Herbalife (NYSE:HLF) has fast become the poster child for what is wrong with MLM. If Herbalife gets cleared in all of the ongoing investigations, that is a huge victory for its shareholders and all of MLM, but if not, we are in for a full-bore confrontation about the future of MLM, and the most serious one in a long time, because of the size of Herbalife and the fact that it is public. After all there are widows' pensions at risk with what could turn out to be a fraud.
Being public brings with it an amount of disclosure that is tough to reconcile with the deceptions that underlie its business model, and ultimately all of MLM. Pershing Square's presentations have uncovered a lot of the evidence of malfeasance. However, as E. Robert Smith describes it in his book "Downline... intolerable potential to deceive," what matters is the nature of the thing, what it is designed to do, and that is recruit, recruit, recruit. The book provides the context to understand the Herbalife information and why it is so damning.
The fundamental lie of all MLM is the idea of offering - for "good and valuable consideration," an "unlimited income" opportunity on a non-exclusive basis to unlimited numbers of people. This sets up the endless chain of recruiting based on the implied, but patently absurd, assumption of an infinite market, and at some point, that runs afoul of the law and turns MLMs into illegal pyramids: a Ponzi scheme wrapped around a product. Herbalife is to the FTC what Madoff was to the SEC, and it will either prove their meaninglessness as a regulator, or enable the agency to forge long overdue meaningful change. The question remains the same, to paraphrase what Harry Markopolos expressed about the SEC in the Madoff case: Is the regulator there to protect the consumers from the fraudsters, or to protect the fraudsters from the consumers?
After 40 years of inconsistent enforcement in this area, it is time to create clarity. If the FTC fails, all investors and entrepreneurs lose, and unfortunately, at least until now, it looks like the FTC is waiting for the Chinese to move first, which would be embarrassing and counterproductive. Like the SEC in the Madoff case, we are now running the risk of a scenario where regulators regulate only after the markets exact their revenge. In the interim, MLM continues its pretense to being a legal way of selling the Brooklyn Bridge in the form of the implication of "infinite markets," and "unlimited opportunity."
Several letters to the FTC have been published, and others no doubt have been sent privately:
- Letter dated July 4th to the FTC by Robert FitzPatrick, following a telephone conversation on June 9th with Ms. Jessica Rich, director of the FTC's Consumer Protection Bureau, with Messrs. Bruce Craig, Esq., former Wisconsin Asst. AG, and Douglas Brooks, Esq., a well-known franchise lawyer, both with extensive MLM litigation experience. It is a masterpiece because it lays out a lot of the relevant legal history and industry developments, to come down to a recommendation based on where we are today.
- A letter by Bruce Craig to the FTC, which was published on SA on July 21st. It pleads in specific detail the absolute necessity, in the most objective sense possible, for clarity in regulations. The uncertainty with the extant legal regime of totally haphazard enforcement actions resting on messy case law, without clear rules, creates an intolerable business climate for all concerned, as much as it makes it hard for prosecutors if they have to retry the same issues over and over again.
By design, MLM pay plans, as they are today, are money transfer schemes in which the money overwhelmingly goes to the recruiters, and those recruiters are the shills that attract the thousands who try their hand at it, based on a misleading representation of the "opportunity," deceptively made real by the size of their checks. The majority of prospects must fail with overwhelming statistical certainty, and to that extent, the recruiters and the companies make their money from failure.
These MLM "leaders" are the exceptions that confirm the rule, but they foster the illusion that anyone can do it, just because someone could do it. The "leaders" are no different from the shills in a game of three-card monte on the street corner. Their testimonies feed a pervasive denial of the effect of market saturation. Deceptive income claims are a necessity to keep this illusion alive. The lie is not even in saying you made $100K, when you really only made $95K and you're netting $50K after expenses, the lie is to imply that the next person can do the same thing if they only apply themselves, pretending that the market is infinite. That is always a lie, and every MLM relies on that claim. It is ludicrous to think that if people can only see the actual checks, there is no lie. The checks are the lie, statistically speaking. This is compounded by the issue of failing to report the business expenses. The lie is the representation that anyone can do it, because markets are not infinite after all.
It is this statistical certainty of decreasing returns which makes a lie out of every opportunity presentation, and that is the outright deception which the FTC has the means to address. The appearance of E. Robert Smith's book at this particular juncture is so helpful because it represents an insider's view. He calls it a whistleblower novel. Clearly, he has fathomed both practically and analytically what is wrong with the industry. So if Pershing Square has the goods on Herbalife from an analysis and information point of view, the book Downline provides the historical and business framework that is necessary to conceptualize possible solutions. The letters by Bruce Craig and Robert FitzPatrick contribute valuable constructive material towards that end from different perspectives.
