On January 10, 2013, Herbalife (HLF) held an Analyst Day during which it promised to refute the "distorted, outdated and inaccurate information" presented by Bill Ackman and his firm, Pershing Square Capital Management. In my opinion, Herbalife failed to address a key issue in its presentation. That issue is the repeated use of deceptive earnings claims by high-level Herbalife distributors in their Herbalife promotional materials. I will explain below why I believe most, if not all, of these earnings claims are deceptive, and that whatever course of action Herbalife chooses to deal with these claims will prove to be extremely disruptive to its army of distributors.
I have been a practicing attorney for over thirty years, during which I have represented distributors and franchisees in cases across the country. I have represented distributors in class actions against MLM companies in about ten cases, including several class actions against Herbalife and some of its high-level distributors. I was one of the attorneys for the class in Webster v. Omnitrition International, Inc., 79 F.3d 776 (9th Cir. 1996), which is the leading case on the standards for determining whether an MLM is operating as a pyramid scheme. I have represented or advised, on a pro bono basis, a number of consumer organizations devoted to educating consumers about deceptive MLM schemes.
Since 1995, I have participated in the Federal Trade Commission's regulatory proceedings concerning the MLM industry and have advocated for better disclosure and regulation of MLM business opportunities. I have never invested in Herbalife or any other MLM stock. I have consulted with investment professionals concerning the MLM industry and various MLM companies, including Herbalife. I am not being compensated for publishing this article. I do not have an opinion about whether Herbalife or any other publicly-held MLM is a good investment.
The primary focus of Ackman's Herbalife presentation, and the subsequent debate between Herbalife promoters and critics, has been on whether Herbalife is a pyramid scheme. However, Ackman's presentation also raises the issue of whether Herbalife and its high-level distributors are making deceptive earnings claims to prospective distributors.
Examples of Deceptive Earnings Claims by Herbalife Distributor Doran Andry
Among the materials included in Pershing Square's website devoted to Herbalife are numerous videos which promote Herbalife's multi-level marketing [MLM] business opportunity (check the tabs on the left side of the home page labeled "Promoting the Business Opportunity," "Herbalife Recruiting Affiliate Videos" and "Nutrition Clubs"). To take an example, consider the series of videos featuring Doran Andry. Mr. Andry, speaking to a room full of people who occasionally break into enthusiastic applause and cheers, claims that after his first four months at Herbalife in 1988, he was making $1,500 per month, after another 90 days, he was making $10,000 per month, after one year he was making $350,000 per year, and after two years he was making $1,100,000 per year.
Later on in the presentation, he states that some of the people in the room want to make $500 to $1500 per month, some want to make $1500 to $10,000 per month, and some want to make $20,000 to $100,000 per month. We are led to understand that all of these goals are achievable if one simply follows Mr. Andry's plan. The Doran Andry materials also include a written presentation which makes a number of earnings claims, including that Herbalife Nutrition Clubs average $2,000 per month and that a volume of 2500 Herbalife "volume points" per month is "very attainable with this model." The written presentation includes a "Herbalife Nutrition Club Business Model" which shows net income starting at $30,190.65 in 2011 and increasing by leaps and bounds to a spectacular $55,712,782.07 in 2020. Based on Pershing Square's presentation, the number of Herbalife distributors actually earning even $500 per month is a tiny percentage.
Federal Trade Commission Standards on What is Deceptive
The Federal Trade Commission has stated that "earnings claims lie at the heart of business opportunity fraud, and are typically the enticement that persuades consumers to invest their money." FTC Revised Notice of Proposed Rule-Making, Proposed Business Opportunity Rule, at page 64.
When the Federal Trade Commission brings enforcement actions against MLM firms, it typically alleges both that they are pyramid schemes and that they are making deceptive earnings claims, both of which are independently actionable under the Federal Trade Commission Act as "unfair or deceptive acts or practices in or affecting commerce." 15 U.S.C. §45(A)(1).
In the past fifteen years, the FTC has sued fourteen pyramid schemes that purported to be legitimate MLM businesses. In every one of these cases, the FTC also alleged that the MLM firm was making deceptive earnings claims:
In the Commission's law enforcement experience, all of its pyramid cases against purportedly legitimate MLMs alleged that the defendant made false earnings representations.
