You can’t make this stuff up. Reality is more bizarre than fiction. Good as “House of Cards” or “Game of Thrones” are, they cannot match the Herbalife battle for the sheer confrontation of economic power, the treachery among rivals, or the political machinations. What the War of the Roses was to Shakespeare, the Herbalife battle could be for future playwrights, supplying them with similar opportunities to exploit well-known historical events for artistic purposes. Can one imagine a future David Mamet writing: “To short or not to short. That is the question.”?
This soap opera began in December, 2012 when shareholder activist, William Ackman, and his hedge fund, Pershing Square Capital Management LP, announced that Herbalife was a pyramid scheme and that they had made an approximately $1 billion dollar bet shorting its stock. But then an even better known activist, Carl Icahn, came to Herbalife’s defense, went long, and publicly called Ackman a “crybaby.” (Shakespeare would find a hidden motive for Icahn’s behavior, perhaps in some unintended snub or possibly a girlfriend lost to Ackman, but journalists have yet to uncover this needed dramatic element). Since the date of Ackman’s 2012 announcement, Herbalife shares have risen an estimated 40% (although there has been some decline over the last two weeks). The result is to place Ackman under extreme pressure. A short position is costly to carry, and to close it out now would mean an enormous loss for Pershing Square. The bottom line is that Ackman and Pershing Square had to do something to focus regulatory attention on Herbalife, hoping that regulatory scrutiny would drive down its stock price. But regulators do not like to look as if they are the pawns of a short seller, and hence they do not march to his orders. Thus, an amended strategy was needed.
Ackman appears to have found that new strategy by subsidizing a small army of underfunded civil rights organizations. Motivated by his contributions, they have brought pressure on state and federal regulators. After a January 22, 2014, letter from Massachusetts Senator Edward J. Markey, the Federal Trade Commission has now commenced an investigation into Herbalife, and its stock price has begun to ebb. That investigation, however, could easily take a year or more.
This column will not predict the outcome in this war, nor take sides (although it does have some skepticism of both antagonists). Written by one of the few unpaid and unretained commentators on this battle, it will attempt only to set forth the legal standards applicable to both sides in this battle. When is a “pyramid scheme” illegal? When could the FTC or SEC charge fraud or deception? What standards apply to a hedge fund that appears to be lobbying regulators through proxies? What disclosures should the SEC require of both sides? But it will also observe that this episode shows much that is dysfunctional in our current regulatory environment.
I. What is a Pyramid Scheme?
Franchises experienced hyperbolic growth in the 1950s and 1960s, and iconic American names—McDonalds, Dairy Queen, Dunkin Donuts—used the franchise business model to expand quickly. But franchise fraud followed quickly on the heels of this success. In response, the FTC adopted a stiff disclosure rule in 1978. The FTC’s Franchise Rule required detailed disclosures by the franchisor but came with large loopholes; these exceptions may have largely swallowed the rule. In particular, the Franchise Rule did not apply if the seller charged less than $500 for the business opportunity or if both buyer and seller agreed that the seller would buy back goods and inventory assembled by the buyer. Pyramid marketing schemes commonly exploit one or both these exceptions to avoid the FTC’s disclosure requirements.
Still, the FTC is not toothless. It can also rely on its statutory power to prohibit “unfair or deceptive acts or practices in or affecting commerce.” Here, however, the major obstacle is the FTC’s Amway decision. In 1979, the FTC ruled that, although Amway used pyramid marketing, it was not an illegal pyramid scheme. The decision defined a pyramid scheme as:
“the payment by participants of money to the company in return for which they receive (1) the right to sell a product and (2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to the sale of the product to ultimate users.”
The FTC essentially found that Amway was not an unlawful pyramid scheme because of three consumer protections that it observed: (1) it bought back goods of terminating distributors; (2) it required distributors to have sales to at least ten customers per month; and (3) it required distributors to sell seventy percent of the products they purchased each month to non-distributors.
Most commentators have agreed that the Amway decision made enforcement by the FTC significantly more difficult. Indeed, the FTC seems rarely to have used this provision. One survey reports that over an 8-year period ending in December 2005, consumers filed some 17,858 complaints with the FTC against alleged pyramid marketing schemes, but since 1990, the FTC has brought only twenty cases against pyramid marketing schemes under the FTC Act—in short, about one or two a year.
