The raging Wall Street debates over the legality and legitimacy of Herbalife have shed much needed light on the opaque Main Street business called "multi-level marketing." The controversy has also exposed a yawning gap between the values and perspectives of Wall Street and Main Street.
Representing Main Street, a 100-year old consumer protection organization, the National Consumer Protection League, studied the 300-slide presentation published by hedge fund, Pershing Capital Square, and publicly called upon the FTC to investigate Herbalife as a possible pyramid scheme.
Over on Wall Street, editorial board member, Holman Jenkins of the Wall Street Journal, considered the very same presentation. He adamantly opposed regulatory action. To the question, "Is Herbalife a Pyramid Scheme?" he issued the rhetorical brush-off, "Who knows?" and characterized the question as a puzzle either too technical or too insignificant to bother investigating. He dismissed the battle of some large hedge fund managers over Herbalife with the editorial equivalent of "Who cares?"
Jenkins expounded a view widely held on Wall Street that investor concern about Herbalife's legality or its possible economic injury to "distributors" is unnecessary. In his article, he argues that the Herbalife pyramid question is for the market to resolve, not pundits, lawyers or activist investors. Appeals to federal regulators by hedge fund manager Bill Ackman and now the National Consumer Protection League to investigate Herbalife, he declared, are unwanted. (Note: The SEC has already announced that an investigation of Herbalife is underway.)
Lost in Translation
To put the Wall Street Journal editor's dismissal of Herbalife's impact on Main Street into a real-life context, his "Who knows?" question should have been expressed in its Spanish equivalent, "¿Quien sabe?" Hispanics, mostly low income, are now the primary funding source of the Herbalife enterprise in the USA. If Herbalife is a fraud, the Hispanic community in the USA is paying a terrible price.
In a Feb. 20, 2013 article entitled, "Herbalife, Under Fire for Alleged Pyramid Scheme, Owes Success to Latinos," Fox News Latino reported, "Hispanics account for up to 60 percent of Herbalife's sales in the U.S. and their involvement in this home-based business seems to be growing, despite allegations the company is a pyramid scheme that aggressively targets vulnerable minority communities."
On the Herbalife pyramid question, Wall Street's and Main Street's perspectives may not only conflict, they might not even be speaking the same language.
The Wall Street/Main Street divide can be expressed in the question, "If Herbalife were a financial predator on Main Street, relying on a deceptive income promise to unsuspecting and struggling consumers, but the company is robustly profitable to investors, (perhaps robust because of its deceptions) should Wall Street not profit from it? Said another way, "Even if Herbalife is a pyramid scheme masquerading as "direct selling", but it remains unmolested by government regulators, and can sustain itself for years to come by deceptive recruiting, should Wall Street investors care?
William Ackman's "patriotic bet" against Herbalife infers sentiments of fairness, ethics, civic responsibility and concern for victims of pyramid schemes. Additionally, he argues that investing in a pyramid scheme will not pay.
Even if he is correct about the folly of investing in a predatory and unsustainable business, the time frame for the arc of justice or market saturation may be longer than most investors worry about.
Mysteries, Main Street Impact and Regulatory Mandate
Having served as expert in more than 20 court cases against pyramid schemes, including two against Herbalife, I know that the question of Herbalife's pyramid status is not a mystery beyond the comprehension of Wall Street editors. It is knowable. The data and facts are available to regulators and the experts at the FTC know very well how to remove "direct selling" disguises and dissect pyramid money flows. From my work as president of a non-profit consumer group that receives urgent questions, tragic stories and desperate complaints from people regarding "business opportunity" scams, I can also attest that far more is at stake in the Herbalife controversy than a duel between rival hedge funds.
In 2012, Herbalife reported that it pulled in over $800 million in revenue from nearly 500,000 distributors in the USA, most of whom joined during the year, replacing the majority who annually quit the business proposition after "failing" to gain a profit. Over a five-year span, the total number of Americans - at the lowest income rungs - who unsuccessfully invest in Herbalife's income promise is in the millions. In 2012, the average investment by a US distributor, based on SEC-filed data and Herbalife's income disclosure to distributors, was more than $1,600. Solicitations to consumers to join Herbalife's income plan are all over AM radio talk shows. On America's streets and calles, the question of Herbalife's legitimacy matters quite a lot.
Herbalife is accused of mass peddling a financial product, a new "sub-prime." This time the American Dream is packaged not as a no-doc mortgage on an over-priced home or as a life-long loan to attend a dubiously credentialed for-profit college. Herbalife packages the American Dream as a home-based income proposition, self-employment, a haven from Recession and a rescue from a life of low wages. The Dream is attained by paying entry fees, buying Herbalife inventory along with high priced sales "leads" and "motivation" training and then by recruiting friends and neighbors to do exactly the same. Herbalife, the critics charge, is selling a subprime business opportunity that is actually a pyramid recruiting scheme, a model that dooms all those at the bottom to "fail."
The question, "Is Herbalife a Pyramid Scheme?" deserves an answer. The FTC and the SEC and perhaps even the Consumer Financial Protection Bureau will not avoid addressing it much longer.
Is Fraud just a Market Factor?
