A few hours before a negative story about the nutritional supplement company Herbalife broke, someone made an abnormally large bet that the company's stock would drop significantly.
At 3:55 p.m. on June 25, 2015 -- just five minutes before the market closed for the day -- an unknown individual made a 1-million-share derivative wager that Herbalife stock would drop. Eight seconds later, another 1-million-share derivative trade in a different, but related, type of security was made. The derivatives in both trades expired on August 21.
Five hours and 54 minutes later, the New York Post published a negative story about Herbalife with the headline: "Video reveals Herbalife boss saw ‘pyramiding’ signs early on."
In July, Herbalife sent a letter to the Justice Department and the Securities and Exchange Commission contending that the timing of the trades relative to the Post's article was suspicious. The letter, which was obtained by The Huffington Post, raises concerns that an individual trader (or traders) had prior knowledge of the story. (The New York Post declined to comment for this story.)
"If I were regulators, I'd want to know who placed those trades. I'd also want to know what contact they had, if any, with the Post," Richard Painter, a law professor at the University of Minnesota who specializes in securities law and enforcement, told HuffPost.
"The most suspicious fact is the timing of the trade," agreed Jacob Frenkel, a former SEC enforcement lawyer and federal criminal prosecutor who is now a partner at the law firm Shulman Rogers.
The article highlighted a 2005 recording in which CEO Michael Johnson tells Herbalife's management team that parts of the company -- which uses the multi-level marketing technique made famous by Amway, Tupperware and Avon -- had been used as a vehicle for some distributors to make "false promises, claims, in hopes for product, for money, for recruiting, for customers, for pyramiding." Pyramiding refers to the practice of distributors rushing to recruit new distributors beneath them, with no regard for actual product sales or demand. Johnson went on to suggest that Herbalife should make changes to eliminate the problem.
The timing of the trade with respect to the article could be purely coincidental, and Herbalife did not present specific information to the DOJ or SEC linking any particular person or organization to the transaction. But the complaint highlights what the company sees as a pattern of suspicious trading before negative news releases, and takes place in the context of an ongoing feud between Herbalife and a hedge fund that has pledged to bring it down.
Referring to unidentified traders whom the company suspects of misconduct, Herbalife spokesman Alan Hoffman told HuffPost, “Unfortunately, we have seen them run this play before and until someone acts, we will probably see it again."
Herbalife's letter requests that the two agencies investigate any potential connection the trades might have to the hedge fund Pershing Square. Herbalife and Pershing Square have been at odds since late 2012, when Bill Ackman, who runs the hedge fund, announced that he had bet $1 billion that the company would fail. Ackman predicted that the stock, which was trading around $42 before his prediction, would go to zero.
Since he announced his short position, Ackman and Herbalife have traded dueling barbs in the financial press, as well as through litigators, lobbyists and public relations specialists, both attempting to sway regulators in their favor. Rival hedge fund managers have lined up both with and against Ackman.
The fight has at times resembled a political campaign rife with dirty tricks, and exemplifies the way shareholder activism has transformed into a very public way for billionaires to fight with each other. As The New York Times pithily put it, Ackman is “staking $1 billion that Herbalife will fail, then lobbying to bring it down.”
Ackman has called the company a "pyramid scheme" and said he will fight it "to the end of the earth." Herbalife denies Ackman's claims, and says that most people become distributors simply to buy products at a discount. In the 2005 video, after Johnson acknowledges the potential for pyramiding, he outlines changes that the company has since enacted to reduce the turnover and financial burden borne by its lowest-level distributors.
Pershing Square denies any connection to the June trades. "Herbalife’s accusations are false," Pershing Square spokesman Francis McGill told HuffPost. He added that Herbalife "is a pyramid scheme that continues to harm millions of people around the world."
The distinction between what constitutes a legitimate multi-level marketing business and a pyramid scheme is at the heart of a Federal Trade Commission investigation of the company. In addition, Herbalife has disclosed that the DOJ and the SEC have asked it for information about its business practices.
Meanwhile, The Wall Street Journal has reported that federal prosecutors are looking into allegations that contractors hired by Ackman to lobby against Herbalife engaged in market manipulation.
Market data shows that the June 25 trades were abnormally large. The first trade consisted of 10,000 contracts for a $40 put option expiring on Aug. 21. This is 294 times larger than the second-largest trade in the same type of derivative for the month of June, which was for only 34 contracts. For most of that month, the total number of put contracts traded each day was in the single digits.
The trade that came eight seconds later, consisting of 10,000 $60 calls options, also expiring on Aug. 21, was similarly massive. The second-largest trade of that nature in June was for just 60 contracts, with most of the other trades in the low single digits.
Exchange information provided by market data firm Nanex indicates that the two trades were done to create a very large position that would profit if Herbalife declined. The call trade appears to have been initiated by a seller, having been done closer to the market selling price than the buying price. The put trade seems to have been initiated by a buyer, since it was done closer to buying price than selling price. Selling the calls would have brought in $2.16 million, while buying the puts would have cost $750,000, generating an initial profit of over a million dollars.
There would be more of a reason to expect larger-than-usual options trades if Herbalife's stock price had been volatile or if trading had been heavier than normal. But on the day in question, volume in Herbalife stock, while slightly elevated, wasn’t conspicuously out of the ordinary: It stood at 2.4 million shares, and its price fluctuated within the narrow range of $54.37 to $55.05.
Frenkel offered an explanation for why the trade may have been made with derivatives that didn't expire for several weeks after they were purchased. "There's more of an argument, as a cover story, that this was done to hedge a position, as a way to explain an aberrational trade," he said.
It wasn't only that there were eight weeks left in the lifespan of the options. In addition, Herbalife's Aug. 5 earnings report was sandwiched in between the purchase and the expiration of the options. The earnings report was an event that could very plausibly move the stock up or down, and one that any investors without any information about the Post story could reasonably want to hedge against.
The volume of trade in Herbalife options was also high on June 30, with around 6,500 total derivative contracts traded, according to data from Bloomberg. However, that was the last day of the third quarter, and such volume is typical for a quarter’s end. The data indicate a comparably high volume of trading in Herbalife options toward the end of previous quarters.
On June 26, the day after the New York Post story ran, Herbalife stock fell from $55.05 to $53.75, or just 2.4 percent. In subsequent weeks, it fell as low as $48.36 but also traded as high as $60.77, following a well-received quarterly earnings report on Aug. 5. The stock closed on Aug. 21 at $56.84. If both options positions were kept open until expiration -- as open interest data indicates is the case -- whoever placed the trade would have made $1,410,000.
The SEC is likely to be "all over this like a fumble at the goal line," Frenkel said, adding that the fact pattern "would be of interest to the Justice Department and likely implicate a parallel criminal investigation."
The SEC and the DOJ both declined to comment for this story.
This story has been updated to include the name of the market data firm that provided information about the two trades.