Is It April Fool's Day At The FTC? Herbalife Thinks So

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 |  About: Herbalife Ltd. (HLF)
by: Matt Stewart

Summary

Herbalife longs take the FTC for granted.

Executive compensation data reveals money transfer scheme.

Herbalife's new Gold Standard Guarantee mocks the FTC's intelligence.

Revisiting Koscot reveals the endless chain.

Today is April Fool's Day or as Herbalife (NYSE:HLF) executives like to call it, "FTC Day". Herbalife has been deliberately pulling the wool over regulators' eyes for a long time now. Investors like Mr. Icahn seem to think that evidence of longevity is also evidence of legitimacy. This may turn out to be an expensive wager.

Michael Johnson is the CEO of Herbalife. Any guesses how much money he made last year? The answer can be found here in Herbalife's Annual Proxy Statement. The quick answer is $10.5 million; this on the heels of a pay day of $10.3 million in 2012 and $24.6 million in 2011.

What other perks does Mr. Johnson enjoy? Exclusive use of a private jet, a $36 million golden parachute, an $11 million life insurance policy, etc. For someone to be making that kind of money clearly this company must be making its distributors rich too, right?

Let's layer in the average compensation for Herbalife distributors underneath the comp of their Top 5 executives. Stitching together the proxy statement and the Average Statement of Compensation we learn the following.

2013 Herbalife Compensation Data

Michael Johnson, CEO $10.3 million
Rich Goudis, COO $3.2 million
Des Walsh, President $3.2 million
John Di Simone, CFO $2.7 million
Brett Chapman, CLO $2.2 million
Top 194 Distributors $724k
Next 452 Distributors $149k
Next 539 Distributors $69k
Next 1,136 Distributors $36k
Next 1,940 Distributors $16k
Next 2,552 Distributors $7k
Next 11,307 Distributors $2.2k
Next 41,617 Distributors $0.3k
Next 434,125 Distributors $0
Click to enlarge

Q. Does this look like a money transfer scheme to you?

For the record, Mr. Johnson's 2013 compensation works out to 2,296x that of the average US-based distributor. The SEC seems to be newly concerned with this kind of data. When you read the Herbalife proxy you should also note that Mr. Johnson is paid mostly on growth in Volume Points - not the profitability of the people in his distributor network.

Q. Is this incentive likely to promote more recruiting in the future or less?

By now, most investors are probably familiar with the Koscot Test. This is the simple test that determines whether or not a company is running a pyramid scheme or endless chain.

In exchange for:

(1) Payment of money to the company;
(2) The participant receives the right to sell a product (or service);
(3) The participant receives compensation for recruiting others into the program;
(4) The compensation is unrelated to the sale of products (or services) to the ultimate user.

John Hempton sees people consuming product and concludes that this makes Herbalife legitimate. This strikes me as an odd conclusion when the Koscot Test clearly states that participants get the right to sell a product. Most assuredly, some of the participants will sell the product. Whether or not it is sold to non-participants is an entirely different question.

Herbalife distributors pay $59 to join a pay plan that also pays them a meaningful commission when downline recruits buy inventory to get to SUPERVISOR. Surprise, surprise; this incentive seems to get participants to focus on recruiting an endless chain.

From the Koscot ruling:

PAR. 8. Respondents' multilevel marketing program, as represented by the above ­quoted statements, contemplates an endless recruiting of participants since each person entering the program must bring in other distributors to achieve the represented earnings. The demand for prospective participants thus increases in geometric progression whereas the number of potential investors available in a given community or geographical area remains relatively constant. Consequently, a person coming into the program at a later stage will be unable, in a substantial number of instances, to find additional investors because the recruiting of participants into the program at an earlier stage by others has exhausted the number of prospective participants. It is self­ evident that respondents' marketing program must of necessity fail when the market for potential distributors has become saturated.

