaying old investors who were promised outsize returns with money from new investors or secretly diverting money to the perpetrators.
DealBook reported that the Securities and Exchange Commission’s enforcement division has opened a preliminary inquiry into the company, which said it was cooperating. The investigation could prove to be a significant distraction for Herbalife because it is likely to cover a wide range of issues.
Another question that has been posed about Herablife is whether it operates a pyramid scheme – which involves selling a product through distributors who primarily make their money from recruiting others and getting a slice of their earnings. Because it depends on an ever-expanding group of new distributors, illegal schemes collapse once the source of new recruits runs dry.
Regardless of whether Herbalife can be fairly described as a pyramid scheme, or even a Ponzi scheme, this is the type of language that draws the attention of the S.E.C.
The agency is still smarting over its failure to uncover the extensive fraud perpetrated by Bernard L. Madoff, so the disclosure of that agency’s investigation is hardly surprising.
While the S.E.C. will look at Herbalife’s sales practices to make sure it is not a Ponzi or pyramid scheme, the more likely focus will be on the financial statements and management’s disclosures about how it generates revenue. KPMG is Herbalife’s outside auditor, and it has given the company clean audit opinions, but that does not preclude an investigation into the propriety of its accounting policies.
Herbalife disclosed in its most recent annual report that it runs the risk of being found to operate as a pyramid scheme, and in 2011, a Belgian court even found that it was one. The company has already acknowledged the potential for crossing the line into illegality, which makes it harder for a government agency to conclude that its disclosures on the topic are inadequate.
The S.E.C. could also investigate on a number of different fronts, including whether any outside investors, like hedge fund managers, might have acted improperly by trying to manipulate the company’s stock price by disclosing false or misleading information.
It is common for companies under attack from short-sellers to complain to the S.E.C. that false information has been released in an effort to drive down their stock price. The Securities Exchange Act of 1934 states that it is a violation to make statements intended to induce others to buy or sell stock “which was at the time and in the light of the circumstances under which it was made, false or misleading with respect to any material fact, and which he knew or had reasonable ground to believe was so false or misleading.”
The S.E.C. has looked into allegations of market manipulation lodged against short-sellers. For example, in September 2008, at the height of the financial crisis, it issued a public statement about a “sweeping expansion” of its investigation of possible manipulation of the stock of financial firms through the spread of false rumors.
As is often the case, however, nothing ever came of that investigation. It is difficult to prove the intent to manipulate stock prices, or that opinions about a company were false or misleading.
Mr. Ackman’s presentation about Herbalife began with a detailed legal disclaimer telling investors that they should not rely on his statements — an effort to avoid being accused of misleading others. But the fact that he has publicly attacked the company will not insulate him from S.E.C. scrutiny if Hebalife raises credible claims of possible market manipulation.
While the S.E.C. investigation will be a distraction to Herbalife, the agency cannot take direct action to shut down operations. The question of whether the company’s business model harms consumers falls to the Federal Trade Commission, which has the potential to be a much greater threat to Herbalife if it decides to investigate.
As Steven M. Davidoff wrote in a Deal Professor column, the real goal of Mr. Ackman’s detailed presentation appears to be to get the attention of the F.T.C. If his arguments about a pyramid scheme leads to an investigation by that agency, then it could cause serious damage to Herbalife’s stock price, making his short position even more valuable.
In the interest of full disclosure, companies typically have to reveal in financial reports filed with the S.E.C. the existence of a government agency’s investigation. However, corporations often try to spin such inquiries as merely “preliminary” while pledging their full cooperation.
Government agencies usually refuse to even confirm the existence of an investigation, which means that the investors can only rely on the smattering of information provided by the companies.
It would be difficult for Herbalife to play down any F.T.C. investigation because the market is likely to interpret it as supporting Mr. Ackman’s claim that the company is a pyramid scheme.
If the F.T.C. does start an inquiry, it is not clear that the agency would reach the same conclusion as Mr. Ackman about Herbalife. In addition, any inquiry would take months – and probably years – to sort out. The stock market’s reaction to such a disclosure, however, will be much more immediate, and I expect quite negative to Herbalife’s shares.
The hedge funds fighting over Herbalife are unlikely to wait around to see how an investigation might conclude, so any quick hit to the company’s stock price is much more important for them. In the push and pull of investor sentiment over Hebalife, the key may well be whether the F.T.C. decides to investigate the company’s operations.