Since David Einhorn of Greenlight Capital asked a few questions about where the revenue of the multi-level marketing (MLM) company Herbalife (HLF) originates, a growing controversy over this company was sparked among hedge fund managers, corporate raiders and investor activists. The issue exploded into a forest fire when William Ackman of Pershing Square Capital delivered a 300-slide thesis against Herbalife in which he charged that Herbalife is an illegal pyramid scheme whose stock value should be zero. Some MLM industry figures have joined the fray, arguing that Ackman's thesis is a dagger aimed at the heart of the entire multi-level marketing industry.
The debate has ranged at times from a rational economic analyses to disputes about the definition and legality of pyramid schemes, to personal clashes between long or short shareholder interest groups. It has spawned an industry of speculation about regulatory prospects and even ethical and patriotic perspectives on pyramid selling schemes.
Herbalife: Latest Chapter in 90-Year Pyramid Debate and Unfinished Regulation
This article offers a historical perspective that shows that the Herbalife controversy is only the latest chapter in a 90-year debate about the free market's evil cousin, the pyramid scheme disguised as a business. This controversy may be traced from the namesake Charles Ponzi in 1920 and through the Enron collapse. Facets of this controversy are also seen in penny stock frauds and in the recent dotcom and housing bubbles.
This analysis is also a clarion call for the FTC, SEC and Congress to finally deal with the unfinished business of law enforcement and regulation of this type of market fraud. Pyramids and Ponzis have grown and morphed over time to epidemic proportions in the marketplace. They plague both Wall Street as financial Ponzi schemes and as "business opportunity" pyramids on Main Street.
The recent FTC prosecution of the MLM, Fortune High Tech Marketing, as a pyramid scheme confirms the urgent need for a discernible regulatory standard for pyramid selling schemes. To ordinary people, Fortune High Tech Marketing was utterly indistinguishable from hundreds of other similar "multi-level marketing" schemes in operation today. It was wrapped in a veneer of legality. It sold name-brand products. It was founded by a well known figure, respected inside the multi-level marketing field. It had celebrity promoters, including the wife of the ex-CEO of Bank of America. Fortune's claim to legality was bolstered by its "Legal Advisory Council" comprised of two former state attorneys general, Chris Gorman who served as Kentucky Attorney General from 1992-1996, and Robert Stephan who served as Kansas Attorney General from 1979-1995.
Business Model, not Practices, in Historical Question
What is historically noteworthy about the Herbalife dispute is that hedge fund managers are taking positions not on Herbalife's growth or profitability prospects but rather on its very legality and sustainability. This is unprecedented, at least in recent decades. There have been vigorous debates about the legality of some business practices that proved to be devastating to the economy. These include the excessive leverage of S&Ls; inflated valuations of dotcoms; the opacity of credit default swaps; deceptive marketing of for-profit education; subprime mortgages, among others. But these debates were about policies, practices and behavior, never about the very legality of an established business model that touches tens of millions of people every day.
The question of the legality of Herbalife addresses not Herbalife's practices but how it is structured. The deceptive practices of a pyramid scheme are understood by regulators as inherent, a function of a pyramid's "uneconomic" structure. If a business is structured as a pyramid, deception will always follow as will large-scale harm to participants. For this reason, the FTC has prosecuted pyramids under Section 5 of the FTC Act, as "inherently unfair and deceptive."
Structural questions about Herbalife's business model include:
- Payment of fees and purchases by participants to gain recruitment-based rewards.
- Reward program that is based on distributor purchases and which one federal court stated, 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 [Herbalife], rather than based on actual sales to consumers."
- Highly leveraged, multi-level sales chain that serves no sales management function but very effectively siphons funds from a huge base of new recruits to the top recruiters; it also structurally renders the chances virtually nil for the bottom level recruits to rise on the ever-widening chain.
- Payout formulas that transfer the majority of all rewards, per sale, to the 1% at the peak of the sales chain
- Accounting system and compensation policy in which purchases by the supply chain - not open market retail sales - are counted as "final sales" that directly fund the pool of rewards for earlier recruiters.
Historical Precedent: The Enron Model Analysis
In modern years, the closest Wall Street has come to a Herbalife-like debate about the business model of a major corporation was the post-mortem analysis of Enron's business model, which in its heyday also claimed to be unique and "innovative." It too dazzled analysts with fast growth and record profits.
Enron's model was based on the same key characteristics that William Ackman accused Herbalife of exhibiting. Famously designed by the "smartest guys in the room," Enron's model employed mark-to-market accounting that posted current profits based on anticipated events, and placed enormous debt and losses into "special purpose entities" off the balance sheet.
