Herbalife, The Company You Keep

In an odd bit of timing we've been lucky enough to receive two key court filings yesterday related to Herbalife. Yesterday Judge Dale Fischer dismissed a class action securities lawsuit against Herbalife (Awad, et al, order embedded at bottom). The lawsuit hinged on three key elements to establish the alleged securities fraud claims against Herbalife:

1. a material misstatement or omission
2. scienter (intent or knowledge of wrongdoing)
3. loss causation 

Judge Fischer ruled that Awad, et al failed to adequately plead loss causation and thus demurred from ruling explicitly on the merits of material misstatement or scienter. Although his ruling is based solely on loss causation and thus renders misstatement and scienter moot, Judge Fischer's memorandum offered the following additional explanation on the merits of the other two elements:

"the Court notes that Defendants’ scienter and material misrepresentation arguments are generally unpersuasive; dismissal likely would have been proper on either basis. At the parties’ March 9, 2015 hearing, Plaintiffs’ counsel acknowledged that Plaintiffs must prove that Herbalife is a pyramid scheme in order to prevail in this action."

Judge Fischer continued to say that:

"any amended pleading will likely fail absent allegations that identify particular misrepresentations concerning specific components of Herbalife’s operations. Plaintiffs’ current scienter allegations are also suspect. A significant portion of these allegations focus on marginally relevant confidential witness testimony and insider trading history, neither of which appears sufficient to establish a strong inference of scienter."

It doesn't sound to me like there is much of a chance of rescuing the case.

Declaration of Prof. William Keep

In addition to the Fischer order, TINA.org entered a motion for leave to file an amicus curae objecting to the settlement agreement in the Bostick class action case. TINA's motion was buttressed by the expert declaration of Prof. Bill Keep. Inexplicably, Professor keep claimed in his declaration (to the best of his knowledge) that the 70% retail rule which Herbalife requires distributors to follow, could somehow "apply to 0% of a distributor's purchases." For some odd reason Keep declared that the 70% requirement applies to what distributors hold for resale and supports this claim by citing a sentence in the Herbalife sales and marketing plan's Production Bonus Requalification guidelines section. That sentence reads: 

"In any given month, a Distributor must sell to retail customers, and/or sell at wholesale to downline Distributors, at least 70% of the total value of Herbalife products they hold for resale, in order to qualify for TAB Team and to earn and receive Royalty Overrides and Production Bonus for that month's business."

Prof. Keep (to the best of my knowledge) first floated what this incorrect assessment of Herbalife's 70% rule in an Atlantic article last year. Prof. Keep, however, somehow missed the Earnings Certification Form that exists in the SAME EXACT EXHIBIT he refers to in his declaration:

He also completely missed the actual rule (Rule 18-C), which is also in the SAME EXACT EXHIBIT that very clearly defines what Herbalife's 70% rule is:

All of this is not to say that this expert declaration lacks utility; it does make me wonder how much of his opinion is supported by what may have been a cursory review of the documents he based that opinion on. Also, with the filing fresh in my mind, I couldn't help but wonder if the TINA motion was the objection "filed by attorneys affiliated with, and potentially funded by, the short sellers" that Bostick Attorney Thomas Foley(counsel for Plaintiffs) predicted was coming so I contacted TINA, which quickly dispelled the idea. Laura Smith, their Legal Director, graciously provided me the following statement:

"TINA.org has not received any funding or support from any of the individuals or organizations you cited in your email* in connection with our amicus brief that opposes the terms of the proposed settlement in the Bostick v. Herbalife litigation.
With respect to the 70% rule, that rule was established in the Amway decision and requires distributors to resell at least 70% of the products they have purchased each month in order to ensure that distributors do not attempt to get bonuses solely on the basis of the products they purchase.  Herbalife's version of that rule, however, as articulated in plaintiffs' complaint in the Bostick case and in Herbalife's own materials, does not require its distributors to resell at least 70% of products they have purchased each month.  Rather, it allows them to count self-consumption to satisfy the 70%. Thus, 0% could have been resold and a distributor could still satisfy Herbalife's 70% rule."

*(I cited the Ackman family, Pershing Square, or its agents/assigns, such as, but not limited to Global Strategy Group, Evelyn Mantilla, and Chris Healey)

I also contacted Professor Keep asking if he could explain the inconsistency in his affidavit and his only response was that he would "wait for the deposition". 

WHOA!?! Who said anything about a deposition? I replied that such a response, "On the heels of the WSJ article and the Courant article...begs the question: what deposition are you referring to? Are you being deposed by the DOJ or are you going to be deposed in the Bostick litigation?" I have yet to hear back, but will update this post accordingly if Professor Keep provides me with greater detail. Maybe it was just a quip. 

The reason I find the Courant article so interesting is because it expands the information provided to us by the WSJ in that it states that a Federal grand jury had subpoenaed individuals regarding the possible manipulation of Herbalife stock. Although there are no reports that indicate Ackman is the actual target or that he is going to be indicted, the chances are pretty high that somebody will be. 

In fact, Columbia Law Professors put the odds of escaping indictment after a grand jury at 11:162,000(standing or otherwise seems to be irrelevant). You've got better odds of winning a Pick 4 straight lottery ticket (although $5000 probably won't buy much of a defense). Until further details emerge, it remains to be seen whether or not our lucky lottery winner should be buying that ticket in New York or Connecticut.

Maybe it's too simple an explanation, but it really strikes me as odd that a Federal Jury dealing with a Connecticut based target would subpoena testimony from Connecticut residents in New York(not Connecticut), unless the investigation was being run out of New York and was focused on a target in New York.

