Pershing Square Strikes 'Gold' In Burnlounge Decision, Dr. Keep Weighs In, Too

| About: Herbalife Ltd. (HLF)


Burnlounge Decision Yet Another Victory for the FTC.

Table of Authorities includes U.S. vs. Gold Unlimited.

Kevin Thompson Misinterprets the Ruling.

Herbalife is a Pyramid Scheme.

Consumer Harm + Pyramiding Policies + Government Intervention = Imminent Shutdown.

Dr. William "Bill" Keep testified as an expert witness in the prosecution of Gold Unlimited. Yesterday, Dr. Keep sent a letter to the Chair of the SEC. That letter can be found here.

Fortunately for America we have concerned and conscientious citizens like Dr. Keep.

U.S. v. Gold Unlimited is a critical case for investors in Herbalife (NYSE:HLF). In this ruling the court addresses a number of important questions including:

  1. The definition of a pyramid scheme
  2. The question of saturation
  3. The commission/rewards system "in practice"
  4. The government's burden v. the burden of the company
  5. "Anti-pyramiding" policies.

As I read this court ruling it would seem that Pershing Square has struck Gold with the Burnlounge ruling. Here are the reasons why.

Q. What is the definition of a pyramid scheme?

B. The Definition of "Pyramid Scheme"

We preface our discussion by re-emphasizing that the parties and district court (and many statutes and opinions) use "pyramid scheme" to refer to a combination of pyramid structures (programs that reward participants for inducing other people to join the program) and Ponzi schemes (programs that pay earlier investors with money tendered by later investors).   Authorities regulate these combination schemes because the programs will inevitably harm later investors.

See Webster v. Omnitrition Int'l, Inc., 79 F.3d 776, 781 (9th Cir.) (contending that these schemes employ " 'nothing more than an elaborate chain letter device in which individuals who pay a valuable consideration with the expectation of recouping it to some degree via recruitment are bound to be disappointed' ") (quoting In re Koscot Interplanetary, Inc., 86 F.T.C. 1106 (1975)), cert. denied, 519 U.S. 865, 117 S.Ct. 174, 136 L.Ed.2d 115 (1996);  Koscot, 86 F.T.C. at 1182 (bemoaning the "serious potential hazards of entrepreneurial chains" and urging the "summary exclusion of their inherently deceptive elements, without the time-consuming necessity to show occurrence of the very injury which justice should prevent");  Note, Pyramid Schemes:  Dare to be Regulated, 61 geo. L.J. 1257, 1261-62, 1293 (1973).

Some structures pose less risk of harm to investors and the public, however, and authorities permit these programs to operate even though the programs contain some elements of a pyramid scheme.   Courts and legislatures recognize a distinction between legitimate programs (known as multi-level marketing systems) and illegal schemes.   See, e.g., In re Amway Corp., 93 F.T.C. 618, 716 (1979);State ex rel. Miller v. American Prof'l Mktg., Inc., 382 N.W.2d 117 (Iowa 1986);   State ex rel. Ieyoub v. Phipps, 634 So.2d 51, 53 n. 3 (La.Ct.App.1994);  Schrader v. State, 69 Md.App. 377, 517 A.2d 1139, 1147 (Md.Ct.Spec.App.1986) (quoting Utah Legislative Survey, 1984 utah L. Rev. 115, 215-16), cert. denied, 309 Md. 326, 523 A.2d 1014 (Md.1987);  State ex rel. Stratton v. Sinks, 106 N.M. 213, 741 P.2d 435, 440 (N.M.Ct.App.1987) ("All multilevels are not considered per se deceptive and unlawful.");   Vincent G. Ella, Comment, Multi-Level or Pyramid Sales Systems:  Fraud or Free Enterprise, 18 s.D. L. Rev. 358, 392-93 (1973).

Gold contends that the jury instructions lumped acceptable MLM programs with illegal pyramid schemes;  as a corollary, Gold argues that its program contained safeguards to protect against the risks that accompany illegal schemes.   This position not only arises for the first time on appeal, but it also apparently contradicts an understanding reached at trial.   Mr. Cox, counsel for Martha Crowe, remarked at trial that "a pyramid scheme should not be defined, however the fact that [the court has] defined ["pyramid scheme"] and used the federal definition [sic] the case law is much more to our liking."   On appeal, Gold's counsel (who remained silent after Cox's statement), appears to argue that the instructions do not reflect an approved definition under federal law.