The contemporary multi-level marketing (“MLM”) industry has in effect been erected on the foundation (and under the protective shelter) of the Amway decision. Assuming that a MLM company observes the three “Amway safeguards” listed above, the only realistic way the FTC can prosecute a pyramid marketing scheme is to show a material misrepresentation, such as a representation that some level of earnings was virtually certain. Thus, so long as the sales literature stresses that success depends on the buyer’s own efforts, the seller/franchiser will be immune from liability as a practical matter.
Critics estimate that “99.9% of investors lose money” in MLM ventures and that over 1.5 million investors a year participate in such ventures. Even more revealing is the disparity between the top tier distributors and those at the bottom. One recent critique finds that 54% of all commissions paid by MLM firms goes to the top 1% of their distributors (who earn on average about $128,000 a year), while the rest lose money. This should not surprise us. Just as in a chain letter, those who get in at the outset can profit, while those who enter later face a mathematical near certainty that the business cannot sustain the exponential rate of growth needed for them to profit.
II. The Special Case of Herbalife
Every MLM distributor will claim that it is distinctive, and Herbalife certainly is. Apparently, as of the end of 2013, it had 3.7 million distributors worldwide (of whom 493,000 were in the U.S.). Thus, it ranks second in size only to Amway. According to a critical recent study, Herbalife’s top 1% of distributors do well, making an average annual income of $206,638 from Herbalife. This top 1% also receives some 66% of the total commissions paid by Herbalife. But, this study further reports that the remaining 99% of distributors receive annual commissions of only $1,116 per year (or $21.46 per week). That may explain some of the anger in minority group communities that Mr. Ackman has been able to focus on regulators.
But this minimal return does not mean that Herbalife is violating the FTC Act or is an unlawful pyramid scheme. That would require evidence of specific material misrepresentations. Thus, the majority of the hedge fund community that is backing Icahn, Soros and Loeb may be correct in betting that Herbalife is not a “house of cards,” even if it is a sucker’s bet for distributors.
III. SEC Enforcement
If the FTC is largely blocked by the Amway doctrine, the other potential enforcer is the SEC. But here a different problem surfaces. First, business opportunities and distributorships are not clearly securities. Under the Supreme Court’s landmark decision in SEC v. W.J. Howey & Co., as mildly modified by later decisions, the investor must (1) invest money, (2) in a common enterprise, and (3) is led to expect profits, (4) primarily from the efforts of a promoter or a third party. The last element is the toughest because the success of the distributor is substantially dependent on his or her own efforts as a salesman of the product.
Some Ninth Circuit decisions have relaxed this standard in cases where the buyer/distributor did not make more than minimal efforts, but those cases involved egregious facts not likely to be repeated in cases involving firms like Amway and Herbalife. Even if the Ninth Circuit is disposed to find pyramid schemes to be securities, other Circuits today require a finding of “horizontal commonality” (which is largely lacking in the case of distributorships). In short, although there probably are jurisdictions in which a pyramid scheme will be found to be a security, there are others in which investors who must focus on selling the product, rather than recruiting downline distributorships, will be deemed not to have acquired securities. Also, the SEC has generally deferred to the FTC and not aggressively pursued pyramid schemes on its own.
But one other possibility for SEC enforcement remains. The SEC (and private plaintiffs) could sue on the theory that Herbalife made materially inaccurate disclsoures to its own shareholders. But this theory first requires that Herbalife’s stock price fall (in order to provide damages to plaintiffs and demonstrate materiality to the SEC). If it eventually falls significantly, the SEC and class action plaintiffs might allege that Herbalife failed to disclose (i) how dependent it was on recruiting new distributors who would pay for the privilege to recruit still newer downline distributorships, and (ii) how great the disparity was between the commissions received by the top 1% of distributorships and all other distributors, implying that some day potential investors would catch on. For the present, however, the SEC seems likely to defer to the FTC—in part to avoid the appearance of being a pawn of Mr. Ackman.
IV. Hedge Funds As Lobbyists
It is time to turn an equally skeptical eye to Mr. Ackman and Pershing Square. The New York Times investigation has already detailed how they have organized protests, conferences and letter-writing campaigns in California, Nevada, Connecticut, New York and Illinois. The New York Times estimates that they have paid at least $130,000 to civil rights organizations to join this effort and identify minority group members victimized by Herbalife.
