On June 2nd, 2014, the Ninth Circuit published its long awaited BurnLounge Opinion. Within hours, both sides of the Herbalife (NYSE:HLF) battlefield issued statements claiming victory about the decision. I've taken the week to process the opinion. During this time, I've tried to keep up to speed with the online chatter regarding various interpretations. One thing is clear: the gray space in MLM law separating legitimate direct selling companies from pyramid schemes has been minimized considerably.
On the one side, Bill Ackman's Pershing Square spun it as validation of its argument that commissions in the Herbalife plan were derived primarily by opportunity driven demand (recruitment rewards) instead of legitimate product consumption. On the other side, the MLM industry (myself included) breathed a sigh of relief, submitting that the decision validates a lot of our main points in responding to common criticisms of the model. This article is intended to cull out the key nuggets in the BurnLounge decision and interpret what it means going forward.
Omnitrition Dicta No More
At first, people were surprised that Herbalife was so quick to applaud the BurnLounge decision. It's important to understand the full context. In its Appellate Brief, the FTC was arguing along the lines of the dicta in the Omnitrition decision. In its brief, the FTC argued,
"As this Court said, 'If Koscot is to have any teeth, such a (non-retail) sale cannot satisfy the requirement that sales be to 'ultimate users' of a product.' Omnitrition, 79 F.3d at 783 (emphasis added). Applying this Court's teachings in Omnitrition, internal sales to other (distributors) cannot be sales to ultimate users consistent with Koscot." The reference to non-retail sales not counting as sales to "ultimate users" has always been interpreted as "dicta," and thus, largely disregarded by those in the industry. Dicta, by the way, is language in an opinion that's not essential to the issue presented before the court. The definition of "ultimate user" is significant because the second element in pyramid scheme analysis is triggered when rewards are unrelated to product sales to "ultimate users." If participants in the plan cannot be considered "ultimate users," all resulting commissions would be treated as "recruiting bonuses," thus, rendering most MLMs illegal.
The FTC's expert in pyramid scheme cases, Dr. Peter Vander Nat, has heavily relied on this dicta in his analysis of pyramid schemes. In the FTC's latest action against a pyramid scheme, Vander Nat wrote (in a footnote), "The critical issue under this test is whether recruitment rewards are related to the sale of products to ultimate users. Under further exposition given in a number of federal court cases, I also understand that the ultimate users of the products - for purposes of the Koscot test - are people who are not participants in the business venture." The BurnLounge opinion turns that assumption completely on its ear.
With the FTC's argument in play, the stakes were incredibly high. The Court was not persuaded by the FTC's argument and landed on a more sensible, case-by-case approach.
So what did the court conclude?
Thoughtful Analysis Regarding the Definition of "Ultimate User"
The Court dedicated an entire section to the definition of "ultimate user." Before diving into the law, it's important to understand the basics: the practice of paying commissions on purchases made by distributors for self-consumption and/or resale is known as "internal consumption." The opposite is when distributors buy primarily to qualify for bonuses i.e. buy things they would never buy at prices they would never pay without the financial opportunity. In BurnLounge, the Court held that participants in the plan can be counted as "ultimate users" provided that the participants bought the products for legitimate "internal consumption" i.e. personal use. Herbalife apparently derives most of its volume via internal consumption, which has been a source of much criticism. The Court has shed some light on the issue.
The Court held, "BurnLounge is correct that when participants bought packages in part for internal consumption, the participants were the 'ultimate users' of the merchandise and that this internal sale alone does not make BurnLounge a pyramid scheme." (BurnLounge Decision, p. 19). The Court went on to say, "Whether the rewards are related to the sale of products depends on how BurnLounge's bonus structure operated in practice." Bottom line: factors need to be weighed when assessing whether commissions are driven by "ultimate users."
What is an "ultimate user"?
In this regard, the Court looked to the FTC's 2004 Staff Advisory Opinion for guidance. The section quoted by the court reads, "In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme. The critical question for the FTC is whether the revenues (that support the commissions) are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in the money-making venture." (emphasis mine).
Back to BurnLounge.
BurnLounge was held to be a pyramid scheme because "the rewards BurnLounge paid were primarily for recruitment, and (distributors) were clearly motivated by the opportunity to earn cash rewards from recruitment." (BurnLounge Decision, p. 3-4). The Court weighed several factors in reaching its conclusion that the majority of the rewards were tied to recruitment, not legitimate product sales to "ultimate users."
