Is Herbalife (NYSE:HLF) a pyramid scheme or just another MLM? That is the pivotal question and certainly the criticism that Bill Ackman has leveled at Herbalife. His live presentation on July 22, 2014, was poor, sloppy, far too long, and lacked clarity and definition. However, it does not mean he is wrong. Presentation is everything, ask any trial attorneys and in that, Ackman failed.
A proper presentation would begin with the clear definition of what a pyramid scheme is, so that we the audience can decide if Bill Ackman's accusations fit within that definition. Bill never clearly offered a definition to preface his presentation and, embarrassingly enough, even his own father at the end of his presentation asked for Bill to offer a clear definition. The first slide of his presentation should have clearly read: What is a pyramid scheme?
What Is a Pyramid Scheme?
"A pyramid scheme is an unsustainable business model that involves promising participants payment or services, primarily for enrolling other people into the scheme, rather than supplying any real investment or sale of products or services to the public." -- Wikipedia.com
From a legal perspective, the most important part of this definition is whether you are primarily selling a product/service or primarily enrolling or "recruiting" others. We should remember this definition and apply it to the evidence the Ackman presented, regardless of our opinions of him or his presentation.
What Is Multi-Level Marketing?
Those that argue against Ackman's position stand on a position that Herbalife is just another multi-level marketing company, much like Avon, Pampered Chef, or Beach Body. However, before we can discuss the difference, we must understand what an MLM is.
Multi-level marketing is when the sales force is compensated not only for sales they personally generate, but also for the sales of the other salespeople that they recruit. This recruited sales force is referred to as the participant's "downline," and can provide multiple levels of compensation.
Is There a Difference?
There is a distinct difference, while they both recruit others to sell products/services; the source of compensation from an MLM is from the commissions of selling the product. Whereas in a pyramid scheme the primary source of revenue is not from selling the product, but from the enrolling others.
I spoke with an attorney on the subject and he said it is very clear, from a legal point of view. If a company's primary source of revenue comes from trainees (enrollees, recruits, etc.) paying to become a distributor and to recruit others with the same intentions, it is a pyramid scheme.
When we look at several legitimate and good MLM companies, we see both in their contracts and commission packages that regardless if it includes recruiting, the primary source of revenue is from commissions selling the products.
What About Herbalife's Practices?
This is where it Ackman focuses his criticism. His presentation and belief is the company's primary source (and growing source) of revenue is from "enrolling" or recruiting distributors.
In his presentation he showed several Clubs (predominately Club 100). The process shows that before anyone can begin collecting commissions, they must first go through a training program. This is normally not a big deal and investigation shows that almost every MLM company has a training program. However, according to Ackman's research, where Herbalife differs is that one must pay to be trained and also pay for the excessive amount of products. Additionally the trainee must also bring others into the program, all prior to becoming a distributor (club owner) themselves.
To simplify Ackman's criticism, you cannot just open a club/store and sign up to be a reseller or distributor and start collecting commission. You must go through a costly and long training process, which includes recruiting others. What Ackman didn't but should have broken down is what the revenue is generated by enrolling vs. revenue generated by actual retail sales of the product. It would seem from Ackman's presentation that Herbalife's clubs' and programs' bulk revenue comes from recruiting rather than selling the product.
A simple breakdown slide or spreadsheet between these revenue differences would be the coup d'état. He would be able to show that Herbalife is a pyramid and not simply an MLM. He failed in doing this or making it clear. Instead, Ackman played on the moral predatory nature on the poor. Sure, this can move hearts and even bring Ackman to tears, but this is not about whether it is morally right or wrong, but whether it is legal or not.
California's Permanent Injunction Against Herbalife?
Ackman's criticism of Herbalife is not new and there is even California's Permanent Injunction against Herbalife (1986), which included very clear legal wording that they may not operate as a pyramid scheme.