The district court's instructions do not appear misleading or incorrect, however.   The district court's definition of "pyramid scheme" (by which we and it mean "illegal pyramid scheme") mirrored that used in several other cases.   The district court derived the instructions from the FTC's opinion in In re Koscot Interplanetary, Inc., 86 F.T.C. 1106 (1975), which enjoined the defendants from, inter alia:

2.  Offering, operating, or participating in, any marketing or sales plan or program wherein a participant is given or promised compensation (1) for inducing other persons to become participants in the plan or program, or (2) when a person induced by the participant induces another person to become a participant in the plan or program, Provided, That the term "compensation," as used in this paragraph only, does not mean any payment based on actually consummated sales of goods or services to persons who are not participants in the plan or program and who do not purchase such goods or services in order to resell them.

Id. at 1187.   In a recent civil case, the Ninth Circuit adopted Koscot 's explication as its test for the existence of pyramid schemes:

The Federal Trade Commission has established a test for determining what constitutes a pyramid scheme.   Such contrivances "are characterized by the payment by participants of money to the company in return for which they receive (1) the right to sell a product and (2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of the product to ultimate users" [quoting Koscot ]. The satisfaction of the second element of the Koscot test is the sine qua non of a pyramid scheme․  We adopt the Koscot standard here and hold that the operation of a pyramid scheme constitutes fraud for purposes of several federal antifraud statutes.

Omnitrition, 79 F.3d at 781-82 (describing the two Koscot factors as "the essential features of an illegal pyramid scheme");  see also Nguyen v. FundAmerica, Inc., No. C-90-2090-MHP, 1990 WL 165257, at *1 (N.D.Cal. Aug.21, 1990) (adopting Koscot 's test as the definition of a pyramid scheme);  People v. Cooper, 166 Mich.App. 638, 421 N.W.2d 177, 183 (Mich.Ct.App.1987) (upholding the constitutionality of an act regulating pyramid promotions, Mich. Comp. Laws § 445.1528, which resembles the final order issued in Koscot, 86 F.T.C. at 1186).   The Koscot test, reprinted above, does not materially differ from the district court's instruction, which dictated that:

A pyramid scheme is any plan, program, device, scheme, or other process characterized by the payment by participants of money to the company in return for which they receive the right to sell a product and the right to receive in return for recruiting other participants into the program rewards which are unrelated to the sale of the product to ultimate users.

It appears that the district court properly defined "pyramid scheme." 5

Herbalife's entire commission system is tied to the SRP (Suggested Retail Price) of the product. Herbalife is also on the record that it does not track nor measure retail sales as a company. Still, the company asserts that not only are 73% of its distributors just "Discount Buyers" i.e. Retail Customers but that the company also has millions and millions of customers who are not part of the network.

Q. What did the 6th District say about the issue of Saturation?

Gold observes that the jury instructions did not inform the jury that a corporation can enact safeguards to ensure that it operates a legitimate MLM program.   Gold attacks the definition because it omits the refinement that, "A pyramid is improper only if it presents a danger of market saturation-that is, only if at some point, persons on the lowest tier of the structure will not be able to find new recruits."   Gold cites two civil cases that discuss anti-saturation policies, see Ger-Ro-Mar, Inc. v. FTC, 518 F.2d 33, 36-38 (2d Cir.1975);  Amway, 93 F.T.C. at 716-17, and Gold bolsters its position by alleging that the record contains evidence to support a jury finding that the program did not present a "realistic danger of market saturation" and that Gold "implemented anti-saturation policies."

One can view Gold's complaint in two ways:  perhaps the government bears the burden of proving the risk of saturation as an element of its case, or perhaps Gold should have the ability to prove an affirmative defense that it established anti-saturation policies.   If the government has the burden, it appears to have met it. Koscot 's second factor-that an illegal pyramid rewards participants for recruitment, not for sales-implies that saturation must occur. Given the district court's instruction that a pyramid exists when a program's rewards relate to recruitment, not product sales, the jury necessarily found the possibility of saturation when it found that the defendants ran a pyramid scheme:  " '[T]he presence of this second element, recruitment with rewards unrelated to product sales, is nothing more than an elaborate chain letter device in which individuals who pay a valuable consideration with the expectation of recouping it to some degree via recruitment are bound to be disappointed.' "   Omnitrition, 79 F.3d at 781 (quoting Koscot ).