Distributor Channel Losses as "Special Purpose Entities"
William Ackman effectively compared the multi-billion dollar losses incurred by millions of Herbalife consumer/distributors to a "special purpose entity" that does not show up on Herbalife's books and is not counted in the supply chain's true costs. He said Herbalife has an enormous unstated liability in its existential requirement to constantly replace the "failed" distributor/investors with new ones in order to fulfill promises of rewards both to shareholders and existing distributors. He argued that Herbalife's stock value is based primarily on an income promise to shareholders that it cannot fulfill without hiding the huge losses to the distributors off the balance sheet.
Because they are off the balance sheet, it is not possible to fully account for the consumer losses of those signed up as Herbalife distributors. However, Herbalife does disclose some data on distributors in the USA. According to Herbalife's "Statement of Average Gross Compensation of U.S. Supervisors - 2011" the bottom 91% of all the "active" Supervisors (the top tier of the sales channel) earned an average gross income of just $111 per month, before all business costs and inventory purchases are deducted. In its 2011 10K, Herbalife disclosed that there were 56,741 active Supervisors in the USA. Active distributors are just 39% of all Supervisors, so the total number of Supervisors in 2011 was over 140,000. The bottom 97% of all the Supervisors, active and inactive, earned an average of just $41 a month, also before all costs are subtracted.
An individual can maintain a Supervisor status by personally purchasing about $3,000 of inventory in a year so these figures indicate potentially very widespread losses year after year. Below the Supervisors is the bulk of the sales force, constituting 75% of the channel or more than 400,000 recruits in America alone. This group is ineligible to receive "royalty" payments and could only profit from retail sales, of which none is documented.
Future Sales Posted as Current Profit
In Ackman's analysis, what Herbalife calls "profits" are really just investment capital gained from new distributors in fee payments and inventory purchases tied to incentives and rewards. The purchases are obtained by making an income promise that cannot be fulfilled due to the pyramid structure which can deliver profitability only to a tiny few at the top.
Equivalent to Enron's mark to market accounting, in Ackman's analysis, Herbalife claims "profits" on the premise that what is sold to the distributor channel will lead to future retail sales. Ackman argued that distributors and Wall Street investors are misled to believe that Herbalife's products are ultimately retailed to end-users and that the business is product-based, rather than driven by its famous "unlimited income opportunity" that incentivizes recruiting and internal inventory purchases by the distributors.
In conventional businesses, selling inventory to distributors who do not resell the goods is called "channel stuffing." It is normally a short term maneuver to briefly off-load costs on to the distributor and to improperly claim revenue in the short term since the product is still in the supply chain and likely will not be resold in the near future. Normally, such behavior leads to a distributor defections which can harm the manufacturer. It is normally considered a failed and desperate move and is viewed as an abuse of the sales channel. But in Herbalife's case, large-scale distributor defection is built into the business model. Losses by the channel are similarly not a problem since they are off Herbalife's books. The "failed" distributors churn at a very high rate. In its 2005 10K filing, Herbalife reported an overall churn rate of 80% among all distributors. Under such a plan, departing distributors can be used to off-load the products and claim the inventory transactions as "sales" even if they are never resold. Then the unprofitable and "failed" distributors can be replaced by new ones who will meet the same fate as they buy for a time, fail to profitably resell the goods, and then quit usually within a year.
Whereas the repercussions of selling inventory to non-selling distributors would be fatal to a sales company, negative consequences are not felt by Herbalife, as long as new distributors can be found.
A Fiction of Future Retail Profits
Herbalife even details the amount of the future and profitable sales by the distributors in a line item on its SEC filings, called "distributor allowance", a figure purported to equate to the distributors' aggregate retail profits equivalent in volume to about 70% of Herbalife's own net revenue. In effect, it is saying that the distributor channel's gross profit from retail sales is almost equal to Herbalife's own sales. SEC filings by Herbalife claim that distributors gain most of their profit from these subsequent retail sales. The retail sale narrative is further supported by Herbalife's charging the distributors sales tax on their purchases, calculated at the retail price, not the wholesale price they actually paid. Herbalife pre-pays sales taxes to the states on hundreds of thousands of future sales that never happen.
Ackman argued that not only do these anticipated and allegedly profitable retail sales seldom occur but that the Herbalife model makes them nearly impossible. The model floods the market with competing would-be retailers, offering each one lucrative incentives to recruit even more distributors and thereby generating ever more investment capital for Herbalife. The inundation of retailers all but destroys profitable retail sales opportunities. It also triggers an ever-larger liability for more recruitment by Herbalife, a requirement that cannot be met indefinitely.