In this article, I'll try to develop a conceptual foundation for a regulatory framework that hopefully makes sense, by not going after symptoms but after the disease. I won't dwell on the details of case law, but on the underlying issues, to suggest ways to get at the nature of the phenomenon instead of silly rules that will be circumvented by lawyers within a short time.
Short-term versus long-term
In the short term, and independent of specific actions taken in the matter of Herbalife, the FTC could start the process of undoing the exemption for the MLM industry from its Revised Business Opportunity Rule, and including MLM instead, lest the FTC be complicit in the widespread deceit in this industry. Given the "intolerable potential to deceive," the disclosures required in the business opportunity rule are a modest first step in creating more transparency in the industry, but more is needed, along the lines of Bruce Craig's and Robert FitzPatrick's letters, and other ideas, including perhaps some suggestions here. Combine the disclosures in the bizopp rule with the removal of the fundamentally fraudulent claim of "unlimited earnings potential" and the misrepresentation that everyone has the same opportunity, and you have the beginning of a sounder basis of operation.
In the area of earnings disclosures, it is imperative that the FTC set specific standards. The Herbalife earnings disclosure (2012) is a study in how figures lie and liars figure. 194 distributors earn above $250K from the company, this is 0.2% of the 17% that are "Sales Leaders with a Downline," therefore, it is .03% of the total base of distributors. But because this is in the past, to the new person looking at the business today, because of saturation, the potential of ever reaching those levels is significantly smaller, perhaps 0.003, 0.0003 or even 0.00003%. This issue should be part of the disclosure, for past performance definitely is not a predictor of future results, since the potential market for the company shrinks with every customer/distributor added. In other words, past successes provide documentation of a diminishing market opportunity. So, if you were planning to pursue the business opportunity, perhaps a lottery ticket would be a better choice - and certainly lesser hassle.
Also, it should be noted that the 71% of customers HLF now refers to as "members" still pay the $60 fee to join and are committed to the distributor agreement. Other companies increasingly have a free "preferred customer" program. That $60 adds up to some $100 million per annum for HLF at the current rate, and 90% write that off within the first year and never renew. In short, the FTC should require companies to have a preferred customer program that is free of charge, or else this classification on the earnings disclosure should not be allowed. These preferred customer programs make it easy to document at least a part of retail activity.
On a silver platter
If Pershing Square brought boatloads of actionable evidence of malfeasance to regulators/prosecutors, the overwhelmingly most important support came from the unforeseen publication of E. Robert Smith's book Downline. The evident reason why enforcement and regulatory attempts have been so haphazard and inconsistent at times, including Amway pulling a fast one on the judge in 1979, is because few people ever put the whole picture together. The dynamic of network marketing is hard to fathom to the casual observer.
Besides the above, nearly all of the authorities in the field have weighed in on the matter, including some here on SA, and many important contributions have resulted. Clearly, the abuses that have been reported at Herbalife were so outrageous that the public reacted incredulously. For those of us who failed to get the problem with nutrition clubs when Bill Ackman explained it so nicely on July 22nd, here it is in more "salty language." One way or another, regulators and/or prosecutors now have a complete overload of information, and they can pick and choose what avenues they want to pursue.
Regulation is the only way forward for the industry
The industry has only one option, and that is to work with regulators towards effective and meaningful regulation. The DSA has failed with their misguided obstructionism pertaining to the business opportunity rule. Those who choose to fight a rearguard action are not likely to come out ahead. The business environment that has so far become the norm from these periodic enforcement actions is intolerable for investors and entrepreneurs alike. A sound regulatory framework is needed.
What not to do: regulation by proxy
Retail sales are an indicator that the product or service is valuable and viable in the market, absent the lure of earnings. Unencumbered retail sales are different from recruiting sales, or qualifying sales, which are in most cases, a requirement for qualification as a distributor. Recruiting sales or qualifying sales are sales by the company to distributors seeking to maintain their qualification. Retail sales outside the network are by distributors to customers outside the network. The Amway ruling of 1979 codified this measure in the form of the 70% inventory depletion and 10 retail customer rule, and a steady flow of manufactured receipts have been the predictable result, if people even took that much trouble. Amway thus attempted to transfer the non-compliance risk to its distributors. But also, many newer MLM business models made the rule obsolete, because direct fulfillment is becoming the order of the day.