The government's proof at trial established that Gold ran an illegal pyramid scheme masked with cosmetic anti-saturation policies.   Expert witnesses testified that Gold's marketing materials, organizational structure, and recruiting policies marked a program destined for collapse (with concomitant harm to investors).   For example, Gold's program, ostensibly predicated on the marketing of gold and jewelry, resulted in a gross profit of only $552,620 from sales of gold coin, yet resulted in the intake of $43 million and the disbursement of but $25 million in "commissions."   The government's evidence, focusing on the actual effect of the plan, deserves far more weight than Gold's trial presentation, which relied on the existence of alleged anti-saturation policies shown by the government already to have failed.   See Omnitrition, 79 F.3d at 783;  SEC v. International Heritage, Inc., 4 F.Supp.2d 1378, 1384 (N.D.Ga.1998) ("[T]he critical determination of the legality of [defendant's] operations will not be based on the written plan but on the actual practices of the company.");  Cooper, 421 N.W.2d at 183 (reiterating this point, and adding that the court should focus on the behavior of a "typical investor" in the plan).

We find it more appropriate, however, that a defendant carry the burden of establishing that it has effective anti-saturation programs. Given the grave risks imposed on investors in illegal schemes, the government should have to do no more than prove that the program satisfies the definition of Koscot.   See, e.g., Amway, 93 F.T.C. at 699 ("There is little doubt that a pyramid distribution scheme should now be condemned even without the demonstration of its economic consequences.   The Commission has studied the effects of such 'entrepreneurial chains' and seen the damage they do and a per se rule should be used.") (initial decision, affirmed by the FTC opinion, 93 F.T.C. at 735);  Koscot, 86 F.T.C. at 1182 ("To require too large an evidentiary burden to condemn these schemes can only ensure that future generations of self-made commercial messiahs will dare to be great and dare anyone to stop them.").   The alternative-placing the burden on the government-forces the government to wait until after the collapse, as that alternative permits operators to maintain that the absence of collapse proves the success of the anti-saturation policies.

MLM Attorney Kevin Thompson wrote an article last week that had the following to say about saturation.

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.

Kevin's argument would be correct if he simply changed the last line to state.

"It's a theoretical conundrum and a practical one."

Churn rates and failure rates in the Herbalife distributor base are obvious evidence of saturation even if the scheme has not outright collapsed. More importantly, the Gold case clearly states that the government does not have to wait for evidence of collapse to prove that a pyramid scheme exists.

Q. How does the commission system function "in practice"?

This is the point where the rubber hits the road. Are the rewards that are paid out in the system directly tied to retail sales or not?

Here is what the court had to say - to reiterate:

As the Omnitrition court observed, "The key to any anti-pyramiding rule is that the rule must serve to tie recruitment bonuses to actual retail sales in some way.   Only in this way can the second Koscot factor be defeated."   Omnitrition, 79 F.3d at 783.   The programs in Amway and Ger-Ro-Mar escaped sanction because they satisfied this anti-pyramiding rule:  in both cases, participants earned commissions not through recruitment, but by product sales (their own sales and the sales of their recruits).   See Ger-Ro-Mar, 518 F.2d at 36 (explaining that the distributors profited from their sales and those of their recruits);  Amway, 93 F.T.C. at 716 ("It is only when the newly recruited distributor begins to make wholesale purchases from his sponsor and sales to consumers, that the sponsor begins to earn money from his recruit's efforts.").   Gold's position conflates saturation of the market for products with saturation of the market for investors and participants, and Gold's plan risked saturation of the latter market.   Gold did not prove at trial that it appropriately tied recruitment bonuses to actual retail sales;  as a matter of law, it did not show that its tinkering with its policies de-linked recruitment and commissions.

Tinkering. Why does this idea sound familiar? Herbalife certainly hasn't made any material changes to its commission structure since Pershing Square launched its allegations. Rather, the company has "tinkered" repeatedly.

Modifications have been made:

  • to the company's Nomenclature (now distributors aspiring for SUPERVISOR are called Members not Distributors).
  • The company's return policy has been modified.
  • The company's Statement of Average Annual Compensation has been changed.
  • The company's training regimen has been tweaked

Still, none of these tweaks changes the fundamental notion that the "behavior of the typical investor" in the Herbalife program focuses on recruiting aspiring SUPERVISORs and not retailing to non-participants.

"In Practice" Herbalife recruiters can get paid recruiting rewards without any evidence that actual retail sales exist nor occur.

How about this for a question for investors?

