Which was your favourite Herbalife moment this year? The billionaire playground spat , an inside trading auditor , the dubious surveys and unanswered questions , George Soros , angry Latinas , the whistleblower , or the high profile departures and appointments ?
Yet the fun has also obscured the underlying issues. While there have been some great pieces looking at parts of the story – the Verge on online scammers pitching the Herbalife business opportunity, or the NY Post on the departure of top Herbalife salesman, Shawn Dahl, for instance – there was little that got to the heart of accusations that Herbalife is a pyramid scheme.
We want to change that, starting with this post about why the question for Herbalife investors should be less about whether the FTC will investigate Herbalife and more about what the Federal Trade Commission has already said and done.
As to Herbalife shares hitting a record high, we would note that the short interest remains considerable. Declining availability of stock in official lending programmes also suggests that institutional owners have been sellers this year. We’ll be very surprised if there isn’t more fun to come.
So, the place to begin is the problem of law: there isn’t any. Or rather there isn’t one US statute that defines a pyramid scheme. Instead the FTC rules are based on broad anti-fraud statutes and case law, in particular two suits from the 1970s, but also on subsequent prosecutions.
The first, known as Koscot Interplanetary, attacked the inherently fraudulent nature of pyramid schemes. But the more relevant case was a 1979 administrative court judgement against Amway Corp that allowed the group to continue selling its brushes and housewares, because it had put certain safeguards in place to ensure that it was legitimate.
Even though Avon had been selling cosmetics direct to consumers for almost a century, the Amway decision is largely seen as the birth of the modern multi-level marketing industry. Direct sellers were handed guidelines for behaviour, and with that legal cover and a deregulation minded White House, the industry flourished. Herbalife began life in Los Angeles in 1981.
Before we get into those rules, and more importantly how they have evolved, let’s pause for a moment to consider why they are needed. A pyramid scheme is an insidious type of fraud because its victims often don’t realise they’ve been had.
Imagine you answer an online ad promising financial freedom from just a few hours of work each week. Perhaps the pictures of people with perfect smiles and new Mercedes won you over. You invest time and money in buying a product to sell, materials to help you sell it, maybe even a ready-made website and “sales leads” to expand your burgeoning empire.
But despite all that investment, it doesn’t work out. You don’t blame the system which has so clearly made other people rich, you blame yourself. If only you had worked harder. If only you had been able to borrow a bit more money to get you to the point where that lifetime of royalty income kicks in.
The game, however, was rigged. As the FTC describes Fortune High Tech Marketing, an alleged pyramid scheme it persuaded a Chicago court to shut down this year (our emphasis):
What about all the rags-to-riches stories the company promotes? Only true for a few at the top tier. In fact, the FTC charged, the company structured its business in a way that guarantees most people who join would lose money. The compensation plan is confusing, and commissions on product sales are very small. There’s no training on how to sell the products — things you might be familiar with and can buy elsewhere — like subscriptions to DISH Network, cell phone services, or dietary supplements. According to the FTC, the only way to make any money working for FHTM is to recruit other employees.
That last line is key. The promise of a pyramid scheme is a lie, an endless steady drip of commissions from the sales people you recruit, and then from the sales from people they recruit, and so on as the pyramid expands.
Each time it expands, the center benefits. Debra Valentine, FTC General Counsel:
consider the matrix from the promoter/con artist’s point of view. He is the person at the top of the pyramid but in fact looks at the scheme from the bottom. He views each new investor as a predicable set of revenues and expenses, with the revenues flowing down to him.
So a very high turnover of salespeople, known as distributors, can be one indicator of a pyramid scheme. There will be a product, but the principal profits within the system will come from recruitment.
Its important to think here about the question of profits within the system as a whole. Herbalife is both a company that makes nutritional shakes and vitamin pills, and a structure around which distributors build their own businesses. The two are separate but intimately intertwined, and investors can only see what the company side chooses to disclose.
Ultimately, it is what the largest distributors do that shapes the business of a multi-level marketing scheme. If they profit mainly from recruitment, it will tilt the whole business in that direction. As William Keep, professor of marketing at the College of New Jersey and a widely consulted expert on pyramid schemes told the FT this year:
The profits made by powerful distributors from providing marketing services, website operations and sales leads to new recruits can, he said, over time “bias an organisation towards recruiting: the tail wags the dog”.
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.
By the 1990s, the FTC and the courts had realised that the Amway rules were useless if they weren’t enforced, and if sales commissions were based on a distributor’s wholesale sales that include those to new recruits. (In the jargon of pyramid schemes, a distributor’s downline ).
A 1996 Federal appeals court reversed a lower court decision in the case Webster versus Omnitrician and added some extra language, moving much closer to the view found in the 1970s Koscot judgement that multi-level marketing schemes are “inherently fraudulent”.
The court labeled Omnitrician, a nutritional supplement company, a fraudulent pyramid scheme. It said that distributors purchased product in order to earn compensation on product orders made by their recruits — again, known in the jargon as a distributors downline:
This compensation is facially “unrelated to the sale of the product to ultimate users” because it is paid based on the suggested retail price of the amount ordered from Omnitrition, rather than based on actual sales to consumers.
