Zeek's Criminal Fraud Case Raises Prospects For More Herbalife Charges

| About: Herbalife Ltd. (HLF)

Summary

US Justice Dept. gained a guilty verdict on criminal fraud charges against the CEO of the country's fastest growing MLM, Zeek Rewards. Zeek had MLM support and extensive legal window-dressing.

Fraud charges against Zeek mirror the FTC's Herbalife complaint of deception and consumer harm. The Zeek trial and conviction raise the specter of criminal charges against Herbalife officials.

Government findings in the Zeek and Herbalife cases are essentially the same. Both companies used deception and both gained revenue not from sales, but from recruiting.

In both cases, the government prosecutors eschewed proving a pyramid or ponzi and focused instead on the factors of required purchases, false income claims, rewards for recruiting and consumer harm.

With the FTC establishing that Herbalife's "sales" are based on reward promises and recruiting not retailing, Herbalife will now have to rewrite SEC filings and create a whole new tale.

As an interested observer, I sat in on much of the recent criminal fraud trial of Paul Burks, co-founder of the fastest growing multi-level marketing, aka MLM, company the world has ever seen. The two-week trial laid out the details of his MLM enterprise, called Zeek Rewards, which he proudly told to the jury was "historic" for its "growth." In this essay, I offer a first person report of the trial and my eerie encounter with Herbalife (NYSE:HLF) while in the courtroom.

Before this trial and before Zeek had been shut down under an agreement with the SEC, the company drew in an incredible one million adherents and nearly a billion dollars in revenue in less than two years. It attracted high profile MLM sales trainers and marketing promoters, including famous MLM legal experts, Kevin Grimes and Gerald Nehra, who effectively gave it a blessing of legality.

In 2010, Grimes' law firm received Direct Selling Association's Partnership Award. The DSA stated:

Grimes & Reese's expertise in the industry is highlighted by the fact that in all of the major FTC pyramid scheme actions brought against direct sellers in the past decade the defendants have sought out their firm for representation. They have a truly unique understanding of legal expertise, marketing practices, compensation plan operation and industry ethics that enables them to provide legal services to direct sellers that other law firms simply cannot match."

Grimes used to be the in-house attorney for the MLM company, Melaleuca. He counts among his MLM clients the industry stalwarts such as Herbalife, Take Shape for Life/Medifast (NYSE:MED), Usana (NYSE:USNA) and Donald Trump's previous MLM, "Trump Network." With Grimes in charge of Zeek's "legal compliance" Zeek couldn't get more legit in the MLM world.

So it seemed. At the end of the trial on July 21, the jury took only two hours to find Burks guilty of criminal fraud for running Zeek. He now faces decades of prison time. Grimes, meanwhile, has sailed on. He has joined the law firm of Kevin Thompson, a newer legal face of MLM promotion and a vocal defender of Herbalife's legality in Seeking Alpha.

Clammy Feeling

As I took notes during trial proceedings in the federal courthouse in Charlotte where I live, I felt a strangely palpable but invisible presence in the courtroom. Like a paranormal phenomenon, I sensed the spirit of Herbalife. Was it an omen of things to come?

The clammy feeling was perhaps conjured by an irksome question that is surely occurring to other observers. Why did the US Dept. of Justice decide to put MLM CEO Paul Burks in prison for running a MLM Ponzi/pyramid scheme, while the government has so far treated Herbalife's wrongdoings as mere civil offenses resulting only in an FTC claim of "unfair and deceptive trade practices" and only against the company, not its CEO?

At the very same time that Zeek's founder was ordered to trade his business suit for prison stripes the FTC announced its settlement with Herbalife. Comparing the indictment document and the evidence at Burks' trial with the FTC's Complaint against Herbalife, it is obvious that the FTC documented the same kinds of deception and public injury by Herbalife that the DOJ is locking up Mr. Burks for, except perpetrated on a vastly larger scale by Herbalife. How is this equitable justice, or is more justice coming for Herbalife and its CEO?