Although some participants in respondents' multilevel merchandising program may realize a profit, all participants do not have the income potentiality represented by respondents, such as described in Paragraph Seven through recruiting other participants and the resultant finder's fees, commissions, overrides, rebates and other compensation arising out of the sale of respondents' products. In reality, some participants in the program will receive little or no return on their investment.

Respondents' multilevel merchandising program is organized and operated in such a manner that the realization of profit by any participant is predicated upon the exploitation of others who have virtually no chance of receiving a return on their investment and who had been induced to participate by misrepresentations as to potential earnings. Therefore, the use by respondents of the aforesaid program in connection with the sale of their merchandise was and is an unfair act and practice, and was and is false, misleading and deceptive.

Last week I addressed how Herbalife's new Gold Standard Guarantee was Fool's Gold; obviously cynical, and the latest arrow in the company's quiver of deception. You see, money back guarantees don't overcome the sinister dynamics of endless recruiting chains nor the mathematical fallacy that they proliferate.

Candidly, at this juncture, it feels to me like Mr. Johnson is intentionally mocking the FTC. If you ask me, the company's response to date to Mr. Ackman's allegations has been downright perverse too.

The first question I asked myself after Mr. Ackman's presentation was this: "Why didn't Mr. Johnson invite the FTC and SEC to investigate the company on day one after the allegation? If the company truly had nothing to hide, why not just open-up the books? Why the need for lawyers and PR consultants, and high profile Latinos on board, or congressional lobbyists? Why waste $30 million when it would only cost 25 cents to call your local regulatory office? Why not enlist the help of your chief regulator to clear your name?

Why act guilty and defensive if you have nothing to hide?

Isn't the answer obvious? If someone accuses you of lying, isn't the quickest way to exonerate yourself to take a lie detector test? Is that what Herbalife did? Of course not. Instead, the company has repeatedly sidestepped regulators and the robust list of questions posed by Pershing Square.

Then it occurred to me, the only reason anyone could be long Herbalife common is simple. Effectively, the long position is a game of regulatory arbitrage.

Of course, Herbalife promotes an endless chain of recruitment. Longs just don't think the FTC is going to do anything about it. Or, at worst, they will give the company a wrist slap. Mr. Icahn has said as much in prior interviews on CNBC. While Webster v. Omnitrition states that for the Koscot Test to have "any teeth" ultimate users cannot be participants in the pay plan; Mr. Icahn and Mr. Stiritz bank on the notion that even if the Koscot Test has teeth the FTC and SEC don't.

How else could anyone own this stock after reading the case law?

Herbalife is like a speeder. The company cruises the nation's interstates without regard for the speed limit. Instead, it acquires fuzz busters and cruises along simply tempting the police to pull them over. Daily life for Herbalife is like the classic movie "Smokey and the Bandit". Seemingly, the company's management team thinks they are like Burt Reynolds' character Bo "Bandit" Darville. Perhaps more importantly, they seem to believe that the FTC is an inept policeman like Jackie Gleason - the "Buford T. Justice" of the world of endless chains.

Mockery, however, is a dangerous course of action. Still, Mr. Johnson and Mr. Icahn seem to mock the regulators at the FTC. April Fool's Day at Herbalife HQ is a day that the company celebrates how easily it has deceived Federal Regulators for so many years. Then again, maybe this April 1st is different?

The trouble Herbalife has now is that regulators like the FTC will not be easily mocked. Those inside the ant farm that is the Herbalife pay plan seemingly fail to see its obvious and sinister mechanics. As an alternative metaphor, when you get too close to the trees it becomes impossible to see the forest. New Herbalife recruits don't see all of the other trees the company is recruiting to compete for customers every day. New participants simply do not see how the company intentionally sets them up to fail.

Fortunately, for society, we now have highly intelligent and motivated regulators who will, in my estimation, clearly see the Herbalife pay plan for what it is - an obvious endless chain recruiting scam that victimizes people around the world with a mathematical fallacy.

