The MLM Racket: Class Action Ruling Exposes Reality Of A 'Direct Selling' Pyramid Scheme

| About: Herbalife Ltd. (HLF)

Summary

A federal appeals court certification of "class action" status for the lawsuit against the MLM, Stream/Ignite, affects pyramid scheme claims against Herbalife and other MLMs.

The case establishes that the operation of a pyramid scheme is sufficient for "racketeering" charges, tripling the potential damages.

The ruling clarifies the reality that pyramid schemes are inherently deceptive, pre-ordaining participants to losses. The sales of products and other trappings of legitimacy are irrelevant to the outcome.

The ruling addresses the reality that all pyramid schemes are disguised, for the purpose of duping people to believe the scheme is "legitimate." People join Stream/Ignite in that belief.

The Stream ruling may awaken regulators and other authorities from uncritically accepting MLMs as "legitimate", and begin examining economic realities without prejudice or fear.

At this writing, end of November 2016, in the world of "multi-level marketing" most attention is focused on one MLM company, Herbalife (NYSE:HLF). This is mainly due to a 4-year Wall Street battle over Herbalife stock price and a 2-year FTC investigation leading to a prosecution announcement and simultaneous Settlement agreement. The Settlement requires a $200 million restitution payment by Herbalife and basic restructuring of its USA operations, affecting recruiting, participant purchases, retail selling and income claims.

One overriding issue lies at the heart of the Wall Street-Herbalife controversy, the FTC-Herbalife prosecution, and, whether stated or not, all other controversies, lawsuits, and prosecutions involving other MLMs such as Nu Skin (NYSE:NUS) or Usana (NYSE:USNA). That issue is "Pyramid Scheme." It is not possible that Herbalife is uniquely or anomalously operating a pyramid scheme, since all MLMs are based on the same recruiting business model, top-loaded compensation plan, and endless chain income proposition. All have the same loss, failure and churn rates among participants. The devastating and hilarious treatment of Herbalife by satirist John Oliver on HBO and Youtube (6.5 million views) extended the label of "pyramid scheme" across the entire MLM "industry."

In addressing this underlying and fundamental issue of inherent fraudulence, a recent US Fifth Circuit Appeals court ruling granting class action status to a lawsuit brought against another MLM, called Stream/Ignite, (Juan Ramon Torres; Eugene Robison, v. SGE Management, LLC. et al.,) may have greater and longer-term impact than all the heat and noise around Herbalife. The lawsuit, originated and driven by Houston attorney, Scott Clearman, argues that the MLM, Stream/Ignite is engaged in "racketeering," under the Racketeer Influenced and Corrupt Organizations Act, generally known as RICO. The racket's purpose, the case argues, is to perpetrate a pyramid scheme. To do this, it engages in mail and wire fraud. The RICO charge hinges on the underlying charge that Stream is a thinly disguised pyramid scheme. If a jury agrees with Clearman, penalties are tripled under the RICO law.

AARP submitted an amicus brief as did the consumer advocacy group, Truth in Advertising in support of the plaintiffs (MLM victims) in the case. Other reports of the ruling are in Bloomberg News and Dallas News. A good overview of the case is provided at the Truth in Advertising website.

Confusion, Vulnerability to Pyramid Fraud as the American Dream

While almost everyone claims to know in general what a pyramid scheme is, public understanding of this type of fraud diminishes sharply when a pyramid scheme is disguised as "direct selling" and includes selling products. Millions of people fall into this form of disguised pyramid fraud and the FTC has stated that the average person could not be expected to see through the "sales company" disguise. Even though such a disguised fraud will do more harm than a more obvious one would, due its disguise as a real business, the FTC and SEC, America's main regulatory agencies against business frauds, have closed down only about two dozen such schemes in 30 years. These few had wreaked enormous harm on an international scale, duping millions of victims and causing billions in consumer losses. Those MLMs that were prosecuted looked and acted just like the others that the FTC and SEC allow to operate with impunity. Neither agency has provided a usable guideline for legality. Two specific and inexplicable regulatory actions in 2016 reveal the regulatory breakdown:

1) The SEC forced the shutdown of the MLM, Zeek Rewards for operating a pyramid scheme. This was done in a Settlement agreement in which Zeek did not admit wrongdoing. Then, the Dept. of Justice prosecuted the CEO of Zeek, Paul Burks, for criminal fraud. The DOJ did not try to prove Zeek was a pyramid scheme but only that the CEO employed deception to gain money from hundreds of thousands of people resulting in most losing money. A jury quickly found him guilty, despite his defense of being a "legitimate MLM." Burks now awaits a prison sentence that may keep him in jail for the rest of his life.