The danger of things like the 70% rule is in the arbitrary nature of it, and that leads to arguments over if it should be 69% or 73% in different situations, and 10 customers also would have to be different with different styles of marketing plans.
Here again, it's all about the nature of the thing; a retail sale outside the network is not an unencumbered retail sale if, as in the case of the "training programs" in nutrition clubs, sales are driven by the expectation of future earnings. For a while, at least, Herbalife was claiming these contrived sales as "retail sales," but given what we know now, it can no longer do so. The lesson here is that never mind what labels you use, there are ways around it. And in that sense, regulations only serve to make prosecution of abusers easy.
A clear distinction should be made, a "recruiting sale," or a "qualifying sale" might perhaps still be commissionable, for commercially it is a sale, but it should not legally be used as an unencumbered retail sale that staves off a pyramid claim. In terms of the reasonableness of some qualification in terms of volume, in many cases personal consumption and a single, retail customer, or at most a couple of them, might be sufficient as a minimum. Companies should be free to require more as appropriate in their marketing models. When the misrepresentations about earnings go away, the motivation to cheat the system will decrease. So these things go hand in hand.
The product drives the opportunity, or the other way around?
Robert Smith, in his books, makes this distinction very clear. An MLM is designed for recruiting, not retail sales. And it therefore makes no difference really if there is or is not a commission for recruiting - a headhunting fee - which is illegal. Just as easily can the reward for headhunting be disguised in the compensation, so if the compensation is structured to favor recruiting over retailing, that is what the beast will do. The result is either an overt scam with fees up-front, and monthly fees, and yearly fees, all to fleece would-be distributors of their money, in the full knowledge that 90% will fail and write it off to experience within a year. Alternatively, it is a covert scam in the form of overpriced products which are padded with enough margin to support the recruiting activity, and the distribution of the margin will be such that it clearly favors recruiting. The result in these cases is either heavy up-front fees, or excessive product pricing that could be justified only in light of the prospect of future sales/commissions.
Applied to Herbalife: the excessive MSRP is designed to motivate people to join at the very least for the discounts, and because no commissions can be paid on headhunting, the $60 for the sign-up kit is pure revenue to HLF that can fund other operational expenses. Apparently very few bother to check that the product is available online at an even greater discount than the 25% off you get for your $60 fee. A seven-day waiting period as per the FTC's business opportunity rule, which presently does not apply to MLM, would give people some breathing room to check these things out. Analyzed properly, the purpose here is selling distributorships, and the MSRP serves to create the motivation for people to pay the $60 registration fee. Based on a churn of about 1.5 million per year, that is almost $100 million in revenue to Herbalife per year in fees from customers who presumably are not even interested in the rights that this sign-up fee and the agreement conveys to them.
In other words, the product is then not a fair value, and it's only the earnings prospects which make it possibly worthwhile. The "opportunity" drives the product, which would be prima facie evidence of a money game, be it a pyramid scheme or a product-based chain letter. Or, to put it differently, the product is priced so high as to incentivize people to join up and start to recruit others. This flies in the face of making retail sales with any consistency. At the extreme, the product is nearly immaterial and the program becomes purely a money game. Always keep in mind that the earnings prospects themselves are a proposition of decreasing value over time.
The alternative is when the product drives the opportunity. The product provides good retail value, and as a result, some customers may be interested to promote it, and compensation would make that worthwhile. In this case, the product drives the opportunity, and therefore, the business proposition is prima facie sound and legal. There could still be multiple levels for building sales teams, even if they are part-timers; it is legit and it requires work.
Somehow it is of essence that regulation capture this distinction: the product selling the opportunity is OK, the opportunity selling the product is trouble. This distinction goes to the heart of the matter.
No more lies
A core issue of any regulation must be to recognize that any form of multi-level compensation provides leverage that magnifies the payoff of fraud. The one pervasive form of fraud in the field is the business opportunity deception of promising unlimited earnings potential non-exclusively to unlimited numbers of people. In addition, there are deceptive product claims that can be either an FTC matter, or in the case of health claims, even an FDA matter.
The illusion of "independent distributorships" adds plausible deniability to the mix, and regulators should not hesitate to use RICO statutes to combat those violations. It has already been recognized that lead generation is one trouble area, and besides the private profits from lead generation that were documented in the Herbalife case, many lead generation businesses are organized as MLMs themselves, thus increasing the lure of pyramid sales, including people getting in over their heads financially, all betting on the come.
No more pyramids?