Retail vs. Non-Retail
It's now a moot point. Up until this case, critics argued that the majority of a company's revenue must come from retail sales i.e. sales to customers outside of the network. Their rationale: rewards via internal consumption were "recruitment rewards," thus, the majority of revenue must come from customers instead of participants. While external sales remain a strong indicator of product value, it's not a bright-line, determining factor. More importantly, it's not a requirement. Critics appear to be backing off of this "retail vs. non-retail" line, focusing instead on the "endless chain" element of network marketing programs, arguing that the nature of perpetual recruitment dooms participants to failure. This argument is made with the full understanding that there has yet to be a program collapse due to market saturation. It's a theoretical conundrum, not a practical one.
Back to the issue of retail vs. non-retail. In its opinion, the Court made itself clear that purchases made by the participants can be counted as legitimate sales PROVIDED... and this is key… there's legitimate consumer demand for the products. In other words, the Ninth Circuit affirms the idea that there are essentially two categories of purchases: (1) those by ultimate users inside or outside the network, and (2) those derived via opportunity driven demand i.e. people inside the network buying to qualify for commissions a/k/a "channel stuffing," "garage qualifying," "inventory loading," etc.
Factors the Court Used in Finding that BurnLounge Lacked Sufficient "Ultimate Users"
It's now reality. Beyond debate - revenue from participants inside the network must be carefully considered when assessing a company's legitimacy. The resulting commissions from internal consumption cannot be blindly treated as "recruitment rewards" as critics (and Bill Ackman) would prefer. If you will recall, in Bill Ackman's initial presentation, he placed great emphasis on the idea that the majority of commissions were driven via "recruitment rewards," thus, proving his point that rewards in Herbalife were primarily driven by recruitment, not legitimate sales. He was treating all Royalty Rewards as "recruitment rewards." (Ackman Presentation, slide 148). Lately, it appears Pershing Square is taking more of a behavioral approach, getting away from the internal consumption issue, arguing that Herbalife distributors are buying primarily to qualify for bonuses based on their behaviors in the field.
What are the factors that the Ninth Circuit used?
Lack of value
Requirements to buy premium products to increase earning potential:
Lack of consumer safeguards
Emphasis of the Marketing
While these factors were not centrally located, they were referenced in various locations throughout the opinion. They're discussed more fully below.
Purchase patterns: The Court was disturbed by the fact that 95% of distributors bought the premium products while only 35% of non-distributors (customers) bought the same. (BL Decision, p. 14). The Court said, "If package purchases were driven by the value of the merchandise included in the packages rather than by the opportunity to earn cash rewards, one would expect to see comparable numbers of (distributors) and (non-distributors) buying the same packages."
As it relates to Herbalife: Herbalife, as a company that sells hard goods compared to BurnLounge (which sold digital goods), will need to show that people outside of the network purchase inventory at a comparable clip to distributors. To the extent distributors buy more than what they personally need (which is very likely if distributors are buying inventory with the intent to resell), Herbalife will need to show that sales to "ultimate users" for retail do occur. It's not important in the sense of determining what percentage of revenue is coming via retail. It's important for purposes of assessing this single factor. If the purchase patterns are out of whack, it's indicative that participants are buying solely to qualify for bonuses instead of legitimate consumption/resale, i.e. it would indicate if the Herbalife distributors are, in fact, "ultimate users" and not simply trying to "garage qualify."
Lack of value: The Court held that the BurnLounge products had limited value, thus, the primary motivation leading to the purchases was NOT for legitimate product consumption. (BL Decision, pages 10, 19). Instead, the BurnLounge distributor was motivated to enhance her earning potential. The Court held, "In practice, the rewards BurnLounge paid for package sales were not tied to consumer demand for the merchandise in the packages; they were paid to (distributors) for recruiting new participants. BurnLounge, through its recruitment efforts, created its own synthetic market.
As it relates to Herbalife: It's not hard to quantify value. Is there a legitimate market for weight loss products? Yes. Are Herbalife's products priced appropriately to penetrate that market? It depends. Prices, ingredients, intellectual property, consumer demand... they can all be boiled down to numbers. As for the motivation of distributors (value driven vs. recruitment driven), this can be learned by way of surveys. On the issue of pricing, Ackman has submitted that based on a per-calorie metric, Herbalife is weak. (Ackman Presentation, slide 16). It's important to remember that Herbalife SELLS A DIET PRODUCT; thus, penalizing a diet product based on fewer calories is confusing. In its rebuttal, Herbalife indicated that its product, on a per-serving basis, fell right in the middle based on the suggested retail prices. (Herbalife Rebuttal, slide 25). If you factor in the discounts available to distributors, the cost per serving would dramatically fall further. I'll leave it to the reader to decide if a per-serving or per-calorie basis is preferable in quantifying value.