FTC Revised Notice of Proposed Rule-Making, Proposed Business Opportunity Rule, at page 41. Significantly, in at least one other case during this time frame, the FTC brought an enforcement action against an MLM company alleging that it was making deceptive earnings claims but not alleging that it was a pyramid scheme. In Nu Skin Int'l Inc., Docket C-3489, 117 F.T.C. 316, 324 (1994).
The earnings claims at issue in the Nu Skin case included both specific dollar amounts as well as charts showing how recruitment of new distributors would increase earnings. They are very similar to the types of "testimonial" earnings claims and charts used by Herbalife distributor Doran Andry discussed above. Accordingly, I think it is beyond any serious doubt that the FTC would consider Mr. Andry's claims to be deceptive. I would also note that in its guidelines for the use of testimonials in advertising, the FTC has opined that simple disclaimers like "results not typical" are not sufficient to avoid a finding of deception.
Earnings Claims under the FTC's Business Opportunity Rule
Another source for determining what the FTC considers to be deceptive earnings claims is its new Business Opportunity Rule. While the Business Opportunity Rule was amended - after intense lobbying by the MLM industry - to avoid "broadly sweeping in all MLMs into the ambit of the Rule," the FTC's analysis of what constitutes a deceptive earnings claim for other types if business opportunities is still relevant. Staff Report to the FTC and Proposed Revised Trade Regulation Rule, page 20.
The Business Opportunity Rule defines "earnings claim" as follows:
(f) Earnings claim means any oral, written, or visual representation to a prospective purchaser that conveys, expressly or by implication, a specific level or range of actual or potential sales, or gross or net income or profits. Earnings claims include, but are not limited to:
(1) Any chart, table, or mathematical calculation that demonstrates possible results based upon a combination of variables; and
(2) Any statements from which a prospective purchaser can reasonably infer that he or she will earn a minimum level of income (e.g., "earn enough to buy a Porsche," "earn a six-figure income," or "earn your investment back within one year"). 16 C.F.R. §437.1(f).
Clearly the types of statements made in the Doran Andry videos and Nutrition Club document would constitute earnings claims under this definition. Under the new Business Opportunity Rule, such claims are considered deceptive unless they are accompanied by an earnings claim statement. The Rule provides that:
In connection with the offer for sale, sale, or promotion of a business opportunity, it is a violation of this Rule and an unfair or deceptive act or practice in violation of Section 5 of the FTC Act, for the seller to:
Make any earnings claim to a prospective purchaser, unless the seller:
(1) Has a reasonable basis for its claim at the time the claim is made;
(2) Has in its possession written materials that substantiate its claim at the time the claim is made;
(3) Makes the written substantiation available upon request to the prospective purchaser and to the Commission; and
(4) Furnishes to the prospective purchaser an earnings claim statement. The earnings claim statement shall be a single written document and shall state the following information:
(I) The title "EARNINGS CLAIM STATEMENT REQUIRED BY LAW" in capital, bold type letters;
(ii) The name of the person making the earnings claim and the date of the earnings claim;
(III) The earnings claim;
(iv) The beginning and ending dates when the represented earnings were achieved;
(V) The number and percentage of all persons who purchased the business opportunity prior to the ending date in paragraph (4)(iv) of this section who achieved at least the stated level of earnings;
(vi) Any characteristics of the purchasers who achieved at least the represented level of earnings, such as their location, that may differ materially from the characteristics of the prospective purchasers being offered the business opportunity; and
(VII) A statement that written substantiation for the earnings claim will be made available to the prospective purchaser upon request. 16 C.F.R. §437.4.
Take particular note of subsection (vi) which requires additional disclosure if the earnings claim portrays persons - like Doran Andry - whose situation is materially different from prospective purchasers.
The Consequences of Making Deceptive Earnings Claims
If the FTC concludes that a business opportunity seller is making deceptive earnings claims, it can bring a civil action for injunctive relief, consumer redress, rescission or reformation of contracts, refund of money, damages, and public notice concerning the defendant's commission of unfair or deceptive acts or practices. 15 U.S.C. §§45 and 57b. For example, in the Nu Skin case there was a final consent order which provided that:
- Nu Skin and the top level distributors were ordered to cease and desist from misrepresenting the past, present or future profits, earnings, income or sales that distributors could achieve.