The concept of an illegal pyramid has long since become commonplace in this domain, as if it were the heart of the problem. It is clear that there should not be compensation for headhunting, or otherwise distortions in compensation that provide excessive rewards for headhunting over retail, as indeed some courts have recognized. It is clear that "good and valuable consideration" cannot be paid for the right to participate in the recruiting benefits. This points in a direction where free referral programs should be legal, but MLMs that charge fees up-front might not be. It would appear that if retail pricing is fair and there are otherwise no fees, a referral system should be OK, but paying for the right makes no sense, again because of the same feature, similar to a Ponzi scheme, that the last people coming in could never make their money back, as markets are decidedly NOT unlimited.
In view of the above, I am inclined to think that absent fraudulent income claims or other fraudulent misrepresentations, if the pricing provides fair value, and there is no investment so that people don't get hurt financially, no customer would ever care who gets paid or how. In other words, it's not the "pyramid" structured that's the problem, but the constituent fraud(s) is/are the problem. Likewise, with the stockbroker who is churning an account, it's not the fact that he earns a commission that's the problem, but the fact that he earns it by stealing from the customer. What makes an MLM potentially into an illegal pyramid is simply the fact that there is deception, and damages result as a matter of necessity for large numbers of people who never make their money back. But absent damages, it's no harm no foul, and it's nobody's business who gets paid or how, as long as there is agreement among the parties about that compensation.
The future of multi-level compensation
With a renewed emphasis on retail, there should be a shift in the compensation program, particularly also because under transparency, people who really want to build a business should be able to do so. Clearly also, retail margins can still be lower than in a normal retail channel because there is no store, and nowadays shipments are mostly dropped directly to the end-customer. Nevertheless, a comp plan should make sense at all levels in order to shift the focus back to retail.
It should be recognized that, again, it makes no sense to write too many detailed rules that can be circumvented; what matters is regulating the core behavior. Also, many companies have already begun to develop variations on the basic MLM concept exactly in an attempt not to be "one of them pyramids," but not always successfully so, as Vemma is finding out, after they made some mostly cosmetic changes, and are still the target of many complaints.
Absent the constant hype of ridiculous earnings claims, which should furthermore become impossible, it would seem that the predominant form of MLM would be a home-based business where someone simply decides to market a product that they love. And, of course, there might be some people who make it a full-time living. But the hysteria of excessive earnings claims should go away, and MLM should become a normal business where the reps simply contribute their product knowledge and that's why they get paid.
Becoming too specific in the rules may be counterproductive. MLM does not have to become a junior franchise with geographical limitations. In our virtual world, that makes no sense. Nor does it necessarily make sense to have some absolute rules on the number of levels of compensation. Under transparency, the shift away from endless recruiting will be inevitable, and compensation levels will tend to be compressed commensurate with the shift to viable retail.
A creative use of the FTC's Revised Business Opportunity Rule
Clearly, applying the Business Opportunity rule to MLMs is a must, for it will increase transparency and eliminate the pressure sales, and in turn, that will force MLM companies to improve their value proposition. One could think of creative ways how to use it. Let's say any customer who signs up for a preferred customer program gets an option after one week to decide if they want to market the product or not, but that option is valid for only one month. Many programs today already offer a free sign-up, but perhaps a modest registration fee might be appropriate in some cases, and perhaps some test of product knowledge and/or applicable regulations might be required. Today, most MLM people have no clue about the applicable laws and regulations.
Companies can offer free replicated websites. But in any case, if that option was only valid for a month, distributorships would be more valuable. The universal complaint in MLM is that 10% of the people do the work, so make the other 90% preferred customers and let the 10% do the selling and get compensated for it. Immediately, this type of a structure also shifts the emphasis from recruiting to retailing. You might even consider offering free product for referrals to preferred customers.
Regulate the relationship of the companies and their reps
Abuses in the industry include restraints that should be illegal, such as restrictions on legal recourse with very unfavorable internal conflict resolution methods. The company store was outlawed some time ago, but it's alive and well in MLM.
Generally, companies provide clauses to enable them to make whatever changes to their marketing plan they see fit, without recourse, and without any requirement to consult with their reps. Such clauses may be warranted to a degree, but it would not be unreasonable to require representation of the reps in any changes, with an advisory counsel that could be 50/50 appointed by the companies and by the reps. Above a certain level, there should be mandatory buyouts if the owners sell out.
Lastly, in many cases, there are provisions that companies can fire reps without cause, even while they are promoting themselves as an independent distributorship which a person owns. That should be impossible. It should be one way or the other. You have employment at will, or you have independent distributors, but if so, they should be able to be terminated for cause only and with sensible appeal procedures.