Under the consent order with the FTC, Herbalife escaped the "P" (pyramid/Ponzi) curse, but the Zeek prosecution raises the prospect that something more serious could follow - the "F" bomb, i.e., Fraud, as in criminal fraud.

What's the Real Business?

It might reasonably be thought that there is some fundamental difference in the core businesses of these two MLMs to account for the disparate legal treatment by the government, that is to say, some reason other than Herbalife's having more money and friends in high places than the ill-fated Zeek did. Burks' closest ally turned state's witness against the company. Herbalife's CEO has former Secretary of State Madeleine Albright and the former chairman of the FTC, Jon Leibowitz, now on his payroll to protect against law enforcement.

Zeek's supposed core business was an online "penny auction" called Zeekler. Herbalife's real business is supposedly person-to-person selling of protein powder drinks. Selling weight loss drinks door-to-door might appear an insane way to try to make money but on its face, it might seem more legitimate than Penny auctions, which might qualify as a red flag for regulators. The FTC has issued consumer warnings about these dodgy auctions, often compared to gambling in which consumers might find bargains at the auction but lose money from the cost of "bids."

But there are many such auction schemes online and Burks' was not a particularly large or even successful one. It would not attract DOJ or SEC attention, just as door-to-door selling of Herbalife's innocuous commodity product (if it ever happened) was not what aroused investigations by FTC, DOJ or SEC.

It was only when Burks, a veteran MLMer, and his colleagues brought the famous MLM recruiting rewards to the penny auction world that hundreds of thousands of people suddenly began to "love" Burks' auction. When millions of dollars a week began pouring into this little office in Lexington NC, Burks accelerated the momentum by proclaiming his auction to be the common man's financial salvation, just as Madeleine Albright - for pay - proclaims that Herbalife spreads global prosperity.

Burks also assured its beneficiaries that it was perfectly legal, because the company was part of the "MLM industry," right in there with the likes of Amway, Nu Skin (NYSE:NUS), and Melaleuca, all of which were mentioned during the trial. Zeek said it was a "legal MLM," just as Herbalife made the very same claim. Reassured and excited, some people invested life savings or took loans on their homes to become "Affiliates" of Zeek's wondrous MLM. Faith in the American Dream was revived among thousands of followers who displayed the same hope and enthusiasm at Zeek's "Red Carpet" events as immigrants and struggling young people do at Herbalife "Extravaganzas."

Common Identity

Unfortunately for Burks, the SEC and the DOJ realized that Zeek's phenomenal rise had nothing to do with penny auctions and everything to do with its MLM reward scheme. It turned out that less than 2% of Zeek's revenue came from auction transactions. All the rest came from "Affiliates" buying "bids" for the MLM reward plan where they were recycled as "shared profits" from last to join to first.

Herbalife's business was similarly revealed by the FTC in its nearly two-year investigation. The extraordinary growth of Herbalife had little or nothing to do with individuals selling ordinary and ridiculously overpriced protein powder canisters. Herbalife's "product" is not what the company really sells, the FTC discovered. Indeed purchases of Herbalife goods by its distributors cannot even be legitimately called "sales." They are required financial transactions to participate in the income scheme. There is little retail-priced demand for the goods and those who would try to make money from selling them at retail do not and cannot succeed, the FTC stated.

All the money in Herbalife is in recruiting and leveraging the funds of later recruits, resulting in success being limited to a tiny few at the top of the recruiting chain, the FTC concluded. All other participants are doomed to financial loss and their enormous losses are well documented. To stop the deception and all the harm it causes, the FTC ordered Herbalife to fundamentally change the reward plan to prevent "required" purchasing and to stop paying for recruiting, among other corrective measures.

