4 Million Reasons Herbalife Is A Money Transfer Scheme

Apr. 3.14 | About: Herbalife Ltd. (HLF)

Summary

Herbalife purportedly sells a business opportunity.

Participants fail at astonishing rates.

Failure rates reveal the massive fraud - the proof is in the pudding.

At the end of 2010, Herbalife (NYSE:HLF) marketed itself in 72 countries around the world and ended the year with 2 million distributors.

In the period between the end of 2010 and the end of 2013, Herbalife recruiters recruited:

  • 1.67 million distributors in 2011
  • 1.96 million distributors in 2012
  • 2.17 million distributors in 2013

For a company that emphasizes retail sales over recruiting, the recruitment of 5.8 million people in 3 years seems like a staggering result.

As of the end of 2013, Herbalife marketed itself in 91 countries (+26% vs. end of 2010) and had 3.7 million distributors.

Solving for X, 4.1 million distributors resigned from Herbalife in the 3-year period ended Dec 31, 2013.

Q. What does this have to do with the pyramid scheme allegation?

The FTC's most recent prosecution of a pyramid scheme occurred in 2013, when the government sought a restraining order and asset freeze against Fortune Hi-Tech Marketing. Investors should take the time to read the FTC's legal briefs, which can be found here.

In this article, I would like to draw attention to the FTC's Opening argument in it legal brief seeking a Restraining order vs. FHTM.

The Federal Trade Commission, the State of Illinois, the Commonwealth of Kentucky, and the State of North Carolina bring this action to put an immediate end to an old-fashioned pyramid scheme that promises vast riches and a lavish lifestyle, but instead delivers significant financial losses for nearly all consumers who fall victim to its claims. Fortune Hi-Tech Marketing, Inc. ("FHTM") bills itself as "the business model of the 21st century" and promises its recruits vast sums of money, but it really distinguishes itself in only one important way: the overwhelming majority of recruits make nothing at all.

In its decade of operation, FHTM has defrauded hundreds of thousands of consumers out of hundreds of millions of dollars. FHTM's victims, including at least 100,000 current participants, live throughout the United States and Canada. The founders of this enterprise, Paul Orberson and Thomas Mills, along with a handful of others, have reaped millions while the overwhelming majority of recruits have lost nearly all of the money they invested in the scheme.

Defendants target consumers with an entrepreneurial spirit, emphasizing that FHTM provides an opportunity to build a business which can rapidly match consumers' current income and provide financial independence. FHTM routinely touts six and seven-figure incomes to new recruits, assuring them that they will be able to achieve these results as long as they are willing to work bard. An increasing number of the recruits targeted by FHTM- particularly in places like Chicago- are Spanish-speaking.

FHTM describes its multi-level marketing ("MLM") program as "network marketing," and it claims to provide an opportunity for consumers to share in the billions of dollars that large companies spend on advertising each year. Strikingly, there is relatively little discussion, either during the recruiting process or even after a consumer joins FHTM, of the products that are to be sold- such as subscriptions to satellite television, utility and cell phone services, or various house-brand shampoos and dietary supplement pills. In fact, FHTM's training is largely devoted to providing motivational guidance and advice on how to recruit new representatives. There is almost no discussion of how to sell FHTM's products, other than vague promises that the products "sell themselves." Further, there is hardly any mention of the hundreds of dollars new recruits must pay in fees and for their own purchases of FHTM products in order to qualify to receive the only meaningful compensation offered by FHTM- bonuses for recruiting others into the program. These fees and essentially required purchases can easily top $1500 annually.

The only real chance a consumer has to break even with FHTM is by recruiting several new people to join the program, who then must pay their own application fees and purchase (or theoretically sell) a host of FHTM products and services which they likely would not otherwise purchase.

As with any pyramid scheme, FHTM's defining characteristic is a compensation plan that is skewed heavily in favor of recruitment over sales. The Plaintiffs' expert, Dr. Peter Vander Nat, has examined FHTM's financial data and determined that at least 88% of the compensation paid by FHTM is in the form of recruitment bonuses, not sales-based commissions. Furthermore, most recruits will never recoup their investments in FHTM. Conservatively, at least 90% of FHTM participants earn nothing through FHTM, and 94% of recruits drop out within a year. In fact, this massive loss rate is the inevitable mathematical consequence of FHTM's business model. If more than a minuscule number of recruits were able to achieve the results touted by FHTM, the bonuses could never be paid and the company would quickly collapse. FHTM's mission is to enroll ever more victims and replace them as they suffer losses and quit the program.

FHTM's scheme resembles an iceberg - at any given time, and no matter how large or small this company becomes, the vast majority of consumers must be, and will be, financially underwater. Only a minuscule number of participants -probably less than 1% - are making even a five-figure annual income, and most consumers will lose more than they gain from their participation in FHTM. In short, this is a rigged game, the true nature of the scheme not readily apparent to the consumers who put in their time, energy, and money but ultimately fail.

Defendants are well aware of their obligations under the law, but continue to engage in this unlawful conduct. Each month that FHTM operates, consumers lose at least $3 million, which is attributable to the company's blatant misrepresentations about earnings and the continued operation of the illegal pyramid scheme.

