Is Herbalife A Pyramid Scheme? A Simple Question Of Law

Mar.26.14 | About: Herbalife Ltd. (HLF)

Summary

There is a legal test for whether a business is a pyramid scheme.

The question is whether an organization is *really* in the business of selling distributorships, rather than product.

The test is whether distributors receive compensation unrelated to sales to "ultimate users".

If Herbalife's product is being consumed, then it isn't a pyramid scheme.

If you're reading this article, you already know what the issue is, who the sides are, and what's at stake. This article addresses whether Herbalife's (NYSE:HLF) business is illegal in America by asking what the law says is the difference between a legitimate business and a pyramid scheme.

The Pledge: Bill Ackman's Argument and Sen. Markey's Letters

I'm sure you recall the famous letters that Senator Markey wrote to the FTC and others regarding Herbalife. If you read those letters as a lawyer would, you'll see that each is missing something crucial. American lawyers say, "First we find the facts, then we find the law, then we apply the law to the facts." (Continental Europeans do it backwards.) The first two pages of Markey's letters are about the "facts." Then, on the third page, there's one paragraph that talks about law. One paragraph. In a four-page letter. And that paragraph only says that pyramid schemes are illegal and multi-level marketing ("MLM") isn't. It doesn't tell us how we can distinguish one from the other. It doesn't tell us what the law is.

I spent a lot of time at large law firms writing letters for other people to sign. A lot of time. I recognize the writing style. (Even if I didn't, the letter uses the system of legal citation set forth in something called the Bluebook, and worse it uses the system properly. No one does that except for lawyers in a few major cities and judges whose assistants will be going to work for those firms.) Some law firm associate spent hours trying to find law that would help Ackman's argument. The answer s/he found wasn't helpful. Unable to say as much as they wanted, the lawyers said less. If they had found law that, when applied to Herbalife, said it was a pyramid scheme, that law would be discussed in the letter.

Markey's letters are nicely written, and to an untrained eye, they may seem substantial, but every lawyer who read them spotted the weakness in the case in a microsecond.

The Turn: In Which The Law of Pyramid Schemes Is Revealed

Before I go further, let me insert a pair of caveats. First, I'm only going to talk about American law. Recently, questions were raised about Chinese law, and China's a big part of Herbalife's business story. I don't know anything about Chinese law. Well, ok, that's not true. But I certainly don't know enough Chinese law to address this. Second, I'm not going to get into state law. Some states have specific "pyramid scheme" statutes. From looking at those laws, it seems that they're identical in effect to the general rule I discuss here. But if I wanted to spend weeks reading statute books, I'd be practicing law.

With that said, back to the meat.

You've surely seen complex analyses of Herbalife's compensation structure, "inside sales" vs. retail sales, whether the "emphasis" is on retail selling or sales to distributors, and so on. (If you hadn't seen them, you wouldn't have bothered reading this far.) All of that is beside the point.

The question is whether Herbalife is defrauding distributors by tricking them into buying Herbalife products, by falsely claiming that they'll be able to profit as Herbalife distributors.

"Pyramid scheme" is a label we use, for convenience, to describe a particular style of fraud scheme. Potential new distributors are told they can make a profit by investing in the scheme, because they can then sign up distributors of their own, who will sell some product for them. That's a lie, though. The truth is that the scheme will necessarily fail as it runs out of new recruits. The fraudster's real business is selling distributorships, not cosmetics, or detergent, or whatever.

Issues like price discrimination and the amount of "inside sales" and "downline" profits tend to be hallmarks of pyramid schemes, because if someone wanted to commit a pyramid scheme fraud, they'd design the compensation structure in a certain way. But those issues don't turn a legitimate enterprise into a pyramid scheme. The question is fraud. Over time, we came to realize that a lot of frauds were similar enough to each other that we gave them a name and looked for some defining characteristics to make our fraud-spotting job easier.

There is a legal test for whether something is a pyramid scheme. In Webster v. Omnitrition International, a federal appeals court considered whether the defendant's business violated the federal anti-fraud laws as a pyramid scheme. The Court observed (citations omitted, emphases added):

Pyramid schemes are said to be inherently fraudulent because they must eventually collapse. Like chain letters, pyramid schemes may make money for those at the top of the chain or pyramid, but "must end up disappointing those at the bottom who can find no recruits."

The Federal Trade Commission has established a test for determining what constitutes a pyramid scheme. Such contrivances

"are characterized by the payment by participants of money to the company in return for which they receive (1) the right to sell a product and (2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of the product to ultimate users."

The satisfaction of the second element of the Koscot test is the sine qua non of a pyramid scheme: "As is apparent, the presence of this second element, recruitment with rewards unrelated to product sales, is nothing more than an elaborate chain letter device in which individuals who pay a valuable consideration with the expectation of recouping it to some degree via recruitment are bound to be disappointed." We adopt the Koscot standard here and hold that the operation of a pyramid scheme constitutes fraud for purposes of several federal antifraud statutes.

Ok? The magic words here are "ultimate users." Not "retail sales," or "outside sales," or anything else. "Ultimate users."

"Inside sales" vs. retail sales, saturation, "inventory stuffing" -- it's all beside the point. Read through that opinion, and you'll see that these are just different ways of getting at the question of whether someone is lying to potential distributors by claiming to be in the retail business, when in fact, they're in the business of selling distributorships. (You can also look at the FTC's first decision on pyramid schemes in Koscot Interplanetary, beginning around page 24 of the pdf; or Amway, beginning on page 81 of the pdf, with the facts set forth around pages 43-50.)

In a simple chain letter scheme, people pay "up" for the ability to recruit others into the scheme. A pyramid scheme is different, because there's also a product. But if new recruits pay initiation fees and distributors are paid "headhunter fees," or new recruits have to make large purchases of inventory (that will go unsold) to join and distributors receive their commission on that sale, it's the same thing as a chain letter. The question is whether anyone is actually using the product, or the company is really in the business of selling distributorships. This is clear in the analysis in the Amway opinion.

The Prestige: In Which Doubt Disappears Along With The Formula 1

John Hempton unraveled this more than a year ago. Herbalife customers pay to become distributors, because then they get a 25% discount on the product and because using the product is a communal experience. How do we know that the distributors are consuming the product? That they didn't buy the product to make a business from selling it, and fail? Because Herbalife is selling 120,000 metric tons of product a year (that's 132,227 actual tons in America), and if nobody's consuming it, it's got to be sitting out there somewhere, and we'd notice it. We don't notice it. So it isn't sitting out there. So someone is consuming it. So Herbalife isn't a pyramid scheme.

It's that simple.

Oh, one last thing -- you'll notice also that Hempton quotes a purported legal test set forth in Bill Ackman's original Herbalife presentation, that a business is a pyramid scheme if participants are paid "primarily" for recruiting new participants. The magic word is "primarily," it's the reason for all those complex analyses, balancing one factor against another, etc. etc., trying to figure out if Herbalife is "primarily" about this or "primarily" about that. Well, that legal test isn't in the Markey letters, and it isn't the test I quote above. That's because Ackman wasn't quoting the law, he was quoting an economist's casual shorthand description of FTC policy on pyramid schemes.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I came really close to taking a long position in HLF in January of last year. I didn't, because the trade was too crowded on both sides, and I didn't want the volatility. Man was that a mistake...