Is Herbalife (NYSE:HLF) a pyramid scheme? That is the question. Longs received a boost this week as Belgium reversed a decision. The actual text of the decision has yet to hit the public. It will be interesting to read what it says.
Of course, laws vary by jurisdiction. It is illegal to drive on the right side of the road in England, to chew gum in Singapore and to wear a red hat in public in Antwerp, Belgium.
Whether or not Herbalife is a pyramid scheme in the USA is an open question.
Investors who have read Herbalife's 10k should pay attention to the following text from the Risk Factors section of the 10k:
Our network marketing program is subject to a number of federal and state regulations administered by the FTC and various state agencies in the United States as well as regulations on direct selling in foreign markets administered by foreign agencies. We are subject to the risk that, in one or more markets, our network marketing program could be found not to be in compliance with applicable law or regulations. Regulations applicable to network marketing organizations generally are directed at preventing fraudulent or deceptive schemes, often referred to as "pyramid" or "chain sales" schemes, by ensuring that product sales ultimately are made to consumers and that advancement within an organization is based on sales of the organization's products rather than investments in the organization or other non-retail sales-related criteria. The regulatory requirements concerning network marketing programs do not include "bright line" rules and are inherently fact-based and, thus, we are subject to the risk that these laws or regulations or the enforcement or interpretation of these laws and regulations by governmental agencies or courts can change. The failure of our network marketing program to comply with current or newly adopted regulations could negatively impact our business in a particular market or in general.
Herbalife knows that on any given day in any given jurisdiction a regulatory authority could find it "not in compliance with applicable law".
Still, Herbalife's CEO is adamant that Herbalife is not a pyramid scheme. On air on CNBC earlier this year he called Mr. Ackman's claims a "bogus allegation." Repeatedly and publicly Mr. Johnson evangelizes Herbalife's legitimacy.
Q. Is this a direct violation of SEC rule 10b5?
It is a violation of securities law to intentionally deceive investors with a misstatement of fact and/or an omission of material information that might otherwise prove important to the investing public.
Mr. Johnson repeatedly advises investors that Herbalife is not a pyramid scheme.
My question to Mr. Johnson is simply this:
How do you know?
The only way to know whether or not your MLM is a pyramid scheme or not is to know how much "retail sales" the sales force produces.
Here is a copy of expert testimony by the FTC's pyramid scheme guru on the matter of what a pyramid scheme is and isn't.
As an aside, this author happens to think the "retail question" is a red herring. I tend to agree with Jon Taylor that any MLM that has a compensation scheme that encourages ad nauseum recruitment of distributors to the point of over-saturation can only end-up disappointing those who are last to enter the party in a given geography. I submit that this factor alone could and should instruct regulators as to whether or not a marketer of a business opportunity is deceptive.
Notwithstanding this view, Mr. Keep and Dr. Van Der Nat have advanced an argument that a cogent litmus test for differentiating a legitimate MLM (if there should be such a thing) from a pyramid scheme is to answer "the retail question". Specifically, what % of sales are made to "ultimate users" who are not participants in the sponsors pay plan? I would argue that this is a less onerous standard than a simple endless chain observation. Nonetheless, it seems to be a standard that is applied in expert testimony in FTC prosecutions.
Whether or not the SEC is as liberal as the FTC in its determination of what qualifies as a pyramid scheme remains an open question.
Still, if one is to prove, categorically, that an MLM is in fact legitimate and not a pyramid scheme then it seems obvious that the answer to "the retail question" must be apparent.
Q. Mr. Johnson. Is Herbalife a pyramid scheme?
A. "That's a bogus accusation"
Q. How do you know?
Is it not true, sir, that you have no system to track retail sales? Is it not true that you issued an 8k last year to correct Mr. Walsh's misstatements on a conference call to Mr. Einhorn?
Isn't the only reasonable answer to the question "Is Herbalife a pyramid scheme?" that would be consistent with rule 10b5 either:
a) "We don't know" or
b) "We don't know for sure but we believe we are in compliance with the law."
If I marry the information provided in your 10k to the statements you are making publicly to investors and distributors alike, isn't it obvious that you are misleading people intentionally with a deliberate misstatement of the facts?
It certainly seems understandable that Herbalife's CEO would be irate at Mr. Ackman's allegation. However, isn't the only rational response to the allegation to prove that it isn't true legitimate data from a proper retail tracking system?
Alternatively, isn't the only tenable legal response you should and could be advancing to investors a simple "I don't know" or "The best I can say is that we believe we are compliant but regulatory intervention is always a risk."
Any Herbalife executive who states, categorically, that Herbalife is a legitimate MLM knows 3 things:
1) That HLF has no system to track retail sales
2) That HLF has made no effort to implement a system to track retail sales
3) That the company has no data at all that would exonerate it against Mr. Ackman's allegation.
Ergo: Any statement that categorically asserts that Herbalife is not a pyramid scheme is an argument advanced without supporting evidence and thus can only be misleading.
Ergo: Advancing, with certainty, the claim that Herbalife is not a pyramid scheme can only be a rule 10b5 violation.
Additionally, it stands to reason that if you can't prove nor track retail sales that it is equally impossible to assert, categorically, that business opportunity seekers can earn real retail profits.
Q. You tell me I can make a retail profit at SRP. How do you know if you don't track that data?
A. We don't know. We are just guessing.
Isn't Herbalife opaque?
Herbalife isn't a legitimate business because Michael Johnson says it is or because Tim Ramey says it is or because anyone else says it is. The question of HLF's legitimacy boils down to evidence, not PR and Spin Doctoring.
Q. Are the following observations "bogus"?
- Herbalife's Marketing Plan does not limit the number of distributors that can be recruited.
- 90% of distributors churn out every year.
- Herbalife does not track retail sales.
- Herbalife pays commission on wholesale purchases.
- There is abundant video evidence of misleading earnings claims, etc.
These are all statements of fact supported by evidence. That is why Mr. Ackman's web site is called "FACTS" aboutherbalife.com and not hypotheticalsaboutherbalife.com.
Mr. Johnson's assertion that Herbalife is not a pyramid scheme is at best a guess. The honest truth is he simply doesn't know.
How could he possibly know without retail sales data?
A. He can't.
Still, we can certainly confirm that Herbalife promotes an endless chain of recruitment, an ad nauseum recruiting juggernaut that intentionally oversaturates geographies with armies of distributors. This is a statement of fact.
Endless Chains are Pyramid Schemes. Curiously, the investing world remains cavalier.
And - if you ever find yourself in Antwerp just make sure you don't wear a red hat. (Is it true just because I write it or not? Or, should you do your own fact checking?)
P.S. Mr. Icahn's lock-up seems destined to unlock in 3 trading days. What will he do next?
When will the audit land?
Disclosure: I am short HLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.