I spent the past day or so digesting the ruling issued by the Appeals court in the BurnLounge Case.
This document can be found here.
I also spent a great deal of time rereading Dr. Keep and Dr. Vander Nat's paper titled "Marketing Fraud: An Approach for Differentiating Multi-Level Marketing from Pyramid Schemes."
This document can be found here.
There are a number of arguments that seem to be accepted as gospel by certain longs and shorts as it applies to figuring out whether or not Herbalife is a confidence game or not. They go roughly as follows.
If a Multi-Level marketer Sells its Product to the General Public it is a Legitimate Company. If it sells to people within its own closed-economy it is a pyramid scheme.
If royalty overrides, fixed overhead costs and retail gross margin can be financed primarily by Retail Sales to participants outside the network then the company is not a pyramid scheme.
If Members who participate in the marketing plan as discount customers are treated as "ultimate users" and therefore qualify as retail customers then the company cannot be a pyramid scheme.
In this article, I would like to advance the idea that none of these ideas is robust enough to determine whether or not a company like Herbalife operates a confidence game.
To advance this thesis, I would like to argue the following case.
1. Assume that 100% of all Formula 1 shake mix is consumed in the gullet of a bona fide homosapien.
2. Assume that 100% of all product manufactured by the company is acquired and consumed by a real, retail customer whether part of the network or not.
3. Assume that retail sales finance 100% of all company overhead, recruiting rewards, sales commissions, etc. (that is to say that the MLM would pass the Keep/Vander Nat test)
4. Assume that The company, senior recruiters and end consumers alike all are "made whole"/remain solvent and/or receive value for their participation in the business model.
Q. Can the company still be found to be the perpetrator of Marketing Fraud or not?
Conclusively, the answer has to be a definitive "YES" if the company promotes an ENDLESS CHAIN
Herbalife's (NYSE:HLF) Business model is simple.
The company manufactures the product and promotes a Marketing Plan that encourages participants to focus on recruiting.
The company's most senior distributors spend almost all of their time promoting the recruitment of new salespeople (see Herbalifepyramidscheme.com for a list of the "The Perpetrators")
The purpose of the Marketing Plan is to expand the supply of Herbalife salespeople endlessly.
New recruits are sold a "Business Opportunity" and the promise of a meaningful part-time or full-time income including lifestyle benefits.
No limits are placed on the number of salespeople recruited by the company and its network of distributors.
In practice, Herbalife is a recruiting company. Its participants focus their energy on recruiting.
That is what the compensation plan encourages them to do.
From the BurnLounge ruling the court had the following to say:
In Webster v. Omnitrition International, Inc., our court approved the FTC's test for determining whether a multi- level marketing (NYSE:MLM) business is a pyramid scheme: a pyramid scheme is "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." 79 F.3d 776, 781 (9th Cir. 1996) (quoting Koscot, 86 F.T.C. at 1180). Not all MLM businesses are illegal pyramid schemes. To determine whether a MLM business is a pyramid, a court must look at how the MLM business operates in practice. See id. at 783-84; see also United States v. Gold Unlimited, Inc., 177 F.3d 472, 479-82 (6th Cir. 1999); In re Amway Corp., 93 F.T.C. 618, 716 (1979).
To assess whether or not Herbalife commits fraud or not, as analysts we must try to identify instances of consumer harm.
Do participants experience economic loss?
Is this loss the result of a fraudulent act?
Absent the fraudulent act, is it likely that the consumer would still be harmed?
For the record, I fully expect various regulators to issue an injunction against Herbalife that will include the following counts:
- Deceptive Advertising
- Misleading Income Claims
- Anti-Trust Violation of Price Discrimination Law
- Conspiracy to Commit Wire Fraud
- Deliberate Operation of a Prohibited Endless Chain Marketing Scheme
- Securities Fraud
This list seems well supported by the evidence before us.
Evidence of consumer harm is apparent.
Millions of people sign-up to pursue the business opportunity. Most fail in less than a year. Those who stick around make little to nothing at all.
Dr. Keep and Dr. Vander Nat's economic model looks at an MLM in aggregate. Simply put, the model asks:
- What % of Sales are to Retail Customers
- What % of Sales are to Distributors
- Is the size of the pool financed by retail sales sufficient to finance commissions and overhead?
Respectfully, I submit there is a more pertinent question to ask.
Q. What is the economic experience of the individual distributor?
This is a granular analysis that seeks not to examine the commission flows for a purported MLM in aggregate, but rather looks at the P&L for distributors on an individual basis.
