Publicly Available Lessons Regarding Pyramid Schemes: What Should We Think About Herbalife?

| About: Herbalife Ltd. (HLF)

Recently we have seen a flurry of articles in Seeking Alpha and elsewhere written by authors claiming to know whether or not Herbalife (NYSE:HLF) is a pyramid scheme. These articles consistently use assumptions and/or data that cannot be independently verified.

What has not been included in the discussion is a consideration of public documents associated with actual pyramid scheme prosecutions. Authors of "what if" scenarios may give a nod to one article or another, but only if they can find support for their stated assumptions. This over-reliance on certain assumptions (perhaps plausible, perhaps not) and under-reliance on available reasoning in court decisions serves to confuse rather than to clarify the issues (an exercise I have, at times, labeled "nonsense").

Let's start with the issue of retail sales. In Koscot Interplanetary the court described a pyramid scheme as having "rewards which are unrelated to sale of the product to ultimate users." Herbalife and its paid consultant Anne Coughlan define "ultimate users" to include distributors. While possibly fitting a definition found in a marketing textbook, this position is not consistent with litigated decisions regarding pyramid schemes. Consistent with Koscot Interplanetary, Amway defended itself against a pyramid scheme charge by assuring the judge that it had and would continue to have a majority of customers outside the distribution network - creating what came to be known as the ten-customer and 70% rules.

Subsequently, in Webster v. Omnitrition the court noted:

In addition, plaintiffs have produced evidence that the 70% rule can be satisfied by a distributor's personal use of the products. If Koscot is to have any teeth, such a sale cannot satisfy the requirement that sales be to "ultimate users" of a product.

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.

Omnitrition cannot save itself simply by pointing to the fact that it makes some retail sales.

Citing Webster v. Omnitrition, Debra A. Valentine, General Counsel for the FTC wrote (May 13, 1998):

The court noted that the "70% rule" and "10 customer rule" are meaningless if commissions are paid based on a distributor's wholesale sales (which are only sales to new recruits), and not based on actual retail sales.

A lack of retail sales is also a red flag that a pyramid exists. Many pyramid schemes will claim that their product is selling like hot cakes. However, on closer examination, the sales occur only between people inside the pyramid structure or to new recruits joining the structure, not to consumers out in the general public.

More recently, in FTC v. FHTM, the court's restraining order clearly prohibits the firm from engaging in a marketing program that "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."

The argument that company sales to its distributors - and in turn, sales to subsequently recruited distributors - comprise sales to "ultimate users" is inconsistent with virtually every court decision and the most recent FTC action. On this matter the FTC could not be clearer.

As with the issue of retail sales, the 2004 FTC Staff Advisory has suffered at the hands of self-interested interpretations. Some interpret the FTC statement that "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" to mean that internal consumption is irrelevant to pyramid analysis. An undergraduate English major would recognize that the advisory letter does not say this - especially given the letter's further review, and related prohibitions, of certain types of distributor purchases (just below). Purposeful misinterpretations try to undercut the role that distributor "churn" and a primary reliance on recruitment play in pyramid scheme cases.

Selective interpretations aside, the 2004 FTC Staff Advisory actually takes the issue of distributor purchases a step further by warning against required purchase levels to qualify for compensation.

Modem pyramid schemes generally do not blatantly base commissions on the outright payment of fees, but instead try to disguise these payments to appear as if they are based on the sale of goods or services. The most common means employed to achieve this goal is to require a certain level of monthly purchases to qualify for commissions. While the sale of goods and services nominally generates all commissions in a system primarily funded by such purchases, in fact, those commissions are funded by purchases made to obtain the right to participate in the scheme.

The Advisory also warns: "[A] multi-level compensation system funded primarily by payments made for the right to participate in the venture is an illegal pyramid scheme."

Here we see a clear distinction between compensation directly tied to successful selling, as one would find with a straight commission, and an arrangement where participants must undertake and maintain a purchase threshold to qualify for compensation. In the latter arrangement, distributor purchases are effectively payments made for the right to participate in the business venture. The current discussion of internal consumption simply ignores this warning against required distributor purchases to qualify for compensation.

