Bruce Craig

Special situations
Bruce Craig
Special situations
Contributor since: 2012
required viewing for anyone interested in, or selling, vitamin supplements
Excellent article. It points out systemic flaws in the MLM/pyramid offering, flaws which are not discussed by the financial press, stock advisers, or those including listed MLMs in their mutual or pension fund offerings.
According to the US Postal Inspector "Chain letters don't work because the promise that all participants in a chain letter will be winners is mathematically impossible." This doesn't mean that we have to wait and see if the entire world gets involved, it means that the statement is inherently deceptive - as pointed out by the FTC in the Koscot decision.
The problem is that an endless 'chain' style offering has attractive elements i.e. that you can offer your recruits the ability to recruit others, for profit, and they can tell their recruits the same thing, ad infinitum. Participants are essentially gambling that they can make their money before implosion. That is why they should be illegal. Disclosure of inherent impossibility doesn't help because the rewards, like with gambling, are attractive. Consider what would be the case if new recruits might, or might not, be entitled to recruit others for profit. No one would join because those they recruit would know that they might not be able to recruit others.
General saturation is already evident by the fact that 80% of MLM business is now done in other countries. When it reaches end-stage, as with Madoff, a lot of professionals are going to be asked why these flaws were not, at a minimum, at least pointed out to potential investors.
For some reason, more public attention has been focused on those who took a stance on legality, specifically Wm. Ackman, than on the underlying issues raised by Mr. Fitzpatrick. Before Ackman spoke up, the matter had been in functional dormancy since the 1979 Amway decision.
Here are some people who should be writing about this matter, but haven't. Maybe send them a copy of this article.
Jesse Eisinger, ProPublica
Frank Partnoy, University of San Diego School of Law.
Steven Davidoff Solomon - NY Times, Dealbook, and Univ. of Cal Berkeley Law
Roger Parloff and Peter Elkind, Fortune Magazine
Alexandra Stevenson and Gretchen Morgenson, NY Times
You can get their emails from the web.
Powershake, looks like you're right. I stand corrected.
Excellent article. Re-phrasing the retail sales question into whether the product would sell, at commercial levels, if the opportunity to recruit is removed, is an excellent start in the right direction. Congratulations to experts Bosley and Vander Nat, and the author, for bringing this to the surface.
The other significant element of the Vemma case is the following quote:
"Vemma contacts only 15 of its over 90,000 Affiliates a month to ask if at least 70% of their sales were for consumption or retail.
And Vemma’s Vice President of Legal Affairs admitted in her testimony that the script for those calls does not really investigate the reason an Affiliate purchased product or check for inventory loading.
Moreover, the Receiver found that, in practice, Vemma is five months behind on its inventory loading audits and has never suspended or disciplined an Affiliate who failed to make the requisite sales to ultimate users.
And Vemma does not even attempt to apply a rule similar to the ten customer rule that was found to be a reliable way to control inventory loading in Amway."
Since many of the Vemma top end people appear to be Herbalife and Amway alumni, this reflects the likelihood that few MLMs take compliance with the "Amway Rules" seriously - even though the Amway case declared that the existence and enforcement of those rules protected all participants from improvident 'inventory loading' and thus rendered an illegal pyramid, as Amway was charged, legal.
Given the functional impact of the Amway case of rendering all MLMs that purportedly have "rules" as legal MLMs, it would seem incumbent on the FTC (after 35 years) to use its investigative authority, as it apparently did in the Vemma case, to determine whether these rules have been enforced and are effective, keeping in mind that thy are intended on protecting ALL participants from losses in a pyramidal proposal once declared 'inherently deceptive'.
Also to be considered is the fact that 80% of MLM business is now done overseas. Even if rule enforcement is supposedly enhanced in the US, will this be applied in other countries - or simply be used as a device to maintain US legitimacy sufficient to permit continued operation in other countries - where most of the money is made?
My suggestion to the FTC is that it confer with staff, and regional, attorneys who have actually litigated its pyramid cases on the development of enforcement policies that would have a greater impact than those implemented to date by its Division of Marketing Practices.
to Lapoonski and Steadson
I don't know whether I'm a crack lawyer or not, but I am capable of reading.
