Tying Together The Herbalife Pyramid Case

| About: Herbalife Ltd. (HLF)


A simple case of lawyers, not law.

Common sense, business cases and the RICO approach.

The holistic view that counters the strategy of winning on points.

The Herbalife (NYSE:HLF) show goes on. A brilliant piece of legal analysis on this site weighs in on the "illegal pyramid" thesis against Herbalife for the defense. It shows again that Gore Vidal was right, we're a country of lawyers, not of laws. Or, to put it differently, any good lawyer instinctively knows that you can defeat any law by honoring the letter, and killing the spirit of it in the process. The murky climate of scant legal regulation, and obfuscation by inconsistent jurisprudence has made the MLM business difficult territory for entrepreneurs, representatives and investors alike, and one way or another the only positive thing that could come out of the current Herbalife flap would be a satisfactory clarification, so that once and for all there would be clarity about the difference between a viable and legal MLM, if there is such a thing, and an illegal "pyramid scam."

To clarify, I am not a lawyer. My legal experience is limited to some business arbitrations and the normal routine legal stuff we all deal with. I have some business experience, including some MLM, and my approach tends to be business and economics, not primarily law. I once designed an MLM business plan for a company. I came to the conclusion that MLM is a flawed system, but that it is by no means sure if those flaws are fatal. In the main, I see a bifurcation between bona fide attempts to monetize the logic of referrals (see this interesting report about Oxyfresh), and personal recommendations on behalf of great products. There is nothing more natural than recommending a great film, book, restaurant, or perhaps a diet shake. Some products almost require the personal touch, and detailed explanation. Why not get paid for it? And if you're good at it, why not get paid to train others to do the same? That seems fine so far. If a company can take a good product and create a marketing plan that leverages word of mouth advertising with an effective alignment of the company's financial interest and that of the sales force, that is a good business concept.

Good MLM and bad MLM

The mala fide variant arises when we have the tail wagging the dog, and the financial interest corrupts the recommendation. That can lead to fraud on the part of individuals at least, but if a business is built on the malicious exploitation of that feature, it may indeed be found to be illegal. And if it is not illegal it is certainly wrong, regardless of the law.

It all comes back to the common sense view that there is nothing wrong with making money if you deliver value, but there is everything wrong with knowingly misrepresenting what you deliver simply for financial gain, then it is fraud. For better or for worse, Herbalife had inauspicious beginnings. In the course of this current saga, a friend told me she used to sell Herbalife because she and her friends were all hyped up on the ephedrine in the product at that time, so one view of Mark Hughes certainly was that he was a drug dealer who successfully exploited the addictive features of his product. Later ephedrine was banned, and continuing the addictive properties of Herbalife's business proposition by other means became vital for the future of Herbalife. We currently seem to be watching a show about how well they've done since then, and since they're public, and some serious investors have weighed in, pro and con, it has become quite a spectacle to watch. CNBC is making a mint selling tickets to the show, the FT has had up to now some of the best coverage, and this site has had its fair share. The New York Post has been on top of it, and recently the Blog of Columbia Law School weighed in as well.

The legal troubles of MLM have all been about the issue of mala fides, misrepresentation and fraud, which is then magnified by the pyramid structure, causing losses on a massive scale. The argument has often been clouded by the use of the word pyramid, as if the pyramid was the problem, when in fact the intent to deceive and defraud is the real problem. The whole issue over "retail sales," and the illegality of payments for "recruiting" also gets it wrong by focusing on the thing, not the issue. A good head hunter is paid for their work, and there is nothing wrong with it. A good trainer is paid for their work, and there is nothing wrong with that either. MLM, because of its multiplier effect, is a perfect set up for serial fraud on a massive scale if the underlying product or service and the "business opportunity" are fraudulent, and there is an active attempt to deceive. MLM is innately harder to deal with than Ponzi-schemes, because of the widely dispersed nature of financial harm and failure, as opposed to the colossal chain collision that is the predictable end of a Ponzi.

Constructive attempt at regulation

The sincere attempt by some industry observers and participants to seek better regulation, through a recent petition to the FTC may also be flawed by focusing on features, not issues, and intent. It is pointless to eliminate all of MLM just because there is a lot of abuse. What is needed is an effective solution to prevent abuse, or prosecute it if it happens, not killing the goose that lays the golden egg.

The end-run around franchise law

Clearly, if Herbalife was about selling a $59 membership in a discount buying club, there would be little wrong with it, even if there was some override for the trainers, as long as that override was for product/services sold, not the act of recruiting. The forensic question is if it isn't really about selling $4,000 supervisorships, and the $59, is just part of the path of deception, in fact a "loss leader" of sorts (on the part of the selling distributor, who gets nothing, but not for the company which gets the $59), and for that price enables the distributor to make the sale of the supervisorship, on which that distributor does make money. Then it is a two step sale, neatly legalized by the fiction of "independent distributors."