Court intervention is necessary to put an immediate halt to the unlawful conduct and victimization of consumers.

Plaintiffs have submitted overwhelming evidence demonstrating both FHTM's deceptive earnings claims and its operation of a pyramid scheme- either of which alone is sufficient grounds to grant Plaintiffs' TRO motion.

Plaintiffs ask that the court enter an ex parte temporary restraining order that includes a freeze of Defendants' assets, expedited discovery, and the appointment of a temporary receiver over the corporate Defendants. The requested relief is necessary to prevent ongoing injury to consumers, the destruction of evidence, and the dissipation of assets, thereby preserving the Court's ability to provide effective final relief.

Pyramid schemes are Business Opportunity Frauds. Effectively, participants are seduced to risk their financial, human and reputational capital in pursuit of an opportunity to earn an adequate return on that capital. Selling a business opportunity that doesn't exist is a fraud. Pyramid schemes sell a business opportunity that cannot exist. Therefore, pyramid schemes are inherently fraudulent.

If investors want to zero-in on data that reveals that Herbalife is operating a fraud, one needn't look further than the company's recruitment data, churn data and compensation data.

To be certain, we can conclude that Herbalife is an effective recruiter. Recruiting is what Herbalife does best. 5.8 million people recruited in 3 years is nothing to sneeze at. Unfortunately for Herbalife, the company has a slight retention problem. Specifically, the vast majority of participants quit in less than a year. Sales Leaders might last 2 years, if they are lucky.

Q. Is it possible to sell a business opportunity if the vast majority of business opportunity seekers don't make any money? Would it not be more accurate to describe what Herbalife is offering as a "loss opportunity" or a "victim opportunity"?

According to the company's own data, the answer has to be an overwhelming "Yes".

Q. Did you know that Herbalife CEO Michael Johnson's 2013 compensation is over 13,000x that of the average Herbalife Distributor in the USA? Average distributor compensation in the USA is just over $700. The median, of course, is much lower - skewed by the fact that over 400,000 distributors make nothing at all. Is it any wonder that most quit in less than a year?

Still, the recruiting juggernaut churns on.

Yesterday, Michelle Celarier of the NY Post tweeted an interesting link to some analysis completed by Robert Fitzpatrick on the economic experience of Herbalife's Sales Leaders. This document can be found here.

Q. Do Supervisors make any money? Or, are they the participants who really get taken for a ride by the Herbalife pay plan?

Why is any of this important?

The FTC is now investigating Herbalife and, put simply, these are the kinds of questions investigators will be asking.

  • Do participants make money?
  • How many quit?
  • Is the company like an iceberg?
  • Are sales made to non-participants?
  • Does the pay plan encourage inventory loading?
  • Is compensation tied to retail sales to ultimate users?
  • Does the pay plan emphasize recruiting over retail sales?
  • Are the results experienced by participants rigged/preordained?
  • Is there evidence the company is a money transfer scheme?

When you contrast the earnings of company shareholders like Carl Icahn and Bill Stiritz or the company's management team with the earnings and churn rates of the company's most junior participants, what do you see? Isn't it obvious that shareholder spoils are financed by the economic losses of those who are recruited with false promises and false hope?

Yesterday, I tried to search on the web for data on the failure rates for some of America's best-known franchises. I found this article written by Forbes magazine in 2012. The results were fascinating. I encourage you all to read it here.

The article is titled The Top 20 Franchises For the Buck

Q. Of the 14,016 locations of McDonald's restaurants in the USA, how many have closed in the past 3 years?

A. 367, or less than 3%.

Funny, endless chains do not promote territorial exclusivity, it would seem. Is it any surprise, therefore, that failure rates are significantly higher for pyramid schemes?

Herbalife common remains well bid here as the FTC embarks upon its investigation. Longs seem somewhat confident that Mr. Icahn has done his homework, even as he has readily admitted that his investment in Herbalife was initiated with a revenge motive on the very same day that Pershing Square presented its short thesis at Ira Sohn in December of 2012.

Whether or not Mr. Icahn's view of Herbalife turns out more like his investment in Blockbuster or Mr. Martin Whitman's pursuit of MBIA common remains to be seen.

Candidly, I am not sure that the interests of either Mr. Ackman or Mr. Icahn will matter much to the FTC at this juncture. No matter what the FTC does now, a billionaire will make a lot more money once the results of the HLF investigation are revealed. Justice will be immensely profitable for somebody.

For my money, I cannot see how an investigation of Herbalife will not uncover the obvious conclusion that Herbalife harms consumers around the world with outrageously deceptive marketing practices.

Specifically, the company harms optimistic entrepreneurs who are just trying to get ahead in life with a rigged carnival game that is the Herbalife pay plan promoted with cynical and delusional income claims.

Every day this pay plan is allowed to proliferate is a day where more and more Latinos and like around the world are victimized such that the pockets of the likes of Michael Johnson continue to be lined. Shutting the company down would be a service to society. Shake mix seekers would do just as well buying Slim Fast at Wal-Mart (NYSE:WMT) for less money per serving.

From 2010 to 2013, Herbalife churned out 4 million reasons why its pay plan is a confidence game. This year, even more business opportunity seekers will be churned out, and so on, and so on, and so on...

The sooner regulators stop the madness, 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.