Specifically, how much retail gross margin is generated should be the most important question to regulators and business opportunity seekers alike.
After all, participants invest in the business opportunity as individuals.
Evidence of marketing fraud is found in the individual P&Ls of the distributors.
Shouldn't the question we ask be simple?
Do distributors make any money?
If not, why not?
The economics of a Herbalife distributorship are simple.
I pay $59 + I invest in a sum of inventory+customer acquisition expenses.
Every sale I generate should generate a sum of gross profit $/contribution margin.
Whether or not I make any money boils down to PxV
P = GM$ realized per sale and
V = Volume of Sales in Units
If the size of that margin pool exceeds my fixed and variable costs I generate a profit. If not, I lose.
As we look at the Herbalife business model, what can we conclude about how the company's policies impact my prospects as a salesperson? What would my PxV pool look like?
How does the company impact my P&L?
Does it harm my prospects or enhance them?
The following is a list of 6 ways that Herbalife as a company harms the business prospects of its distributors and therefore defrauds them.
#1 - Shipping and Handling Upcharges - Shipping and Handling Upcharges increase the COGS for distributors. Distributors must pass through this cost to consumers in order to recover full GM$ on a per sale basis.
#2 - Endless Chain of Salespeople - Herbalife grants too many sales licenses per geography intentionally saturating end-markets with distribution. This reduces average volume available per distributor by zip code and lowers the market clearing price for product to cost plus 25% to 35%.
#3 - Price discrimination. Supervisors are able to buy inventory at a lower COGS than Success Builders or Qualified Producers or lowly Distributors. This makes it impossible for non-Supervisors to compete on price with Sales Leaders for Retail Customers.
#4 - Channel Conflict. Herbalife allows customers to sign-up as Members and buy product directly from the company at a 25% discount effectively circumventing salespeople who are trying to make a living selling shake mix at Full SRP.
#5 - Territorial Overlap. Herbalife does not grant its distributors any territorial exclusivity effectively allowing all distributors to compete against one another for a finite opportunity set.
#6 - Rewarding Top Distributors for Recruiting. The more distributors the big guys sign-up, the more the company pays its Top Recruiters Mark Hughes bonuses. As a low level distributor, the sponsor at the top of your upline is encouraged to saturate your market with more salespeople in any way he/she can.
De facto, this is the way Herbalife's business functions "in practice". Last year, 2.1 million distributors were recruited on top of 1.9 million the year before. Day in and day out the supply of distributors is expanded with malice and intent by a pay plan that emphasizes recruiting.
Q. What does any of this have to do with the importance of whether a sale is made to a retail customer or not?
Through my lens, the answer is nothing.
Q. What does it have to do with retail profits?
Through my lens, the answer is EVERYTHING
After all, if there is no retail profit pool then there simply is no business opportunity unless you are a recruiter.
I think it is quite conceivable that the following outcomes could be achieved by an MLM that has product people actually wish to consume.
1. The pay plan sponsors could make a fortune
2. The Chief recruiters in the upline could make a fortune
3. The end-user could get to acquire shake mix that might reduce his/her waistline at a favorable price
Except for one thing, all of these economic results are subsidized by a tepid pricing environment and the monstrous failure rates of the business opportunity seekers who may actually be trying to operate a retail business.
However, because the company licenses an ENDLESS CHAIN of distributors there is no structural profit nor average volume left in the micro-economy such that business opportunity seekers can make any money.
This is the dynamic that Mr. Hempton misses when he visits a Nutrition Club or when Mr. Icahn says Herbalife creates lots of jobs "for Spanish people".
To close, there are a number of ways to skin a cat we are told.
True, Dr. Keep and Dr. Vander Nat's paper puts forth "An" approach to differentiating an MLM from a Pyramid scheme. Is it robust enough? I'll let you be the judge. For certain, there are others.
What the courts seem to be concerned with is "how does the MLM function in practice?"
For an even better summary of this point of view, I will defer to the comments of former Pershing Square analyst Shane Dinneen who had the following to say in response to a critique by Fusion Research last year.
Fusion Research assumes that the "basis of [our] pyramid 'proof'" is the economic model in the second half of Vander Nat & Keep's 2002 paper. The implicit assumption here is that since we use the definition of a pyramid scheme in the first half of the paper, then it follows that we are reliant on the economic model in the second half of the paper for our pyramid scheme "proof."
