Bill Ackman’s quest to expose Herbalife Ltd. (HLF) started with a tip from a friend. The call came from a reporter turned stock researcher, who had penned a book about the hedge fund manager’s last big short and was now telling him that Herbalife smelled like a pyramid scheme. Enlarge image Bill Ackman On Dec. 20, Bill Ackman went public with a three-hour presentation, accusing Herbalife of using inflated pricing, misleading sales information and a complicated incentive structure to hide a pyramid scheme. Photographer: Scott Eells/Bloomberg Herbalife a Pyramid Scheme, Ackman Says 14:05 Dec. 20 (Bloomberg) -- William Ackman, founder of Pershing Square Capital Management LP, talks about weight-loss supplement company Herbalife Ltd., his short position on the stock and his claim that the company is a pyramid scheme. Ackman speaks with Erik Schatzker and Stephanie Ruhle on Bloomberg Television's "Money Moves." (Source: Bloomberg) Bill Ackman's 18-Month Herbalife Campaign 1:43 Jan. 7 (Bloomberg) -- Stephanie Ruhle reports on Bill Ackman's quest to expose Herbalife. Ruhle speaks on Bloomberg Television's "In The Loop." (Source: Bloomberg) Enlarge image Ackman Herbalife Short Selling Started With Friendly Tip The Herbalife Ltd. logo is displayed on a monitor on the floor of the New York Stock Exchange in New York. Photographer: Scott Eells/Bloomberg Sponsored Links Buy a link The discussion 18 months ago grew into a research project that pulled in much of Ackman’s team, two law firms and forensic accountants. On Dec. 20, Ackman, 46, went public with a three- hour presentation, accusing Herbalife of using inflated pricing, misleading sales information and a complicated incentive structure to hide a pyramid scheme. The shares plunged 32 percent in the next three days. Amid heated denials from the company, which is preparing to lay out its case at an investor conference in New York on Jan. 10, the shares had by Jan. 4 rebounded 42 percent from their post-Ackman closing low of $26.06. Ackman, an activist investor who has lobbied for shakeups at companies from Target Corp. (TGT) to Canadian Pacific Railway Ltd. (CP), is just getting started with Herbalife. “We’re prepared to spend whatever it costs and do whatever is required to make sure that the world understands the facts about this company,” he said in a telephone interview. “We can’t imagine how the SEC or the Federal Trade Commission or any other relevant regulator will ignore what we have said.” Ackman said he would make all his information available to U.S. regulators. His conclusions center on the company’s network of 3 million distributors in at least 81 countries who sell vitamins, shake mixes and skin gels. Those independent contractors earn revenue by hawking products directly to customers and recruiting new distributors, for which they earn a share of those sales and incentives from the company. Classic Schemes Classic pyramid schemes attempt to make money by solely recruiting new participants into the program, according to the U.S. Securities and Exchange Commission. “Once you realize that this is about promoting a business opportunity -- you recruit five friends who each recruit five friends who each recruit five friends -- it becomes very clear that it’s a pyramid scheme,” Ackman said. “Pyramid schemes are inherently fraudulent.” Herbalife Chief Executive Officer Michael Johnson has accused Ackman of manipulating markets to profit from more than 20 million short shares held by his hedge fund, Pershing Square Capital Management LP. While a court in Belgium has deemed Herbalife an illegal pyramid scheme, no U.S. regulator has made such a determination. Herbalife Denials Barb Henderson, an Herbalife spokeswoman, said the company looks forward to this week’s investor meeting. The company stands by its previous public statements denying Ackman’s presentation, she said. Henderson also said the Belgium ruling “contained factual errors” and that Herbalife is confident it will be reversed on appeal. Mitchell Katz, an FTC spokesman, declined to comment. Ackman began researching Herbalife after a call from Christine Richard, a former Bloomberg News reporter who by then was working for Indago Group, a New York-based boutique investigative research firm. Richard had just published “Confidence Game,” a book detailing how Ackman, warning of an impending bond-insurance market collapse in the runup to the recent recession, had shorted credit insurer MBIA Inc. (MBI) Short selling refers to the practice of borrowing shares and selling them, with the goal of profiting by repurchasing them later at a lower price. Richard declined to comment for this story. The more Ackman and his team dug into Herbalife, the more they became convinced the 32-year-old company would collapse or be shut down by regulators, he said. In the same interview, Pershing’s in-house attorney, David Klafter, said he, too, is convinced the law is against Herbalife. Herbalife Profits Ackman’s chief argument is that Herbalife products are commodities sold at inflated prices to mask incentives that mostly enrich the top echelon of distributors. He estimates that more than 90 percent of profits earned by distributors come from recruiting. Herbalife’s Henderson disputed this in an interview, saying that amount is zero. Distributors, some unsophisticated or desperate for work, are sucked in with false promises of easy wealth, only to learn that such success is more rare than presented and comes with a heavy up-front cost, according to Ackman. “The company’s so-called earnings statement is materially false and misleading and enables Herbalife to deceive new distributors about the potential profitability of the business opportunity,” Ackman also said. Henderson disputed that accusation, as well, saying most distributors are discount customers, not business builders. Premium Prices While Herbalife touts science, research and development to justify premium prices, its powders, vitamins and other products are similar to a glut of competing products on the market from companies including Unilever, Abbott Laboratories and GNC Holdings Inc. (GNC), Ackman said. Herbalife CEO Johnson, a former Walt Disney Co. executive, has said the company performs research and development around the clock while at the same time telling the SEC such expenditures are not material, according to Ackman and Klafter. By last spring, Ackman’s team was convinced Herbalife was worth shorting if they could identify a catalyst, an event that would drive down the shares, he said. That came on May 1, when Greenlight Capital Inc.’s David Einhorn dialed into an earnings conference call asking for more disclosure. He wanted to know why Herbalife stopped giving a breakdown of three groups of distributors it had previously provided. Einhorn had dredged up skepticism that has long plagued well-established direct sellers from Avon Products Inc. (AVP) to Tupperware Brands Corp. (TUP): Are they selling products or a business opportunity that is ultimately flawed? Plunging Shares Ackman started shorting Herbalife before the call was even over, he said. The shares plunged. Ackman kept selling the shares, assuming Einhorn would present a short case for Herbalife at an Ira Sohn conference both men would attend two weeks later, Ackman said. Einhorn didn’t, and the investor hasn’t said a word publicly about Herbalife since his conference call inquiry. That left Ackman to his own devices. He spent the next six months preparing a presentation to see what it would look like before deciding to give it at a special Ira Sohn conference in New York on Dec. 20. He and two associates laid out a 340-slide case against Herbalife and called for regulators to step in. The subsequent campaign includes pages of supporting research posted at a website Pershing called factsaboutherbalife.com. Short Selling Pershing has shorted more than 20 million shares of Herbalife stock. The most recent were executed just before Ackman’s December presentation, he said. Herbalife has lost almost half its value since Einhorn’s conference call questions. Pershing has not covered any of its short and there are no plans to get out now, Ackman also said. He has shown great patience before, holding his MBIA short position for six years, he said. Any money Ackman makes personally on the Herbalife short will be donated to charities run by Ira Sohn and a Pershing foundation, he said. Pershing investors stand to reap millions of dollars of profit on the short trade if Herbalife collapses or is shut down by regulators. Ackman isn’t the first to allege impropriety by Herbalife, he said. The difference is that his firm has the resources to withstand the company’s attacks. “We’ve done a lot of the work for the regulators,” Ackman said in a later e-mail. “We’ve provided the data and a legal road map for regulators to determine that it is a pyramid scheme.”