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Summary

  • Likelihood of RICO prosecutions becomes clearer.
  • Investment fundamentals are deteriorating.
  • Foreign governments increasingly are taking action, showing up the FTC and SEC.

Herbalife (NYSE:HLF) remains in the financial news as the deteriorating results are causing the stock to start to fall in line with the waves of criticism that came by way of the Pershing Square short.

The ongoing challenge now is understanding the prosecutorial and regulatory developments around the company, although it is very easy if you focus on the final outcome, as any good value investor would, for inevitably the market will catch up to the obvious. This is the reason for (most likely) Pershing Square rolling over its 2015 puts to 2016, allowing for time, but not doubting the result. It is also the reason why some think Mr. Icahn is increasingly likely to be hoist on his own petard, as I also suggested in my first article on Herbalife on this site, here. Needless to say, there are some hopefuls out there who think the Icahn/Stiritz camp will prevail.

The RICO strategy, unproven yet full of promise

The fundamental construct of MLM is of "independent distributorships" creating a moat of "plausible deniability" around companies that perfectly well know what is going to happen, for their business plans assume that it will happen. They can keep up appearances for a long time by occasionally ridding themselves of some bad apples, or banning some methods that generate too much heat, as Herbalife did with lead generation. The RICO - criminal conspiracy - approach to MLM was developed by the father of the RICO statute, Robert Blakey, in the context of the Procter & Gamble lawsuit against Amway, over the rumor it was spreading that P&G was an instrument of the devil.

The RICO approach did not do wonders for P&G in that case, but it lives on, and is likely to produce results sooner than later. There is a class-action cum RICO suit going on against MLM company Ignite/Stream. And now there is a new analysis from a superb investment analyst, Tom Salvatore, who is a frequent contributor in the comments around Herbalife on this site, but has published about it on his own blog. Tom uses the analogy of what happened in pharmaceuticals, and how RICO prosecutions were successfully used, and how and why they might be used the same way against Herbalife or MLM in general. His arguments are very powerful indeed, and very suggestive of some of the likely turns we might yet have to look forward to in the Herbalife story. After Herbalife, the entire industry will have to come to grips with the same issues, for a conspiratorial pattern has become the norm. A whole plethora of ancillary service industry has sprung up and some of them are MLMs themselves.

Deteriorating prospects: A Ponzi on top of a pyramid?

All too often the bond market is more exacting in its analytical rigor than the stock market, and indeed the adventures of the HLF convertible that was created to prop up the stock in the face of nasty but 'entirely unfounded' allegations (or so the bond holders might be led to believe), mean that the bond market effectively has rendered the economic judgment that said offering was possibly a Ponzi scheme, to the extent that the underlying business might not have the capability of repaying investors from earnings, but in this case, raising more money the same way seems unlikely because the deteriorating prospects are out in the open. Of course management is entitled to believe that the sneak attack by Darth Vader (excuse me: Bill Ackman), was without merit, and ignore the fact that they've tacitly acknowledged some of the issues he raised, and have been furiously making changes to correct some of the most obvious abuses.

Foreign governments likely to beat the FTC and SEC to the punch

India may have released the CEO of Amway India on bail, but the case is far from over. China has been repeatedly looking into MLMs and has some of the tightest regulations around. And clearly the ruling in Italy against Vemma, may be a harbinger of things to come. Vemma again was the company where one of the top talents of Herbalife went after his lead generation methods were outlawed at Herbalife. In short, to the extent that MLM companies have used the stock market to gain credibility, and expand their con-game around the world, foreign governments and regulators are now serving notice that this may not always be appreciated.

The recent Telexfree shutdown has also set off a growing sense of urgency internationally to not let the situation get out of hand any further. Everything says this is going way beyond just US regulators, the unfettered growth of these scams has long since become an international problem, and, interestingly, ethnic targeting is one of the themes.

Focusing on the forest, not the trees

The winding history of case law, and regulatory failure, culminated in such hit episodes as a lawyer, Timothy Muris, whose former firm represented Amway, running the FTC under Bush Jr., and staffing up with other defenders of prohibited schemes. That time may be coming to an end for the foreign pressure will grow, and make it impossible to avoid dealing with this political hot potato for much longer.

