Pyramid schemes come in different shapes and sizes. What they have in common should be well known by now. Pyramid schemes design incentive systems that compensate participants when they recruit new members into the scheme. This compensation serves as an incentive to get participants to focus their energies and efforts on recruiting. It is the emphasis on recruiting that unleashes an endless chain of new recruits. Taken to the logical end state, those recruited in the later innings are destined to be disappointed when they discover that their downlines end-up empty or that saturation in the marketplace makes it impossible to earn profits.
Obvious pyramid schemes pay a headhunting fee to the recruiter for signing-up a new recruit. e.g. If I pay $500 to you as my recruiter the company might pay you $250 and keep the difference. And so on and so on and so on.
Product based pyramid schemes are more complicated but the mechanics are similar to a scheme that pays a headhunting fee. The only difference is the trigger that releases the recruiting reward. In an inventory loading scheme, the trigger for recruiting rewards is the acquisition of an opening level of inventory. New recruits are encouraged to sign-up and stock-up. When they stock-up, the recruiter gets paid.
The tricky part for the recruiter is easy to see. How do you get the recruit to stock-up on inventory so you maximize your commission?
Fortunately, for Herbalife recruiters, Herbalife (NYSE:HLF) has a well-crafted answer to this question. EL SUPERVISORA.
Herbalife charges its distributors different wholesale prices for inventory based upon the Volume purchased. The discount curve is simple:
If you want a bigger discount, you have to buy more inventory. It is as simple as that. Herbalife also tethers some pretty cool titles to these discount levels. Private, Corporal, Sergeant, Captain don't cut it in the Herbalife world. Instead, we have Distributor, Success Builder, Qualified Producer, and Supervisor. $3,000 gets you to Supervisor right out of the gate while lining the recruiter's pockets too. Amazingly, Herbalife's recruiters focus their energies on hunting for Supervisors. Go Figure.
The slick design of the Herbalife pay plan is impressive, until you consider the following idea. PRICE DISCRIMINATION IS ILLEGAL.
Why is it illegal?
Turns out that if you charge one group of salespeople one wholesale price and another group of salespeople a higher wholesale price you are gift-wrapping a monopolistic advantage to those who pay a lower price for inventory. In Herbalife's case, SUPERVISORS hold a distinct competitive advantage as retailers v. lowly distributors.
Q. Do we see evidence that SUPERVISORS actually use this advantage "in practice"? The answer is, of course. Herbalife's Formula 1 shake mix is ubiquitously available online with free shipping to boot at many websites at prices well below a lowly distributor's actual COGS. (see herbalwell.com, amazon.com, eBay.com, herbal-living-shop.com)
Q. Does this seem fair to you?
If your answer to this question is "No, it does not seem fair." then already you understand the gist of Section 2 of the Clayton Act.
40 Years ago the FTC prosecuted Koscot in a product base pyramid scheme. Count III of the indictment zeroed-in on Glenn Turner's pricing policies. As a reminder, here is what the case said.
Alleging violation of Section 2(A) of the Clayton Act.
PAR. 16. The difference in net cost among the various distributors of respondents' products, each of whom is in competition with other distributors of respondents' products, results in substantial discrimination in the net prices for products sold to the nonfavored customers, who are both direct purchasers and indirect purchasers of respondents' products...
The effect of respondent Koscot Interplanetary, Inc.'s discrimination in net price as alleged herein may be substantially to lessen competition or tend to create a monopoly in the line of commerce in which its favored purchaser is engaged, or to injure, destroy, or prevent competition between the favored and nonfavored purchasers or with the customers of either of them.
The aforesaid acts and practices of respondents constitute violations of the provisions of Section 2 of the Clayton Act as amended.
In the judgment issued in 1975, the following was written:
III. Restraints of Trade
B. Price Discrimination
145. The facts as to the price discrimination charge (complaint, Count III) may be briefly stated.
Koscot discriminated in price between competing purchasers of its products. To distributors Koscot sold at 65 percent off the retail price, while to supervisors or subdistributors (hereinafter 'subdistributors') it sold at 55 percent off retail price. [FN25] (P36, supra) Since both distributors and subdistributors sold to beauty advisors at 40 percent off the retail price, the distributor's gross margin on such sales was 25 percent, while that of a subdistributor on such sales was 15 percent. On direct sales to consumers, distributors enjoyed a gross margin 10 percentage points above that of subdistributors.
(B) The products involved were of like grade and quality.
