Nu Skin, An American Pyramid In China?

| About: Nu Skin (NUS)

Nu Skin is in the news - in China - and many American investors and analysts are once again having to enter the hall of mirrors that is called "multi-level marketing" (MLM). Some had hoped to navigate this hall by focusing only on one set of mirrors, reported growth and earnings, while ignoring all the other reflections on how Nu Skin (NYSE:NUS) and other MLMs get their money in the first place and skirt anti-pyramid scheme laws. Strangely, it has taken an official newspaper of a Communist government to force captains of capitalism in America to examine the MLM business model, which was invented in the USA. Now that Nu Skin is in trouble in China, the fates and fortunes of Herbalife (NYSE:HLF), Usana (NYSE:USNA), and Avon (NYSE:AVP) are directly affected too.

Whether or not the Chinese government takes regulatory action against Nu Skin requires political speculation. But assessing whether or not Nu Skin is likely employing its American-style pyramid recruiting model in that country should not require taking a slow boat to China while solving complex economic formulas. One can just look at Nu Skin's historical roots, and review Nu Skin's current defense of its model right here in the USA to make a reasoned assessment. And as for why Nu Skin might have been singled out in China, Nu Skin's domestic record of misrepresentations, political missteps and PR embarrassments offers clues.

Shady History

To put recent events into context, remember that Nu Skin is, essentially, a copy of Amway and a progeny of the Cambridge Diet Plan. The company was launched by a top Cambridge recruiter immediately after Cambridge went bankrupt and about five years after Amway survived the FTC prosecution for pyramid fraud in 1979. That perplexing court ruling, that followed successful FTC prosecutions of earlier MLMs, Holiday Magic and Koscot Interplanetary, cleared a narrow legal path forward for Amway. That path turned into an expressway by the "de-regulation" policy of the Reagan FTC in the crucial years that followed the court ruling with virtually no oversight or enforcement of court rulings. MLMs multiplied in number and exploded in growth across America and the world with their unique and electrifying promise of "unlimited income" for Every man.

Nu Skin emerged in this new industry, now called "multi-level marketing," from of the ashes of an earlier adopter of the Amway model, the bankrupt and discredited Cambridge Diet Plan. A young Sandie Tillotson, the flamboyant Nu Skin founder, and one of Nu Skin's largest shareholders today, had been one of Cambridge's top recruiters. She became the link from Cambridge Diet Plan's demise to Nu Skin's rise.

At its peak, Cambridge had 150,000 counsellors" (recruiters) in the USA to hawk its low calorie diet drink, an early version of Herbalife's protein shakes. A "Cambridge-sponsored survey" (sound familiar?) claimed as many as 5 million people were users of the product. But almost as rapidly as it rose, Cambridge's recruiting took a deep dive and the company plunged into Chapter 11 bankruptcy, partly due to the lavish corporate and personal expenditures of the company owners and top recruiters.

Snake Oil Roots

Cambridge founders, Jack and Eileen Feather and their son, Vaughn, began the Cambridge Diet Plan as an MLM recruiting and sales business after nearly 20 years of famously selling through the mail what the US Postal Service claimed were fraudulent and absurdly over-priced health and diet products. Ads for these ridiculous devices were a staple in popular magazines of the 60s and 70s showing flattened tummies and miraculously "enhanced" busts. In 1978, the Feather family paid $1.1 million to the government to settle fraud claims and agreed to stop selling the bogus "bust-developers" and other phony diet and health products.

On that foundation of fakery, the Cambridge Diet Plan was built by the Feathers. No longer using the mail service, which had led to mail fraud charges, the Feathers chose the new MLM model of "person-to-person" transactions for the Cambridge Plan. It was the Cambridge Diet Plan's short but spectacular rise in the new multi-level marketing field of the early 80s that attracted the young and ambitious Sandie Tillotson. Tillotson's fateful conjunction with Cambridge begat Nu Skin, which is now regarded as a Utah and Mormon pillar of respectable business.

