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Summary

  • BurnLounge ruling affirms that a "pyramid" finding should be based operating facts, not accounting fiction or legal gobbledygook.
  • The end-user/sales outside the network issue is central to any definition of an illegal pyramid.
  • The parallels between Herbalife and BurnLounge matter more than the differences.
  • Regulation cannot succeed unless it rests on a clear definition of a "legal MLM" as opposed to an "illegal pyramid".
  • In a "legal MLM" the product drives the opportunity, and in an illegal pyramid the opportunity drives the product - meaning the product is irrelevant in a pure money game.

Herbalife (NYSE:HLF) excelled once more in PR spin and the art of newspeak, called the ruling of the 9th circuit court "supportive." For a reliable Reader's Digest version of the ruling and its meaning, Prof. William Keep is the go to, here.

BurnLounge had argued that because their "Mogul" (read "supervisor/sales leader") package included retail product, therefore it was not paying for recruiting, and not a pyramid scheme. The court held that the retail sales might have some value, but were immaterial, and that, never mind the nomenclature, the clear purpose was recruiting, and the primary revenue was from recruiting, not selling product. The 9th Circuit reaffirmed the "illegal pyramid" finding of the lower court. Pershing square points out here how the ruling strengthens the hand of the FTC, and therefore the short thesis, by pointing to the structural analogies between the Herbalife model and the BurnLounge model, and that Herbalife's victory claims are evident nonsense. Clearly, the court focused on actual business practices, and was not confused by formalities, and interpretations of lawyers trying to re-label things as something else than what they are.

As in Omnitrition, the evidence in this case shows that BurnLounge's focus was in promoting the program rather than selling the products. (FTC v. BurnLounge, 6/2/2014)

The 9th Circuit allowing in BurnLounge that some personal consumption may indeed constitute a valid sale could be considered a victory only in that it reduced the risk of the casuistic reasoning that all personal consumption and internal sales might be excluded, a position which defies common sense. In the end, the real issues are twofold: channel stuffing driven by qualifying for commissions (becoming "garage qualified,") and the fact that sales motivated by such qualifications do not prove retail demand, but they are still sales. Personal consumption is a valid use, channel stuffing is not. The vaunted "70%" has always been viewed as fairly arbitrary and circumstantial. In MLM, it is understood that the participants (reps, distributors) are themselves users of the product ("How can you lose with the stuff we use," becoming a "product of the product," or "eating your own dog food.")

By reaffirming that what matters is what actually happens, not what some lawyer or accountant calls it, the 9th Circuit reaffirmed plain common sense by upholding Koscot/Omnitrition. The FTC and other regulators should consequently not be impressed by Herbalife's re-labeling campaign which made "distributors" into "members" of a putative discount buying club.

Assuming that the belief of many analysts is correct, that the FTC was purposely waiting for the resolution in the BurnLounge case, things may now start moving faster, and HLF may become merely the poster child for the MLM "industry." Investors in all of (NYSE:USNA), (NYSEMKT:CVSL), (NYSE:PRI), (NYSE:NUS), (NASDAQ:MTEX) and others should pay attention.

Defense Motion to Strike Expert Testimony Denied, but not to be ignored

Defense (Lawrence Steinberg, Esq.) made an interesting motion to strike the testimony of Dr. Peter Vander Nat as not meeting the standard for admissible expert witness testimony (you can listen to it here - at ca.20:50 minutes of the recording), which was denied by the court, but it has a certain logical validity that lends itself to being revisited and re-framed in other circumstances. Aside from the clear and straightforward two-prong "Omnitrition" test to determine an illegal pyramid, an economic assessment by Dr. Vander Nat had been used.

To put it in context, all of FTC, SEC, and FBI on their websites talk about how to distinguish between a legal MLM and an illegal pyramid, and there are no laws saying multi-level compensation programs are illegal. In short, it should reasonably be possible to tell a legal MLM from an illegal pyramid, yet Dr. Vander Nat testified that his test had never identified a "legal MLM," and was not sure if it would ever do so. Thus, even though the motion to strike was denied summarily by the Court, this observation is valid on the face of it, and logically pretty compelling.

In the end, this approach is a different way of arriving at the same observations I made in my article here, on "Nailing pyramids to a tree," if we accept that there exist both "legal MLMs" and "illegal pyramids," then someone needs to be able to tell the difference. All of the various websites with consumer advice fall short of that type of clear distinction. On that basis, anyone who wants to be involved in that industry, clearly needs advice of expensive lawyers, who could only tell them they don't know either. They may believe one thing or another, they may attempt to handicap deals based on various parameters, but they can't tell for sure. Again, on this site Matt Stewart has offered some interesting analysis to suggest it's time to go "back to the drawing board," to arrive at a clear test to distinguish "legal MLM," from "illegal pyramid."

Personal Consumption, End-users, Retail Sales and Amway '79

The upshot of the current ruling is that it is clearly unreasonable to disallow all personal consumption as a legitimate sale, as some might have liked for the court to find. If there is ONLY personal consumption, that would lead to a pyramid finding, and the current case found the actual retail sales insufficient in this case. Notice that the BurnLounge model made tracking of actual retail sales easy, and the court still discounted the included retail sales for personal use, allowing they had "some value," but still finding them immaterial for the purpose of averting a pyramid finding.

