Herbalife (NYSE:HLF) seems to be a popular topic on SA. There are certainly two camps. Whenever someone writes an article, scores of commentators come out, almost like it's a sports event. Each respective team is trying to score points, pump up their side and, unfortunately, trash talk the other side.
The issues surrounding Herbalife should be more than just a back and forth exchange of gunfire. Whether Herbalife is ultimately ruled a Pyramid Scheme, or not, will affect millions of people and billions of dollars. Anyone considering investing in Herbalife, either on the long or short side, would be wise to take an objective view and make a reasoned determination of the issues and their potential consequences.
The "elephant in the room" is whether or not Herbalife is a Pyramid Scheme. There are other issues, such as exaggerated claims of income opportunities or product results. However, the "other issues" are not a determinant of whether or not Herbalife is a Pyramid. These "other issues" may be how a Pyramid can be propagated, but they do not define a Pyramid.
Since the "other issues" usually appear as separate counts in a trial, I'm not going to discuss them and instead concentrate on the "elephant in the room".
Let's start off with what should be an easy task... but one that is often muddled.... What, exactly, is a Pyramid?
There are many different explanations and different definitions. Most are very similar, with some small verbiage differences.
We could spend a lifetime debating this question, so let's just look at the definitions that are most likely applicable to situations such as Herbalife.
Let's look at what the FTC advisory says....
..." The critical question for the FTC is whether the revenues that PRIMARILY (emphasis added) support the commissions paid to all participants are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money making venture..."
Now, let's look at Vander Nat's statement........
....."pyramid scheme is an organization in which participants obtain their monetary rewards PRIMARILY (emphasis added) through enrolling new people into the program rather than selling goods and services to the public..."
Lastly, let's look how at how the Ninth Circuit incorporated Omnitron in its recent decision.....
...." BurnLouge's scheme satisfied both prongs of the Webster v. Omnitron International, Inc, 70 F.3rd. 776 (9th Cir.1966), pyramid scheme test because Moguls paid for the right to sell products, the rewards BurnLounge paid were PRIMARILY (emphasis added)for recruitment, and Moguls were clearly motivated by the opportunity to earn cash..."
It's pretty apparent that these sources want to draw a line around the word "Primarily". How exactly one determines "Primarily" is open to some interpretation and the 9th Circuit has opened the door with ....
......"The rewards BurnLounge paid were primarily for recruitment, not for the sale of products. Because the outcome in this case is clear under the Omnitrition test, we do not need to decide the degree to which rewards would need to be unrelated to product sales in a case presenting a closer question."
I would like to think everyone could agree that PRIMARILY is at least 51%.
How does this "jive" with the Amway 70% test (93 F.T.C.)? Well, simply stated ... it does not.
The Amway 70% test was designed to test for "inventory loading" not source of income. The theory was that if product was being sold, not just accumulated, the rest would fall into place. But the 70% test doesn't address who makes what off of whom.
The direction has changed since the Amway Test. It is now one of peeling back the layers and focusing on "Primarily". So, do we look at the structure or the operation? How it looks or how it happens?
This has received much debate on SA, so let's look at what the 9th Circuit has to say.
.... "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 (emphasis added). 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, 7...."
So, if one takes the lead from the sources presented, we need to look at Herbalife's primary operation. Specifically, we must look at who earns how much and from whom.
Now, wouldn't it be nice if we could just point to some number and know the answer? We could all just sit around and have a philosophical debate. But the number, even if it exists, has not been revealed.
This means we must try and see if we can get a reasonable feel for it. But first we need to set some ground-rules.
Personal consumption: This is a critical component. If a distributor buys product and consumes it, which side of the issue does it fall? I've seen many opinions, but, for purposes of this article I choose the latest Court decision...
....." BurnLounge is correct that when participants bought packages in part for internal consumption (to obtain the ability to sell music through BurnPages and to use the package merchandise), the participants were the "ultimate users" of the merchandise and that this internal sale alone does not make BurnLounge a pyramid scheme...".
This is good enough for me... internal consumption is "ultimate user". Whew! Glad to get that out of the way.
The next issue starts to get "slippery". Is the compensation earned on account of product sales or recruitment?
This may be the most critical area to discuss. If earnings are PRIMARILY for end user sales, Herbalife would seem to pass the tests. If not, they may have no way out.