(Keen Herbalife watchers will know that Herbalife’s system also relies on suggested retail prices.) More from the case:
On its face, Omnitrition’s program appears to be a pyramid scheme. Omnitrition cannot save itself simply by pointing to the fact that it makes some retail sales….
The mere structure of the scheme suggests that Omnitrition’s focus was in promoting the program rather than selling the products.
The court looked at the Amway defences and found that just because Omnitrician required distributors to certify that they were following the rules did not make it so:
There is no evidence that this “certification” requirement actually serves to deter inventory loading.
It was then specific about what constitutes a retail sale:
Importantly, the requirement can be satisfied by non-retail sales to a supervisor’s own downline IMAs. This makes it less likely that the rule will effectively tie royalty overrides to sales to ultimate users, as Koscot requires.
And the judges had harsh words about counting orders by recruits towards retail sales:
Omnitrition’s “70 per cent Rule” allows supervisors to count products sold at wholesale to their own downlines toward their 70 per cent sales requirement. This allows supervisors to be compensated on the basis of sales other than “sales made to persons who are not participants in the scheme and who are not purchasing in order to participate in the scheme.”
That last bit being a key quote from pertinent Californian law, which as the FT has said could also be important to Herbalife.
However, the picture has since been muddied by the FTC. In 2004 the commission made public a Staff Advisory Opinion sent to the Direct Selling Association addressing questions about internal consumption. In asking for clarity, the industry gained useful ambiguity:
the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme.
This letter has a tendency to bring out the animated side in long-term campaigners against pyramid schemes, who see in it further evidence of the influence of effective lobbying by a well organised industry, one which also persuaded lawmakers in 2007 that multi-level marketing schemes did not need to be covered by business opportunity fraud legislation.
But for investors considering Herbalife, go back to the court decisions, in particular one rendered against BurnLounge this year. The court emphatically endorsed the Koscot and Omnitrician decisions, and attacked the reasoning of the defendants:
Defendants argue that, like Amway, BurnLounge paid commissions to its Mogul-distributors for internal sales to recruits. They pull isolated references from an FTC staff opinion and from Whole Living to support their claim that commissions for internal sales for the purchaser’s own use are not proof of a pyramid.
The court chastised the defendants for “misreading these authorities”, and then reaffirmed the view of the earlier judgement.
This Court in Omnitrition definitively ruled that “ultimate users” are the external customers for the business’s ostensible product, not the business’s own internal sales force…
As this Court said, “If Koscot is to have any teeth, such a [non-retail] sale cannot satisfy the requirement that sales be to ‘ultimate users’ of a product.”
Pretty emphatic, and finally that brings us to the point that investors should look at what the FTC does, as well as what it says. Go back to the complaint filed by the FTC this year against Fortune High Tech Marketing (an alleged pyramid scheme that has said it will defend itself and expects to be exonerated).
FRTM claims that its representatives will be able to easily sell its products and services to consumers not affiliated with FRTM. In fact, few of FRTM’s products and services are ever sold to anyone other than the Reps themselves. Furthermore, Reps receive minimal financial rewards from FRTM for selling the products and services to outside consumers.
And in the FTC’s restraining order, it enjoins the group from taking part in any marketing scheme that (emphasis ours):
Pays any compensation related to the purchase or sale of goods or services unless the majority of such compensation is derived from sales to persons who are not members of the Marketing Program.
Where does that leave us? It is clear that large amounts of sales to your own distributors is a problem for a direct sales company. Herbalife has said many times that it is legitimate. We think it still has some tough questions to answer about the nature of its customer base — questions it has chosen to answer with external surveys rather than its own hard data.
We’ll take a closer look at its responses and the issue of Herbalife’s sales to its own distributors in another post.
Another conclusion is that it would be unwise to assume that the FTC’s inaction so far means that it has no intention of acting, or relying just on the old Amway defenses and a benign reading of the 2004 advisory opinion as a basis for doing business.
Indeed, Bill Keep has suggested that one thing the FTC could do is issue a new staff advisory opinion to clarify the waters it has muddied. That would give investors greater confidence in the Commission’s views, and might give state attorneys general confidence to bring their own prosecutions against pyramid schemes.
California in particular was active in prosecuting such frauds in the last century, and in 1985 won an injunction against Herbalife that is still in force. It also has a large Hispanic population, and at least one Congresswoman who is concerned about the issue.
As we said, we’ll be very surprised if there isn’t more to come.
*UPDATE: We have amended that point about defining retail sales, as we were too generous before on that particular point. While Amway counted sales to other distributors (that downline jargon) for the purposes of its rule requiring 70 per cent of inventory to be sold each month, distributors were required to go find at least 10 real customers, not counting their downline.
Related Links: Herbalife distribution network in the spotlight – FT FTC urged to probe Herbalife claims – FT Herbalife hit as regulator spooks investors – FT