Herbalife: FTC's Worst Nightmare

| About: Herbalife Ltd. (HLF)


What is the Best Evidence?

What Does the Expert Really Say?

What Can we Expect?

This represents my fourth article in the "Can We Talk" series. As in all three previous articles, I choose to discuss aspects of Herbalife (NYSE:HLF) that aren't being discussed anywhere else.

Before I get started, I'm amazed that, with all the articles that are being written about Herbalife, that some of the most important and relevant issues continue to be overlooked. But, if that's what the others leave, I'm happy to oblige.

When I studied law I remember a professor stressing that the most important part of case preparation is to uncover the WORST thing that could happen and prepare an answer for it. If one can do that, everything else will fall in place. Over the years this advice has served me well ... in every aspect of life ... especially in developing investing strategies. I've found it much more useful than just planning and hoping on favorable outcomes.

So, when it comes to the possibility of Herbalife facing off against the FTC, I can't help but ask ... what would the FTC's worst case be?

Reasonable people will have differing opinions, but I think the worst thing that can happen in any trial is the opposing party using your best evidence to make their case. If you have doubts about this ... well ... just think of OJ Simpson and the "glove". Many watching the trial knew it was over, right there and then..... remember Cochran's "if it doesn't fit, you must acquit".

So, what is the FTC's best evidence and can it be turned against them?

I submit for your consideration ... Peter VanderNat ... the FTC Chief Economist, acknowledged expert on pyramids/MLMs and previous FTC expert witness.

In my previous article I gave a "sneak preview" of a few problems in his Formula and it's limited utility.

Let's start with VanderNat's (and William Keep's) definition of a pyramid ... a definition cited by the BurnLounge court....

"... pyramid scheme is an organization in which the participants obtain their monetary rewards primarily through enrolling new people into the program rather than selling goods and services to the public ..."

This definition, or something very close to it, surfaces continuously in just about every discussion involving pyramids, including the FTC's own advisory. Most importantly, it has been embraced by the court and is likely to represent the "battleground" in any future litigation.

So, where is the weak link?

Simple, very simple ... the word primarily. What is critically important is "primarily" is the dividing line between an MLM classified or not classified a pyramid. That's pretty significant

I've discussed this previously in the context of it meaning something more than 50%.

In footnote 12, of VanderNat and Keep's paper, Marketing Fraud: An Approach for Differentiating Multilevel Marketing from pyramid Schemes, he also simply acknowledges it as something greater than 50%.

VanderNat developed his formula, utilizing 50%. He details various scenarios, all pivoting around this "magic" 50%.

However, the 50% dividing line isn't set in stone. If the dividing line was set higher than 50%, the less likely the MLM to be classified as a pyramid. So, an MLM considered a pyramid at 51%, might not be a pyramid at 55% or 60% or some other higher number.

When VanderNat used 50%, he recognized it was just a number, a number that did not really define "primarily". He even footnoted that neither the FTC nor a court has addressed this issue.

"The court has never addressed this issue" ... Can that still be true?

Let me leave VanderNat for a minute, and go back to the court in BurnLounge. Here's how they dealt with "primarily" ...

" ... Because the outcome in this case is clear ... we do not need to decide the degree to which rewards must be unrelated to product sales in cases presenting a closer question ..."

What is the court saying? Well, BL was so obviously a pyramid that a definition for "primarily" wasn't even necessary. However, in a case that isn't so obvious, they would need to define "primarily" before being able to render a verdict.

So, back to VanderNat. Now, there is no question in my mind that VanderNat is an intelligent, forthright and knowledgeable person. He certainly seems to approach his work seriously and in many cases as an academician. Did he ignore this or did he deal with it?

Let's look at exactly what he says (emphasis added) ...

" ... any quantification of the term "primarily" implies a policy decision. Wherever the bar may be set for the meaning of this term (e.g. 80%, 70% or greater than 50%), the model computes a corresponding critical retail percentage that incorporates the chosen threshold. Specifically, a policy decision could change the current reference point of 50%.. to (say) 70%. The model provides the method for implementing the policy decision without dictating a decision a priori ... "

VanderNat did address it in saying there is no set definition of "primarily". It is a POLICY DECISION. The 50% is merely a reference point. He was concerned enough about the possibility that it wasn't 50%, he made sure his formula could accommodate any other set point.

The 50% is just an example not a conclusion. There is no technical or economic basis for setting the bar at 50% or any other number. It is just a decision that someone (possibly the courts) will have to make.