Images of Stability and Legitimacy
Herbalife argues that its growth, profitability, employment, manufacturing, and 30-year tenure are indisputable evidence of legitimacy. Enron also flaunted its commercial success, power, and influence. Enron's business model claimed unstoppable growth, and the company inferred that market forces that controlled the fates of other companies did not apply to it. Enron's stock rose to record heights. Its SEC filings were not challenged by regulators. It gained Fortune Magazine's award as "America's Most Innovative Company" for six straight years. Enron employed nearly 20,000 people with revenues of more than $100 billion in 2000. Enron's extraordinary political influence and insider connections in the 2000 election of George W. Bush are also well documented.
After its collapse, Enron's "innovations" turned out to be mere sleight of hand, and its model to be unsustainable.
Historical Precedent: The Ponzi Model Analysis
Analysis of Enron only occurred after it collapsed. The last true business model debate of an existing and flourishing business that was historically as significant as the Herbalife controversy occurred in 1920. The debate was over the legality and sustainability of Charles Ponzi's "innovative" business, called, ironically, Securities Exchange Company (SEC). William Ackman hearkened that analysis in his own research report on Herbalife. He called Herbalife a modern day Ponzi scheme.
Herbalife's business is like Ponzi's, according to that analysis, in that Ponzi's was based on a false promise of extraordinary income for participants. The profits that were paid to investors, in fact, depended upon constantly enrolling new investors. The profits were internal transfers of capital investments. There was not enough "outside" revenue earned in the open marketplace by Ponzi to cover payments to earlier investors.
Though Ponzi's scheme, today, appears transparent and he himself is seen as clownish and amateurish, he was larger than life in his time. An Italian immigrant, he exuded confidence and faith in the American Dream. It is now estimated that his bogus enterprise drew in more than $250 million in today's dollars in only about a year and mostly just in the Boston area. To measure Ponzi's true significance one might add to that figure all losses that have since been attributed to businesses that ignominiously have been labeled with his namesake. Bernard Madoff was merely a resurrected Ponzi and the subprime mortgage debacle might be seen as Ponzi's revenge. Madoff and the housing market disaster are but more evidence that Ponzi's scheme is still not understood by regulators who consistently fail to stop the frauds in a timely fashion.
Ponzi's investment business boomed, attracting mostly middle class investors at first and then poorer people who saw Ponzi as a savior. Ponzi was hailed in the media and by thousands of supporters as a champion of the little guy, who was delivering returns to small investors at a level that the banks and big investors supposedly got. Ponzi promised 50% return in 45 days. Rival newspapers argued whether his business was legitimate or a fraud. Banks too took sides. In fact, five banks who were attracted by Ponzi's amazing cash flow and growth were dragged down when Ponzi's business collapsed.
It should be noted that Ponzi's business never generated significant consumer complaints. Critical questions and accusations, rather, came from muckraking journalists who took legal and professional risks to question the scheme. Critics were often viciously attacked by Ponzi's investors as elitists, big business manipulators, anti-business socialists, or small minded individuals who resented or envied Ponzi's success. The tide changed only when an authoritative voice weighed in against Ponzi. That highly respected figure was Clarence W. Barron, the de facto founder of the Dow Jones news service and the publisher of the Wall Street Journal and Barron's Magazine.
Internal Money Transfers
Like Ackman's thesis on Herbalife, Barron's analysis of Ponzi was market-based, not a legal opinion. Barron's conviction about Ponzi's fraud, like Ackman's conviction about Herbalife, was also not daunted by celebrated growth, popularity, philanthropy, profits and payments of commissions and dividends. Barron's research concluded that Ponzi's business model had to be a fraud because Ponzi's advertised investment strategy, buying international postal coupons in one country and selling them for a profit in another based on currency exchange rate differences, could not produce the volume of dollars he was obligated to pay out. This was because there were not enough such coupons in the market to be traded. The business, therefore, had to be based on transferring later investor's funds to earlier ones.
Ackman made the same claim against Herbalife. He argued that there is not enough retail revenue generated by the company to pay the recruiters' rewards, which Herbalife calls "royalties", calculated at 33% of net revenue in its SEC filings. He also charged that excessive shipping charges are, effectively, fees paid by new recruits to bolster Herbalife's payments to recruiters. Ackman calls these royalty payments based on purchases and shipping charges to new recruits internal money transfers. His attorney argued that Herbalife's payments to recruiters from funds ultimately sourced from purchases and fees paid by the newer recruits, rather than from retail sales in the open market, define the Herbalife business as a pyramid scheme.
Ackman's Herbalife analysis mirrors Barron's conclusion about Ponzi. Both charged there was no free market basis for the companies' profits. Barron said Ponzi was not generating profits from trading postal coupons. Ackman said Herbalife is not generating enough revenue from selling its products on a retail basis in the open market. Ackman and Barron both charged that the respective businesses they researched operated on a false income promise. They gained revenue and they dispensed payments on the strength of the income claim, not from legitimate trades or free market sales. Both companies, according to the respective analyses of their times, could pay dividends only as long as they are believed and can find new investors/distributors.