Regarding distributor motivation, Herbalife commissioned Lieberman Research to drill into the expectations of its distributors. The results are between slides 36 and 45 in Herbalife's rebuttal presentation. The results indicate that 73% of FORMER DISTRIBUTORS said they joined with the desire to save money on product. While critics seem quick to question the methodology, the result is significant. What incentive does a former distributor have in being dishonest on their responses? 400-plus former distributors were surveyed. Out of the people surveyed, 87% would recommend Herbalife products to family or friends. The 73% number jives well with the 71% number referenced on Herbalife's Income Disclosure Statement. 71% of Herbalife distributors never sponsor a single person. Those looking to put Herbalife out of business are quick to argue that people are loading their bellies with weight loss shakes with the hopes of recovering their "losses" by way of future earnings from downline recruits. If these participants are truly victims as claimed by critics, it's not reflected in the volume of FTC complaints. In 2012, the peak of Herbalife's evil ways prior to Ackman shorting the stock, the FTC received only 18 consumer complaints. While critics claim that victims are less likely to complain because of social anxiety, the FTC makes it incredibly easy for consumers to anonymously complain on their website.
Regarding product value and consumer demand, the metrics are in Herbalife's favor.
Requirements to Buy to Qualify: In BurnLounge, participants were REQUIRED to buy the premium packages to qualify for deeper commissions. When the motivation driving distributor consumption is crucial in pyramid scheme analysis, BurnLounge was immediately dead in the water when it required distributors to buy. The Court held, "The district court found that because purchasing a package was required for participation as a Retailer or Mogul, and because Moguls earned cash for selling packages, '(distributors) by default received compensation for recruiting others into the program." (BurnLounge Decision, p. 10, emphasis mine). Plus, distributors had to recruit several additional participants to qualify for the basic bonuses ("concentric retail bonuses"). Without question, the plan forced people to focus on recruitment and buy items they never would've bought at prices they never would've paid but for the income opportunity.
As it relates to Herbalife: Participants can hit the Supervisor rank without sponsoring a single person. Therefore, there's no default commission. While participants CAN buy to qualify, the issue boils down to whether they're primarily buying to qualify or buying for personal consumption/resale. It's absolutely possible for participants to buy to hit the Supervisor rank. In BurnLounge, participants were obviously investing in worthless products to earn recruitment rewards. Herbalife can submit that the majority of people are buying with the intent to use, resell and/or get discount on product. This is an area that'll be sorted out by the FTC based on Herbalife's production to the FTC's discovery requests.
Lack of Consumer Safeguards: This is a point that's more nuanced. While the Court did not reference the "Amway Safeguards" specifically, they did note that Amway was found to be legitimate due to its policies. As a recap, the FTC held Amway to be a legitimate enterprise largely because of its consumer safeguards. Specifically, Amway had a 70% rule (where 70% of all purchases needed to move to other people), the 10 customer rule (where distributors had to certify that products went to at least 10 customers each month) and the buyback rule (where distributors had 12 months to return sellable inventory). These safeguards were not specifically referenced in the opinion. However, in response to BurnLounge's argument that it was just like Amway, the Court said, "Though Amway created incentives for recruitment by requiring participants to purchase inventory... it had rules it effectively enforced that discouraged recruiters from 'pushing unrealistically large amounts of inventory onto' recruits."
In my opinion, the 70% rule and the 10 customer rule are no longer relevant. This is especially true now that the dicta in the Omnitrition case (that referenced the 70% rule) has been disregarded. Those rules are vestiges from an era that pre-dates direct fulfillment. In those days, the "directs" had to purchase inventory on behalf of their entire organizations and fulfill the orders; thus, warranting rules that ensured the inventory was moving to "ultimate users." Today, unique orders can be shipped to individual homes. The risk of inventory loading is greatly reduced PROVIDED that there's a robust/easy-to-understand/clearly communicated buyback policy.
The Court held that BurnLounge had zero policies to prevent bonus buying. Once bought, the products were non-refundable.
As it relates to Herbalife: The point here is well documented. There's a 12-month, 100% buyback policy. There's a 90 day, 100%, no questions asked policy on the administrative fees to join. Prior to 2013, the buyback policy was 90%. The amount of total refunds: 0.5%. If participants are investing for the rights to maximize their earnings, they're given the ability to return all unsold/unwanted inventory, resulting in all recruitment commissions being clawed back out of the plan.
With Herbalife, new participants are asked to certify that they've seen and understand the income disclosure statement (disclosing that the average person makes nothing), they're asked to certify that they understand that there's no requirement to buy to qualify for bonuses and they're asked to certify that they understand the buyback policy. If I were to define the population of victims, it would be the group of people that buy AND USE the product under the assumption that they'll recover the "investment" by way of recruiting more participants. Since the product is used, there's nothing to return. This is the opportunity driven demand that the regulators are trying to prevent. Speaking of victims, I'm sensitive to the people that volunteered to be on Ackman's documentary about Herbalife. Their injury was clearly deeper than financial. They were embarrassed. And for their willingness to be candid about their experience, I commend them. The challenge: when you offer a financial opportunity that's driven solely on production, how can you create a program that guarantees success? How can you create a program that guarantees better than a 50/50 shot? A 90/10 shot? It's especially difficult when the cost of joining is under $60 and anybody can join. The alternative would be to charge more, like a franchise. And then, we'd still be talking about failure rates, but with fewer people and larger amounts.