Thus, after separately probing their respective "businesses" - portrayed by each CEO as EveryMan's financial salvation - FTC and DOJ investigators of Herbalife and Zeek came to identical conclusions, though only one prompted criminal fraud charges. In both cases, the regulators concluded that the core businesses operate as fronts. The actual business is the same for both enterprises - pyramid recruiting and money transfers. Herbalife and Zeek are united by their common MLM reward plans which caused both enterprises to engage in the same forms of deception and to cause large-scale harm to their believers.

Different by Degree

Ironically, the trial did reveal two significant differences between Zeek and Herbalife that make the respective legal actions against their CEOs even more inexplicable. A significantly smaller proportion of Zeek's total participants actually lost money than Herbalife's did, and Zeek paid more of its total revenue out in rewards than Herbalife did. About 88% of all of Zeek's total participants during its entire tenure lost money, the SEC concluded. Losers in Herbalife, over its 30-year span are virtually 100%, and the total number of people harmed by Herbalife dwarfs Zeek's victim count. Burks paid out 55% of Zeek's total revenues to "affiliates" in rewards. Only 38% of Herbalife's sales revenue was transferred. Zeek, it turns out, did far less harm to the public than Herbalife has been doing.

"P" Words Redacted

Beyond a shared core business of pyramid recruiting and Ponzi money transfers, the DOJ's courtroom strategy against Zeek and the FTC's against Herbalife were remarkably similar, as were the respective defenses of the two MLMs.

Both of these MLM companies, for example, vehemently protested the "P" label (for Pyramid/Ponzi). At the trial, Zeek's defense attorneys convinced the federal judge that the copy of the indictment given to jurors when they went into verdict deliberations would have the "P" words redacted. They argued that the terms are "prejudicial" and emotional. When jurors retired for a verdict, they never saw the term, ponzi, in print.

Herbalife, it is reported, achieved a similar success by somehow "negotiating" with the FTC to redact the same words from the FTC Complaint. Detailed evidence including types of deception and resulting consumer harm of a pyramid scheme were vividly presented in the FTC Complaint against Herbalife, yet the words, pyramid or Ponzi, were nowhere in the text.

The Herbalife/Zeek strategies of keeping the curse of "P" from official documents is integral to all MLMs' disguise and game of words, but in these two cases it did not change results. However, because Herbalife's CEO was not put under arrest, he and his company have been allowed to claim the absence of the word means absence of the fact. Burks did not get the chance for such guileful duplicity.

In the end, it appears that federal regulators and prosecutors did not care so much about these words. Apparently, on their own they concluded that proving a pyramid or ponzi is a no-win zone due to the lack of legal clarity. Moreover, both apparently realized that proving a pyramid is not necessary to stopping one or even to jailing the leader. The jury needed just a couple of hours to bring back guilty verdicts on Zeek's CEO.

Over at Herbalife, after three years of making aggressive, sometimes threatening and absolute claims that it was "perfectly legal" and would be "totally" exonerated, Herbalife capitulated to comprehensive and humiliating changes and penalties: to end all deception about income claims; to ban its incentives for pyramid recruiting over retailing; to stop tying purchases to promises of future rewards; and to pay $200 million restitution to "victims." The FTC achieved this without bothering to claim Herbalife's income deceptions, recruiting trickery, and inflicted consumer losses all added up to a technical "pyramid scheme."

"F" Trumps "P"

I asked one of the government's prosecuting attorneys at the Zeek trial, Assistant U.S. Attorney Jenny Sugar, why she had not called to the stand her retained expert in the Zeek case, Dr. Peter Vandernat, recently retired from the FTC where he served as in-house pyramid expert. She told me her DOJ team chose not to prove that Zeek is a Ponzi, only that Burks "used deception to get money from people," resulting in harm to them, that is, the essential elements of criminal fraud.

The other DOJ attorney in the trial, Corey Ellis, explained to me the complication that there is no federal law against Ponzi or pyramid schemes. However, he noted, the deception that is employed to perpetrate a Ponzi is illegal when it leads to harm, and federal criminal statutes do cover that wrongdoing. In order to bring its criminal fraud case, the government only had to show deliberate deception used in getting people's money and to document the resulting harm to them. Additionally, it showed that the scheme was a conspiracy that used mail and wire (phone and internet) services to carry out the fraud.

