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Summary

  • The words "legal MLM" denote a purely hypothetical construct, not a legal fact.
  • Unlimited Income Potential granted to limitless participants for their "valuable consideration" is a fraud.
  • Herbalife inevitably has become the poster child for the ills of a would-be "industry".

Herbalife (NYSE:HLF) is not alone, and while the current investigations may turn up issues that are unique to Herbalife, the company seems destined to be the poster child for what is wrong with the MLM "industry." After three decades of uncontrolled growth, based, at least in part, on legal fiction, it is now time for a clean-up, or so it seems. The time for pretending "business as usual," is over. Clearly, MLM companies going public was part of making the model acceptable, but being public also brings increased scrutiny of the problems in the business model.

It is interesting that Bill Ackman once championed PrePaid Legal, long before its eventual buyout by MidOcean Partners and subsequent reincarnation as LegalShield, while nowadays he sends warning letters to HLF board members about their potential liability for promoting Herbalife. That little factoid just adds an interesting nuance to the whole story. It is easy to be fooled by MLM.

We now have an exegesis of the BurnLounge decision by an MLM-lawyer, meaning a lawyer whose clientele retains his services because they want to believe that MLM-law is settled, and that they have him on their side in case it is not. He may not have any position in HLF stock, but his investment in the interpretation is readily apparent. And we have an exegesis by the dean of a college who specializes in the topic of Direct Sales and MLM since quite some time, and is not on the take from anyone, strangely preferring his academic independence. You decide which one you like best.

At the same time, the BurnLounge decision strongly reaffirmed that it's all about what actually happens, and not about the nomenclature. As if on call the voice of E. Robert Smith (see below), added profound experience with how MLM actually operates in practice to the discussions on this site. The contrast has been shrill. The casuistry of MLM-law has constantly focused on playing with words to fake compliance with the letter (and sometimes not even that), while violating the spirit of the law, but the BurnLounge reaffirms that the only thing that matters is what happens on the ground, how the business actually operates, and Robert Smith has argued from the point of view of the nature of the beast--that MLM does what it was designed to do, and that is: recruit, recruit, recruit, simply because the incentives are on recruiting not selling.

Meanwhile, the Herbalife stock is on life support with the share buyback expiring soon, and some fairly significant insider sales in May and June, by folks who apparently would rather be safe than sorry. The analysts who look only at the financial reporting, not at the legal challenges, continue to think HLF has great prospects, and set their price guidance accordingly. But then again the efficient markets hypothesis is long since dead, as Bill Ackman knows from his MBIA experience. There is a long distance between information being nominally available, and being digested and understood, and the barriers to understanding are not very rational.

The fact that so many MLMs are now public has brought about a lively conversation on this site, and it should be noted that all of them are potentially affected, as is the whole MLM-"industry." The list is extensive, though in some cases the ownership is buried in conglomerates or holding companies, as with Pampered Chef, and LegalShield (previously PrePaid Legal), it includes the following: Blyth (NYSE:BTH), Just Energy with their Momentis subsidiary (NYSE:JE), LifeVantage (NASDAQ:LFVN), Mannatech (MTEX), Nu Skin (NUS), Primerica (NYSE:PRI), Reliv' (NASDAQ:RELV), USANA (USNA), and others.

On the whole, thanks to Herbalife being public, this site has become a historical source for investors, attorneys, prosecutors and regulators alike. To understand the developments, there are three things you need:

  1. The book Confidence Game, by Christine S. Richard, in order to understand that Bill Ackman does do his homework, and is not easily dislodged by billionaire opponents who don't.
  2. The original Herbalife presentation by Pershing Square, available on their site www.factsaboutherbalife.com
  3. The book by E. Robert Smith, Downline... intolerable potential to deceive, to fill in the operational understanding of what an MLM actually does. The book is the best witness account investors or regulators could have ever hoped for. In the process, it provides an amazing account of the regulatory and legal developments that got us to where we are today.

