Does The Herbalife Pay Plan Break Canadian Law?

| About: Herbalife Ltd. (HLF)

Earlier this week, NY Post reporter Michelle Celarier reported that Herbalife (NYSE:HLF) is being investigated by Canadian authorities. The article can be found here.

The Government of Canada has a website that publishes a detailed overview of the law that regulates MLMs as well as a pamphlet on the guidelines. This document can be found here.

It is important to explore the law in different jurisdictions for a number of reasons.

  1. The laws are not the same from jurisdiction to jurisdiction. What is legal in one place may not be legal in another. eg. Women can't drive in Saudi Arabia, it is illegal to drive on the right side of the road in England, etc.
  2. Laws in some jurisdictions may be more "enlightened" than others. Most would agree that denying a woman the right to drive is medieval thinking.
  3. We can learn about our own investment thesis in a more roundabout way by examining the way the rest of the world views pyramid schemes/MLMs.

I am Canadian so know quite a bit about Canada. Canada is a nation roughly 1/10th the size of the USA. Herbalife only generates 1% of company sales from this country and a very small percentage of North American sales. Canadians are a more skeptical lot I would say. Maybe my own cultural bias helps me see how obvious the Herbalife fraud is. Who knows? For certain, most Canadian haven't latched on to the idea that Formula 1 is the cure for global obesity that it is in say Mexico.

Weird right?

In this article I would like to highlight a key area in the Canadian law that puts Herbalife offside with the Canadian Competition Act. Those who like to dig on their own can read the law themselves.

Specifically, I would like to revisit the discussion on Price Discrimination

In a prior article (found here)on HLF I have argued that the fact that the company charges distributors different prices for wholesale inventory makes Herbalife a particularly sinister animal.

Price discrimination creates the incentive for a new recruit to strive for Supervisor, creates the incentive for participants to inventory load, makes it impossible for junior distributors to earn profits as a retailer and triggers upline commissions facially unrelated to retail sales.

What does the Canadian government have to say about this issue?

7.2 Purchase Requirements as a Condition of Participation

Pursuant to paragraph 55.1(1)(NYSE:B) of the Act, an MLM plan may not have as a condition of participating in the MLM plan, a requirement to purchase a product at a price above the seller's cost. In addition, an MLM plan may not require existing participants to purchase products above cost in order to attain a higher commission/benefit level.

Paragraph 55.1(1)(b) allows a requirement to purchase products at the seller's cost for the purpose of facilitating sales. Accordingly, a plan is not likely to raise an issue under this paragraph if a participant is required to purchase a "starter kit" (manual, directives, product samples, promotional material) at the seller's cost (see the definition of Operator's Cost or Seller's Cost under section 5.6).

An MLM plan may not have a requirement to purchase a product which is at a price above the seller's cost. This applies whether the purchase requirement is an explicit condition or an implicit "de facto" condition. In determining whether an MLM plan includes a requirement to purchase product the Bureau considers factors including the following:

  • whether sales are made to participants at a price that exceeds the seller's cost and are not accompanied by a commercially reasonable buy-back guarantee;
  • whether the plan directly or indirectly promotes purchases of product by participants solely to achieve sales requirements or maintain compensation levels;
  • whether the plan requires the sale of product to receive compensation, reach a level of compensation or maintain a level of compensation in the marketing plan, and if so, whether:
    • the purchases made by a participant are in commercially reasonable quantities given the nature of the product,
    • the purchases made by a participant reflect sales that can be expected to be achieved over a reasonable period of time given the nature and price of the product; and
    • the terms offered by the seller for the return of the product are commercially reasonable;
  • whether the product is meant for sale to non-participants of the plan; and
  • the nature of the product involved in the plan (e.g. tangible good, membership, etc.)

The Bureau will consider each MLM plan on a case by case basis in determining whether participants are required to purchase product to participate in the plan.

While purchase requirements are likely to contravene this section, sales requirements involving the sale of a product or products to non-participants of the plan are not likely to contravene this section.

What the Canadian Competition bureau seems to be saying about MLMs is simple.

You can't treat distributors differently based upon where they sit in the pay plan. The rationale for this law seems quite obvious.

If the sponsor of an MLM charges participants different wholesale prices for product, automatically one segment of the salesforce is given an unfair competitive advantage over another. This issue has been identified in prior articles. In Canadian law it has teeth.

An MLM is a salesforce that has multiple levels. Upline sponsors get paid commissions when downline recruits acquire inventory. The legitimate purpose of the inventory is for resale to "ultimate users" (non-participants).

If, on the other hand, participants are purchasing inventory to secure a higher level of compensation/margin/benefits/commissions in the pay plan then the Canadian regulators, at the very least, seem to have a problem with this idea.

Charging distributors/participants in an MLM the same price for wholesale inventory seems to lend credibility/gravitas to a pay plan.

Price discrimination is an obvious hallmark of a pyramid scheme.

Imagine the Herbalife pay plan without the perverse incentive to "GET TO SUPERVISOR" to secure a 50% discount, royalty overrides, and titular recognition.

How much product would distributors actually buy? How many people would Herbalife actually be able to recruit? How would the rags to riches recruiting tale change?

I invite all longs and shorts to read the law in Canada - the true north strong and free.

Judge for yourself.

Is Herbalife breaking the law or not?

It seems obvious to me that junior distributors who pay higher prices for Formula 1 than Supervisors is a major "No-No".

Whether or not it is also a US anti-trust violation remains to be seen.

The market clearing price for Formula 1 is well below 25% off SRP. Distributors who pay 25% off for inventory have no hope of making money as retailers.

Selling a business opportunity on the premise that they can and will make money at full SRP is a fraud.

Canadian law seems to understand this.

Will other jurisdictions like the USA ultimately agree?

Herbalife is a global pyramid scheme that proliferates a business opportunity fraud. Millions churn out of the business every year unable to make a return on capital. The sooner regulators shut it down the better.

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.