(C) Distributors and subdistributors performed the same function in the sale and distribution of Koscot products. Both classes of customers purchased directly from Koscot and resold to consumers, either directly or through beauty advisors.
(D) There was competition between distributors and subdistributors, not only in direct sales to consumers, but also in the recruitment of beauty advisors and in sales to beauty advisors.
(E) There is evidence of actual or potential injury to competition as a result of the discriminations. Irrespective of such evidence, however, the magnitude of the discrimination was such as to warrant an inference that the effect may be to substantially lessen competition.
(F) There was no showing by Koscot that the price discriminations were justified on any of the grounds specified by the applicable statute (CPF 494 508).
146. Accordingly, such discriminations in price were in violation of Section 2 of the Clayton Act, as amended.
Q. What would happen to Herbalife's pay plan if the FTC were to tackle this Anti-Trust violation directly?
Q. What would happen to Herbalife if the company had to sell wholesale inventory to all distributors at the same price?
Q. What would happen to Herbalife's SUPERVISOR program?
Q. What would happen to Herbalife's pyramid scheme?
Imagine for a moment that starting tomorrow, everyone who signs-up to become a distributor can immediately buy stock for the same price as a SUPERVISOR. Imagine that 50% off is the going rate for wholesale inventory whether you buy $100 worth or $5,000 worth.
Now, imagine you are a new recruit signing-up for the business for the very first time.
Q. How much inventory would you buy?
a) $3,000 worth.
b) Far Less than $3,000 worth.
c) Far more than $3,000 worth.
If you think quickly, you can answer this question "Just In Time."
The obvious answer is that you would take a minimum amount of inventory risk as you pursue and grow a legitimate book of retail customers.
As a "business opportunity" seeker, this would be very good for you. Trouble is, your recruiter would really be put out. No longer could he sell you tickets to SUPERVISOR training sessions or convince you to load-up your credit card to become a SUPERVISOR the "traditional way." No longer could your recruiter earn a headhunting fee on your inventory load and then throw you to the wolves as you compete for clients with the other 3.9 million distributors that exist around the world.
Overnight, the entire Herbalife incentive system would change and change for the better.
Overnight, inventory purchases would become tethered in some way shape or form to actual final demand for this over-priced placebo v. to qualifications and advancement and recruitment into a pyramid scheme.
Q. What is the fastest way for the FTC, investors and the public at large to discover just what intrinsic value Formula 1 has as a legitimate consumer product?
A. Drive a stake through the heart of its SUPERVISOR program with an anti-trust prosecution.
Presto! Overnight, the Goose that lays the Golden Eggs for Herbalife recruiters would be put down for good.
You might be asking yourself as you read this article, "Why doesn't Herbalife flatten its wholesale pricing on its own?"
Instead of offering up a 100% Money Back Guarantee as part of its Gold Standard Protection Package, why doesn't the company just obey the law?
Isn't the company aware that Glenn Turner was prosecuted for price discrimination? Doesn't the company know that its SUPERVISORs hold a huge competitive advantage over its junior ranks?
A. Of course it knows.
What the company also knows is that if you kill its SUPERVISOR program you kill its pyramid scheme. If you kill its pyramid scheme you kill its revenue stream. In much the same way that Burnlounge saw demand for its products collapse when the "Mogul" program was put out of business by the FTC, investors should know that the death of Herbalife's SUPERVISOR program shutters the mechanics of its confidence game. Formula 1 then gets exposed as just another shake mix.
Q. Is a simple Anti-Trust prosecution the shortest distance between two points for the FTC?
A. Did Al Capone get prosecuted for Income Tax Evasion? (RICO MIGHT HAVE WORKED TOO)
If at first you don't succeed, try, try again...
Ostensibly, a simple Anti-Trust case would seem to get to the heart of the matter. The evidence already exists that Herbalife price discriminates. It's all in "Black and White" in its compensation plan. The word "primarily" doesn't even enter the equation.
A standard 50% off wholesale price should, by extension, lead to a standard market clearing retail price. At the very least, all salespeople would exist on a level playing field as they bash their brains out one oversaturated geography at a time for actual retail customers.
Whether or not the Clayton Act will be used by the FTC after its investigation into Herbalife remains to be seen. At the very least, we know how it turned out for Glenn Turner.
For now, All's Quiet on the Western Front. How long the silence persists is anyone's guess.
In the interim, any guesses what Herbalife distributors are doing today?
If you said RECRUITING ASPIRING SUPERVISORs then you understand how this business works "in practice" too. Bravo!
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.