In other words, by requiring some standards of operation, a certain decent style of operating is encouraged, which makes abusive practices less likely. Some of the agreements that are now common are more suggestive of indentured servitude than an independent business relationship of equals before the law, and abusive practices breed... more abusive practices.
One important issue is that there should be required training in product knowledge and understanding of the applicable laws for any reps, and it could be made mandatory to include certain training. Today, it can all be done online, so it is no big burden. This could be part of an annual requalification, and companies should be required to offer this free of charge.
It's about damages
The only rationale for regulation is the prevention of damages. In a Ponzi, the damages are clearer than in a Pyramid case, but they are equally predictable to the extent that there is investment in any form. If there are no damages, there is no case in principle, except damages are hard to prove if they are widely dispersed, as they are in MLM. Mathematically, damages are completely predictable for over 90% of participants. Therefore, once the problem is understood, regulation is in order.
The damages are of three kinds:
- Outright money spent starting from the initial kit, and related business expenses, which is $60 in Herbalife but as high as $500 or more in other cases. In the Herbalife case, there is also a wholesale premium until you reach a level where you can start to make more money - this is part of the cash "investment." Likewise in the Herbalife nutrition club training program, there is mandatory consumption of a significant number of diet shakes in order to qualify; this is all part of the investment. From what we've been shown, it can run as high as $3,000 and is totally undisclosed.
- Various related business expenses, attending meetings, trainings, etc. Specifically, it should be noted that the widespread misleading earnings hype sets people up to overspend, and that's how we hear the stories of people losing thousands and sometimes tens of thousands of dollars. Again deception drives the engine, and needs to be eliminated.
- The opportunity cost of the time, and reputation. If in franchising the joke was that people paid for a job, in MLM it is insidious. 99% of people are permanently under water, and never recover what they put in. And then in the end, most end up in the NFL league - No Friends Left - to the extent that they exposed friends and family to the deceptive claims of a fraudulent business proposal.
Finally, there is the RICO aspect, to the extent that organizations knowingly promote frauds, they are criminal conspiracies, and they incite their members to criminal behavior, while maintaining the illusion of plausible deniability behind the construct of "independent distributorships." This issue needs to be addressed categorically, so that everyone knows that if the companies teach them to lie and deceive, they are criminally liable.
The sane way towards the future of MLM is that it should be geared to enable fans of a product to make some money marketing it, if they so choose. Some products and services do lend themselves to a person-to-person approach. And, of course, it should be possible for people to build themselves up to become trainers, and leaders and trainers of trainers, and so on, but it should be much less steep than it is today, for today's typical structure breeds abuse by putting too much incentive at the top.
As it applies to Herbalife
Anyone can go back to the two websites Pershing Square has created to document the issues at Herbalife. Here is just a listing of some of the potential issues in the Herbalife model as has been documented until now.
- False income claims, driving a money game that funnels money to the top from the assured failure of the vast majority of those below. This is a key feature. A top-heavy system by definition preys on the predictable failure of those below.
- Misleading product claims.
- Inventory loading, supposedly countered by a new and improved return policy, without regard to all the factors that ensure little product will ever be returned, including instructions to nutrition clubs to open their product right away.
- Misclassifying "recruiting sales" as regular, unencumbered retail sales, specifically in the nutrition club format, and the "training programs" for aspiring operators of nutrition clubs, which merely surreptitiously drive product consumption.
- Generally, an absence of bonafide, unencumbered retail sales.
- Potential violations of labor laws in the context of the nutrition clubs.
- In terms of preventable damages, to make the 71% who are allegedly not interested in the business pay $60 for a membership is absurd on the face of it. Offer them free "preferred customer" type arrangements, and give them the option to decide later if they want to become a distributor. If they pay the $60 and are bound to the agreement, they're reps, not "members" of the Herbalife discount club.
Evidently, there are potentially many other issues at Herbalife, but these may be the main ones that are relevant to considering MLM-regulatory measures.
Hopefully the FTC is mobilized to address the issues. The very fact of the June 9th conference call lends credence to that idea. They have a unique opportunity to clean up a long track record of ambiguous rule-making which has allowed MLM companies to become exchange-listed and the concept to be exported to other countries.
The difficulty will be to capture the essence of the MLM dynamics that drive fraudulent claims and behaviors and create the track record of losses that many people have experienced, without getting bogged down in detail. Clear and simple regulation is needed.
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.