Pershing Square’s Bill Ackman Tells PwC, “Herbalife Is Your Problem Now”

Herbalife is a very interesting company, followed by incredibly interesting people, who are passionate about its incredible success and highly interesting business model.

I’ve only written about the company in relation to its relationship with its auditors.

KPMG used to have that role.

Now it’s PwC.

On September 11, to further his thesis, Bill Ackman went beyond his ongoing accusation that Herbalife is pyramid scheme. Ackman sent a 52-page letter to Dennis Nally, Chairman of PricewaterhouseCoopers International Ltd. and Bob Moritz, Chairman and Senior Partner of PwC US. He warned them PwC is exposed to enormous liability if it signs off on Herbalife audit opinions and Qs without a full investigation of several accounting, tax and bribery allegations. ( My sources tell me PwC was not answering Ackman’s request to meet in private to discuss their client.)

The text of the full letter is here.

Ackman used my work, the only journalist mentioned in his letter, to bolster a request for more information from PwC and the SEC, about how PwC would manage its auditor independence. The firm admitted conflicts of interest with Herbalife when it accepted the engagement after KPMG’s forced resignation. The SEC acquiesced to the appointment, according to Herbalife’s CFO.

A little background:

Short selling is a hotly debated topic. The last time the subject was really hot was when Greenlight Capital’s David Einhorn shorted Lehman Brothers. Einhorn told attendees at a famous investment conference he was short because Lehman’s accounting was highly questionable.

He was right.

In the early days of the financial crisis, many banks and investment firms, like Lehman, blamed short sellers for the collapse of their share prices rather than the deteriorating fundamentals driven by nearly worthless mortgage-backed securities stuffed with fraudulently originated and overrated mortgage paper. The SEC even parachuted in to reassure CEOs, including Lehman’s Dick Fuld, it would vigorously enforce rules against abusive or “naked” short selling, that is, selling short without having the shares available for delivery and intentionally failing to deliver the shares within the standard settlement period.

I wrote recently about short selling, as a pessimistic trading technique, and its benefit to the capital markets at the University of Chicago Booth Capital Ideas Blog. That post is called, Efficient markets come with tradeoffs:

Chicago Booth’s Maffett and his colleagues come to three key conclusions in their paper on the market and social value of “pessimistic trading.” The accuracy of the RMI model in predicting corporate defaults improves, on average, in countries where “pessimistic trading” such as short selling is not prohibited or unnaturally constrained. When short selling constraints limit the extent to which prices reflect publicly available default risk information, model accuracy also improves if accounting information is incorporated in the default prediction model.

This time around Pershing Capital’s William Ackman is on the wrong side of heavyweight investors like Carl Icahn, George Soros and others because of his unwavering bet against multi-level health supplements marketer Herbalife. So strongly do the “longs” feel about Ackman and his trade they’ve bought even more Herbalife shares to force Ackman’s hand. That’s cost Ackman hundreds of millions of dollars as the shares rose instead from the significant buying activity. The Herbalife trade is no longer about the fundamentals of its business or whether its business model is a fraudulent pyramid scheme, as Ackman claims. Ackman’s short selling, and the overwhelmingly contrary response to it, are now driving the price and the trading activity in the shares.

I wrote in Medium.com about Herbalife, its troubles with its audits and the death of fundamental investing:

Icahn’s and Soros’ trades aren’t driven by real audited numbers. Herbalife’s numbers for the last three years and the most recent 10-Qs are now unreviewed and unaudited by an independent certified public accounting firm after the scandalous resignation of auditor KPMG in April because of insider trading by its partner in charge. In other words, all bets on financial reporting integrity and completeness are off. Icahn and Soros are simply swinging big sticks to move the market their way.

Maybe Soros and Icahn just want to bet against William Ackman, the head of hedge fund Pershing Square who holds a 20 million shares short position. That’s primal enough. Ackman’s trade, a gutsy move too, required selling borrowed shares on the expectation that the price would fall and the borrowed shares could be repaid with cheaper ones. That’s a $1 billion bet that is based on fundamental beliefs— Ackman feels strongly that Herbalife is a pyramid scheme, a fraud that investors will soon abandon and regulators will eventually shut down. Herbalife says it spent approximately $15.1 million after-tax in the first six months of 2013 to respond to Ackman’s allegations.

In the meantime, Icahn’s and now Soros’ investment pushed the stock price higher and made it hundreds of millions more expensive for Ackman to unwind his trade, assuming he has not already begun to reverse course.

Herbalife is “unable, without unreasonable effort or expense”, to file a complete Form 10-Q for the quarter ending June 30, 2013 with the Securities and Exchange Commission. Herbalife is “deficient” according to the SEC because it is not filing timely financial information that has been reviewed by a certified public accountant. Herbalife’s auditors KPMG resigned on April 8, 2013 because the firm was no longer independent. KPMG former partner Scott London, who until April 5, 2013 was the KPMG engagement partner in charge of the Herbalife audit, plead guilty to criminal charges of passing confidential information to a friend about Herbalife, Skechers, and three other clients .