Despite the objections of the Wall Street Journal's Holman Jenkins to a government investigation of Herbalife, it would seem obvious that if markets are perverted by calculated, sophisticated deception, action of government regulators is warranted. Buyers and investors cannot be expected to discern fraud that may be unwittingly spread by friends and neighbors, endorsed by celebrities, and perceived as perfectly legal based on the inaction of government regulators. Markets are not designed to factor and filter out such frauds. They need protection from them to function.
After a near meltdown in trust in our capital markets caused by the Madoff fraud, and after middle-class life savings were almost destroyed by mortgage and collateralized debt fraud, which was promoted by trusted financial institutions, it would also seem obvious that fraud discovery is a worthy public endeavor, even for hedge fund managers. This couldn't be more true than in the case of suspected pyramid schemes.
Pyramid/Ponzi Schemes: Fraud on Steroids
In a May, 2001 court declaration, Dr. Peter VanderNat, the FTC's pyramid expert, wrote, "From the perspective of consumer protection, it is always better that a pyramid scheme fail sooner rather than later." Dr. VanderNat was referencing the inherent feature of pyramid schemes to increase their public harm exponentially.
In the FTC's 2001 prosecution of the multi-level marketing fraud, SkyBiz, Inc., it was reported that in just two years SkyBiz had spread from its base in Oklahoma across the entire nation and then into 200 countries, packaged as an ideal "home-based" business.
In 2012, the SEC acted against another MLM pyramid fraud, called Zeek Rewards. Based in the little town of Lexington, NC, Zeek separated one million people in America and worldwide from $600 million, in just 18 months.
Most recently, the FTC intervened to shut down a wildly popular multi-level marketing company, called Fortune High Tech Marketing. Allowed to operate for more than 10 years before federal regulators acted, FHTM drew in well over 500,000 households in the USA. In its prosecution, the FTC stated, "…recruits were told they could earn high commissions by selling products to people outside the operation, but instead only minimal compensation was paid for sales to non-participants, and few products were ever sold to anyone other than participants."
The FTC stated that 96% of people that sign up with Fortune Hi-Tech should expect to lose money, not because they don't work hard or don't seek income; their loses are due to the elegantly disguised business model that positioned them in the lowest two levels of the company, where income was not possible. 94% of members quit after one year, the FTC said, only to be replaced by others who fell for deceptive income promise, believing the business to be perfectly legal.
FHTM was a financial killing machine on Main Street, artfully disguised as the answer to the average household's most basic needs for survival. FHTM was so well camouflaged it even attracted the public support of the wife of the former CEO of Bank of America and a wide array of celebrities from the sports world.
Markets might have eventually brought down SkyBiz, Zeek and Fortune High Tech Marketing without regulatory actions, but how long would it have taken, and at what cost?
Despite his claim not to know, (Who knows?) the Wall Street Journal's editor actually came quite close to unlocking Herbalife's pyramid mystery and the factors involved in other recent prosecutions of multi-level marketing companies such as FHTM, SkyBiz, Burnlounge and Zeek. He wrote, "Herbalife… sells to distributors who recruit other distributors and earn a commission on their sales." He then asked, "Does it really matter if many of these "'distributors'" don't make any money and end up consuming their inventory for their own use?"
In that brief description and analysis, he identified red flags of Main Street Ponzis disguised as sales companies - financially induced purchases, the false promise of rewards tied to endless recruiting of new salespeople (participants), a record of wide-spread losses by participants, and a lack of external revenue (retail sales). In the Zeek Rewards case, the SEC stated, "Approximately 98% of Zeek Rewards' total revenues, and correspondingly the purported share of "'net profits'" paid to current investors, are comprised of funds received from new investors."
If Herbalife's revenue is mostly from the distributors' own purchases, not from their subsequent and profitable retail sales, then Herbalife's promised rewards are, similar to Zeeks', gained from "funds received from new investors."
Eat the Inventory
So, do Herbalife recruits recoup their investments by reselling the goods to retail customers? Herbalife claims it does not know. Some Wall Street commentators infer that it does not matter, not to Wall Street, at least not for now.
On Main Street, though, this is a huge deal right now. The answer distinguishes a viable business opportunity from a financial trap, one that few people, especially of low income and minimal reserves, can afford to fall into in these times. If Herbalife recruits don't or can't profitably retail Herbalife products, then only a tiny few at the top of the massive recruiting chain could ever benefit. All others are doomed "by design" based on their lower positions. They would have no option for recouping their investments except "consuming their inventory."
Dr. VanderNat reported in the FTC SkyBiz case that "under an optimal scenario…some 94% of Sky Biz participants either earn nothing or fail to recoup $100."
Herbalife recently reported - for the first time - similar loss rates among its "participants." According to the company, 88% earned zero commissions in 2012. The significance of that statistic is inextricably tied to the pyramid question which, in turn, is unlocked with information on where Herbalife's revenue ultimately comes from - retail sales made by the distributors or "funds received from new investors" (the distributors themselves). This information is knowable, not a mystery. Regulators will inevitably ask Herbalife to provide it.
Down on Main Street, among the unemployed, the financially strapped and the hopeful immigrants who lose money in Herbalife and wonder if they were swindled in a pyramid scheme, the "Who knows?" dismissal and the "Let markets decide!" dictate from Wall Street will likely be heard as, "Hasta la vista, baby!"
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.