Legal Pyramids? A 93-Year Question
While Barron's market-based analysis that coupon trades were insufficient to generate Ponzi's profits was a strong case for impending and massive investor losses, it was not clear - from the laws on the books - that it constituted a crime. Investors take risks, it was noted, and there was no documented evidence regarding the actual volume of postal coupons traded at that point.
In Ponzi's day, some people argued that the transfer of some later investors' money to earlier ones, as part of a larger investment strategy that was based upon legitimate arbitrage, is not necessarily illegal. They argued that those who attacked Ponzi did not understand his overall business model and they had no hard data for proof, only theories and speculation.
An astute observer will note the uncanny similarity to today's controversy around Herbalife. As there was no market data on Ponzi's postal coupon trades, today there is no documentation available on Herbalife's retail sales, the very data that David Einhorn asked for and that sparked a billion dollar sell-off of Herbalife's - and a similar amount of Nuskin's (NUS) - stock. Herbalife says it "does not have visibility" to end-users. More recently it has offered conflicting data and survey evidence but still maintains that hard data is unavailable.
Mirroring Ponzi's defenders in 1920, it is now argued by Herbalife and the Direct Selling Association that, even if there are only meager external retail sales, the internal transfers in a closed market are not illegal. Ackman and many others charge that if there is not adequate retail revenue, Herbalife's business involves a continuous money transfer from later recruits' investments to earlier ones, filtered through "qualifying" purchases stipulated in the compensation plan. Ackman's attorney pointed out that federal courts have consistently ruled that MLM companies like Herbalife must fund rewards to recruiters from end-user retail sales in the open market, not from purchases from other "downline" salespeople who participate in the recruitment-based pay plan.
Retail sales revenue from non-distributors, sufficient to fund Herbalife's enormous payments to recruiters (33% of sales and shipping charges to the distributors) are the business model equivalent to Ponzi's postal coupon trade profits as "outside" revenue critical to legality and sustainability.
Herbalife has claimed that the internal transactions qualify as bona fide "retail" sales. But this assertion requires an entirely new definition of retail and wholesale that is unknown in the business world. Under the terms of Herbalife's contract with its distributors, all such transactions among the distributors function within a closed market in which pricing is firmly fixed and trade is strictly restrained by Herbalife. Herbalife sets the terms and the pricing under which the distributors can sell to each other. Herbalife distributors are not allowed to shop around for other distributors to possibly get a lower price from. Sellers of products to other distributors inside the system cannot advertise or sell to downlines of other distributors.
All Herbalife distributors also are banned from selling products for other MLM companies. They do not own their own customer lists of distributors they recruited and sell to. Rather, under the contract, the names belong to Herbalife. Herbalife authorizes unlimited numbers of new retailers into all territories.
Without substantial retail sales opportunities in the open market, the closed market of Herbalife distributors inevitably requires constant expansion of distributors to fulfill Herbalife's income promise to the newest recruits. They must recruit more new distributors to sell to or to gain royalties on their inventory purchases.
No Laws, No Rules, No Regulation
In 1920 as now, there was no explicit law against "endless chain" fraud or what we now call a pyramid or a "Ponzi" scheme. America today still has no federal law that even includes or defines the term, "pyramid scheme." Multi-level marketing , which is Herbalife's business model, is similarly not legally defined or regulated as, for example, franchises are. MLMs are also exempted from FTC "business opportunity" rules for disclosure of costs, loss rates, average income, etc., to its Main Street participants who are solicited by the millions upon millions to invest their money in the "income opportunity."
Herbalife's all other MLMs' sales of their hallmark "unlimited income" proposition may the only financial instrument that is not regulated and which carries no disclosure requirements.
Without a clearly defined law against the money transfer model, Ponzi was charged by the state of Massachusetts on 22 counts of "larceny". A jury, dazzled by his charisma and sympathetic to his acclaimed mission of helping the common man and fulfilling the American Dream, acquitted him. Ponzi won without hiring a lawyer. It was the federal government that actually convicted him initially and that was only for illegal use of the mail service. Ponzi was later deported and ultimately died a pauper in Brazil.
So, while today's debate about the legality of Herbalife's business model is unprecedented in recent years, it has deep historical roots specific to the still unaddressed questions about defining pyramid and Ponzi schemes, how to identify them when they are disguised as businesses and how to regulate them.
It is obvious that our laws have still not caught up to the challenge of defining and explicitly prohibiting the use of pyramid and endless chain money transfers, now called "Ponzi schemes." Perhaps the new battle over Herbalife will finally lead regulators to address this growing problem.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.