The Koscot ruling stated:

46. The Koscot marketing program clearly contemplated an 'endless chain' in that it involved the continual recruitment of additional participants, since each person entering the program had to bring in other distributors to achieve the specified earnings. The demand for prospective participants thus increased in geometric progression while the number of potential investors available in a given community or geographical area remained relatively constant (Westing 1271­72, 1278; Nelson 1718­19; Darling 1445).

47. The fallacy in the 'endless chain' aspect of the Koscot marketing program, with each distributor supposedly recruiting successively two other distributors a month, is that it involves a geometric progression which, carried through to its ultimate result, would mean that in 18 months the entire United States population (203 million in 1970) would be involved in the plan (CX 536; Westing 1273; Darling 1445­48).

48. Aside from the mathematical fallacy inherent in the Koscot plan, an endless chain scheme must, in any event, ultimately fail to provide returns to all participants. Such a scheme must cease when it exhausts the number of people willing to invest in it. The exhaustion of prospects results from over­ saturation, leading potential purchasers to realize that their chance for success is limited in view of the numbers already recruited; lack of funds on the part of otherwise potential purchasers; or a negative reaction on the part of potential purchasers for any number of other reasons. Recruiting must always cease, and those recruited into the program at or near its conclusion must lose (Westing 1271, 1273; Nelson 1729­30). And the fact is that most Koscot distributors lost by relying on the endless chain aspect of the Koscot marketing program (CPF 225).

It might be easy to point a finger of blame at regulators for failing to intervene up until to this point. Still, this frustration would seem to be misplaced.

Remember, up until the end of 2012, Herbalife had perfected its deception in its public filings. Distributor allowances were presented as if they were de facto retail sales, churn and resignation rates in the sales force were not disclosed, average compensation to distributors was doctored and enhanced, lead generation systems were allowed to flourish while ignored.

The list of "fuzz-busters" employed by the company goes on and on and on. "Mocking Smokey" has been Herbalife's stock in trade.

They say it's hard for a leopard to change its spots or a tiger to change its stripes. Herbalife's entire organization functions on the cornerstone of a culture of deception. From the top on down the company's response to Mr. Ackman and Mr. Dineen's impressive forensic analysis has not been mea culpa. Instead, the company continues to recruit ad nauseam with its exaggerated earnings claims and false promises that profitable duplication is both probable and achievable. Recruiting to the point of pain is what Herbalife does best. The pay plan is designed to promote recruiting. The FTC should spot this easily.

In Dr. Peter Vander Nat's expert testimony v. Trek Alliance he had the following to say:

"...for as long as recruitment does proceed according to a stated pattern, the vast majority end up at or near the bottom of the pyramid in which case the compensation schedule ensures they cannot qualify for the promised rewards; in which case the earnings claims turn out to be false."

Last year Herbalife recruited 2 million new distributors. If they all recruit 5 each, 1 level deep that would be 10 million distributors around the world. Due to the fallacy in the premise, Herbalife is stuck with less than 4 million salespeople and has been for a few years now.

Regrettably, as long as Herbalife can continue to recruit money will continue to be transferred to Mr. Johnson's pockets.

Herbalife is a deceptive marketer and a recruiting scam that relies upon an endless chain of recruits for its sustenance.

Don't believe me?

If Herbalife had its druthers it would recruit 10 million people to compete against one another tomorrow. Then it would ask those 10 million people to recruit ten million more. And so on, and so on, and so on.

Q. Are you smarter than a 5th grader? Can you see the obvious problem with this kind of business plan?

Evidently, Herbalife seems to think that the FTC isn't smarter than a 5th Grader. Evidently, Herbalife thinks that its Gold Standard Guarantee will be just the right amount of lipstick for this pig such that the culture of deception will be allowed to prosper yet again.

If you are long, don't bank on it.

Herbalife is an endless chain recruiting scam as outlined in Koscot. Regulators will shut it down.

This will be Herbalife's last April Fool's Day as a publicly traded pyramid scheme.

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.