The FTC took a nearly identical legal approach to Herbalife. It focused on the practices used by MLM pyramids. These practices are steeped in outrageous deception and inexorably result in massive consumer harm, as only a tiny percentage of participants could ever recoup their investments, and those practices are illegal on their own merit.

Gurus for Hire and Better-Call-Saul

Herbalife and Zeek are also linked in spirit by shared supportive figures from the "MLM industry" - MLM accountants playing prominent roles, and bloggers and publicists who touted both enterprises as legal and virtuous before prosecutions are announced. The well known MLM "leads" generator and sales trainer Peter Mingils, for example, was brought to the stand by the Zeek defense for his paid role in "training" Zeek followers. After this testimony, government prosecutors did not even bother to question him.

Nevertheless, Zeek's attorneys based much of Burks' defense at the trial on Zeek's paid support from such famous pro-MLM "experts," attorneys, marketing gurus, and sales trainers. The closing arguments from the defense listed some of the MLM "experts" that Zeek employed as "proof" of Zeek's legitimacy. For example, it was noted that ubiquitous MLM hypester, Troy Dooley worked for the scheme. MLM marketer, Keith Laggos helped craft the Zeek story and reshape wording. Laggos was charged in 2004 by the SEC for deceptively promoting another MLM for pay. Famous MLM attorney, Gerald Nehra who previously served as in-house counsel for Amway, was touted by the defense for his legal work for Zeek. Nehra later confessed that Zeek was a pyramid and for lending his "MLM expertise" he agreed to pay a fine of $100,000.

Of course, there were common ties to the MLM lobbying group, the Direct Selling Association, keeper of that sacred covenant, the DSA "Code of Ethics." Herbalife is on the DSA Board and Zeek was shielded by claims of legitimacy by its DSA-award winning attorney and compliance officer, Kevin Grimes, now part of a rising MLM legal defense team with Kevin Thompson. The two met while Grimes was representing a former Amway kingpin that had defected to the miracle fruit-juice MLM, MonaVie, now defunct. Thompson was in-house counsel for the MonaVie kingpin. MonaVie had extensive legal and regulatory battles over pyramid scheme and false medical claims before defaulting on a nearly $200 million debt and then disappearing.

Now with Zeek closed and its CEO awaiting sentencing, some of these "industry" figures who hyped and propped up Zeek have been sued by the federal receiver who is "clawing back" Zeek payments and redistributing over $300 million to victims. Kevin Grimes agreed to repay more than $1 million, for instance.

On the other hand, those industry figures who have been loudly and confidently telling investors, media and consumers that Herbalife was "perfectly legal" and would be given a clean bill of health just keep on with their myth-making.

Closed Market Swindle and Last Ones In Lose

In case you still feel my sensing the ethereal presence of Herbalife in the Zeek courtroom was a delusion or prejudice, let us drill down one step further to the legalistic factor at the center of both Zeek's criminal case and Herbalife's FTC investigation - the source of their money used for reward payments. Where does the money come from? the FTC asked of Herbalife. Is it from retail customers in the open market, or is it mostly coming directly from the same group of people Herbalife promised to pay in "royalties," the participants themselves?

The FTC discovered that virtually all the people paying in to Herbalife and those getting the rewards are inside the same closed network bound by the same contracts, restrictions and offered the same incentives to buy products for promised rewards. So how could everyone inside that contractually closed network take out more than they put in? The reward payments are drawn from their own money that is just being moved around from "members" to "members"! The "winners" are just getting the "losers" money. And, if extending or enlarging the recruiting chain is the only activity that leads to potential profit, then, sadly, the "last ones in" have to lose. Harm on an industrial scale is guaranteed.