Order GRANTING Defendants’ Motion to Dismiss (Docket No. 60) by theskeptic21

Speculation Around Markey Manipulation

There seems to be a lot of speculation surrounding the WSJ report that the DOJ is investigating Ackman hires with respect to possible manipulation of Herbalife stock. Who is the target? Who are the sources? Rubenstein had an interesting sleight of hand in the Pershing Square PR about that WSJ article. In the very first sentence the response highlights "unnamed sources" in what appears to be an attempt to minimize the purported accuracy of the article.

That is followed by today's television roadshow by Ackman himself, in what appears to be a further minimization of the potential ramifications of such an investigation. Pershing's release also completely sidesteps the fact that Pershing's agents were in fact subpoenaed, including the agency that lobbied Senator Markey to write his now infamous three letters to Herbalife, the FTC and the SEC.

GSG is confident they are not the target of the Federal investigation and if it really isn't GSG, that leads you in two directions: up the flag pole or down the flag pole. Sure, maybe they're targeting one of the subcontractors involved for wiretapping, pretexting or something like that, but it's probably more likely they're going after the bigger fish with the gilded gills. It's entirely possible they're going after a subcontractor in connection with all the bugs found in Herbalife's corporate offices, but the journal specifically calls out the phrase "market manipulation," not illegal wiretapping.

Ackman's response today is very interesting too. Today he repeatedly said that he hasn't traded around his Herbalife short. What exactly does it mean to say that you "haven't traded around the Herbalife short" anyway? Aside from showing off a nonpublic letter on his iPhone from Representative Sanchez to his dinner compatriots, or hosting a nonpublic letter from Adriano Espaillat on his website, or the two different versions of the Senator Markey letter (cc: @copieratpershingsquare) or the grossly inaccurate disclaimer on Pershing Square's anti-Herbalife website, and all the necessary actions and trades it would have required to build/restructure a position around, and concurrently with these events, I'm not really sure what he could be talking about. He certainly can't mean that he isn't trading the Herbalife position now can he? Not surprisingly, it appears he is. Clearly the position size is shrinking in terms of AUM and exposure on the position. How could this be???

"What we've done since then is simply rolled those puts and kept on approximately the same size investment." 

As of February 28th, that position was -5% of his exposure with $19.9B AUM. Back in November when the AUM was $900M smaller, his exposure was also at -5%.

Herbalife closed at $43.25 at the end of November and closed February at $31.01 (a 28% decline). For Pershing's performance reports to be true and accurate, his Herbalife position had to have been between 21.8M-24.0M shares at the end of November(or $943-$1,036M in value). Assuming that he didn't trade around the position in that period as he claims, his exposure on HLF would have grown by $267M-$293M. The increase in value associated with the decline in the stock would have put his exposure on the position at a minimum of 6.1% and maximum of 6.7% at the end of February. That leaves two options for our dear amigo: Pershing's performance statements are inaccurate, or Ackman's statements about not trading around the stock are inaccurate.

The strokes he uses to describe the interactions with the Fed have a much finer point though. Ackman has seemingly been very careful to draw a clear line that the Feds haven't contacted him regarding market manipulation or misconduct with respect to Herbalife. That turn of phrase has turned up time and again in his TV onslaught today.

Makes me wonder if they have contacted him regarding manipulation or misconduct with respect to Pershing's Allergan, Valeant or Actavis investments. It was very recently that Pershing announced that they had a major position in Valeant as well as disclosing in court filings last week that Valeant was still a member in PS Fund 1, which is controlled by Pershing. Weird, amiright?

The WSJ article also mentions that the Feds opened their investigation into allegations about both Herbalife and Pershing Square, but that the investigation shifted focus to market manipulation this year. Maybe it didn't take too much effort for the Feds to figure out there wasn't too much meat on the Herbalife bones and focus their attention elsewhere.

I can't help but wonder if I were the Feds who's leg I'd gnaw on? Would I be going after a company like Herbalife or Ackman/Pershing Square? You don't have to dig too far to determine the Herbalife bone, is pretty thin (aside from the constant exercise, there isn't a lot to the complaints in my opinion). For instance, the FTC's Consumer Sentinel Network report recently released ALL complaints in its entire reporting structure directed against multi-level marketing at 1,703 total complaints in 2014(0.07% of all complaints filed). Even IF (and this is a big if) you assume that every last one was a legitimate complaint specifically against Herbalife, that would represent 0.3% of Herbalife's total US distributor/member base. Aside from the fact the Connecticut Attorney General did not identify a single organic complaint that was valid, or that much of the froth in Illinois is based on Pershing's local LULAC affiliations with Julie Contreras, or that we are also recently instructed by the class action suit against Herbalife in which not one single objection to the proposed class action settlement has been filed. Not ONE. If Herbalife was as terrible and ruthless as Ackman claims, why aren't there any real complaints out of the millions of people represented by the class? There is also an awesome little easter egg hidden in Thomas Foley's March 10th declaration in that case. After discussing the fact that no objections had been filed, Mr Foley, whom is the attorney fighting against Herbalife said:

"I anticipate that objections to the proposed settlement will be filed by attorneys affiliated with, and potentially funded by, the short sellers." 

Sure it's entirely possible the Feds could be targeting Herbalife, or they could be targeting one of the little fishes hired by Global Strategy Group, but then again, on the heels of Fannie Mae, Allergan, Valeant, Actavis and Herbalife, if you were Mr. Bharara wouldn't you be targeting somebody with $19B in AUM that you'd already deposed? It's probably true that Ackman hasn't been subpoenaed or visited by the FBI, the real question is: how long will that remain to be true?