Emphasis of the Marketing: The Court held that BurnLounge participants focused primarily on recruitment over product value. The Court wrote, "The district court also found that BurnLounge's marketing focus was on recruiting new participants through the sale of packages." (BurnLounge Decision, p. 10). Additionally, the Court referenced the factor in the Omnitrition case when it wrote, "Omnitrition was likely a pyramid scheme because of its recruitment focus." In BurnLounge, the pay plan literally required participants to recruit several people to achieve the basic levels in the plan. Plus, the products had minimal value, leaving distributors with little choice but to focus on the financial opportunity.
As it relates to Herbalife: This is for the fact-finder. The other factors referenced above are more objective in nature. "Emphasis" is a bit more gooey and requires an extensive analysis of how the products and opportunity are being positioned in the marketplace. In other words, I don't know.
BurnLounge was held to be a pyramid scheme. In its opinion, the Ninth Circuit clarified a lot of contentious issues surrounding the industry. The factors assessed in reaching that determination are informative for long and short investors going forward. And of course, the factors are informative for the industry as a whole. While the people betting against Herbalife have argued that the entire industry has been propped up with bubble gum and duct tape over the years with clever interpretations of case law, this opinion clears the air considerably.
The issue of "retail vs. non-retail" revenues was put to bed. It all boils down to the amount of commissions derived from "ultimate users." Put in another way, legitimate network marketing companies exist when the rewards are primarily driven by product sales to ultimate users. Regarding the gray between rewards for "ultimate users" and recruitment rewards (generated by people looking to maximize their earning potential), Dan McCrum summarized it perfectly when he wrote, "What is not clear is the point at which legitimacy disappears and scumbaggery takes over. The debate around Herbalife, so far as the law is concerned, is where it falls on that spectrum."
I agree with him. There's a spectrum. And Herbalife's fate will be determined by where it falls on that spectrum. There's no bright-line test. The lack of a bright-line rule is not evidence of a conspiracy of sorts. Using a case-specific/totality of the circumstances standard is not unique to this area of the law. When determining if someone was negligent, courts weigh factors. When determining if someone is an employee or a contractor, courts weigh factors. When determining if a constitutional right was violated, courts weigh factors. And when determining if a company is a legitimate MLM or a pyramid scheme, courts weigh factors.
What does this mean going forward?
Network marketing companies will get more intelligent in delineating between "ultimate users" from everyone else. The market is already moving toward preferred customer programs where people can receive product discounts as preferred customers WITHOUT joining the business. Since we know these are metrics the courts want, it's important to show clean data. Absent clear delineation, we have the factors provided in the BurnLounge case to help. Currently, when people join to save money on product (as my friend recently did with an essential oils company), short sellers treat them as "victims" or "failures" for purposes of beefing up the failure rate and finding a pyramid scheme. As the BurnLounge opinion makes clear, it's not proper to make such distinctions without carefully considering the motivation driving the sales.
What does this mean for Herbalife?
I stand by my original prediction made with Bob Chapman in January of 2013. Herbalife will be fine. They do a lot of things right. Their product is proven. Their pay plan does not require recruiting or buying. While their attrition is high, it's likely attributable to two compounding factors: the nature of the weight loss category (where 70% of all dieters quit within 12 weeks) and the nature of people pursuing business opportunities (where the majority of people quit within a year). While there's room for manipulation in their plan where people can "garage qualify" and buy more than they can use or sell, the consumer safeguards shore up the exposure (though it obviously does not eliminate it). Do they have some knuckleheads in the field? Yes. Will they be required to pay for those sins? Possibly. Will the FTC sue them and shut them down. No. Will there be a consent decree where Herbalife will be required to report to the FTC on an annual basis regarding the enforcement of their policies? Possibly. As for the other publicly traded MLMs like Nu Skin (NYSE:NUS) and USANA (NYSE:USNA), their fates are inter-woven with Herbalife's.
I'm not here to give advice on whether Herbalife is a safe investment. I'm not sure how the analysts will quantify the risk that's out there. I'm also not paid to be Herbalife's advocate. But I do know that there are two sides of the HLF battlefield, and I think the BurnLounge opinion decidedly favors Herbalife over Ackman.
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. The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author has never been retained by Herbalife or any other publicly traded network marketing company.