The kicker for Herbalife, and anyone who counts on some integrity in Herbalife’s financial information and disclosures, is that when KPMG was forced to withdraw its audit reports and opinions the auditor said those reports should no longer be relied by investors.

Herbalife’s CEO and CFO told analysts and investors on its most recent earnings call that the second quarter 10Q was filed without new auditor PwC’s review and without the required Sarbanes-Oxley Section 906 certification of all financial disclosures.

PwC has to re-audit three prior years and review all the 10-Qs before the SEC or investors have financial information that can be trusted again. Herbalife expects that to happen by the end of the year. Of course, Herbalife executives and its audit committee, the one that hired and was supposed to be keeping an eye on KPMG inside trader Scott London, assure you that “the financial statements covering the referenced periods fairly present in all material respects the financial condition and results of operations of the company as of the end of and for the reference period, and they continue to be relied upon, and that the company’s internal controls over financial reporting was effective during these periods.”

Herbalife is confident of its ability to put together its financial information without new auditor PwC’s review, even after finding out its prior auditor was corrupt and even though a successful investor has made serious accusations about its business model being a fraud. Herbalife went ahead and prepared the 10Q and, for kicks, even did a “revision” restatement to correct some “errors” in the prior three years of balance sheets. A “revision restatement”, according to research firm Audit Analytics, is one that’s included in a periodic report without a prior disclosure in Item 4.02 of an 8-K. Thus, it doesn’t undermine reliance on past financial statements and is less disruptive, meaning the stock price doesn’t suddenly and precipitously drop because you’ve admitted that prior financials were all wrong perhaps due to a big error or accounting manipulation.

Herbalife shares reached a 52-week high September 17 on speculation, according to the LA Times, that the company may begin an aggressive share repurchase. Speculation about an imminent leveraged buyback is rampant even with the taint of an auditor, KPMG, who sold confidential information about the company for a few pieces of gold, a lack of SEC compliant audited financial statements for the last three years and no auditor review of any Qs this year, and serious allegations by a respected activist investor of fraud at the company.

Keep in mind, Herbalife is forbidden to issue public debt to finance a share repurchase unless it has SEC compliant financial statements. That means an auditor’s opinion on prior years’ financials is required and the auditor’s review of all recent Qs.

An explanation of the rules by law firm Chadbourne & Parke LLP:

Form S-3 is commonly used by seasoned issuers to put in place debt, equity or universal “shelf registrations” under which future securities offerings can be accomplished through “takedowns” from the shelf with relative speed. Among other eligibility requirements, in order to utilize Form S-3, issuers must have timely filed all required reports (including annual 10-Ks, quarterly 10-Qs and certain current 8-Ks) under the Exchange Act during the twelve calendar months and any portion of a month immediately before the filing of the registration statement.

Thus, if a company has missed a filing date for a Form 10-K or a Form 10-Q (and has not filed the report within the permitted 12b-25 grace period), absent a waiver from the SEC, it will not be eligible to file a Form S-3 registration statement until filings with the SEC have been timely made for a full year.

I do not write about the questions regarding the Herbalife business model. The “pyramid scheme” belief is the primary basis for Bill Ackman’s short thesis but that’s obviously not his only basis for his trade and very negative outlook on the company.

There are people who have more interest in this part of the story and can explain this part of the story better than I can. Dan McCrum, for example, has been following the legal and regulatory aspect of the Herbalife story very closely at the Financial Times:

What the FTC has looked for to spot frauds are two things: inventory loading and a lack of true retail sales.

To begin with, the Commission focused on inventory loading, one of the more obvious ways to run a pyramid scheme: you load up new distributors with boxes of products they will never be able to sell, then make it really hard to return unsold stock. Price gouging on the shipping and handling is also a nice way to juice profits.

The 1979 Amway decision was largely about inventory, and it was the internal company rules championed by Amway that became industry standards. Distributors were able to return Amway’s brushes and soaps for a refund; they were required to sell at least 70 per cent of their existing inventory each month on a wholesale or retail basis; and they had to make at least 10 sales per month to a retail customer.

You can see this standard in Herbalife’s own rules, updated in 2011. Distributors “must personally make sales to at least 10 separate retail customers” in any given month to qualify for royalties and bonuses, and “at least 70 per cent of the total value of Herbalife products a Distributor purchases each volume month must be sold or consumed that month”.

Now, after Herbalife answered some questions from David Einhorn last year, the SEC wrote a series of letters to the company looking to clarify the role of the 70 per cent rule. As Kid Dynamite has dissected, the company eventually walked away from the rule saying there are other safeguards in place.

But what is important here is the way Herbalife defines its “retail customers”. In line with the Amway decision, distributors can count sales to other distributors below them in the chain as retail sales.

We have arrived at the fundamental question. The second central characteristic of a pyramid scheme, as far as the FTC is concerned, is a lack of retail sales. And the case law since the Amway decision suggests a different view of what counts as a retail sale from Herbalife’s definition.