Aside from those three, you can pursue the details as far as you want. Much of it is now on Seeking Alpha. The play is about to become more interesting, as foreshadowed by a recent LULAC letter to Jim Hood, the President of the National Association of Attorneys General. Lastly, if E. Robert Smith has his way, a congressional investigation may move out of the realm of fiction, and add an interesting twist to a real life ending of this story.

The Centrality of Damages

Why is a Ponzi-scheme bad, and illegal? Because it leads to inevitable, predictable, and therefore preventable damages. The damages are very cut and dried: investment losses are certain if the underlying business (if there is any) does not generate sufficient operating profit to honor the promised returns.

Why is an "illegal" pyramid bad? Because it leads to predictable and therefore preventable losses. Except the claim here is fuzzier, it is "business profits" of the independent reps, and it can remain hidden by parading the exceptions that confirm the rule, and by lying by omission in the form of talking about revenues, not net incomes. Statistically, the certainty of failure is overwhelming however, so never mind how good the product, the business opportunity rests materially on misrepresentation. In other words, failure is more widely dispersed in space and time than in the case of a Ponzi, but the losses are proportionally bigger, because they are capital plus labor, and expenses, not to mention reputational harm. The key insight is that if the opportunity drives the product, rather than the other way around, you most likely have a problem.

Lastly, another emerging concept is a customer referral model, which has the risk of becoming a chain-letter wrapped around a product, absent reasonable retail sales. A chain letter also is illegal, because it inevitably, and predictably leads to damages, which can be limited by shutting down the scheme ahead of time. This model may have merit however if the incentives adequately favor retailing over recruiting, so that the product now drives the opportunity instead of the other way around.

In any variation, the prospect of certain and therefore preventable damages should drive the regulatory or enforcement agenda. Conversely, absent such damage, there is a case of no harm, no foul, and the structure of the compensation should be of no concern. Clearly, the material about Herbalife that has already been produced has made the losses quite tangible.

The Franchising Example

Pershing Square has produced an enormous amount of information exposing the problems with Herbalife. However, before we get too crazy about the Herbalife situation, and what it will lead to, we should remember that franchising was a Wild West scene before regulation, and then the industry became a rip-roaring success thanks to the regulation, which created by and large a win/win for franchisers and franchisees alike. This is a point E. Robert Smith raises in his book Downline. It is time for a clean-up. The book is probably the best piece of information that came along in this market since the day Pershing Square presented their short thesis against Herbalife, and it's a fun read to boot.

The hypothetical "legal MLM" company

There does not seem to be any operating definition of a legal MLM, other than that to be legal it must not do any of the things that MAY (sic!) turn your MLM into an illegal pyramid. The websites of FBI, SEC, and FTC, all speak of how to make that distinction, while avoiding the hard chore of defining a "legal MLM." In retrospect, they might have been better off avoiding the term altogether, but now coming up with clear definitions seems imperative. As it stands, there may not be much MLM left, once you remove the "illegal" before pyramid. Robert Smith in his book certainly provides a foundation by focusing on the nature of what an MLM is, and how it thrives on deception, both about the opportunity and the products. Sometimes product claims can trigger a pyramid investigation, and not only the FTC, but also the FDA can trip an investigation if fraudulent product (health) claims are involved. Importantly it's the multi-level structure, which literally multiplies the damages.

In short, would-be entrepreneurs or investors in MLM are always in a position that the Herbalife nightmare could happen to them, for the rules are probabilistic in nature. Their only consolation are the MLM-lawyers who treat the law as if it's a settled matter, and will be happy to bill you if there are any regulators or prosecutors who would challenge their opinion. At this writing Gerald P. Nehra, Esq. who could arguably be the dean of the MLM-law field, claims on his website that no company that consulted him prior to launch ever was shut down. So now you know what mistake TelexFree and Zeek Rewards made.

