Is The Issue Of Illegal Saturation Of Concern To Investors?

Includes: HLF
by: Bruce Craig

Now that Messrs. Icahn, Soros, and Stiritz have declared their positions regarding Herbalife (NYSE:HLF) and taken what I understand to be a "long" position, it might be helpful to go back to square one on the MLM/Pyramid question to determine just what is involved and why there is an expressed enforcement concern about this type of marketing proposal. The long-standing position of the FTC, albeit confounded by its Amway decision and its subsequent inaction, is the fact that the offering of an "endless chain" of a business opportunity, funded by product purchases required for participation, is inherently deceptive because at some time, in the words of the FTC's Holiday Magic case, the universe of potential recruits will be "effectively exhausted."

As the Holiday Magic court stated:

"The mere, unqualified, holding out of an open-ended, pyramidal distributional system allowing for uninterrupted recruitment as a reasonable business opportunity for all inevitably creates the potential for massive deception, and the fact that this potential was realized on an enormous scale in this case only underlines the patent illegality of the scheme. Implicit in the holding-out of the system as a reasonable business opportunity is the promise that the party to whom the system is represented can earn profits in it by means of recruiting others. This representation may be true with respect to those to whom the representation is initially made; those at the beginning of the chain or the top of the pyramid. But, since a fundamental aspect of the system is that those at the beginning will be able to succeed by promising others the same ostensibly lucrative right to recruit, and so on, it is a virtual certainty that at some point the representation that profits are to be earned will be made to individuals to whom it will still appear plausible but for whom it is blatantly untrue, by virtue of the fact that the universe of potential recruits has been effectively exhausted."

The "70% retail and 10 customer rule" and other exculpatory elements stated in the FTC's 1979 Amway decision were intended to minimize the problems stated in Holiday Magic by insuring that endless recruiting would be limited by internal rules that required actual retail sales and thus dampen the abuses of endless exponential recruiting. This essentially insulated all MLMs that claimed retail sales under the "Amway Rules." The FTC, even though requested, has never factually determined that the assumptions in its Amway decision actually reached the desired result. Since then there have been further attempts to extend these rules to claim that the 70% figure is only an example, and could be lower, and that retail customers can also be distributors that sign up solely to consume the product.

The problem, aside from the fact that a pyramidal type program is still offered, is that neither the FTC nor the MLMs have established any meaningful enforcement mechanism to verify, under the flawed legal standards set forth in the Amway case, just how many retail sales are actually accomplished by each of these companies and just what the term "retail' means. A legal standard with no ongoing enforcement mechanism, or clear terminology, to determine compliance with the law is an essential green light for the acceleration of the practices involved, here and abroad, and the entry of new MLM offerings that may further exacerbate the problem. In fact, it is worse than no standard at all since it blesses ongoing marketing efforts with implicit legality due to the absence of enforcement, barring the occasional case.

There has been a good deal of discussion whether the FTC is going to act in respect to Herbalife, or any other pyramid style offering, and if it does, what legal standards will be applied. However, the Commission has explicit enforcement responsibilities and the current administration will be viewed as accountable in the event things do not continue to work out as well as currently projected. A particular concern to some in the US Latino community.

Whatever happens in the short term, investors, regulators, and politicians will still have to concern themselves about the elements of a pyramidal offering that can, and likely will, eventually result in the "universe of potential recruits" being "effectively exhausted." The valid response to this question, at present, is that some MLMs have been in business for over 30 years without the saturation predicted by the Holiday Magic court. While this is true, there are some things to consider.

The implicit blessing of the FTC has enabled MLMs to enter a large number of countries on the basis of purported legality in the US, and listing on the US stock exchanges. Herbalife claims activity in 89 countries. This can considerably extend the saturation periods through the involvement of recruits from other countries unaware of some of the problems and legal concerns in the United States. It is also likely that the governmental officials in these countries will accept a US blessing as a signal of legality and allow entry, although some countries have resisted this tendency.

This implicit legality conferred by the US has also dampened public complaints to regulatory authorities, here and abroad, due to the simple explanation that failure was not the result of illegal conduct but rather the inability of the participant to work hard enough to succeed. This also reduces the information available to new recruits and thus expands the time limit on exhaustion of potential participants.

The question is whether this ability to expand without participant saturation is truly endless or whether it is reaching the limits initially projected by the FTC in 1974? There are only so many countries to visit and so many potential participants in each country. Given documented turnover or "churn" rates of over 80% every two years and over 90% distributor failure rates, it would appear that the word would eventually get out and the pool of new recruits would diminish considerably. This could be further exacerbated if a particular country became concerned about the losses experienced by its citizens and expressed these concerns elsewhere or with internal litigation (which apparently has happened in parts of India). China, an area of considerable activity and some internal restrictions, could become concerned about growing numbers of participants and the "cult"' aspect of some offerings -- a particular concern in that country.

Any blip on the radar, here or abroad, which indicates negative public information that would diminish the current pool of prospective participants could reverse the momentum presently favoring MLM recruiting efforts. This would be particularly of concern for a business offering, which relies on a continuing supply of new recruits, due to documented drop-out rates, rather than the fundamental popularity of its products in the general population.

According to information provided by Herbalife expert Anne Coughlan in 2011, there were 15.6 million direct-selling distributors in the U.S., who generated $29.87 billion in retail sales. Worldwide direct-selling sales were $153.727 billion in 2011, generated by over 91.5 million direct-selling distributors. This means that roughly 17% of MLM sales are made in the US. This could be viewed favorably, but my question is what happened to all the US retail customers? Certainly the percentage would shrink with expansion abroad, but it raises real questions about US retail customer loyalty as to the basic products being sold.

Another interesting fact in this context is that Herbalife claims that 60% of its current US customers are Latinos. I don't know what percentage of US citizens are Latino, but this fact certainly indicates to me, of the 17% US share of MLM customers, that non-Latino Herbalife customers must numerically be relatively small in the country in which Herbalife was founded and where retail sales should be expanding. Maybe there is a simple answer to all this -- I'm not an economist or demographer -- but it at least raises some concern in my mind about the potential for longevity of these business offerings.

I have no doubt that Icahn, Soros, and Stiritz have staffs that are highly competent and that have fully evaluated the legal framework of these companies, the enforcement environment, and the demographic data on the potential for customer saturation. I am a bit unsure, however, whether their interests in Herbalife are as long term as indicated by their current participation.

I really don't know what further to say about this issue, a fact that I am sure will be applauded by my many critics, but as I have stated in my other Seeking Alpha articles that I have some real concerns for the victims of these offerings, the regulatory posture concerning the legal status of these companies, and, to a lesser extent, for the investors who have placed their faith and savings in an area where significant legal questions remain and which are subject to the vagaries of continued recruitment of new participants here and abroad.

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.