2) At about the same time, the FTC concluded that the MLM, Herbalife, was also engaged in massive deception leading to even greater losses from even more people and over a much longer period of time. Herbalife also signed a Settlement agreement in which it did not admit wrongdoing. Herbalife, however, was allowed to stay in business, subject to payment of a $200 million fine and agreement to stop illegal practices. Subsequently, no criminal charges were filed by the DOJ. The CEO was not prosecuted. Billions in shareholder funds are still in his trust.

One can only conclude that size, wealth, and, apparently, political influence among MLMs (Paul Burks had no political friends in high places and did no significant lobbying) determines which ones get prosecuted, among the very few that ever do. Overall, the MLM model remains unexamined, unregulated, seemingly above the laws against fraud.

"Multi-level marketing" enterprises, the sector that includes Zeek, Herbalife and Stream/Ignite and the source of the pyramid scheme confusion that leaves the public so vulnerable, are everywhere these days, at work, in churches, synagogues and mosques, at family gatherings, online, all over Facebook, and at high school and college campuses. This phenomenon of the pyramid income proposition replacing true work opportunity and outrageously representing itself as the promise of the American Dream is primarily due to government corruption, incompetence and neglect. If MLMs are frauds and not the extraordinary income opportunity they claim to be, millions of consumers reason, how could so many operate openly? It has reached a scale where the recruiting scheme is now viewed by millions of Americans as the last best hope for opportunity, while traditional jobs, trades, professions, businesses and public service work are viewed as unattainable, unfair, or diminished in value, just as MLM promoters constantly declare.

The Disguise and Disinformation of Products and "Sales"

But beyond MLMs buying protection from the law, there is the matter of the disguise itself. Pyramid schemes of the "product" type can be elaborately disguised organizations, with manufacturing facilities, distribution centers, lobbyists, lawyers, and even stock sold on exchanges. The camouflage is enhanced by years of confusion and dis-information sown by the Direct Selling Association that falsely spreads the story that any enterprise that gains revenue from product-purchase transactions is exempt from the definition of a pyramid scheme.

In fact, as indisputably verified by math and tragically revealed in the documented losses among MLM participants, approaching 100% loss rates for those joining each year, a pyramid scheme is the same deceptive and destructive fraud whether it is a simple chain letter, a Madoff-style Ponzi or a global "sales" operation like Herbalife. Last-ones-in always lose and the last-ones are always the vast majority of the total.

Implications of Steam/Ignite Lawsuit for Other MLMs

Stream/Ignite, now the defendant in a class action pyramid scheme lawsuit certified by a federal appeals court, purports to sell energy services such as electricity. It does not produce or own or have any expertise in energy but functions merely as a reseller. The case argues that reselling electricity in the open market is not a viable and profitable business for Stream. It serves as a device for the real business, the plaintiffs claim, of perpetrating a financial fraud; a fraudulent pyramid income promise generates the "sales" not the value of its product offering.

In the suit's litany of revelations of Stream/Ignite's income claims, structure, pay plan and marketing tactics, Houston attorney Scott Clearman demonstrated a rare insight into the reality of multi-level marketing and the nature of a pyramid scheme disguised as "direct selling." The court ruling certifying Clearman's RICO suit as "class action" to represent about 200,000 victims of Stream/Ignite, may put all other MLMs at risk for similar RICO/Pyramid scheme charges and lawsuits. The federal court's positive ruling on class certification on the case will be cited in other cases against MLMs.

Beyond its legal impact, the logic and reasoning that support Clearman's arguments are important for understanding what a pyramid scheme is and for penetrating the "sales company" disguise. This form of disguise (other large-scale pyramids are disguised differently as social clubs, personal growth programs, or "sharing/gifting" networks) not only obscures the money transfer and economic harm, but even more importantly, the purchase transactions are designed to obscure the recruiting incentives, impossible income promises and to confuse the millions of people that fall victim.

The payment for the right to gain rewards from recruiting is disguised as a "purchase" transaction, even when a purchase is required to gain the right to recruit and recruiting a certain number of people is required to obtain rewards, and most of the purchases are made by the recruiters.