Clearly, the now infamous "70%" (and 10 customers) for retail sales, before reordering is permitted, as accepted in the 1979 Amway ruling, is somewhat arbitrary, it just happened to be a number the court would accept at the time, and the industry has treated it as if it were carved in stone. The truth is however that the 70% rule was never enforceable, and is honored more in the breach than the observance, and remains a potential Achilles heel for the industry. Even Amway has unilaterally reinterpreted the rule as it changed its operating procedures, as documented here. Ultimately, clarification of this issue remains desirable. Seventy percent or some other percentage might even be dependent on the specific business model.

It should be noted that Herbalife does not exist in isolation, nor is regulation the only issue. If Herbalife does not have "visibility" to the level of retail sales, how come other companies do? If there are regulatory challenges, it should also be noted that with the proliferation of the MLM industry, there are now so many business models, all trying to address these various issues in different ways, and that information is also available to regulators.

Clearly, in some other, newer business models, inventory loading tends to be less of a problem since customers and reps alike order for personal consumption on-line. And the incentives for inventory loading are disappearing. What evidently remains outstanding is exactly what proportion of "out of network sales" will prove sufficient in the context of the ambivalence on this topic in the BurnLounge ruling. Clearly, the BurnLounge case focused on what "primarily" happened, and the actual split of commissions paid was 75% recruiting (ignoring the small "some value" of included product for personal consumption), and 25% actual retail.

Not Just Regulation, Economics Too Has a Role To Play

There is an economic framework too, and from the beginning Pershing Square has focused on that, demonstrating that the actual retail market for Herbalife product is nowhere near at the price level the company claims.

This generalizes to the point that in an MLM-model, if the retail pricing of products is unrealistic, in principle participants in the program have a claim against the company for business opportunity fraud, because they cannot actually sell their product at the projected price. This is very much the case in Herbalife. The obvious reason why there is not more action on this front, is because for participants it involves biting the hand that feeds you. Hence regulatory oversight is needed.

What does Downline have to do with it?

Downline is a "whistleblower novel," by one E. Robert Smith, an erstwhile industry insider, and it exposes the fraud and abuse of the MLM industry in all its gory details in narrative form, so that everyone can understand it, not just the people who have an interest in doing their own legal research. It is a must read for anyone who thinks they want to invest in MLM, or for that matter want to participate in the industry in any form.

The industry has been operating in a legal grey area, as demonstrated again by the bizarre situation that both longs and shorts are claiming the recent BurnLounge ruling as a victory. Downline is fiction based in solid fact, but it weaves a scenario that is fictional in that it has not happened as described, but could very well come to pass in some way. Some of the characters are fictional, even if they occasionally bear a resemblance to real people, but the historical development of the industry and the attendant legal cases and the history behind them are analyzed brilliantly.

Probably the single most important statement in the book occurs in a fictitious congressional testimony by an MLM-pro turned state's evidence:

If the scheme features unlimited recruitment, where the recruiter pays valuable consideration for the right to recruit, it is illegal. Are products valuable? Are they not bought primarily in order to recruit others? Yes, it's as plain as the nose on your face. Products do not change the nature of the scheme. (Downline, by E. Robert Smith).

And further on in the dialog, it is summed up as follows by a fictitious Senator leading the investigation:

If I understand you correctly, you are saying that an accurate legal definition of an illegal pyramid scheme must be concerned with the nature of the contrivance and less with its form.

To put it differently, the nature of the fraud is that in most cases the "opportunity" drives the product (and the product is irrelevant, because it is a Ponzi wrapped around a product, and therefore an illegal pyramid scam), versus when the product drives the opportunity, which would be a legitimate distribution model. These considerations also make it clear why a recent petition to the FTC for better regulation of the MLM industry will not succeed if it only addresses the form, and fails to capture the essence of the problem, which must start with a clear operating definition of what is a legal MLM versus an illegal pyramid. Having said that application of the FTC's own business opportunity rule to the MLM industry would eliminate many problems to begin with because full disclosure would wipe out the pervasive business opportunity fraud that goes on today.

A most useful distinction offered in the book is between "recruitment sales," and "retail sales," to clarify the fact that distributors buying in order to qualify for commissions represent a different economic motivation from pure retail purchases by end users outside of the network - because pure retail buyers buy the product only for the product benefits.

Summary

  • With gathering storm clouds, it is evident that the "illegal pyramid" issues go well beyond HLF, and that the company increasingly faces the likelihood of some regulatory action, if not an outright shutdown.
  • BurnLounge strengthened the FTC's hand, not Herbalife's.
  • Mere enforcement of the FTC business opportunity rule would bring most of its operations to a grinding halt.
  • HLF seems to be well positioned to become a poster child for abuses in the MLM industry, but regulators in the long run will need a clear and conclusive test to tell an illegal pyramid from a legal MLM.
  • As long as you need a lawsuit every time to determine if a company is a legal MLM or an illegal pyramid, the MLM-business model will become an endangered species, and investors would need an unnatural appetite for risk to give it a second thought.
  • An $0 target price for HLF looks more realistic than the current levels that are supported by the ongoing buyback, the question is when? Countdown should start sometime after the end of this month.

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.

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.

Source: Herbalife: Watch What I Do, Not What I Say