What this means is that the currently accepted definition of a pyramid is ... well ... not fully defined.

But, VanderNat doesn't stop there ...

" ... For each of the cases reviewed previously, the prosecuting agency showed that the connection between upline rewards and retail activity was either trivial or so small that any presumption of a primary or even main connection between these two could be overwhelmingly rejected ... The Government chose cases in which success was deemed likely in whatever way this term might reasonably be defined. In this same regard, one of the prosecutorial applications of the model lies in supporting policy decisions that seek to avoid close calls ... "

Tying this together, there are cases (add BL to the list) where the pyramid scheme is so obvious, the FTC can pursue them without having to worry about a numeric value of "primarily". This is exactly what the FTC did ... pursue the "slam dunks" and leave the rest alone. So if one wants to speculate on why the FTC left Herbalife alone before Ackman, this is a good answer.

But, until the bar is set, all other cases ... cases that are not so obvious ... cannot be properly classified.

That means, in a case like Herbalife, where there is complexity in areas such as personal consumption, end-user sales, effectiveness of return policy and the level of legitimate retail activity ... quantifying "primarily"... setting the bar... would be a necessary step.

This presents a problem for expert testimony. The bar must be set before Herbalife can be properly classified AND the court would decide on where the bar should be set AFTER all testimony has been made. Wouldn't it then follow that if VanderNat was questioned by a skillful lawyer, he would be unable to affirm that Herbalife is a pyramid? In fact, he might be led to admit that Herbalife might not be a pyramid, or even IS NOT a pyramid.

If he hedged an answer, based upon a "reference" value for "primarily", a skilled lawyer need only question if the value could be "theoretically" at some other level. The value could "theoretically" be 80% or more. It is a POLICY DECISION where to set the bar, not a mathematical, legal, technical or economic issue. It is, until the court rules, just someone's opinion. A "gut feel" if you will.

Perhaps, since it is a policy decision and not one based on an economic model, VanderNat's expertise may not even be relevant.

Creating even more problems, if the FTC set the bar, it could be exposed as just an arbitrary POLICY DECISION. It could just as well have been set somewhere else. The FTC would not be in a position to utilize VanderNat's expertise to affirm its validity using economic principles.

Now, if that isn't the FTC's worst nightmare, I don't know what is.

Summary: A careful review of VanderNat's paper will produce some very interesting results. The further one reads into the document the more apparent it becomes that VanderNat is not really developing a formula for purposes of assisting a legal determination of whether or not a specific MLM is a pyramid.

Quite the opposite. He is trying to develop a model that could be used by the FTC to run various "trial calculations" to help them steer clear of "close calls".

Some MLMs are so egregious they are litigation "slam dunks". But, unless a particular MLM is a "slam dunk" ... the key metric to determine if it is a pyramid ... defining "primarily" ... has yet to be addressed.

Conclusion: So what does all this really mean? VanderNat, the FTC and the courts know what lies in front of them when it comes to MLMs such as Herbalife. It is simply ... Where is the bar set in quantifying "primarily"?

It is my sense in order for the FTC to prevail, they would have to present convincing argument defining "primarily" numerically and that Herbalife fits reasonably within that number. I can't imagine a scenario that doesn't require this.

It is also my sense that the FTC doesn't like to fight these types of battles. In fact, one of VanderNat's objectives in establishing the Formula was to keep the FTC from pursuing "close calls" and having to fight over "primarily".

I doubt the FTC is in any hurry to ask the court to find against a party based upon a metric that didn't exist beforehand. This is difficult to envision. If a bar is set at, say, 51% a trivial difference in sales or over-rides would mean the difference between Herbalife being a pyramid or not.

Doesn't make sense. Pyramids are supposed to be a fraud, a scam, whatever. Something very serious ... not an arbitrary number. And certainly not a number absent economic modeling.

It is my sense that the FTC will not publicly set the bar in anticipation of taking Herbalife to court. Just not the way things are done.

The FTC may well be boxed-in by VanderNat's paper. It will be interesting to see if they try to punch their way out of it or just go quietly through another door.

Post Script: This analysis does not address deceptive sales practices or other types of fraud alleged against Herbalife or its distributors. Other articles on SA have dealt with this many times over. The FTC should and probably will address these concerns. This article is intended to address only the pyramid aspect and does so with full understanding that there are other issues outstanding.

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.