Though it is a clone of Amway, Nu Skin Enterprises has never had anything close to Amway's political influence or success at shaping its own image. Nu Skin, instead, has struggled for credibility. It has been a target of salacious news stories of family feuds and divorces in conservative Utah, of regulatory prosecutions for deception and two successful class action lawsuits brought by distributors who charged pyramid fraud.

In the early 1990's, Nu Skin was prosecuted by attorney general offices in Florida, Michigan, Illinois, Ohio, Pennsylvania, Utah and Connecticut for deceptive marketing or for operating a pyramid scheme. It settled the charges by agreeing to pay hundreds of thousands of dollars in refunds to consumers. Later, Nu Skin was forced to pay more than a million dollars in fines to the FTC two times, once for deception regarding its income claims and another time for false product claims.

The FTC's 1994 charges of false-product claims involved a reputed Nu Skin cure for baldness. Citing the FTC press release, the products and representations at issue in the FTC charges included,: Nutriol Hair Fitness Preparation, allegedly promoted as a product than can prevent, cure, or reduce hair loss, and that is as effective as, or more effective than, the prescription drug Minoxidil; Face Lift with Activator, which was advertised as a non-surgical face lift that permanently will remove facial wrinkles, and is as effective as, or more effective than, Retin-A; and Celltrex, allegedly advertised as a product that will promote the healing of third degree burns, which otherwise would require skin grafting.

The FTC also alleged that the respondents made deceptive earnings claims. According to the complaint, Nu Skin promotional materials stated that distributors "will earn in excess of $60,000 - $80,000 their first year without jeopardizing their present income," and that "a lot of other people" are earning $14,000 a month … $168,000 a year."

The FTC alleged that, Nu Skin represented falsely that such earnings were typical. Additionally, Nu Skin failed to disclose that only a very small percentage of Nu Skin distributors had earned more than a small monthly income - a material factor, according to the FTC, in consumers' decisions about becoming Nu Skin distributors.

Three years later, Nu Skin was fined again by the FTC, this time for $1.5 million, for making false product claims over the fat-loss, muscle-maintenance and other unsubstantiated health claims made for unregulated food supplements. Nu Skin's products were given medical sounding names, "Metabotrim," and "GlycoBar."

More recently Barron's described Nu Skin's "ageLOC" product, its latest non-medical "health" sensation, as a "$300 gadget" that, according to the company, "resets" the skin's "youth gene clusters." Barron's noted also that a Nu Skin pamphlet claims that Stanford University research supports its anti-ageing claims, but includes no scientific data or citations. In 2012, Stanford University sent a "cease and desist letter to Nu Skin to stop using the name of Stanford geneticist Stuart Kim, which it said Nu Skin listed as a "Nu Skin Partner" in developing its ageLOC anti-ageing products. Stanford said Kim has nothing to do with the company.

Personal and Political Missteps

Nu Skin's public persona has also been controversial in a business that portrays itself as the embodiment family values, patriotism and religious faith. Nu Skin's official biography includes a pious Mormon affiliation and, more recently, Republican party connections.

The church and political ties were united when Nu Skin purchased a $20 million sponsorship from organizer, Mitt Romney, during the 2002 Winter Olympics in Utah, where Nu Skin is based. The Olympic sponsorship proved fortuitous for Nu Skin because it helped Romney claim that he redeemed the Olympics from financial insolvency. With the prestige of Olympic ties along with Nu Skin leaders' and Romney's mutual connections to the Mormon Church, Nu Skin appeared to be building its own political base behind a Romney presidency, which could protect it from regulators. Two of Nu Skin's officials each sought to make secret donations of $1 million each to Romney's presidential campaign. And Nu Skin co-founder, Sandie Tillotson, reportedly held a fundraiser for Romney at her penthouse in the luxurious Mandarin Oriental Residences of Manhattan's Time-Warner building.

The former Republican governor of Utah, also a Mormon, Jon Huntsman, was the US Trade Representative to China and reportedly promoted the MLM industry to China. While governor, Huntsman took Nu Skin officials to China on a trade mission. An investigative piece in the Mother Jones magazine details other political connections of Nu Skin among Republicans in Congress such as Orrin Hatch, a Utah Senator.