How is it possible to have an effective anti-pyramiding policy framework as discussed in U.S. v. Gold Unlimited when you have no system in place to track nor measure actual retail sales at all?

Q. What would Herbalife do if it was actually serious about implementing anti-pyramiding polices?

How about these 5 obvious ideas?

#1 Track Retail Sales

The company's 10 Customer Rule and 70% rule are farcical. They are analogous to posting a 65 MPH speed limit and then allowing drivers to cruise at Autobahn speeds.

Tracking Retail Sales would also reveal just how silly SRP is as a representation of the potential retail profit pool that exists for Herbalife distributors. This data on its own would show how fraudulent Herbalife's claims are that Distributors can make 25% to 50% retail profit as a retailer. Very little product is actually sold at SRP.

#2 Tie Commissions and Overrides to Actual Retail Sales

This is an obvious way to ensure that all product purchased at wholesale is resold or personally consumed.

#3 Limit Commissions and Overrides to 5 layers deep in the Pay Plan.

This would limit the proliferation of salespeople and promote the development of an actual retail book of business.

#4 Charge the Same Wholesale Price for Inventory

If all participants in the Marketing Plan pay the same price for product there is absolutely no incentive in the system for new participants to inventory load to buy status or discount or both.

More importantly, all distributors are treated equitably and therefore can compete for retail customers on a level playing field.

#5 Establish and Track Sales to a bona fide Consumer Network where "Preferred Customers" declare that they cannot pursue the Business Opportunity or SUPERVISOR status unless they sign a separate agreement.

Even with these policies in place, Herbalife and other MLMs run the risk of recruiting too many salespeople and saturating end markets with distribution.

Still, with policies like these recruiters should become somewhat indifferent towards recruiting v. retailing. "In Practice" it could be argued that with a flat wholesale structure participant emphasis might actually spin primarily towards retailing.

Q. What does Herbalife's "Business Opportunity" look like in that scenario?

Participants would sign-up for the right to sell a product and for the right to recruit others to sell a product to retail customers where all compensation is tied to direct evidence of retail sales either to a "Preferred Customer" or an "Ultimate User" who does not participate in the network.

Inventory simply cannot be acquired to qualify for bonuses, discounts, incentives, etc.

In effect, the pay plan is cleansed of Pyramiding policies.

Then Herbalife could summarily terminate all of the nonsensical consulting contracts, Board appointments, lobbying deals and PR deals as well as all legal fees it is paying to defend itself v. Mr. Ackman's claim.

Q. Wouldn't these policy changes be the obvious lane of least resistance?

Of course they would. Trouble is, they would also spell the death of Herbalife as we know it.

When you take away Herbalife's SUPERVISOR program you take away its pyramid scheme. When you take away its pyramid scheme you take away the fuel that pays recruiters. When you take away the fuel that pays recruiters, the recruiting juggernaut stops.

Lest we forget, Herbalife not only focuses on recruiting new distributors, it depends upon it.

Q. What would Herbalife look like if it either:

a) voluntarily implemented anti-pyramiding policies with teeth

b) the FTC imposes these kinds of changes through an injunction or

c) the Pay plan is shuttered entirely.

A. Ask FHTM or Burnlounge what happened to their businesses once the government intervened.

Dr. Keep knows a thing or two about pyramid schemes. His recommendation to the SEC is to have MLMs submit a dossier of anti-pyramiding policies and procedures for regulatory review every 5 years. For certain, he has latched on to the idea that the current regulatory regime is both piecemeal and entirely inadequate.

People who sign up for Herbalife today are not signing up for a "business opportunity." THEY ARE THE BUSINESS OPPORTUNITY. Specifically, they are the obvious victims of a Money Transfer scheme that recruits and endless chain of distributors day in and day out.

Since the beginning of 2008, Herbalife has recruited 10 million Distributors. Over 6 million of these people are no longer registered with the company.

"In practice" it seems just a tad obvious that Herbalife participants are always recruiting new salespeople.

After all, isn't that what pyramid schemes are designed to do?

Herbalife will be shut down by regulators. Mr. Ackman's argument struck Gold when the Burnlounge appeal referred to US v. Gold in its table of authorities. Herbalife's anti-pyramiding policies are obviously absurd and totally inadequate.

Nobody knows this better than Dr. Keep. Certainly his voice has gravitas.

The sooner regulators stop the harm the better.

Disclosure: The author is short HLF. 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.