Will The State Of Michigan Join The Fight Against Herbalife?

Jun. 9.14 | About: Herbalife Ltd. (HLF)

Summary

The Michigan AG has a clear understanding of pyramid schemes.

The state website does a fantastic job explaining why it is a fraud.

The Michigan AG also reveals that even MLMs with retail customers can be deceptive.

Should investors fear the Michigan AG joining to prosecute Herbalife?

Will the FTC or other federal regulators apply Michigan's logic?

As a global enterprise, Herbalife (NYSE:HLF) conducts business in many jurisdictions around the world. Laws obviously vary from country to country. Even within a given country, laws vary from state to state or even from municipality to municipality. What is legal in one jurisdiction may be outright illegal in another.

Example #1: In Ontario, Canada, the drinking age is 19. In Quebec, it is 18. In most US states, it is 21.

Example #2: Some states have prohibitive gun control laws. Others allow citizens to carry a gun for personal protection.

Example #3: In Bermuda, cars drive on the left side of the road. In the USA, they drive on the right.

You get the point.

Right now, as I sit here, a number of agencies and jurisdictions have revealed that they are investigating Herbalife here in the USA.

At the Federal level, the SEC and FTC and DOJ are "under the hood" investigating allegations that Herbalife operates a pyramid scheme and/or commits marketing fraud.

At the State level, we have been advised the NY AG and Illinois AG are also involved.

Q. Will others join the fray?

I have been reviewing a number of websites for different States in the USA that cover MLMs, pyramid schemes, and marketing fraud. One of the more interesting websites I found belongs to the State of Michigan.

This website can be found here.

I would like to highlight two very specific sections on this website in order to drive home the following point. Whether Herbalife is an MLM or a pyramid scheme, the company is the sponsor of a MARKETING FRAUD.

Here's what the Michigan AG has to say:

Some companies call themselves multi-level marketing when they are really operating pyramid schemes that violate Michigan's Pyramid Promotion Act. Even when a multi-level plan does not violate Michigan's Pyramid Promotion Act, the marketing of the plan may violate Michigan's Consumer Protection Act, if the acts, methods, or practices are unfair, unconscionable, or deceptive.

It is understandable that consumers often have difficulty telling the difference between an illegal pyramid scheme and a legitimate multi-level marketing opportunity. Governmental regulators and the industry continue to debate where the legal lines are drawn. Multi-level marketing is a lawful and legitimate business method that uses a network of independent representatives to sell consumer products. Commissions should only be paid on the sale of goods or services to non-participant end-user consumers.

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The AG goes on to say:

When investigating a multi-level marketing opportunity, you should ask about market saturation and determine the saturation levels in your area of distribution. Legitimate companies do not have too many distributors in one area.

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There are a number of fallacies that continue to float around on the subject of whether or not Herbalife is a "business opportunity fraud" or not.

Fallacy #1 - In order for Herbalife to be found a fraud, the company must be found to be a pyramid scheme.

Fallacy #2 - If the company actually sells its products to retail customers, it is impossible for the company to conduct itself in a fraudulent way.

Fallacy #3 - If the company can prove it makes retail sales to retail customers, then it will be free from prosecution by both State and Federal Regulators.

On the heels of last week's ruling in the BurnLounge case, by now, investors should realize that each of these arguments is poppycock.

To be clear, Mr. Ackman's thesis is that Herbalife is a pyramid scheme. Mr. Ackman is on record stating the position that absent Herbalife's efforts to perpetuate an endless chain of business opportunity seekers, there would be limited retail demand for Herbalife's overpriced, uncompetitive placebos that are undifferentiated from other substitute products in the macro-economy. Of course, these products become even more overpriced when taxed with Shipping and Handling upcharges, etc.

This is a very specific charge. The idea is that Herbalife is a closed economy, where participants who chase the business opportunity constitute the bulk of end-demand for products. Primarily, rewards in the economy are tied to recruitment bonuses and not retail demand.

Of course, there is a second prong to the argument that Herbalife is a fraud. I will call this prong the RETAIL SATURATION prong. In practice, Herbalife promotes an endless chain of distributors by geography.

