Herbalife (NYSE:HLF) is coming to a theatre near you, or better yet: the big screen. Other than that, the saga continues unabated with little real news, except some moves by traders, that could be either opportunistic or material, and there's a corporate buyback for general support. Generally volumes are low and prices on the high side, considering the overhang of issues. It is time for investors, especially longs, to consider that there is more than a mere risk of regulatory action. Namely, given the increasing pitch of regulatory publications and action in this area, including specifically FHTM, Zeek Rewards, and TelexFree, Herbalife is likely to become the poster child for the next chapter in enforcement and regulation. Zeek and TelexFree were both Ponzi-schemes, it's time for a juicy pyramid sales case. The fact that the investigations are taking some time cannot be mistaken as cause for comfort. Last, not least, there's the action against Vemma in Italy, and Amway in India, and SEC and FTC are probably motivated not to wait for American regulations to be pre-empted by China, Italy, India or Zimbabwe.
With all the investigations that have already been announced, it is hard to see decisive change until there are clear actions from regulators and/or prosecutors, but the risk of waking up to a $0 listing any day remains ever present. Nobody is going to tip their hand. What is clear, however, is that the major agencies concerned (FBI, SEC, FTC) have put out information this last year (summarized here) or so to clarify the distinction between "illegal pyramid" and "legitimate MLM." The recent paper on the history of MLM by Prof. William Keep and Peter vander Nat, the FTC economist, is yet another fresh attempt to frame the whole subject in a clear way. FHTM has happened. Except, the definitions remain clear as mud, because of the casuistic legal history involved, and the only development that could clear things up is not just another one-off action by regulators, but how that action is framed, including by any subsequent prosecutions, and if it will lead to a useful clarification of regulations.
Meantime a few interesting insider sales have taken place by CEO Michael Johnson, and board member John Tartol, selling right into the corporate buy-back.
In short, Herbalife is the perfect setup to be made an example of, and if rigorous action is taken, the whole MLM industry might be affected, and certainly all investors in publicly traded MLMs Primerica (NYSE:PRI), Just Energy (NYSE:JE) -- Momentis division, Blyth (NYSE:BTH), NuSkin (NYSE:NUS), Reliv (NASDAQ:RELV), LifeVantage(NASDAQ:LFVN), Mannatech (NASDAQ:MTEX), Usana (NYSE:USNA) and/or holding companies with MLM interests might pay attention. If there is no decisive action, we'll be back to waiting for the next precedent-setting case until clarity is provided once and for all.
Illegal pyramids: Nailing Jello to a tree
In Ponzi schemes it is all so clear and simple. A Ponzi is an investment scheme that will yield to a simple, objective analysis of the returns on the business without consideration of new investment. If there is not a legitimate business producing the returns, existing investors are paid not from profits, but from new investment, and then, when concerns mount, and withdrawals set in, it crashes at an accelerated rate, but it was never sustainable in the first place. The crash is entirely predictable, and therefore preventable, and a shutdown can prevent otherwise inevitable damages. That much is relatively straightforward.
The reason "illegal pyramids" are an elusive species, is because you do not have an investment principal that can be withdrawn, and no resulting hard crash. A "business opportunity," is an inherently fuzzy animal, not a hard money claim, and arguably, if one person made money, it is an opportunity, never mind if 99% lose. You do not have nice and clean, hard, investment returns, and withdrawals. You might have a limited product return policy, but that's just window dressing, relatively speaking. Analytically, it seems simple enough: an illegal pyramid is a Ponzi wrapped around a product. That still leaves the question of exactly what distinguishes an illegal pyramid from a legitimate MLM, and none of the regulators provide clear guidance, only a symptomatic approach.
I want to suggest these definitional difficulties arise because we are trying to nail Jello to a tree by focusing on the "pyramid" and not the underlying and associated fraud(s), and as a result we end up with the quip of MLM-attorney Jeffrey Babener writing on Herbalife:
Rather, the answer as to whether or not an MLM/Direct Selling program is a pyramid, for which federal prosecution is justified and predicted, may be driven by a case by case fact scenario that answers a "gut instinct," as noted by Justice Potter Stewart (on pornography) … I can't define it, but I know it when I see it.
The problem is not the compensation structure, except when it is clearly illegal, such as paying for headhunting. The problem is the fraud. It all reminds me of learning to fish for eel as a kid: you can't grab them because of the slime they produce, so you learn to grab them with a handkerchief. And in this case the legal handkerchief is provided by the various fraud statutes. In practice, the problem decomposes into either fraudulent product claims or business opportunity fraud, which can be extended to include mail fraud etc. At the extreme it may be racketeering (RICO), and that approach has already been attempted, and another potentially large case is currently developing (Ignite/Stream). The Herbalife case is an open invitation to that approach, based on what has been aired to date.
The compensation structure, if it is otherwise legal, is only the multiplier of the fraud, for it provides leverage. In itself the idea of multi-level compensation, within prescribed bounds, is neutral, the only problem is that it is easily abused. If there is no fraud, no deception, and the company delivers fair value to consumers, and representatives are not being misled about their prospects, then there are no damages, there is no fraud and no case. No harm, no foul.
Pershing Square has it right in their Herbalife presentations to focus on the damages and the deceptive claims, both product claims and earnings claims. Pershing Square is slipping around in the slime of pyramid allegations, along with various regulators and prosecutors, when they make out as if the pyramid shape of the organization, is a proof of fraud all by itself. QED nothing.