- Nu Skin and the top-level distributors were ordered to cease and desist from "representing, in any manner, directly or by implication, by use of hypothetical examples or otherwise, that distributors earn or achieve from such participation [in Nu Skin] any stated amount of profits, earnings, income or sales in excess of the average profits, earnings, income or sales of all distributors in any time period respondents may select, unless in conjunction therewith such average profits, earnings, income or sales are clearly and conspicuously disclosed, and the percent of all distributors who actually achieved such stated profits, earnings, income or sales in such time period is clearly and conspicuously disclosed."
- Nu Skin was ordered to deliver a letter explaining the terms of the consent order to each of its current distributors and to all future distributors for a period of five years.
- Nu Skin was ordered to institute a surveillance program to determine whether its distributors were complying with the order for a period of five years, and to terminate any distributor who made deceptive earnings claims in violation of the order.
- The top level Nu Skin distributors were ordered to advise the FTC of any change in their employment or business.
- Nu Skin had to pay $1 million and the top-level distributors had to pay $225,000, which the FTC could in its discretion use for consumer redress or pay to the U.S. Treasury.
Herbalife's Statement of Average Gross Compensation is Also Deceptive
Herbalife provides a document entitled "Statement of Average Gross Compensation of U.S. Supervisors - 2011." The Statement appears in Herbalife's Sales and Marketing Plan and Business Rules, as well as on Herbalife's website. Obviously this is done in an effort to disinfect the outrageous earnings claims made by high-level Herbalife distributors. However, this Statement is itself extremely deceptive:
- It excludes Supervisors who are "inactive" and thereby overstates the average "earnings" at each level. Thus, distributors who purchased sufficient volume to reach the "Supervisor" level but who failed to make sufficient purchases to be considered "active" are arbitrarily excluded from the averages.
- The Statement fails to identify the unique or special circumstances which make particular earnings claims deceptive, such as Doran Andry's huge downline built up since 1988.
- Most importantly, the "average earnings" do not reflect any of the business expenses incurred by Herbalife distributors. As Herbalife acknowledges in Item 7 of its 2011 Form 10-K (which I suspect is not provided to prospective distributors), Herbalife distributors incur many expenses in addition to their purchases of Herbalife products:
If a distributor wants to pursue the Herbalife business opportunity, the distributor is responsible for growing his or her business and personally pays for the sales activities related to attracting new customers and recruiting distributors by hosting events such as Herbalife Opportunity Meetings or Success Training Seminars; by advertising Herbalife's products; by purchasing and using promotional materials such as t-shirts, buttons and caps; by utilizing and paying for direct mail and print material such as brochures, flyers, catalogs, business cards, posters and banners and telephone book listings; by purchasing inventory for sale or use as samples; and by training, mentoring and following up (in person or via the phone or internet) with customers and recruits on how to use Herbalife products and/or pursue the Herbalife business opportunity.
As Pershing Square makes clear, using settlement data from one of my cases against Herbalife among other sources, these expenses can be quite substantial, averaging over $10,000 per claimant in that case.
Herbalife's Hobson's Choice
With respect to each earnings claim, such as those made by Doran Andry, Herbalife has two options. Option A is to approve the claim and somehow explain how it is not deceptive. Option B is to state that the claim was not approved, and explain how it will discipline the distributor who is responsible for making the claim and ensure that the deceptive claim is not repeated.
I believe that this situation creates a Hobson's choice for Herbalife. If it elects Option A it will be faced with the impossible task of reconciling outrageous earnings claims with the Federal Trade Commission's standards for determining whether such claims are deceptive. If it elects Option B it will be forced to disown the promotional activities of a large number of its highest level distributors, whose "downlines" collectively account for what must be a substantial percentage of Herbalife's distributors. I call this the "overzealous distributor" defense, where the MLM company is forced to say that "we are shocked, shocked, to learn that our trusted distributors are violating our strict rules against deceptive earnings claims." Taking this position would likely force Herbalife to discipline these high-level distributors or, at the very least, require them to withdraw or make substantial revisions to their promotional materials and practices.
Whichever option it chooses, Herbalife and its highest level distributors face the serious threat of litigation from both defrauded distributors as well as the FTC and state enforcement authorities.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.