With the fact now established by the FTC that Herbalife had no profitable external retail market, will the SEC weigh in? On all Herbalife SEC filings Herbalife has been claiming that the largest single source of income for its participants comes from the "distributor allowance," that is, the retail margin, which it lists as 50% of the retail selling price. It would appear that Herbalife has some rewriting and explaining to do with its investors and the SEC.

The plain truth is nobody really cared about the Zeek's silly penny auction, just as few consumers really want Herbalife's absurdly high priced powder - except for how the auction bids and the protein powder can serve as magical currencies for gaining "unlimited" rewards.

Fairy Tales and Games of Words

DOJ Prosecutor Corey Ellis began his closing argument to the jury with the statement, "Every fraud has a fairy tale." Zeek's, he explained, was about the most popular and profitable online auction the world had ever seen, able to generate 1.5% profit for its participants every day, forever and ever, i.e., a goose that lays golden eggs.

Herbalife's, he could have also said, is about a magical powder that cures all manner of ailments while also providing eternal and "unlimited income" to all those who pay to become "Supervisors" and find others to follow in their footsteps, i.e., a magic beanstalk leading to a treasure in the sky.

To maintain the fairy tales, both Herbalife and Zeek have relied on an elaborate game of words, which the MLM "industry" has made into an art form. As the FTC Complaint against Herbalife documented, when investigators began examining its operations Herbalife started renaming its independent contractors "members" (which is the opposite of independent contractor) but it resulted in no actual change. Earlier, Herbalife changed the title of most distributors to "discount buyers" (which is the opposite of a distributor) but it resulted in no actual change. Both word changes were to fool regulators about the money transfer and to hide from them the reality of a massive income scheme disguised as "direct selling."

Magical Retailing

The one word that both Herbalife and Zeek infused with the greatest of magical properties is "retail." Zeek banned the term "compounding" and began calling its system of rewards "retail profit points," RPP. In fact, profit was a euphemism for gross revenue while the word "retail" bore no connection to reality at all.

By falsely labeling funds gained from investors inside a closed network as "retail" revenue, and implying open and competitive purchase transactions based on consumer demand and preferences, Herbalife's and Zeek's remarkably similar wordsmithing cover over the true nature of consumer payments to their schemes. "Retail" hides the reality that the "purchases" are required payments to join the deceptive income plan, aka "pay to play."

While investigating Herbalife, researcher Christine Richard encountered the word game when she asked Latino participants at Herbalife "nutrition clubs" why they came to the clubs. Though some could barely speak English, they uniformly responded with the same word, "consumption." Consumption? Who talks like that? Someone had coached all these people on what to say and what not to say. ¿Comprende?

At Zeek, the government identified the person who trained Zeek followers on what to say to fool regulators, journalists and researchers. It was the DSA award-winning attorney, Kevin Grimes who personally signed "compliance" certificates.

Cross examining one Zeek graduate of Grimes' compliance training who was also a veteran MLMer, the government tried in vain to get him to say that he "put money in" at Zeek or gained a "return." Repeatedly, the Zeek-trained witness corrected the government attorney that he only made "purchases." He insisted that Zeek's "bids," which he admitted he never used in the auction, were MLM "products" and were "just like in Amway and Melaleuca," claiming that in those MLMs participants also don't have to sell or even use them.

Magicians

At age 69, poor old Paul Burks, the Zeek CEO, now awaits a prison sentence. The magical spell of his Zeek fairy tale has been broken. Herbalife CEO Michael Johnson, though, remains free and is still smiling. He still insists Herbalife is an enchanted enterprise even as the FTC confiscates his mirrors and smoke machine.

If the smiling Herbalife leader escapes further legal action while Burks spends his last days in jail, it may be due not just to the unequal wealth and political influence of their respective fairy tale enterprises but also to their unequal skills as magicians. Before founding Zeek, Burks did magic tricks for residents in nursing homes. Herbalife's CEO previously ran the Magic Kingdom for Disney.

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. I have no business relationship with any company whose stock is mentioned in this article.