This conclusion is not correct. The definition of a pyramid scheme found in the first half of the Vander Nat & Keep paper has been used by the FTC in the prosecution of pyramid schemes and is part of the case law. For example, in FTC v. Five Star, the Final Judgment defined a pyramid scheme thusly (http://1.usa.gov/XVWYZd):
"'Prohibited marketing scheme' means a pyramid sales scheme, Ponzi scheme, chain marketing scheme, or other marketing plan or program in which a person participates under a condition that he or she make a payment, directly or indirectly, to receive the right, license or opportunity to derive income as a participant primarily from: (1) the recruitment of additional recruits by the participant, program promoter or others; or (2) non-retail sales made to or by such recruits."
The same definition was employed in the Final Judgment of FTC v. Futurenet (http://1.usa.gov/Ww8NuQ).
More recently, in November 2012, the FTC published a consumer alert on its website that similarly focuses on how an MLM's compensation plan incentivizes distributors - without regard to the company's profit or "indirect retail commissions":
"One sign of a pyramid scheme is if DISTRIBUTORS sell more product to other distributors than to the public - or if they make more money from recruiting than they do from selling." (emphasis added)
This is the effective equivalent of the definition of a pyramid scheme employed in our presentation, and it has a solid foundation in the case law. On the other hand, the model in the second half of Vander Nat & Keep's paper is purely academic. I would challenge Fusion Research to point to any Final Judgment in any pyramid scheme case law (FTC or otherwise) that employs the term "Advance Retail Commissions."
A court will determine what a pyramid scheme is and how to distinguish one from a legitimate MLM. In doing so, the courts will rely on the case law, not the economic model in the second half of Vander Nat & Keep's paper. After careful review of the case law, it is our opinion that when a court compares the profits earned from retail sales versus recruiting rewards to determine whether or not participants obtain their monetary benefits primarily from recruitment, the profits earned by the company (aka "indirect retail commissions") will not factor into the equation.
Instead, we believe the courts will focus on factors such as (I) the failure rate of participants, (ii) financial harm, (III) the extent to which upline rewards are skewed toward the top of the pyramid, (iv) the extent to which marketing materials promote recruitment and the business opportunity, (V) enforcement of the company's so-called "Amway rules," (vi) the structure of the compensation plan, including whether it provides greater rewards for participants who actively recruit, (VII) whether or not participants can receive commissions without purchasing product, (viii) whether commissions are based on the sale of product to ultimate users, (IX) the relative merits of the retail opportunity, and, last but not least, (NYSE:X) the extent to which sales occur "outside" the distributor network. With the exception of #10, none of these factors are incorporated into the Vander Nat & Keep model.
Fusion Research says our pyramid scheme analysis is flawed because we don't rely on the economic model in the second half of Vander Nat & Keep's paper. I say Fusion Research's analysis is flawed precisely because it does rely on that model.
Herbalife sponsors a pay plan that promotes the relentless recruitment of an ENDLESS CHAIN of recruits. This deliberate and intentional policy unleashes a set of economic forces that leads to a predetermined result.
Specifically, the last participants to join the party get left holding the proverbial bag because they can only fail as retailers when they discover there is no retail margin to be had.
I submit that this negative outcome would occur even if 100% of product was sold to retail customers or if you prefer "ultimate users". This is certainly what we see in the churn data evident in Herbalife's 10ks and Quarterly Regional Metrics reports.
"In practice", people sign-up and fail very quickly.
Herbalife asserts the notion that its Money Back guarantee immunizes participants from loss. Of course, this idea is complete nonsense. Conceptually, a distributor could sell through all of his $3,000 Supervisor order to customers at Cost or Cost + 20% and still lose money on a net basis after deducting all fixed and variable expenses.
Isn't this the common sense answer to why so many distributors quit?
Herbalife tells entrepreneurs they have a business opportunity, "the solution for these tough economic times". You can watch this nonsense here.
Getting to the heart of the fraud is analogous to spotting the irony in this little ditty...
"I'd like to welcome you all and congratulate you for joining this exclusive business opportunity."
ENDLESS CHAINS ARE FRAUDS FOR GOOD REASON. HERBALIFE PROMOTES AN ENDLESS CHAIN "in practice".
Recruiters exaggerate earnings claims to lure people in, promote the acquisition of a SUPERVISORSHIP to qualify for downline rewards, and indoctrinate participants to duplicate and duplicate to the point of inevitable SATURATION.
These dynamics doom participants to economic failure retail sales or not.
The sooner regulators shut it down 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.