If the real business model is selling $4K supervisorships, then it's an interesting end-run around the franchise law, and the forensic analysis that was started by Pershing Square, and continued by some authors on this site and elsewhere. It may well be nominally legal, but there could be no question that economically that is what is going on.

Other examples abound. I was once in the telecom business, and was repeatedly pitched on ACN, almost from its inception. Financially, that company has been standing still for years now, selling $499 distributorships (to stay below the $500 limit that would make it a franchise), with $50/month "maintenance fees," saddling the beginning entrepreneur with $1,100 in first year hard costs, and raking it in because 9 out of every 10 fail, and the company is making money on the churn, practically standing in place at $500mln in sales. After all, they only have to pay out commissions on actual sales of product or services...

Here's how the pyramid effect gets serious. ACN sells only commodity services, services where anybody who can fog up a mirror can walk into a company and sign up for free as a sales rep, be it in telecom and Internet services, alarm services, cable TV, credit card processing, etc. When a serious ACN rep thinks you make a good target, here's the offer you will get (from my own experience as well as from others): bring three friends into the deal and I'll pay half the fees. In short a representative of ACN will put down $998, if you can bring in three other people for collective a total of $1,996 in start-up costs. Notice: all four people are then starting to pay the $50/month fees. And obviously a group of four like that can at least bring in some business. No wonder companies like this can give away cars and what not to top "performers," they just can't pay for recruiting directly, but indirectly they can fuel the flames.

If you put all this together with the fact that it is a proven, safe business assumption that 9 out of every 10 will fail, there is at least a constructive end run around the franchise law going on, for in a situation like this a company raises thousands for every "successful" rep. "Successful" usually means someone who renews after the first year, for which there often is another fee, like $100 or so.

Enter the criminal dimension

The father of RICO once weighed in on the criminal aspects of the Amway model. That analysis hinges on taking a high-level view, and piercing the nominally legal separations of various actors which has characterized that business. When you look at it that way it certainly does look like a conspiracy. Clearly the Pershing Square research has not been one dimensional either, but has taken a pretty comprehensive view of the situation, as one could see from reading between the lines of the material they have published. Some of the features PS has highlighted would lend themselves to similar analysis as Blakey brought to the Amway matter.

A civil case that is currently going on against a private MLM company, Ignite/Stream, in the "commodity" service of retail energy seems to be headed down Blakey's track, as it just gained RICO status. It would be fair to guess that the relevant parties are watching such developments with interest. It could spell the end for "pay to play" selling of opportunities in multi-level fashion.

Should an MLM be public?

The nature of the MLM model is that it requires low capital, because there should be little or no advertising as the word of mouth model is sales and advertising is one, and all done on a commission basis. That joining of interests would at the very least suggest that the only fair way for an MLM to go public is if they offer their distributor force a good stock option program, otherwise it is a cynical stab in the back of the people who built the business. And either an IPO or a private sale would tend to be the same in that regard. The histories of Excel communications and Slick-50 and many others have demonstrated that point. In many of those cases then the problem will end up being the same as in investment banking or trading, and the good people will leave once they see the money being taken off the table. The owners may cash in, but the business will leave.

On the other hand there are interesting products with a lot of IP and development cost involved that might legitimately be better served with a word-of-mouth marketing solution like MLM. Websites don't talk, people do. If the regulation of MLM could be cleaned up and made workable that could be a boon for the economy, for modern communications enable person-to-person selling better than ever, and the delusion of "disintermediation" from the early internet days is well behind us at this point. All marketing, distribution, promotion and sales has a cost, the question should be about effectiveness. MLM has been suffering from legal obfuscations too long and shady practices have been the predictable result.

The big picture

From the beginning it seemed clear that Pershing Square had done their homework thoroughly, and certainly had not hinged their case on a single dimension of the problem. However, even if their analysis was correct, that does not mean their position will be vindicated financially or even legally. If they lose, they'll lose on points, to arguments like that presented by Distressed Debt Analyst. If they win, it will be on understanding the big picture and addressing all aspects of the problem simultaneously. Time may be against PS, so if they lose by running out of time, they'll be just another victim of a pyramid scam, and someone else, some other day will win, for the big picture would not change one iota. After all, who in their right mind would want to be in a business where they know full well that 9 out of 10 people they recruit are destined to lose their money. If it isn't provably illegal, it is certainly unethical, and it would leave you being inducted in the NFL (No Friends Left). The ones who pursue these opportunities knowingly would have to be either malicious fraudsters, or otherwise totally deluded themselves. The intentional lack of disclosure and outright deceit are an integral feature of such business, even if the "independence" of reps tends to afford the legal obstacle of plausible denial.

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 am involved in a business referral system which offers multi-level payout.