When the financial data reveal massive losses and obvious ties between purchasing and recruiting rewards, the perpetrators claim the motives of the victims are related only to purchasing products, rather than seeking income. Even the act of recruiting is obscured since rewards also require that the new recruit make a purchase before the recruiter can actually be rewarded. The false identity of a "sales company" serves to protect the executives from fraud charges and confuses the victims about how they lost their money. Also after victims have engaged in the required purchasing and recruiting, many understandably become fearful that they are now implicated, making any complaints to authorities unlikely. The code of silence is maintained by inducing victims to believe they are also perpetrators.

Products as Currency Supplemented by Fees and Charges

Stream is a typical MLM, however, the key elements of a pyramid scheme - (1) pay-to-play-purchasing, (2) endless-chain recruiting-requirements and (3) rewards-for-recruiting and (4) closed market/absence of retailing - are more readily recognized at Stream than in some other MLMs. As a reseller, not a producer, of energy, Stream starts out with only a very small gross profit margin. Under the classic MLM program the entire "upline" chain of recruiters gets a "commission" on every purchase of electricity made by those recruited and their "customers," if they have any. The lawsuit claims that Stream/Ignite makes little or possibly no net profit at all on reselling electricity. But, whether the enterprise is profitable or not (as a private company, its books are not public) from reselling electricity, it is impossible for Stream to provide adequate funding to pay the whole upline out of this small margin; and that small margin, gained only from monthly energy purchases, would also not provide the necessary upfront cash for "fast start" bonuses and other typical MLM incentives for immediate recruiting.

Embedding Recruiting Reward Money in Pricing or Adding Fees

This financial limitation differs from schemes like Herbalife or Nu Skin that make their own "products" and can set high prices yielding gross margins as much as 80% or even more, out of which they pay 40%-50% in recruiting rewards, with the rest covering operations, administration and profits to the owners. In those schemes, almost all the recruiting rewards are embedded in the inflated price of the commodities, e.g., soap, face cream, protein powered, etc. The key pyramid factors of the endless chain, pay-to-play-purchasing and recruiting-for-rewards are the same in all MLMs but the funding for the rewards is more obscured by embedding the payments-to-participate and the rewards-for-recruiting inside the product's high price.

Like some other MLMs - such as North Carolina-based ACN, another "energy and utility" MLM and the one hyped personally by Donald Trump - that also have lower-margin goods or services to sell, Stream is forced to get additional money from participants besides product/service purchases. In Stream's case, each recruit must pay over $300 to sign up and about $30 a month to remain qualified. This gives Stream tens of millions in additional revenue gained directly and immediately from new recruits and out of which it can pay "endless chain" recruiting rewards and "quick start" bonuses to energize recruiting before the "losing" recruit eventually quits.

The difference between the high-margin and low-margin MLMs is incidental. In fundamentals, these two types of MLM schemes are otherwise identical and they produce exactly the same loss rates since "rewards" are based on the "endless chain" recruiting that flows upward from last to first. Stream just offers a clearer window into the "direct selling" disguise.

No Customers

Supporting the view that Stream's true business is a pyramid recruiting scheme, the class action lawsuit offers evidence - the very same type of evidence is often presented in other MLM cases - that profitable "retail selling" is not feasible for the participants and the pay plan does not support retailing, aka "direct selling" and none of the participants are profitable from personal selling.

In the Stream pay plan, (as in nearly all other MLMs) almost no customers are required for a recruit to qualify for recruiting rewards, and very little income could ever be gained from just personal reselling. Each participant generally has only a few real customers to qualify for the promised recruiting money. Under the recruiting-based plan, recruiters can even count themselves and the purchase of the scheme's website "back office" as "customers" for reward qualification purposes.

The only feasible way for the participant to gain a net profit is not from "reselling" electricity to customers, but from recruiting others into the pay plan that do the same. The lawsuit's claims that Stream's and its distributors' profitability is based on recruiting not retailing, and that the retailing opportunity does not exist are exactly the same charges the FTC leveled against Herbalife. By design and the laws of math, such a recruiting-based income plan must result in only a few of the total ever being profitable since their profits must be based on the unprofitable work and payments of all the others. Additionally, the vast majority of all participants must, by design, be in the no-profit bottom ranks. What makes this calculated scam more visible at Stream is that, even with a significant downline, the rewards gained by a dedicated recruiter as "commissions from the reselling of electricity" would be minimal due to the low margin that Stream has available to work with as a reseller. The plan can only work if more recruits are enrolled who pay the $300+ to join and the monthly fees on top of purchasing energy and continue the recruiting process - ad infinitum.

