Herbalife (NYSE:HLF) finished a surprising recent run-up with a slightly down close last Friday, but resumed its climb on Monday. Nothing in the reports warrants the recent run-up, except if someone were attempting to orchestrate a short squeeze based on the dubious reporting on "talks" with the FTC, which has been over-hyped by all the usual suspects - cheerleaders masquerading as 'analysts.'
The company's language on the talks with the FTC was neutral, but the subsequent hype was not, and the whole episode was put in perspective by Quoth the Raven, here. It is by no means clear that this reports indicates a positive outcome for the company. If indeed FTC files a complaint that is contested by the company, we're in for the long haul, except the rats will start leaving the sinking ship, and that could get ugly quickly. For reference the relatively quick implosion at Vemma could serve as a guide, but it will be worse for Herbalife - the latest results were neatly summarized in a tweet, here:
The last few days we have seen the futile argumentation from a stubborn, but well-argued long, Old Analyst, here, and a very matter of fact assessment on why it's time to dump Herbalife while the dumping is good, from Terrier Investing, here. If we were to do a deeper look behind the headlines, nothing much good emerges. Moreover, aside from the one long argument, there have been many recent articles here on SA alone, including Whitney Tilson's report (Herbalife's Shocking Confession) of the outrageous mix-up in management reporting at Herbalife, which had painted a completely illusory picture of growth, and which may yet trigger the curiosity of the SEC.
Analytically, even if an acceptable financial performance was reported, looking just below the surface, the growth of the business is stalling, and the excessive exposure to China would be a real concern. Venezuela is off the map for the foreseeable future. In other words, it simply does not wash to simply project out the financial results into the distant future, and ignore the dark clouds everywhere in view. Only a dwindling number of cheerleaders, with fund manager John Hempton for a chorus, are even attempting to support the stock. Carl Icahn remains stuck with no way out. Bill Stiritz is already halfway out of his position, and if he's smart, he'll be all the way out before long.
The structural problem of the MLM industry
Most recently Robert FitzPatrick provided a very comprehensive article here on SA, documenting how the MLM industry is starting to implode in on itself. In earlier articles I have also pointed out that if you take the list from the DSN (Direct Selling News) Global 100, you will see that the growth is in the younger companies, and stagnation and decline overwhelmingly prevails at the top. This is an industry that is increasingly cannibalizing itself.
NY Senator Klein pursues legislative option
Recently the announcement of the proposed MLM legislation by NY Senator Klein got some attention in the press, as Bloomberg, among others, reported on it here. While the proposed legislation is hardly ideal, it would probably be reasonably effective, because it provides specific enforcement tools. In the process it really shows the FTC and other federal agencies, that where they fail, eventually the states will step in, for they cannot possibly tolerate the ongoing abuse of the citizenry by the MLM/pyramid scheme racket.
There is a lot to be said for the matter-of-factness of the Klein proposal, for it eliminates a lot of opportunity for fraud, requiring a truthful disclosure document co be submitted to the department of law, including six data points, which would preclude a lot of MLM's typical lying by omission:
- the total number of agents, contractors, or distributors said company had in the state;
- the number of new of agents, contractors, or distributors added by said company in the state;
- the total sales generated by agents, contractors, or distributors of said company in the state;
- the number and percent of sales generated by purchases made by agents, contractors, or distributors of said company in the state;
- the number and percent of sales generated by purchases made by persons who are not agents, contractors, or distributors of said company in the state;
- the average and median amount of income earned by agents, contractors, or distributors of said company in the state;
The bad news about this proposal is that by its casual use of the undefined term "multilevel distribution companies," it leaves a lot of ambiguity because once again, just like the FTC's Amway '79 ruling it allows for the possibility that MLM companies - aty least conditionally - may be legal and not be pyramid schemes, because only some companies have problems. In other words, once you do understand that MLM is simply a construct that is purpose-designed to make a pyramid scheme look like an actual sales or distribution business, it is unhelpful to shift the attention to regulating the fraud, even if it is simply because the federal government fails to enforce the laws. In other words, it legitimizes the MLM concept by implication, and to that extent it increases the confusion, and further blunts the already muddled legislative landscape around the MLM issue.
