What's at the Center of the Debate Over Herbalife In the wake of the bombshell announcement that Daniel S. Loeb's Third Point has taken an 8.9 percent stake in Herbalife after the company's shares were shorted by William A. Ackman of Pershing Square, the question is: Which very rich hedge fund manager is right? Is Herbalife a pyramid scheme as Mr. Ackman alleges and the nutritional supplements company heatedly denies, or is it a growth business model as Mr. Loeb seems to be betting? It's not an easy answer as you would think. Part of this is because Wall Street runs on fear, and the taint of allegations by such a prominent investor is hard to escape. And now it will run on bullish spirits spurred by Mr. Loeb. But the uncertainty is also because, although Mr. Ackman's arguments were impressive in length and thoroughness, it is sometimes hard to understand what he is trying to do with them. This is in part because they was no doubt vetted and vetted again by Pershing Square's lawyers in order to protect Mr. Ackman and his firm from any defamation claim. Herbalife may still sue anyway, if for nothing else than to show that it can play offense as well as defense and gain back further momentum - after all, what does it have to lose? But it is also because Mr. Ackman is not just trying to get the market to believe his presentation, which was first offered in December and has now supplemented with a shorter executive summary version. More fundamentally, Mr. Ackman is hoping regulators, namely the Federal Trade Commission, will step in and declare Herbalife to be a pyramid scheme under the law). If they do so, then they will shut down Herbalife's business in the United States and send the stock price to zero. In other words, this may be the most aggressive and largest short of all time. And that is why there was a lot of legal talk in Mr. Ackman's presentation. He is not just betting that the market will turn against Herbalife; he is going for the regulatory takedown. And so, his presentation was really just a brief for regulators, designed to be so impressive that they will have to act. Whether the regulators do anything depends on these central questions: Is Herbalife selling its product to people outside its network or to its own distributors? And are those distributors making more money by pushing product than actual sales? The reason is based on a decision from the 1970s by the F.T.C. that rejected claims that Amway was a pyramid scheme. Multilevel marketing models like Herbalife and Amway sell their goods through distributor networks. People make money not only from sales, but by recruiting people to make sales and recruit further salespeople. The recruiters earn a commission on any sales made by people they recruit or people who their recruits recruit, and so on. The problem is that when the money made is all on commissions and not on sales to outsiders, the model becomes a pyramid scheme that will eventually collapse when new people stop entering at a sufficient rate and sales are only made to people buying the goods to earn commissions. The regulator based its decision that Amway was not a pyramid scheme in part because of Amway's rule that distributors had to sell to 10 customers a month and also sell 70 percent of their product each month to others. Since that time the "70 percent rule" and "10 customer rule" have been rough metrics by which the F.T.C. partly assesses other multilevel marketing programs to decide whether they are pyramid schemes. So is Herbalife a legitimate sales operation selling to outsiders? Or are all of its sales to distributors who purchase the product to make commissions from themselves and sales people beneath them in the marketing scheme? For Herbalife, providing an answer is harder than you might think. While Herbalife has rules to bring it in compliance with the F.T.C. guidelines, including the 70 percent and 10 customer rule, it does not directly track sales to distributors outside its network and has not disclosed this information in the past. When David Einhorn asked a few questions on an analyst call focusing on this question in May, Herbalife's stock tumbled. The company then engaged Lieberman Worldwide Research. The market research firm found that in a 90-day period, 5.6 million American households stated that they had purchased Herbalife products, and that 90 percent of these households were outside the Herbalife distributor network. It's a bit odd that Herbalife would have to determine its outside sales through a research firm, but still the company also states that 20 percent of its volume is shipped directly to consumers outside its network instead of through distributors, further supporting this finding (the rest, the company asserts, is sold directly by distributors to outsiders). The 90 percent number, by the way, was repeated by Herbalife's chief executive, Michael Johnson, on CNBC shortly after the Ackman presentation. So, how does Mr. Ackman make his case that Herbalife is a pyramid scheme and sales primarily occur in network to earn commissions? From my reading, he does it in two stages. First, he asserts that Herbalife products are commodities and available on eBay at significant discount to the suggested retail price. This is an easily verifiable claim, one that anyone can check. But Mr. Ackman then asserts that if that is the case, no rational person outside the distribution network would ever purchase product at the full retail price. He goes on to assert that if this is true, the only real way to make money from Herbalife is not by retail sales but by recruiting sales people and earning commissions. A number of other claims come from this: that Herbalife does not adequately enforce its rules discouraging pyramid schemes, that Herbalife's accounting does not adequately disclose in-network sales, that Herbalife's distributor network has high rates of churn, and that the company charges excessive rates of shipping and handling to further earn profits from its network. Again, Herbalife heatedly denies these claims, but they are really all a sideshow to the main one about the price at which a distributor can sell Herbalife. Assuming the company agrees with what is apparent, that Herbalife can be bought online well below the suggested retail price, this does not mean all is over for Herbalife. The company gave its presentation Thursday, and it will have some momentum with the disclosure of Mr. Loeb's stake. Reading through Herbalife's copious promotional materials, I assume Herbalife could assert that people pay more than the eBay price because of the outstanding salesmanship of its distributors. That distributors become a customer's life coach - helping get the customer in shape and lose weight. These are the claims that health companies typically make. And the customer gladly pays the extra amount to obtain these services. And that is why Herbalife has a $2 billion brand without advertising. This is the squirmy part of multilevel marketing - your friends and families become sellers and the inherent trust in these relationships drives sales. And because these types of programs are not prevalent among people of higher economic class, this is largely a game that most Wall Street executives have no contact with in their daily lives. Yet, Amway shows that these networks can succeed and do so based on this type of salesmanship. The real question Mr. Ackman is raising is whether this network is also a success at Herbalife. (On Herbalife's call with analysts and investors on Thursday, Des Walsh, the president, said that eBay prices were not a proxy for market prices. "Most people I know use eBay to buy branded products at a discount price," he said. "A small, small fraction of Herbalife products are actually sold on eBay.") All told, it shows how hard truth can be to discern on Wall Street when the information is spread through conferences and presentations and not in the field. It means that there is likely to be no knockout punch here until people actually go and do some real field research. So Herbalife and Mr. Ackman and now Mr. Loeb will be duking it out for a long time.