Here's where it starts to get "tricky". All monies earned selling to an unaffiliated user should be "to an ultimate user" .... or maybe it isn't.
When a distributor consumes or sells to an unaffiliated customer, that profit is clearly on account of product sales. But in the case of a supervisor receiving their "wholesale mark-up" or royalties it isn't so clear.
Let's look at the problem. A distributor purchases product with the intent to resell. However, the Supervisor receives their compensation whether or not the product is, in fact, ever sold. So it seems pretty clear that the Supervisor's compensation is not on account of sale to the ultimate user.
Many argue that if the product is actually sold to an end user, the Supervisor's earnings ARE on account of ultimate user. I think this is fallacious reasoning. What happens after the Distributor buys product (sale, personal use, inventory, etc.) only affects the Distributor's earnings, not the Supervisor.
Furthermore, these Supervisor earnings can be treated as payment by the distributor to the Supervisor. Is there any substantive difference between the Supervisor buying at a 50% discount and selling, at a 25% wholesale mark-up versus the Distributor buying direct at a 50% discount and paying, or kicking-back, a 25% fee to the Supervisor? Perhaps, it is "Substance over Form".
We need to ask if up-line earnings are really transfer payments and not product sales payments even if the product is sold, if they are not contingent on product being sold?
If the Supervisor gets paid for each distributor purchase, then the payment may be considered on account of the Supervisor having recruited the distributor and classified as recruitment pay. This would also hold true for bonuses and any other compensation that could be paid, up line, to anyone.
It is my contention, that up-line earnings that are contingent upon sale to an ultimate user are product related earnings. If they are paid without qualification, they can be classified as "recruitment income".
This is critical, because if we examine the Herbalife Compensation plan the Supervisor earns as much on a sale to the Distributor as the Distributor would earn if the Distributor sells all the product they purchase. Add in additional compensation to other "up-lines" and the up-line actually earns more than the Distributor even if the Distributor sells or personally consumes all their product.
Do the math ... if these up-line earnings are considered "on account of recruitment", in a best case scenario, more than 51% of the earnings are "recruitment" not "ultimate user".
Compare this result with a more traditional distributorship enterprise. A "wholesaler" has many "retailers". It is not unusual for the "wholesaler" to make more money than any one particular "retailer". But it is very unusual for a "wholesaler' to make more money than all their "retailers" combined... no matter how many. Herbalife's Compensation Plan is structured in such a way that a successful "Supervisor-wholesaler" with, say 25 "distributor-retailers" would make more money than all the "distributor-retailers" combined. And that's if they all sold all the product purchased.
We may not even have to go to whether or not the product is sold or for personal use, because the result is always the same. The up-line makes more, guaranteed, than each distributor could make under the most favorable of circumstances and, most importantly, the up-line makes more than all the distributors, combined. This could be interpreted as Primarily for recruitment.
Now, one has to go into much more detail for an official estimate. For instance, many Distributors "break-away" and become Supervisors, themselves, and this mitigates the issue. However, if they "recruit" or are replaced in the chain, then the problem resurfaces.
Also, this assumes that all product is actually sold (or returned) by the Distributor. Even a modest inventory hold becomes a problem as it reduces the potential income of the Distributor, while the Supervisor income remains intact.
In conclusion: If we try to cut through the diversions and get to the heart of the Herbalife Dilemma we may find that everything can turn on whether or not Herbalife earnings are Primarily on account of recruitment as opposed to sales to ultimate users.
The 70% rule, even if satisfied; the lack of inventory loading, even if satisfied; the "claims" even if proven lawful may be irrelevant if the income earned by the up-line can be considered "recruitment fees". That is because they very likely exceed 50% of all direct retail earnings. Furthermore, they could be considered primarily "recruitment" fees.
If the FTC and other investigators make the argument that compensation, unless contingent upon ultimate user sale, is "recruitment" compensation and if the Court buys into that argument, then Herbalife will have some serious problems.
This, alone, could trump all other issues.
Of course, no one knows if the argument will be made or if the Court will accept it.
But, if I was an investor in Herbalife, I'd pay very close attention to this argument. If Herbalife goes to trial and if this argument is put forth, it might well be wise to play it safe and consider folding.
>>Go to Part Two
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.