Unlimited Income Potential-fraud in the inducement

The fundamental opportunity fraud inherent in all MLMs is about the deception of "unlimited earnings potential," which exists nowhere in the known universe. To add insult to injury MLM-companies, while selling that opportunity (for cash or credit) to any hopeful who would listen, retain the unrestricted right to continue selling that same right to an unlimited number of other hopefuls besides. As Robert Fitzgerald has pointed out, MLM income claims are based on the math of infinity, not on the finite reality of the physical world, leading to a disconnect with normal business analysis. His report on Why Wall Street can't understand MLM is destined to be a classic. The way the deception is usually enabled is by parading people who are already making good money with the venture (the exceptions that confirm the rule), without disclosing the true mechanics of the compensation structure, nor the business expenses that these folks incurred in generating their incomes. Full disclosure as per the FTC's business opportunity rule, including earnings disclosures, would go a long way in preventing such misrepresentations, but that opportunity was missed at least for now.

Marketing Miracle based on legitimizing deception

Holiday Magic, Dare to be great, and Koscot Interplanetary were famous cases that served to establish the illegality of the inherent deception of this unlimited earnings from endless chain recruiting model, based on the predictable damages to many, allowing a few to make money. An illegal pyramid is clearly similar to a Ponzi, except it was wrapped around a product, and it had no hard investment claims but vague "business opportunity" prospects. Yet ultimately, those prospects were verifiably false, as the earnings disclosures of any MLM company would show. The 1979 Amway decision however provided a veneer of legitimacy by dint of the 10 customer requirement, and the rule that 70% of inventory had to be sold before a new order was placed, except it was unenforceable in practice. Moreover commissions were computed on purchases, not sales.

The truth is that the '79 Amway rule showed up in most MLM distributor agreements ever since then, but was ignored in practice, and that has now again become an issue in the Herbalife case--the company infamously "does not have visibility to that level." The DSA meanwhile tried to gut the Omnitrition decision once by having Joe Barton of Texas sponsor HR1220 in 2003, which never made it, and instead, more recently the BurnLounge decision in the 9th Circuit court broadly reaffirmed Omnitrition. But, by lobbying heavily against the FTC's new business opportunity rule, the DSA gives cover to industry abuses, and does a disservice to any companies that would attempt a better business model. In short, by agreeing to the MLM-exemption, the FTC is now complicit in the typical obfuscations and lack of disclosure that enable the serial business opportunity fraud that makes MLM what it is.

Regulation is the only way forward

It seems unlikely that Herbalife will become another one-off case. Regulation is obviously needed. Reasonable steps could include the following:

  • Adopt the FTC's business opportunity rule for all "independent distributorships," and this should include disclosure requirements for any exceptions to their marketing plans which companies engage in, so that "special favors," and under the table deals that sell participants down the river become impossible.
  • Require published, audited financials for any company that wants to offer such "independent distributorships," perhaps with a lower threshold of $10 million in sales.
  • Allow no more than a small registration fee at most ($40 or less), for customers who would like to market a given product or service, and include all administrative fees in that number whether they are charged up front or later. The point being that now companies are doing an end run around franchise laws, by charging a plethora of fees, which can put first year expenses well above the $500 franchise limit.
  • Require companies to have compliant sales materials and to forbid any other representations, and make compliant materials available for free electronically to their participants. Again, requiring participants to use company materials but charging for them is clearly abusive.
  • Deal with personal consumption and qualification in a clear and explicit manner, along with clearly distinguishing the issue of "retail sales" (as opposed to "qualifying sales," or "recruiting sales"). In many cases this has become easier because of direct fulfillment, and under those conditions even the requirement of having a single retail customer at all times, along with a reasonable retail profit, might be adequate to prevent the majority of the abuses. There could be no reason not to require documentary proof of ad hoc retail sales from personal inventory.
  • Create a clear distinction between the product driving the opportunity (legal), versus the opportunity driving the product (illegal money game), in the spirit of Omnitrition and now BurnLounge, which reaffirmed the principle. This means unencumbered retail sales (as opposed to "qualifying" sales, or "recruiting" sales) validate the economic viability and legality of the business model. This does not mean that qualifying sales, "recruiting sales," are not sales, they just can't be the only sales.
  • Establish some prerequisites for fairness in contracting, to make the abusive practices, which prevent participants from having legal recourse, furthermore illegal. An internal conflict/complaint resolution procedure is reasonable, preventing legal recourse under all circumstances is not.

