Three federal agencies and one billionaire hedge fund manager have placed Herbalife under the microscope, scrutinizing whether the diet-supplements company is a pyramid scheme.
But Herbalife is not the only one under investigation. Some federal authorities are pursuing other inquiries that might expand the regulatory gaze from Herbalife to the traders who traffic in the company’s stock.
The authorities have trained their focus on traders with contrasting views of Herbalife, according to people briefed on the matter who spoke only on condition of anonymity. As one group wagered that Herbalife was a pyramid scheme â€" William A. Ackman, the billionaire hedge fund manager, has staked a $1 billion bet on that belief â€" other investors expected the company to emerge unscathed.
Neither side has been accused of wrongdoing. Still, a number of well-timed bets for and against Herbalife caught the eye of the Securities and Exchange Commission and the F.B.I., the people briefed on the matter said, raising questions about possible insider trading, disclosure violations and market manipulation.
The S.E.C. sent requests for documents to several investors betting on Herbalife’s success, the people said, including investment firms founded by Carl C. Icahn and George Soros. The S.E.C. and F.B.I. are also beginning to question whether Mr. Ackman’s hedge fund, Pershing Square Capital Management, improperly encouraged other traders to bet against Herbalife just before bad news emerged about the company, including Mr. Ackman’s initial announcement of his bet in December 2012.
For now, the inquiry has not yielded evidence of transgressions. And in a statement, Pershing Square said it did not “leak to anyone any information about its Herbalife position or its Dec. 20, 2012, presentation prior to its public release. In fact, the firm went to great lengths to avoid any premature disclosure.â€
Yet some details of the presentation managed to slip out. The S.E.C. sent a subpoena to Pershing Square, the people said, as part of a previously unreported insider trading inquiry involving a winning bet against Herbalife. The inquiry appears to focus on a person outside Pershing Square who placed his own bet that Herbalife shares would falter â€" a trade he made after learning private details about Mr. Ackman’s campaign. Pershing Square is not the focus of that particular investigation.
Together, the investigations have thrust the authorities into the uncomfortable role of picking winners and losers in the billion-dollar game. If regulators conclude that Herbalife is a pyramid scheme, it could throw the company’s stock into a nose dive and produce a windfall for Mr. Ackman, who mobilized a network of interest groups against the company and personally met with federal authorities to outline his accusations. But if the S.E.C. files an action against those speculating in Herbalife’s shares, it could briefly distract from Mr. Ackman’s campaign.
As a central element of its campaign, Pershing Square lobbied the S.E.C. and the Federal Trade Commission to open civil inquiries into Herbalife. News of the F.T.C. investigation in March sent the company’s stock to its lowest level in eight months.
While the F.B.I. also opened a preliminary investigation into Herbalife, the inquiry has stalled, a person briefed on the matter said.
The S.E.C. and F.B.I., which might ultimately close the Herbalife-related investigations without taking action, declined to comment.
The focus of the S.E.C.’s insider trading investigation traces back to late 2012, when Mr. Ackman was preparing to announce his trade against Herbalife. Before the announcement, the people briefed on the matter said, one of Mr. Ackman’s junior employees mentioned the planned trade to his roommate.
The conversation was not necessarily illegal. The junior employee, who like Pershing Square has not been accused of any wrongdoing, may have shared information with his roommate in strict confidence.
But the roommate may have crossed a legal line when he helped a friend place a bet against Herbalife. After Mr. Ackman’s presentation pummeled the company’s stock, the people said, the friend reaped at least $20,000.
The investigation into the well-timed bet, a small fraction of a broader billion-dollar battle, is an unusual one for the S.E.C. The agency typically investigates leaks from corporate insiders about earnings and the sharing of other confidential tidbits.
Given the unusual circumstances and the small gains, it could be a tough case to file. Under the laws that govern insider trading, the bond between roommates does not inherently require a duty of confidentiality. But if the roommate violated an explicit promise to keep the information confidential, he could be liable. The junior employee has since left Pershing Square, one person said, a move that was unrelated to the investigation.
While Pershing Square is not suspected of wrongdoing in that matter, authorities are starting to scrutinize whether the hedge fund encouraged others traders to make well-timed bets against Herbalife.
Taking a page from Mr. Ackman’s playbook, Herbalife’s lawyers have provided the S.E.C. and other regulators with documents that show a surge in options trading soon before damaging news reports about Herbalife were published, a person briefed on the matter said. The trading also took place a month before Mr. Ackman announced his bet. The trades involved put options, contracts which allowed traders to place bearish bets on Herbalife without buying the company’s shares, and many of the options expired two days after Mr. Ackman’s presentation. The traders’ identity is unknown, and some options may have belonged to Pershing Square.
While the S.E.C. and F.B.I. are reviewing the information, they face a high hurdle to proving fraud or market manipulation, defined as “intentional conduct designed to deceive investors by controlling or artificially affecting†a stock. The S.E.C. has filed only a few such cases.
And even if Pershing Square spread advance word, it did not necessarily violate any rules. As long as Mr. Ackman told the truth â€" and did not violate Pershing Square’s own rules for disclosing information â€" he is free to exercise his First Amendment right to attack a company, as many hedge fund managers do.
Despite the barriers, Herbalife has continued to draw attention to Mr. Ackman’s campaign. A consulting group that works with Mr. Ackman’s team, Herbalife says, helped establish a website called StopHerbaLies while presenting the site as if it were the creation of community activists.
“If there is an undisclosed connection, financial or otherwise, between Ackman and that website, the S.E.C. should be interested,†said John DeSimone, chief financial officer of Herbalife.
Pershing Square has said that the outside consultant played a role but that the hedge fund was not involved. It is unclear whether the S.E.C. is investigating the issue.
Those supporting Herbalife, including the funds created by Mr. Soros and Mr. Icahn, have also drawn attention from the S.E.C.
It is possible the scrutiny stems from Mr. Ackman’s private plea to the S.E.C. last year to examine whether rival traders improperly collaborated to buy Herbalife shares and drive up the price of the stock. If Mr. Ackman’s rivals acted together to collectively buy 5 percent or more of Herbalife stock, they would have to disclose it within 10 days. Mr. Soros’s and Mr. Icahn’s investment funds have not been accused of wrongdoing.
Mr. Ackman, who says his effort to bring Herbalife to its knees stems from a sense of civic duty, has promised to donate any personal gain to charity. His investors, though, would still benefit from Herbalife’s troubles.
At the heart of Mr. Ackman’s wager are Herbalife’s marketing practices: The company distributes its products through a network of sales representatives, who Mr. Ackman contends are lured with the false promise of riches. He also argues that many representatives, who are forced to assume the risk of buying Herbalife’s diet shakes, are ultimately unable to sell to consumers.
Herbalife does not publicly disclose its sales results to consumers outside the network, but it does refer to a third-party survey showing that 87 percent of people who purchased Herbalife products were outside the network. The company, which commissioned that report, also cites a survey of former Herbalife members in the United States, 73 percent of whom reported joining Herbalife for the discounts, not to sell to consumers.
Still, if the bulk of Herbalife’s revenue is derived from recruiting, and not the sale of diet shakes to outside consumers, then the company could face regulatory action. The F.T.C. would typically have to show “unfair or deceptive†practices. The S.E.C., which has placed a renewed emphasis on pyramid schemes, would have to demonstrate that Herbalife misused money or misled investors about potential returns.
At least for now, the walls have not closed in on the 34-year-old company. Shares of Herbalife are more than $10 above where they were trading when Mr. Ackman revealed his position.