All we need to do is recall Mr. Ackman's presentation that highlighted the number of nutrition clubs vying for customers in Queens, NY, and we get an immediate picture of what RETAIL SATURATION looks like.

Alternatively, does Mexico need 30,000 Nutrition Clubs?

By now, we should all surely understand how granting too many sales licenses in a geography poisons the well for profit seekers who seek to make a living as retailers.

  • The market clearing retail price falls well below SRP
  • Avg. sales volume per distributor license falls
  • Business opportunity seekers trip over one another in pursuit of profits
  • Most participants fail

As an investor, I can't tell you how much I am impressed by the Michigan AG's grasp of the issues facing entrepreneurs trying to make a living in the MLM space.

For certain, this representative of the people of the great state of Michigan seems to understand clearly that fraud can certainly be perpetuated, whether or not product is sold to internal customers or "ultimate users", when an endless chain that promotes saturation is involved.

With this foundation for thinking about marketing fraud as a backdrop, it seems obvious to me that the array of options available to prosecutors at this point to challenge Herbalife's business model simply got a whole lot broader in the past week.

Q. How does the company function "in practice"?

In practice, Herbalife recruits millions upon millions of distributors. In practice, most of them fail.

Do they fail because Herbalife is a closed market swindle, aka a Pyramid Scheme?

Do they fail because there are too many retailers chasing a finite pool of real retail customers?

Does it really matter in the end?

Aren't both economic results equally fraudulent?

Of course they are.

Section 5 of the FTC Act gives regulators the latitude to apply a number of legal standards/approaches to perpetrators of fraud.

Stick with me for a moment here. What if the FTC simply charged HLF with the following violations?

  • Misleading Earnings Claims
  • Deceptive Advertising
  • Price Discrimination in Violation of US Anti-Trust Laws

Do regulators then have to go the extra mile to prove that Herbalife is a pyramid scheme, or is this approach alone enough to shut the company down?

What do you say Mr. Hempton? True or False?

What if the Michigan Attorney General concluded that the reason Herbalife business opportunity seekers fail is not because the company has no retail customers, but rather because it grants too many sales licenses? Is this fact alone enough to shut down the company's marketing plan?

Herbalife longs and the company itself still have to overwhelm the obvious mathematical data that tells us clearly in the company's 10ks and Regional Key Metrics Disclosures and Statement of Average Annual Compensation that most of the people who pursue the business opportunity fail out of the business in short order.

Isn't the obvious question for Mr. Johnson in the wake of this data simply:

"Hey Mr, Johnson, if you truly have the solution for these tough economic times how come most of your salespeople never make any money?"

Put another way, where is the evidence that Herbalife sells a legitimate business opportunity at all?

Regulators are concerned with schemes or businesses that are run that cause harm to participants in our free market economy. In the case of Herbalife, evidence of harm is everywhere.

The only outstanding question is... why?

Is Herbalife, in the words of David Brear, a "closed market swindle"?

Is Herbalife an MLM that engages in deceptive marketing practices, including the sale of an endless chain of salespeople?

In the end, does it really matter?

Don't both realities result in the same amount of harm for those who actually risk their capital as entrepreneurs?

Of course.

Whether marginal participants are at the end of an endless chain of retailers or an endless chain of recruiters seems to be a data point without distinction.

Whether retail customers exist or not, there is no profit margin to be earned. There is no retail profit pool to be secured. There is no return on invested capital to be made.

Therefore - participants fail.

Certainly, telling people they can make $10,000 a month is an obvious lie.

That is how endless chains work "in practice". They sell a mathematical fallacy to investors. That is why they are called "Prohibited Marketing Schemes".

Hopefully, the Michigan AG will join the case soon to help bring his understanding of this reality to the discussion.

A commitment to consumer protection requires it.

Herbalife is a global confidence game - pyramid scheme or not. "In practice", business opportunity seekers are harmed due to oversaturation.

Regulators will figure this out shortly and shut the company down.

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.