Section 5.A. defendants shall not establish, maintain or operate a marketing program in which:
(1) A participant pays a valuable consideration for the chance in whole or in part, to receive, either directly or indirectly, compensation, which is based on other than retail sales for introducing one or more additional persons into participation in defendants' marketing program or for the chance to receive compensation., either directly or- indirectly, when the newly introduced participant introduces a new participant into defendants' marketing program;
(2) Any compensation, however denominated (including but not limited to "commissions," "overrides," "achievement bonuses," or any term of similar import), defendants pay or participants receive is based upon anything other than the retail sale of defendants' products; and
(3) A participant can obtain any specific level in defendants' Marketing program based upon criteria other than the amount of retail sales made by the participant or persons introduced into defendants' marketing program by the participant.
B. defendants shall be in compliance with this Section 5, as long as a verification or documentation system they implement allows them, at any given point in time, to verify or: document to plaintiffs that any and all participants who receive commissions, bonuses, overrides and/or advancement from defendants in defendants marketing program, after entry of this judgment, are based on retail sales made by or through such participant or others introduced directly or indirectly under participant. Plaintiffs shall not seek such verification or documentation prior to 90 days after entry of this judgment., and defendants shall be in compliance with this verification or documentation requirement it their records are current and accurate to a point in time which does not precede plaintiffs' request for verification or documentation by more than 90 days. Plaintiffs' request for verification or documentation of retail sales shall be made to defendant's counsel of record.
C. The term "retail sale" as used in this Section 5 means a sale at defendants' product in any of the following situations: (1) to persons who are not part of defendant's marketing program or distribution system; or, (2) to persons who are not buying to become part of defendants marketing program or distribution system; or, (3) to persons who, although desirous of becoming or who are a part of defendants' marketing plan or distribution system are buying for their own personal or family use.
I think the California Permanent Injunction against Herbalife is fairly clear. Why didn't Ackman show a slide of this and clearly show how, through the recruiting these "clubs" that Herbalife is in violation?
What We Do Know
We know that Herbalife is a MLM at best and they follow many typical MLM practices, which are legal. This includes recruiting others to sell "downstream." Ackman did offer some compelling evidence that in some cases, such as the "clubs," that Herbalife's revenue in these situations is suspect as to whether the bulk of the revenue is generated through recruitment vs. actual commissions of selling the product.
What We Don't Know
Are these "clubs" and the revenue generated from recruiting a primary source of revenue for Herbalife? Are these "clubs" even sanctioned by Herbalife? Is Herbalife even aware that the bulk of revenue generated from these clubs from "recruiting" (forcing inventory loads)?
No doubt that in all MLM programs there are people outside the company that abuse the system, create false websites, make promises that the company can't, and even create their own pyramid schemes. The question is: Is Herbalife directly involved, encouraging such action, sanctioning such action, and rewarding such action? I am sure their crack legal team has put as many legal barriers in as possible to limit the company's liabilities, but is the company still culpable to end practices of rouge pyramid schemes?
Ackman does raise some compelling questions where the line blurs between pyramid schemes and MLMs. He also offered some evidence that pyramid schemes are operating with Herbalife products, but whether they are a direct program sanctioned by Herbalife or independent is questionable.
I do appreciate Ackman's moral cause and those that feel strongly should protest companies that prey on the poor. However, we can't mix our moral beliefs of business practices with legal practices. Ackman is married to his position, is emotionally changed and moved by Herbalife "seemingly" taking advantage of the poor. Has he lost his objectivity?
I think there is something to Ackman's claims, unfortunately Ackman has failed to; articulate them, remain objective, focus on the math, and focus on the legal. The presentation was embarrassing and I think buried in his presentation there are some truths; however, we may never know because if Ackman remains the only champion of his cause, all the truth and facts can be buried by his emotions and certainly his short position, which he is married to.
For the record: I have a long September and November 60/55 and 62.5/57.5 P/S.
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. The author has no business relationship with any company whose stock is mentioned in this article.