Symptomatically, at least one of these organizations was cold-blooded enough to attempt to start a bidding war between Herbalife and Ackman. Apparently, in a free market economy, even protest is for sale to the highest bidder. The New York Post has also reported that Herbalife donated money to at least five of seven Hispanic groups that signed a letter supporting the company.
Although everyone in this story comes off looking tawdry, is there anything legally objectionable in these tactics? Some have suggested to me that Ackman’s and Pershing Square’s failure to disclose publicly their financial support to their civil rights allies was a material omission. That is legal nonsense! To be sure, from time to time, the SEC has sued investment advisors who made strong stock recommendations, without disclosing their own positions. These “scalping” cases have usually asserted that the defendant was acting as an unregistered investment advisor. But these cases are easily distinguishable. Ackman and Pershing Square were not communicating securities recommendations to investors; rather, they were lobbying regulators. Also, their massive short position was hardly undisclosed, but rather was front page news. Nor, as outsiders, did they owe any fiduciary duty to the shareholders of Herbalife that makes them liable for a material omission.
Further, no one has yet questioned the sincerity of Mr. Ackman’s Hispanic allies (even if their level of fervor may have grown after his donations). At most, one can make a colorable claim that some regulators and legislators were deceived by this lack of disclosure (probably about as much as the venal French Inspector in Casablanca who is “shocked” to discover gambling at Rick’s). But even if there was such deception of regulators, Rule 10b-5 does not cover their deception, but only deception in connection with a purchase or sale of a security.
Finally, all citizens, including short sellers, have a First Amendment right to petition the Government (including the SEC and the FTC). The Supreme Court has refused to read the federal securities laws in a manner that cuts back on First Amendment rights.
The bottom line appears to be that neither Ackman nor Pershing Square have violated the federal securities laws on the evidence to date, and Herbalife can probably only be found to have breached the FTC Act or the federal securities laws if specific evidence of material misrepresentations to distributors can be shown.
These conclusions should not leave us satisfied. The Amway decision trivialized the anti-fraud provisions of the FTC Act, and the federal securities laws will only provide any benefit to investors if franchise distributorships are deemed securities (which seems possible, but generally unlikely in the majority of Circuits). Thus, MLM franchises remain a toxic trap for gullible investors.
Reform can come by means other than the expansion of the antifraud rules. If an Amway or a Herbalife had to disclose a fuller breakdown of their revenues, with clearer allocation between product revenues and revenues from the sale of distributorships, it would become clearer to the market whether they were achieving sustainable growth. Fuller disclosure about the annual turnover and termination of distributorships would also clarify this same question. Next, do distributors make or lose money on average? If they usually lose, that information may be material to the company’s shareholders because it suggests that one cannot expect this cycle to continue endlessly. You can fool all of the distributors some of the time, and some of them all of the time, but probably not all of them all of the time.
With respect to Mr. Ackman and Pershing Square, this drama seems but another illustration of Citizen United’s growing shadow over our political life. Still, the SEC might consider this question: Who is paying the political donations he is making? Is it Ackman himself (which would be unobjectionable)? Or is it Pershing Square (and do its investors know where their money is going)?
One final thought: the U.S. legal system has long recognized and respected the private attorney general, but this case shows the private attorney general on steroids. And practices could evolve even one step further. Recently, the SEC has had some success in paying whistleblowers, and some hedge fund activists wish to pay the directors they elect to corporate boards. Perhaps, Mr. Ackman should try this strategy as well, donating the information so gained to the SEC or assisting victims to sue. That would carry the privatization of law enforcement to its ultimate extreme.
John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia Law School and Director of its Center on Corporate Governance. This article was originally published in the New York Law Journal on March 20, 2014.
 No. One cannot imagine David Mamet saying that, but Saturday Night Live, with better writers, could.
 Carl Icahn was quickly joined by some other prominent proactive shareholders, including Daniel Loeb and George Soros, thus suggesting that the hedge fund community does not believe Herbalife is an easy target. See “Ackman’s Attack on Herbalife Gains Political Traction,” Australian Financial Review, March 17, 2014 at p. 23. Or it may suggest, as in “Game of Thrones,” that hedge funds enjoy sticking knives in their rivals’ backs.