Remember, if HLF's "churn" is 1.5 million, that alone is nearly $90 million in annual sales for "memberships" in the HLF "discount" program, which then enables the "members" to overpay for the product until they qualify for "Supervisor." In other words, the total cost of achieving that position is $59 plus the price difference they pay to get there, as well as any business expenses they incur.

The FTC's Business Opportunity Rule is a good place to start

The MLM-exemption of the business opportunity rule was a clear case of undue influence by the industry, and lack of disclosure is the primary factor that enables the most common business opportunity fraud in MLM, the exaggerated earnings claims (unlimited earnings potential). At the same time, fraudulent product claims and especially health claims should be prevented at the source, by making companies responsible if they fail to dismiss repeat offenders. MLM is no different from other areas of sales, where the lure of a dollar makes it attractive for companies to nominally have ethical procedures but to reward violators in practice with bonuses, except that because of the leverage of the MLM-model, the rewards of deception are bigger.

Pershing Square Parallels

Then, it was Warburg Pincus piling into MBIA opposite Bill Ackman with about a billion dollar long position. Now it is Carl Icahn and a few others who have piled into HLF stock opposite Pershing Square, and the seeming parallel is once again that Pershing Square did the homework, while there is no evidence the others have, other than looking at the financials, and proceeding in the assumption that the legality would never be seriously questioned. Bill Stiritz has not spoken. Carl Icahn did, but with very evident lack of comprehension of the business model.

The longs in general seem to have analyzed Herbalife as a normal business, but the top line numbers have never been the issue. The fundamental issue is the lack of a legal foundation for how the business operates in practice. Investors ignore that at their own peril. In another way there is a parallel. MLM has struggled for a long time to separate the presumably legal MLMs from the illegal pyramids, an attempt that gets punctured periodically when another pyramid prosecution takes place. With the public listing of MLM companies, another credibility threshold was created, and in this sense HLF is a bellwether, in a somewhat comparable fashion MBIA once was. It would be the largest public MLM to ever be challenged. The information value of that is quite significant.

Conclusion

As MLM has entered into the public domain, the industry has invited more scrutiny to itself, and Herbalife is likely to be the poster child. You can't have your cake and eat it too, and Bill Ackman was the perfect guy to "out" the industry, as he once did for MBIA, and its fallacious business model. It was "insuring" bonds, which were insurable only because they had no appreciable default risk, and maintaining double standards in ratings, now it is the fallacy of unlimited earnings under endless recruiting. Without the financial incentive of short-selling, the job would never have been done, as thirty-plus years of very piecemeal regulatory action has shown.

The support for investigations is gaining strength. Pershing Square has staying power. Better and better information on what really goes on in the industry is now becoming public, so the process of assimilation, digestion, and reflecting all this information in capital markets has now started in earnest. The only way forward for anything resembling MLM would be with a clear legal framework, for no investor can tolerate the absurd situation we have today. Pretending legality of the enterprise by "work-arounds" or "plausible deniability" of clearly illegal behaviors, or even calling them something else, will no longer work. Those days are gone. The light is shining in.

Editor's Note: This article covers a stock 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: MLM-Legal Fiction, Economic Fallacy, And Marketing Miracle

Additional disclosure: The author has been involved in MLM off and on, including once developing an MLM-style business plan for a company. The author believes that some legal form of MLM potentially has a role to play in marketing certain products and services that lend themselves to such a business model.