Judge Questions Key Part of Herbalife's Defense

With Bill Ackman staying out of the spotlight, and Carl Icahn focusing on Apple and Netflix, Herbalife seems to have faded from investors' memory. Year to date, shares of the multilevel marketer are still up nearly 100%, but have traded in a fairly tight range since early August. The same can largely be said for Nu Skin and USANA , two companies with similar business models whose shares have largely mimicked Herbalife's all year.

Still, investors shouldn't remain complacent -- a lawsuit against Herbalife is moving forward.

The lawsuit moves forward
Dana Bostick, a former Herbalife distributor, sued the company earlier this year on the grounds that it was an "inherently fraudulent pyramid scheme." Herbalife tried to get the lawsuit tossed out, but federal Judge Beverly O'Connell earlier this month allowed it to move forward.

O'Connell called into question one of Herbalife's key defenses -- that many of its distributors are also end users. In her ruling, the judge cited a previous case, FTC v. Koscot, that created the so-called "Koscot test." If a multilevel marketing firm like Herbalife violates the provisions of the Koscot test, it can be considered a pyramid scheme. The second provision reads, "Distributors pay money for the right to receive recruiting rewards unrelated to user sales."

That is to say, while multilevel marketing firms like Herbalife pay out bonuses to distributors, those bonuses must be based on user sales. If they are not based on user sales (but, rather, recruiting new Herbalife members), then they may violate the Koscot test.

Herbalife pays its distributors a percentage of their retail sales, including sales done by the Herbalife distributors recruited by the member in question (their "downline"). But this is where the problem lies -- as Herbalife admits, many of its members join simply for the discount they receive on Herbalife products; they join Herbalife for self-consumption, not to sell to others. According to Judge O'Connell, these distributors cannot be classified as end users:

Although [Herbalife] contend[s] that distributors should be classified as ultimate users ...'[i]f Koscot is to have any teeth, [a sale for a distributor's personal use] cannot satisfy the requirement that sales be to 'ultimate users' of a product.'... Therefore, downline distributors are not ultimate users for purposes of the second element of the Koscot test.

Will Ackman's bet payoff?
In a letter to investors back in August, Ackman -- whose hedge fund Pershing Square Capital Management is betting against Herbalife's stock -- wrote that shares of Herbalife could become worthless within one year. Ultimately, Ackman's argument rests on the possibility of regulatory intervention -- he is betting the government will shut Herbalife down.

Certainly, the government is willing to shut down pyramid schemes -- earlier this year, the FTC went after Fortune Hi-Tech Marketing, and more recently the SEC froze the assets of CKB168.

Multilevel marketers in the crosshairs
If the government does take action against Herbalife, it's likely to reverberate through the industry. Although a move against Herbalife wouldn't necessarily affect the businesses of USANA or Nu Skin, as multilevel marketers a hostile regulatory environment could discourage investment.

Shares of both companies plummeted last year when Ackman first made his allegations against Herbalife public, then rebounded along with Herbalife shares throughout the year. In fact, while Herbalife has been a great stock to own in 2013, both USANA and Nu Skin have been better buys -- rising about 180% and 200% this year, respectively.

In fact, Nu Skin shares just hit a new all-time high on Tuesday, after the company reported strong earnings. In particular, Nu Skin cited China as being a key market, contributing a great deal to its growth. USANA shares, however, went in the opposite direction and dropped significantly on Wednesday; earnings came in better than expected, but the company cut its guidance for the fiscal year.

Ackman has never mentioned either Nu Skin or USANA, but that hasn't stopped other short-sellers. USANA has had a consistently high short interest -- currently hovering near 30%. Citron Research has targeted the company in the past but has been even more critical of Nu Skin, alleging that Nu Skin's business practices in China (the source of much of its growth) are illegal.

For now, investors in both companies appear to be reacting to their underlying businesses -- a rarity in recent months. But as long as the potential for regulatory action hangs over the industry, there's reason to be cautious.

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The article Judge Questions Key Part of Herbalife's Defense originally appeared on Fool.com.

Sam Mattera has no position in any stocks mentioned. The Motley Fool recommends Apple and Netflix. The Motley Fool owns shares of Apple and Netflix and has the following options: long January 2015 $50 calls on Herbalife Ltd.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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