 For the 40% gain figure, use Sara Germano and Brent Kendall, “Herbalife Attracts FTC’s Scrutiny,” Wall Street Journal, March 13, 2014 at BI. The stock has fallen some 13%, however, over the last two weeks.
 The New York Times deserves much credit for uncovering this story. See Michael Schmidt, Eric Lipton and Alexandra Stevenson, “After Big Bet, Hedge Fund Pulls Levers of Power,” N.Y. Times, March 10, 2014 at p. A1.
 See “Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures, Promulgation of Trade Regulation Rule and Statement of Basis and Purpose,” 43 Fed. Reg. 59, 614 (Dec. 21, 1978).
 See Sergio Pareja, Sales Gone Wild: Will the FTC’s Business Opportunity Rule Put An End to Pyramid Marketing Schemes?,” 39 McGeorge L. Rev. 83, 91–92 (2008).
 Id. at 92–93.
 See 15 U.S.C. § 45(a)(1).
 In re Amway Corp., 93 F.T.C. 618, 710 (1978). Amway was a retrenchment on an earlier FTC decision, In re Koscot Interplanetary, Inc., 86 F.T.C. 1106 (1975), which had ruled more broadly.
 93 F.T.C. at 715.
 Id. at 717.
 See Pareja, supra note 6, at 95–96.
 Id. at 94.
 See Douglas M. Brooks, Robert Fitzpatrick and Bruce Craig, THE PYRAMID SCHEME INDUSTRY: Examining Some Legal and Economic Aspects of Multi-Level Marketing (2014) at p. 2.
 Id. at p. 20. In the case of Herbalife, they find that those not in the top 1% of distributors make a “Maximum Possible Gross Rental Profit” (as defined) of $13.63 per week. Id.
 See Germano and Kendall, supra note 2, at p. B1.
 See Brooks, Fitzpatrick and Craig, supra note 14, at p. 20 (estimating number at 493, 862 as of 2012). It is presumably higher today.
 Id. at 20.
 See SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
 See, e.g. SEC v. Glenn W. Turner Enterprises, 474 F.2d 476, 482–83 (9th Cir. 1973); Webster v. Omnitrition Int’l Inc., 79 F.3d 776, 781–82 (9th Cir. 1996). In effect, Omnitrition may fashion a “per se” rule for pyramid schemes, but, precisely for that reason, it may not be followed by other Circuits. See also SEC v. Koscot Interplanetary Inc., 497 F.2d 473 (5th Cir. 1970).
 For a leading case requiring horizontal commonality, see Wals v. Fox Hills Development Corp., 24 F.3d 1016 (7th Cir. 1994). The Second Circuit has not indicated whether it will require horizontal commonality but does require at least “strict vertical commonality.” See Revak v. SEC Realty Corp., 18 F.3d 81, 88 (2d Cir. 1994).
 See Schmidt, Lipton and Stevenson, supra note 4.
 See Ryan Chittum, “The Great Herbalife Astroturf War,” Columbia Journalism Review, March 14, 2014 (discussing the United States Hispanic Leadership Institute, which received funds from Herbalife and wanted indemnification from Ackman and Pershing Square).
 Id. at p. 2.
 This line of cases begins with SEC v. Capital Gains Research Bureau Inc., 375 U.S. 180, 186–187 (1963). A relatively recent and controversial case is SEC v. Gun Soo Oh Park A/K/A Tokyo Joe and Tokyo Joe’s Societe Anonyme Corp., 99 F. Supp. 2d 889 (N.D. Ill. 2000).
 The leading “scalping” case is probably Zweig v. Hearst, 594 F.2d 1261 (9th Cir. 1979). Because it is before Dirks and O’Hagan, its continuing relevance is debatable, although it does involve affirmative positive representations by a journalist in his newspaper column that filed to disclose the columnist’s own recently acquired position.
 See Lowe v. SEC, 472 U.S. 181 (1985). Here, in a case involving whether a newsletter sent to as many as 9,000 subscribers made the publisher an unregistered investment advisor, the majority construed the statute narrowly to avoid a constitutional issue, while the minority found the statute unconstitutionally overbroad.