Yet with Romney's defeat, and the fact that the China government-backed newspaper specifically targeted Nu Skin and not other MLMs seems to indicate that Nu Skin, in fact, may have little political cover now.

Tarnishing the personal and "values" side of Nu Skin's crafted image, Sandie Tillotson recently filed a much publicized lawsuit against one of her three ex-husbands. This followed an earlier marital controversy in which a book written by a different ex-husband made charges of profligate lifestyles and sexual escapades among Nu Skin's Mormon leaders. In the lawsuit against the latest ex-husband, Tillotson claimed that he holds secret information about Nu Skin that Wall Street investors believe is damaging to the Nu Skin business. She blamed the ex-husband for a Nu Skin stock price decline and sued him for $60 million, raising the question, "What destructive information?"

If you think these controversies are unrelated to Nu Skin's stock value or its reputation in China, consider the lengthy feature story that Fortune dedicated to the salacious details and their connections to short selling by award-winning journalist, Peter Elkind, entitled, Nu Skin and the Short Sellers, and the stock-focused article in Barrons, by Bill Alpert detailing the relevance of Tillotson's behavior to Nu Skin's claims to legitimacy. To attract followers, and with 50-80% attrition rates attracting followers is MLM's Job One, multi-level marketing companies rely heavily on instilling "confidence" in prospects and supporters. Their leaders typically hold themselves out as role models and paragons of virtue. MLMs are keen to attach themselves to symbols of legitimacy and goodness. It is not for nothing that Amway has associated itself with Harvard University in China.

American Pyramid in China?

For questions about what business model and practices Nu Skin is actually employing in China, the universal factor of intractable corporate culture and the limits of business model experience must be considered. Nu Skin, unlike Avon, has never been anything other than an Amway/Cambridge Diet clone from its inception. It has no experience in selling products, without also attaching its income opportunity and that income opportunity is always based upon the multi-level pay plan and pyramid structure that offers "unlimited" income from an "endlessly" expanding recruiting chain. The pyramid model is part of Nu Skin's DNA. China specifically bans the multi-tiered pay plan and pyramid model.

With just a cursory look at Nu Skin in China, it is impossible not to see evidence of MLM's hallmark "infinite expansion" promise with mass gatherings in China in which the followers, according to some Chinese officials, appear "brainwashed." Traditional door-to-door selling with rewards based only on one's own personal sales seldom engenders such passion, while the electrifying promise of "unlimited income" ignites fanatical zeal wherever it is delivered. It is similarly difficult to explain Nu Skin's rapid sales revenue growth in China based only on its dubious "anti-ageing" products, of which there are many others in China.

But perhaps the strongest evidence that Nu Skin would have great difficulty changing its stripes in China is the company's militant defense of its pyramid model right here in the USA where the model is also challenged. Nu Skin might have made the bad call to ignore China's anti-pyramid laws because Nu Skin officially rejects the US government's definition of a pyramid scheme for its operations at home. And it has, so far, paid no price for this flouting.

The FTC has argued and prosecuted other MLMs on the legal grounds that rewards to MLM recruiters must come from retail sales to non-distributors. An internal money transfer from one level to the next is regarded as a pyramid scheme, leading inevitably to massive losses for the "last ones in." In Nu Skin's investor presentations the company has laid out its business model to explain why it is not a pyramid scheme. To investors, Nu Skin has not argued that its rewards come from outside the chain, as the FTC and federal courts say they must. Instead, Nu Skin claims that sales to its own salespeople are retail sales. Nu Skin sought to convince investors that it is perfectly legal by asserting that 84% of its contract salespeople in the various lower levels are actually "retail customers." This claim is maintained by Nu Skin even though those salespeople are legally inside the sales chain, have personally signed sales contracts, buy at wholesale prices and are legally subject to commercial incentives and restrictions as "independent contractors." They even are charged sales tax on the suggested retail price, though they purchased at the lower wholesale price, inferring that it is expected they will resell the goods at full retail price and recoup the additional retail sales taxes that Nu Skin collected from them in advance!