Both the low-margin-additional-fee schemes like Stream and ACN and high-margin schemes like Herbalife, Nu Skin and Usana, (which don't need to charge "fees" but do often induce large volumes of purchases into the thousands of dollars from recruiters) depend totally on deceiving recruits into believing they can make money from "direct selling" and that everyone who "tries" can always be profitable, no matter when they join or where they are on the chain. Also, as in all MLMs, the scheme relies on personal purchasing and fee-payments - from the distributors themselves - obtained through false income promises and quota-driven purchasing, rather than on market-based purchases by actual customers.

Pyramid Scheme Racketeering

What gives the Stream lawsuit special significance is the charge - now included in the certified class action status - of racketeering. RICO is usually associated with prosecutions of organized crime, especially the Mafia. It can also be applied in civil suits, as it is in this case. The racketeering charge has been brought against other MLMs. In fact, the author of the RICO statute, Professor G. Robert Blakey, wrote a famous expert report in a lawsuit brought against the largest of all MLMs, Amway, in which he showed how Amway mirrored a Mafia organization, exhibiting the defining characteristics of a racket:

  • engaged in illegal activity (deceiving and harming consumers);
  • was closely held by two families;
  • top-gun recruiters, numbering about 8 at the time of his report in the late 1990s, equivalent to Mafia families working under the authority and in close coordination with the ruling families;
  • a diverting labyrinth of official-sounding corporations to prevent law enforcement or money tracing;
  • real operation dictatorially governed through an informal network of power relationships between the families, top recruiters, downliners, attorneys, and suppliers, equivalent to the famous Mafia hierarchy of Don, Underboss, Consigliere, Capo, Soldier and Associate;
  • everyone in the organization required to abide by the rules exactly; no innovation, independence or dissent allowed. Any efforts at change or objection within the ranks is met with immediate dismissal or extreme financial and social punishment;
  • code of silence;
  • through a uniform set of policies and the total dependency of the recruiting "families" on the ruling families, even the lowest level and newest recruits are required to follow the rules totally without deviation. Any sign of defection or independence can be quickly detected by the recruiting organizations whose responsibility is to report any deviance and deal with it swiftly. As Dr. Blakey noted, such imposition of uniformity and obedience can extend even to clothing styles sales, vocabulary, attitude expression, sexual practices and family relations. "Amway becomes a way of life for its participants, much like those involved with the Mafia," Blakey wrote.

In the Stream case, the plaintiffs argue Stream's true purpose is to operate a pyramid scheme. The promoters collaborate with the knowledge of operating a "robbing Peter to pay Paul" enterprise, that will not - and cannot - deliver on its advertised promise of an "income opportunity" to any more than a tiny handful at the top; all others are doomed to losses. The collaboration involves deceiving and cheating over 200,000 people out of tens of millions of dollars. The underlying nature of the scheme as a pyramid scheme makes the collaboration an act of racketeering, including mail and wire fraud.

The lawsuit and the federal court ruling affirming class action status cut through decades of confusion and disinformation about what a pyramid scheme is, and how people are lured into them and harmed. For example, the suit argues and the court agreed that it is Stream's claim to being a "legitimate MLM" that draws people into Stream/Ignite. Therefore, if a jury finds that Stream is a pyramid scheme, "the legal requirement of RICO, that a cause exist between company actions and victims' harm is met "through a common sense inference that they (Stream participants) were duped into joining the pyramid scheme based on the representation that Ignite is a legitimate enterprise."

Further, the case argued, and the court agreed, that injury to victims is not subject to the classic MLM defense that the causes for losses are specific to each "loser," e.g., dropped out, did not follow the plan, did not try hard enough, did not want to make money in the first place or that the victim must prove specific misrepresentations by the company. The court accepted the lawsuit's claim that "it is enough to show that a 'foreseeable and natural consequence' of the allegedly unlawful pyramid scheme is "that the vast majority of the unwitting IAs (participants) would lose money."

As the court stated, "Pyramid schemes are 'inherently fraudulent' and are per se mail fraud, a RICO predicate act. And, by design, a pyramid scheme's fraud inheres in its concealment of the deceptive nature of the "robbing Peter to pay Paul" payment structure."

Simple translation:

(1) The vast majority of people that join a pyramid scheme are doomed from the start whether or not they "try" or "want" to make money or not, or follow rules or not or "believe" or not or even whether the company lied to them. Virtually all who join will meet the same fate by virtue of the scheme itself, not due to any personal circumstance or individual experience in the scheme.

