In 2012 activist hedge fund titan Bill Ackman announced a $1 billion short of Herbalife stock by his fund, Pershing Square Capital Management.
Making such shorts public is rare, but even more unusual are 342-slide presentations like the one Ackman subsequently delivered arguing that Herbalife's business model amounted to an illegal pyramid scheme. Ackman, of course, is free to make his case to the public in hopes of causing an investor exodus so he can cash in, but his efforts have also been directed at government.
In response, several federal agencies have or are currently conducting investigations. Should his ongoing lobbying for legal action against Herbalife ultimately bear fruit, it could usher in a new era of destructive cronyism.
Although often maligned as destructive – or even unpatriotic – and in need of heavy regulation if not outright banning, short selling overall is beneficial for free markets. It provides a counter to runaway enthusiasm, and when the seller is correct can hasten the removal of a failed business from the market. It is what happens when the bet is wrong that is now of concern thanks to the work of Ackman, or more specifically, what might start happening if his extensive lobbying succeeds and sets a precedent.
In the three plus years since his very public attack on Herbalife, Ackman hasn't simply relied on the facts and his persuasive abilities to get other investors on his side, but has instead sought to wield the power of government to his benefit. If his gambit pays off and regulators sweep in to punish Herbalife, it could encourage other hedge funds to make similar plays, reducing regulators to nothing more than a profit-making tool of financiers to be sicced on any business that they think could make an attractive target.
If government regulators prove to be so obviously beholden to powerful financial interests, it will start a new lobbying rush on Washington, D.C. The more that government picks winners and losers, the more it redirects resources away from the productive sector of the economy and toward the parasitic class. It also orients businesses even more toward pleasing politicians and regulators instead of customers.
Ackman has staked his hopes on the idea that because Herbalife is multilevel marketer, it must therefore be an illegal pyramid scheme. He wants government regulators to shut it down on the basis, allowing him to cash in on the short.
The $35-billion-per-year multilevel marketing industry features household names like Avon and Tupperware, and is characterized by its use of independent contractors to distribute product as well as recruit additional distributors. Despite the insistence of some critics that all multilevel marketers are illegitimate, the Federal Trade Commission in 1979 gave its blessing to the structure as a legitimate business model so long as they adhere to certain safeguards aimed at ensuring sustainability. Specifically, recruitment itself shouldn't be the primary source of revenue. The company should actually move product, and not just to its distributors as the final destination.
As far as the law as currently understood is concerned, it's not enough to simply point to the structure of the company as a multilevel marketer to prove it is a pyramid scheme.
Despite hiring lobbyists and drawing from his considerable funds to hunt for victims and connect them with regulators, officials so far have not been convinced of Ackman's charges. According to a recent report from the Wall Street Journal, investigations by both the FBI and the U.S. Attorney's office failed to find evidence of criminal wrongdoing. Investors aren't buying it either, as Herbalife stock – while volatile with so much Ackman-induced legal uncertainty – has not declined as he hoped it would.
It's not over yet, however, as Ackman has also enlisted congressmen in his crusade by convincing them to write to the Federal Trade Commission, and he has made presentations to the Securities and Exchange Commission and other federal agencies in hopes of using the government to accomplish what his lengthy presentations have not: a major hit to Herbalife stock.
While there's always the possibility of some new revelation in the future, or a change in government rules, right now it's hard to see how Herbalife qualifies as a pyramid scheme. It has done business for 35 years, which excepting the government-backed Social Security system is much longer than pyramid schemes usually last. And unlike more suspect multilevel marketers, the $5 billion-in-revenue Herbalife moves substantial product. Its main offering, a meal-replacement shake, sells more than its top three competitors – including SlimFast – combined.
Bill Ackman has every right to scream that Herbalife is a pyramid scheme, and should perhaps be commended for putting his money where his mouth is, but it would set a terrible precedent should government now step in to bail him out. If rich hedge fund managers can simply call on regulators to target companies when fellow investors fail to respond how they expected, it will only encourage more such destructive predation in the future.
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