Referring to the 16% at the upper end of the pyramid who have recruited "downlines" Nu Skin's states, "We consider these distributors to be in our sales network because they are the only distributors who have declared their intention to build a sales network, are eligible to receive commissions on a multi-level basis, and are actively recruiting both customers and distributors direct retail customers. By contrast, Nu Skin's consumer network is comprised of (1) consumer retail customers, (2) company-direct retail or preferred customers, and (3) non-Executive distributors who are essentially wholesale consumers purchasing for personal consumption or resale. Those in our consumer network are not actively recruiting others into the business."

Nu Skin separates the contractors based on who is or who is not "actively recruiting others into the business," a strange definition indeed for a company that insists it is a sales company and not a recruitment pyramid scheme.

The key question in America is where does the money come from that Nu Skin uses to pay recruiters? In China, the question is even more basic. The law in China explicitly prohibits payments from one level of salespeople based on purchases made by multiple levels of salespeople. In America, the multi-tiered plan has been generally permitted as long as the payments to the upper levels ultimately come from outside the chain, that is, from consummated retail sales. China bans the chain itself.

So far, this Nu Skin claim that it does not need to account for retail sales because its own salespeople qualify as retail customers appears to have kept US regulators from action. With apparent regulatory acquiescence in America, Nu Skin might have been inclined to try to similar tricks in China, reclassifying the same persons with two different identities simultaneously. Other MLM companies make the same claim. Amway calls the closed market model, "buying from yourself." Salespeople do not need other customers, only to buy from "their own store" and then recruit others to do the same, allowing the reward chain of all the "stores" to expand, forever and ever. A recent Bloomberg investigation of Amway operations in China revealed evidence of similar practices in China.

Nu Skin bolstered its convoluted explanation to investors about retail sales and classifications of contractors by also assigning new definitions to the sales transactions within the distribution channel. Nu Skin informed investors that some of its third party contract sales are actually "direct sales" made only between the company as seller and the contractor as buyer. Nu Skin characterized purchases made by some of the salespeople as "buying directly" from the company. However, in fact, Nu Skin does not sell "direct." It has no in-house sales force. Sales are made through independent distributors. On every sale that is made to a distributor or a "preferred customer" (Nu Skin has never revealed how many of these there are) a commission is paid to an entire chain of other distributors who are credited with making the sale. In all the world, this is called distributor sales, not direct sales. No company pays commissions to a "third party" for sales the company made "directly."

Now, in the public glare of regulatory investigation, Nu Skin must explain to China how its current model and practices in that country are not "multi-level." This may prove harder in China than making the smoke and mirrors PowerPoint explanation for "retail sales" and "direct sales" in the USA. America has no explicit law against pyramid schemes, facilitating the current confusion and regulatory reticence. China, however does have such a law, the strictest in the world. Here is some of the ominous text of the law.

Article 7

The following acts belong to the pyramid selling:

(1) An organizer or operator seeks for unlawful interests by recruiting persons to participate in pyramid selling, asking the recruiters to persuade others to participate in pyramid selling, calculating and paying remunerations (including material awards and other economic interests, the same below) to the recruiters on the basis of the number of persons a recruiter has directly or indirectly recruited in a rotating way;

(2) An organizer or operator seeks for unlawful interests by recruiting persons to participate in pyramid selling and asking the recruiters to pay fees explicitly or in any disguised form like purchasing commodities for obtaining the qualification for participating in pyramid selling or recruiting others to participate in pyramid selling; and

(3) An organizer or operator seeks for unlawful interests by recruiting persons to participate in pyramid selling, asking the recruiters to persuade others to participate in pyramid selling so as to form a multi-level relationship, and calculating and paying the remuneration to an upper-level promoter on the basis of the sales performance of the promoters below.

It may require much more than a fancy PowerPoint presentation for Nu Skin to talk its way out of a China investigation.

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.