(2) All pyramid schemes disguise their true nature and so no one can be said to have voluntarily "joined" a MLM that operates a pyramid scheme. What they think they joined - e.g., direct selling - is not the reality.

Confusion or Willful Ignorance about Pyramid Scheme's Inherent Deception?

Perhaps the most important aspect of the federal court's class action affirmation is that it upheld the basic premise of this lawsuit. This is that if the MLM, Stream/Ignite, is found to be a pyramid scheme by a jury, all the disguise of sales and the contradictory statements and promises and disclaimers are irrelevant. RICO-fraudulence is based upon what the scheme is, not in specific actions, statements, products or policies. All of that is just disguise, and disguise is an intrinsic element of all pyramid schemes.

Despite the reality of the inherent deceptiveness of a pyramid scheme with preordained harm to participants and despite the reality that "disguise" is an integral part of such a racket, the "sales" disguise seems to overwhelm, confuse and stop many legislators, journalists and regulators from even examining MLM reality. The disguise is accepted without inquiry, on faith, almost as if the scheme would have to tauntingly advertise itself as a fraud for the regulators to wake up. As long as the pyramid is properly dressed up to look like a real business, the regulators appear oblivious and make no investigation. This has led to epic regulatory neglect and to the sad practice of major news organizations mindlessly re-publishing provably and obviously false data from the Direct Selling Association - including totally impossible "income averages" as valid facts, without fact checking! It has also led them to ignore obvious contradictions of economic fundamentals and the laws of math and physics, such as the claim of immunity from market saturation, "infinite" sales chains" and eternally unlimited opportunity. The absurdity, the irony and the tragedy manifested in the MLM data on losses and churn rates seem to completely elude the media and the regulators. All manner of ridiculous rationalizations have been accepted or concocted to evade facing reality.

Pyramid Fundamentals

Dissecting a MLM pyramid requires only a basic understanding of the fundamentals of pyramids, including its essential element of disguise. Expertise in economics, law, marketing or finance can sometimes be as much handicap as asset. What is most needed is the freedom of mind to avoid preconceived perspective. For example, it is nearly impossible to recognize the pyramid in plain sight if the scheme is accorded, from the start of an inquiry, the status of "direct selling" or even "legitimate business." This type of flawed or pre-judged approach taken by many journalists and regulators is illustrated in their futile search for some "bright line" of illegality to distinguish the "good" MLM from the fraud. In searching for evidence of "inventory stockpiling", for example, they gloss over the fraudulent income proposition based on "infinity" that led to the inventory purchases in the first place and pay little regard to 99.7% consumer loss rates.

Many investigators unthinkingly accept MLMs' identity of "direct selling" even though the MLMs encourage all their "direct sellers" to recruit their own competitors! One-on-one sales is claimed to be the basis of the MLM business while profitable direct sellers cannot be found, only predatory recruiters.

Legal scholars, major economists, universities or investigative journalists are oddly missing from this international controversy, despite hundreds of billions in consumer losses globally, Wall Street warfare, class action lawsuits, whistle-blowing websites and books, FTC and SEC prosecutions, and the shocking exhibition of millions of people being led to believe that MLM is their only hope to achieve the American Dream.

In its certification of the Stream lawsuit as "class action," the US Fifth Circuit Court of Appeals has perhaps opened the door for regulators and others to finally look past the disguise and examine MLM economic reality. Citing a much earlier landmark FTC case against the MLM fraud, Koscot Interplanetary, the court wrote, " Indeed, the very reason for (pyramid schemes') per se illegality... is their inherent deceptiveness and the fact that the futility of the plan is not apparent to the consumer participant."

And it went on, "Because pyramid schemes are per se mail fraud, which include inherent concealment about the deceptive payment scheme, one who participates in a pyramid scheme can be harmed 'by reason of' the fraud regardless of whether he or she relied on a misrepresentation about the scheme. An inherently fraudulent pyramid scheme . . . would fall within the broad definitions of fraud under RICO even if no misrepresentations occur. Participants are then harmed by the fraud involved in pyramid schemes not because of any misrepresentations, but because … harm to participants, is a direct and foreseeable consequence of such structure."

When the true nature of a MLM pyramid is understood and its inherent deceptiveness is grasped, the fact that hundreds of such schemes are allowed to operate can only be seen as an American tragedy.

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.