The use of the undefined term "multi-level distribution companies" creates further unnecessary confusion. MLM companies will make their usual effort to call themselves something else, just like Maleleuca has done in recent years, and also Vemma was attempting to do prior to the FTC's action against it, by calling itself an affiliate marketing company, and comparing itself to Amazon.com - even if it was to no avail in the end.
Assuming someone were proposing to include a definition of the term before this proposal turns into law, it would have to be clear that this is about companies that allow limitless recruiting, and whose compensation structures favors recruiting over retail, in other words, pyramid schemes. Then again, if pyramid schemes are illegal, but nobody is prosecuting them, what might more laws accomplish? After all, in New York State, AG Schneiderman has studiously avoided the blatantly obvious pyramid scheme that is Herbalife. If that definition is not clarified, almost every direct sales force could possibly be construed to fall under this rule, including real estate and insurance agencies. They all have multiple levels... as the rule is now written it has the same problem of Justice Potter Stewart's definition of pornography: "I know it when I see it."
Aside from that objection however, the pragmatism of this proposal probably has some merit, and will serve to prevent a lot of problems. One could only hope that it would prompt federal action to deal with this unprecedented forty year corporate crime spree once and for all. When all is said and done, an MLM/pyramid scheme remains little else but a Ponzi scheme on the installment program for people who don't have readily investable cash... Therefore, by definition, it targets people in financial distress, and induces them to lose money they mostly don't even own, which is the reason for the outrageous losses that we have seen.
Chicago and New York count victims...
Currently both New York and Chicago are producing a growing list of victims, as a result of the work of LULAC in Chicago, and Make The Road in New York, in collaboration with NY State Senator Klein and NY City Public Advocate Letitia James, through under cover investigations. The lossess are truly staggering in individual cases, especially with the Herbalife nutrition clubs.
Importantly, the symposium in Chicago included participation by FTC, SEC, FBI and the Illinois AG. The SEC's director of Enforcement, Andrew Ceresney gave a speech, (text on SEC website), which was a bit muddled on some points, but still reasonably straightforward in pointing out that if recruiting runs the show, you're likely dealing with a pyramid scheme. It is unfortunate that Ceresney still obfuscates the point that MLM could be legitimate if it distributes "real products," which is an evident absurdity, since clearly a pyramid scheme is a financial crime, which has nothing to do with what the products are, but with the compensation structure. If in doubt, see the Vemma case - although that was brought by the FTC, so we can be assured that the FTC gets it, even if the SEC is lost in the woods. On the plus side, the SEC reports bringing 11 pyramid prosecutions since 2012, but the selection of cases makes it clear that they've gone after schemes with very fuzzy products, and have largely ignored the main stream MLM/pyramid schemes, and leaving that to the FTC. In other words, the SEC has not learned anything from the Madoff affair, and are still protecting the crooks from the public, instead of the public from the crooks by their selective prosecutions.
Putting together the outcomes from the events in Chicago and New York together, the upshot is that significant forces are mobilizing against this multi-generational program that produces nothing but losses upon losses for over 95% of people who get involved. NY AG Eric Schneiderman may have been MIA in this matter - with indirect ties to Herbalife through his ex-wife and SKDKnickerbocker lobbyist for Herbalife - Jennifer Cunningham. CA AG Kamala Harris likewise may have been MIA, with a similar connection because her husband's law firm has done work for Herbalife, nevertheless the end is in sight, because the population is not taking it any more, and the grass roots politicians are feeling the heat.
I just recently became aware of another leader in my community who told me that twenty years ago he was involved in Amway and Herbalife and lost "thousands." It all adds up. MLM is running out of places to hide, and there is a credible case to be made that criminal prosecutions may be now be possible, even besides the regulatory actions.