Deconstructing the MLM-model
One of the issues in any regulatory action will have to include to what extent various precedent-setting rulings are relevant or should be challenged and reviewed, going back to the original reasoning. Next, there is going to be the issue of proliferation of MLM-models, and there is not one easy way to regulate them. Some are clearly abusive other seem pretty harmless. Here are some points to consider:
- Chain letters and Ponzi-schemes are clearly illegal for good reason. They are clear-cut cases of structures that can ONLY produce financial harm -- damages -- by deceit and fraud.
- Referral marketing schemes may be problematic, because they can be chain letters wrapped around a product. The evident cases are commodity products at three times the price. But if the product provides fair value, i.e. there are retail buyers, without any fraudulent product claims there should be no problem. The mere fact that products may be "expensive" is meaningless, especially if they are unique (e.g. patented), and even then, overpriced products eventually undermine the business opportunity, which potentially makes it an opportunity fraud. In short, pricing is an art, and the product must be marketable for any program to exist at all.
- Illegal pyramids are Ponzi schemes wrapped around a product. The biggest tip-off of an illegal pyramid is payment of commissions for headhunting, which is clearly illegal, and there are various other circumstantial indicators. "Pay to play" should likely become illegal, regardless if the recruiter gets paid a direct commission, or only benefits indirectly. Pay to play programs take an end-run around the $500 limit that would subject them to franchise law by charging sub-$500 at sign-up, augmented by monthly and annual fees.
Relevance or otherwise of precedent-setting rulings
The 70% rule (Amway). The context was a tendency for channel stuffing, or people becoming "garage qualified," by buying their next commission check. Amway's defence, which was accepted, was that they required 70% of inventory to be sold, before reordering, and retail sales to at least 10 customers, and buyback of remaining inventory from distributors who quit.
Applies to HLF how? Similar, except the point is exacerbated by the requirement of a huge order for the supervisor position, which is an invitation to inventory loading.
In general, the 70% number is fairly arbitrary, but "external sales," i.e. to consumers outside the network serve to demonstrate the demand for the product by people other than those who have a direct financial stake.
Personal-consumption. This issue is frequently misconstrued. It came about as a would-be exception to the 70% rule, but has been rejected for good reason. IF the 70% rule is used to "prove" the absence of inventory loading, evidently it is external sales of that inventory that matter, since presumably the other 30% may include your own consumption. Again the purpose of these rules is to prevent inventory loading, and to document revenue from retail sales. Likewise, at the other extreme, personal consumption cannot be the ONLY sales, lest the program be a mere chain letter wrapped around a product.
Applies to Herbalife how? Simple, Herbalife claims to have a 70% rule, and so they would not be able to count any personal consumption towards the 70%. They infamously "don't have visibility" to that level of detail, so the rule is vacuous.
In general, we might note that in the internet age, and with more modern marketing plans, in newer companies, inventory loading is much less of an issue, since retail customers and reps alike order online for personal consumption. So HLF stands out for its antiquated marketing program, even if lately they seem to have been editing out some of the more noxious features. That may be too little, too late.
No commissions on headhunting. The purpose is obvious. If in doubt, have I got a bridge for you!
Applies to Herbalife how? As much as there is an argument that the supervisor position is the real "opportunity" in Herbalife, since the regular "members," are now being viewed as members of a discount buying club, the initial investment of $3,000 may technically be a product sale, but functionally may be construed as a way of making headhunting commissionable, as some have argued.
- Franchise law. In general, MLMs like to avoid running afoul of the franchise law. For that matter the cost of entry is kept below $500, though the industry has produced numerous work-arounds. In the minds of some, the $3K "supervisor" "buy-in" may cross over that line, and it will be interesting to see if that gets tested. In combination with the formerly "approved" sales method of nutrition clubs, which has now become a step-child, the required investment may be even more problematic.
Racketeering. A pattern of related frauds, which are independent in name only, but really support each other by mutually limiting liability for practices that could be questionable.
Applies to Herbalife how? Possibly the formerly "approved," but now orphaned "business methods," including lead generation and sales, as well as nutrition clubs could give rise to a racketeering case.
Regulators don't regulate but enable
The MLM-industry has triumphantly used the different rulings, starting with the '79 Amway ruling and its "70%" rule as if it were a clear regulatory and legal framework. Instead, what it really is, is a patchwork-quilt that is in urgent need of repair. That framework has kept would-be "MLM-attorneys" busy. Fuzzy rules are found money for lawyers.
As a corollary to the above the DSA is its own worst enemy. Actions such as its resistance to the FTC's business opportunity rule merely reinforce its role in giving cover to scoundrels. Any legitimate business could never have a problem with full disclosure, as required in the business opportunity rule. And the DSA stance protects the dubious companies, and undermines the ones that are above board, which is the opposite of what self-regulation should do.
By yielding to the lobbying of the DSA, the FTC became complicit to continued abuses in MLM, and they may see an urgent need to reverse themselves on this point. That alone would take the wind out of the sales of MLM-scams, while solid companies with serious products would barely flinch.
In conclusion, the trouble barometer keeps rising, abated only by elapsing time. The various fraudulent patterns are readily identifiable, and there maybe some new legal issues that could be tested in this case, but the pyramid structure itself is not necessarily the primary problem. The constituent frauds are the problem. Besides what investigations have been announced, there is mounting pressure because of the international attention to the problem. Increasingly, a reasonable person would surmise regulators have compelling reasons to act decisively, instead of putting it off once again for a rainy day.
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 have in the past developed an MLM-business plan for a company and I'm convinced that for some products MLM is a good model, and can be done ethically and legitimately.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.