The FTC reinforced that message in the 2013 FTC Complaint against FHTM. Here is a clear example of a multilevel marketing company effectively requiring distributors to maintain a certain purchase level in order to qualify for compensation (p. 9, paragraph 37) "FHTM instructs its Reps to purchase sufficient products and services through FHTM to be eligible for bonuses, and to spend their time recruiting others to become Reps. Including the required fees, FHTM Reps may spend more than $1500 annually to remain eligible for such recruiting bonuses." In this case, the message of "pay to play" is unmistakable.

What then are we to think about Herbalife? I have never accused any multilevel marketing firm of operating a pyramid scheme unless a court found that to be the case. I have, however, consistently criticized Herbalife's haphazard response to the pyramid scheme charge and have called for greater transparency. On the issue of retail sales, Herbalife's public statements have been wildly inconsistent with each other. Perhaps the most frequently mentioned evidence is the Lieberman survey. Here again, we have a lack of transparency as the sample protocol and actual survey questions remain secret. Even without having the sampling protocol or survey questions, a brief review by a respected statistician raises serious questions as to the reliability of this survey.

From my experience, if Herbalife can present independent verifiable data showing 70% of purchases are made by non-distributors - a type of defense that dates back to the 1979 Amway case - the FTC would probably have no interest in exploring a pyramid scheme charge. On the other hand, if Herbalife continues to send the message that their claimed data are unverifiable and yet above reproach, then I encourage the FTC to investigate.

In addition to arguments that ignore previous court decisions and rely on inconsistent and unverifiable evidence, we have an obvious lack of a shared understanding as to what constitutes a pyramid scheme. Consider the following exchange in the five-year FTC v. BurnLounge case. Here Mr. Wayne Alan Luce explains his understanding of a pyramid scheme. Mr. Luce is a witness for BurnLounge, a lawyer, and a former Chairman of the Board of the Direct Selling Association (DSA):

Q. What, in your mind, is an illegal pyramid?

A. An illegal pyramid is one where there is no value to the product or ‑‑ true value in the marketplace to the product or service that's being purchased by the participants in the pyramid, and that the purchase of that valueless item actually funds the scheme itself.

Q. And do you know where ‑‑ what's the basis for your definition?

Where do you come up with that definition?

A. Forty years of experience as a direct seller in this marketplace.

Q. Is it based upon any legal analysis?

A. It's based upon a practical analysis of what differentiates a pyramid from a legitimate direct sales opportunity. You have other types of trade practice issues; but when you come down to a fundamental pyramid, in my view it circulates around inappropriate inventory loading. (Deposition Transcript. pp. 46-47).

Mr. Luce's explanation of what constitutes a pyramid scheme is stunningly incorrect when compared to actual pyramid scheme cases. First, the relative value of a product (i.e., product efficacy) is not a primary consideration in pyramid scheme prosecutions. Products that perform as promised have increasingly become a necessary condition for modern pyramid schemes. Second, by the end of the brief exchange Mr. Luce appears to change his definition from one concerned with product efficacy to one concerned with inventory loading, an entirely different issue.

Comments from the former Chairman of the Board of the DSA suggest a complete and possibly willful lack of understanding of pyramid scheme decisions. Rather than working to develop a shared understanding, multilevel marketing firms appear to argue that the industry will be irrevocably harmed if regulators create an environment that more clearly separates pyramid schemes from legitimate multilevel marketing.

Should Herbalife present truly defensible evidence that compensation to participants relies primarily on sales to customers outside of the distributor network, the Ackman v. Icahn drama would quickly fade. However, if Herbalife continues to put forward evidence easily criticized for its accuracy and reliability, then investors, regulators, and potential participants will continue to face unnecessary and costly uncertainty.

[I choose to not post anonymously and I encourage you to do the same.]

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have no financial position regarding Herbalife and have received no compensation from any party directly or indirectly related to either side of the Herbalife question.