One precedent that is worth studying was recently reported by Robert L. FitzPatrick in one of his newsletters, here:
Can Participation in a MLM Be Evidence of Criminal Behavior?
That participating in a MLM carries risk is well established, including financial loss (99% of consumers never make a profit in MLM), liability for losses of those recruited, and clawback court orders to return "profits" when the scheme is prosecuted. These financial risks are in addition to the social and psychological jeopardy associated with commercializing friendships and family and becoming deluded by the "endless chain" proposition.
But, could an individual's involvement as a bottom-level "distributor" in a large, prominent MLM ever be treated by the federal government as per se indicator of personal criminality? Could solicitation of recruits be used by the federal government against a person in a court of law to claim criminal intent or bad character, deny bond or impose greater punishment?
It would appear this is what happened in a federal court case (United States of America vs. Andrew S. Mackey and Inger L. Jense, Criminal Indictment: No 1:10-CR-310-WSD-JFK) heard in 2012 in the US District Court, Atlanta Division, in which the defendant's involvement as an entry level distributor in MLM was cited by the Dept. of Justice as damning evidence that may have influenced his ability to get bond or even have affected his sentencing.
The personal risks all consumers face in MLM, the current Wall Street war over Herbalife's legality, and the case cited here in which the question of a MLM's legality affects an individual's treatment by the government in a criminal case are all the result of the FTC's failure to distinguish legitimate direct selling from pyramid recruiting fraud.
Other related developments
The pursuit by Elizabeth Warren of Primerica and upcoming new fiduciary regulations for the financial industry skidded right past the pyramid scheme issue, but shines an interesting light on the innate conflict of interest that is created by the MLM system, in which business is really done by institutionalized bribery, which in this case clearly compromised the integrity of the advice with respect to financial products.
Meanwhile an interesting article on the involvement of sports figures in Advocare offers many interesting parallels to Herbalife. Last, but not least there is some tantalizing new insider information on Herbalife being reported here. From the looks of it, that could be explosive.
Regulatory capture is the norm, not the exception
As demonstrated by the drama in Flint, regulatory capture is a general problem, and should not surprise us. If there are no major scandals for awhile, all regulators tend to become complacent, and such inattention often creates a false impression that things are working, when the opposite is the case.
It is now the turn of the MLM issue to come to the surface, and there is every indication that today's FTC gets it. We can't un-ring the bell any more. Too much has been published, and even now we see new, and potentially very damaging evidence against Herbalife coming to the surface with regularity. The SEC may as be as much a captive regulator as the FTC has been in the past, but even so, the string of pyramid schemes it has recently shut down is impressive, and given that their participation in the Chicago event exposed them to the tales of Herbalife victims, it is not too late for the agency to change course, and take action, and stop being bamboozled by the products, and focus on the financial crime, as they should.
If in doubt as to how regulatory capture works, a review of Tammany Hall is in order, and a recent new book by Richard Zack: Island of Vice: Theodore Roosevelt's Quest to Clean Up Sin-Loving New York - would help anyone to see that regulatory capture is very normal. As an example, one NYC police captain in 1890 collecting thousands every month in bribes from brothels in his district is a remarkable achievement... today regulatory jobs are a portal for lucrative careers in rackets like Herbalife, as we can see before our eyes.
In spite of Herbalife's ability to continue putting out financial reports in which the casual observer may not see the deterioration, the mess with the misreported growth figures alone demonstrates that there is no credible growth story here. What there is, is wave upon wave of damning information against Herbalife coming to the surface almost continuously, and a significant amount of corollary information on other MLM/pyramid scheme companies. While it is always possible that the FTC would cave in and snatch defeat from the jaws of victory, it seems increasingly unlikely. And the SEC has been given a new opportunity with the misreporting of growth figures by Herbalife management. Today's elevated stock price may be one of the last opportunities to sell out without ripping your shirt.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.