Dodging bullets is not a long-term business strategy

When the MLM industry gained an exemption from the FTC's Revised Business Opportunity Rule, this involved a lot of political arm twisting, and it defied common sense. Anything that is legitimately a good deal will still be so seven days later, and earnings disclosures and transparency should be the best tools of business unless the intent is to deceive.

It only stands to reason that the extreme abuses that are now being reported in the case of Herbalife still have to be validated by regulators, investigators and prosecutors, but once that is done and appropriate actions taken, the FTC would surely have to look into serious regulation, and reversing the said exemption might be a first step. There is indeed a risk, as Tom Salvatore points out in the article referenced above (about RICO), that the abuses of Herbalife are so extreme that it provides the rest of the industry with some cover, but I don't think that is a likely outcome. Especially since the appearance of E. Robert Smith's whistleblower novel, Downline... an intolerable potential to deceive, the climate has changed. It is furthermore clear that it is an industry problem, although naturally some companies are worse than others.

The fact is so-called "MLM-lawyers" have made dodging regulatory bullets into an art form, which has not been conducive to a stable business environment, and companies' reliance on deception, actionable or otherwise, likewise has not created long-term stability either. Amway entered into another settlement ($150 million that time) in 2010, and seems to have another class-action suit brewing now.

Back to the future

The future of MLM will of necessity look more like direct sales than MLM, although variations might be possible. What will matter most is that any regulation does not kill off those parts of the industry that might be viable. Was MCI's "Friends and Family" illegal, immoral, or unethical? I don't think so. It was a great idea. The basic principles should be clear:

  • If the opportunity sells the product, that's likely illegal.
  • If the product sells the opportunity, that's most likely legal.
  • If "unlimited income opportunity" is being promoted, that's a blatant lie. Nothing is unlimited, and markets are not infinite.
  • Withholding information is not OK. Companies should volunteer to adopt the FTC's RBOR even now.
  • Building sales teams is OK, and so is earning overrides.
  • If compensation favors recruiting over sales, the plan is a rip-off, and the only way people would stand for it is if they were lied to about the opportunity (as is almost universally the case today). Under appropriate disclosures these kinds of misrepresentations should be impossible.

Investment outlook, HLF and other MLMs

I've argued here recently that if you can't make up your mind about Pershing Square's piles of evidence, and want to be agnostic about the outcomes, even then, on the basis of pure probability, HLF is more likely a $30 stock than a $50 or $60 stock. The recent articles by "Shock Exchange" (referenced above) on this site point in the same direction. And, for all the reasons discussed here, and in other articles, any regulatory action and/or prosecutions are unlikely to stay confined to HLF for too long, for the FTC can hardly keep closing its eyes to the fact that it is dealing with an entire industry that is violating section 5 of the FTC regulations almost without exception, as Dave Ritchie rightly argues here.

Accordingly, Herbalife will likely be the start, but hardly the finish of the challenges for MLM until one way or another a new regulatory framework is established, after which the MLM-industry will have more in common with the direct-sales industry of years past than with the faux-business opportunity it has become.

Conclusion

Regardless of the unending noise to the contrary, the noose around Herbalife is tightening, and it seems virtually assured that the whole MLM industry is going to see more stringent regulation. Sooner would be better than later, for uncertainty is the biggest enemy of business, and the international community dislikes MLM only slightly less than tobacco.

Change will in part come from within the industry as some companies are indeed experimenting with newer models, even if they don't always successfully avoid the problems of the past. Examples I've mentioned earlier include "preferred customer" programs, which are free in many companies now, and don't involve either complicated agreements or up-front fees, as with Herbalife. There can be no doubt the industry is changing, even ahead of regulations. New regulations will just speed up the change.

Lastly, if you're not convinced by the recent options move, apparently by Pershing Square, go back and watch Bill Ackman's presentations. The other shoe has already dropped, on July 22nd, but the unwinding will come after the break, and the break may be longer than average since the agencies involved have to digest the information before they can act on it.

Source: Herbalife: Enough Is Enough

Additional disclosure: The author has has 30 years of exposure to the industry and occasional involvement, and has been a user of some MLM products off and on for 20 years, without necessarily always promoting them, or the attendant "business opportunity." The author has at least once developed an MLM/Direct Sales business plan and believes on working for change within the industry.