Commissioner Pitofsky, in the Amway case, stated:
"The Commission had described the essential features of an illegal pyramid scheme:
Such schemes are characterized by the payment by participants of money to the company in return for which they receive (1) the right to sell a product and (2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of the product to ultimate users. . . . As is apparent, the presence of this second element, recruitment with rewards unrelated to product sales, is nothing more than an elaborate chain letter device in which individuals who pay a valuable consideration with the expectation of recouping it to some degree via recruitment are bound to be disappointed. In re Koscot Interplanetary, Inc., 86 F.T.C. 1106, 1180 (1975) (emphasis added), aff'd mem., sub nom. Turner v. FTC 580 F.2d 701 (D.C. Cir. 1978)."
MLM transactions involve inventory purchases both as a qualifying factor in entitling a 'direct' distributor to profit and the purchase when one of his recruits buys inventory which generates the profit to the recruiter and entitles the now qualified recruited distributor to repeat the transaction, and profit, when someone he recruits buys inventory. Thus the 'endless chain' of concern to the FTC.
There is nothing within these inventory transactions that indicates, on their face, that any of these purchases are for the purpose of retail consumption - this creates the situation stated by the Judge in Amway - without proof that these transactions are "related to product sales" the company is presumptively a pyramid scheme. Because of this, Amway was initially charged with being a pyramid scheme.
This shifted the 'burden of proof' to Amway to show that it had rules which would assure that those seeking to profit from recruiting didn't just put the product in their garage and hope to make more money from recruiting than selling at retail.
Here's the quote on burden of proof from my article, quoting the Gold Unlimited case, for those crack commentators who bothered to read it.
"We find it more appropriate, however, that a defendant carry the burden of establishing that it has effective anti-saturation programs. Given the grave risks imposed on investors in illegal schemes, the government should have to do no more than prove that the program satisfies the definition of Koscot. See, e.g., Amway, 93 F.T.C. at 699 (“There is little doubt that a pyramid distribution scheme should now be condemned even without the demonstration of its economic consequences. The Commission has studied the effects of such ‘entrepreneurial chains' and seen the damage they do and a per se rule should be used.”) (initial decision, affirmed by the FTC opinion, 93 F.T.C. at 735); Koscot, 86 F.T.C. at 1182 (“To require too large an evidentiary burden to condemn these schemes can only ensure that future generations of self-made commercial messiahs will dare to be great and dare anyone to stop them.”). The alternative—placing the burden on the government—forces the government to wait until after the collapse, as that alternative permits operators to maintain that the absence of collapse proves the success of the anti-saturation policies."
Amway claimed to meet this ‘burden of proof’ with its rules and the Amway Judge accepted this proof. Mr. Steadson asked, as to verification of these rules, “How would you suggest this be done? Searching their house for unsold and unused products?”
Perhaps reading the Herbalife Rules, also cited for those who actually read the article, would help. They indicate:
“Rule 18-E:
Maintenance of Records Distributors must maintain records of all their product distribution for a minimum of two (2) years. The records must contain the name, address and telephone number of the customer or Distributor to whom products were sold, complete information on products bought, and amount and method of payment. These records must be provided to Herbalife immediately upon request. Herbalife maintains the right to contact retail customers and downline Distributors to confirm these transactions and the level of service provided by the Distributor”
It would be of value to everyone if the Federal Trade Commission would require that Herbalife produce a significant number of these records, selected at the Commission’s direction as to number and source, for the purpose of determining their existence, accuracy and veracity. The FTC could make the appropriate contacts with the customers identified in them, and the distributors who submitted them, to make these decisions. This inquiry would also answer the question whether all Herbalife distributors submit these records, as required.
This data, after full verification, would have a significant impact on the question of the identity of primary consumer of ‘retail sales.’ My only concern is whether the reports submitted would contain sufficient data on 'purported 'self-consumption and distinguish between sales to another distributor as opposed to an actual retail customer – the question asked by Mr. Einhorn. The Commission would have to be able to determine the relative quantities within each of these categories in order to make an accurate determination on the issue of inventory loading and related issues involving pyramid schemes, otherwise the concept of protecting participants with ‘rules’ would be lost in non-specific data and would fail to meet the company's 'burden of proof". It would also create the impression of 'legality' when none existed
The basis of the Amway ruling was 'evidence' that its rules were enforced and prevented losses predicted by the Koscot case.
Enforcing a rule has to be more than just accepting a form affidavit from an independent distributor and filing it in a drawer.
It would require the company to enact procedures which would enable it to verify the veracity and extent of the contents of the affidavit and conclude that participants are, in fact, being protected - as Amway told the FTC they were. It would also have to prove that the rules were enforced as to all participants, not just some - otherwise there is no protective value.
The burden of proof previously discussed would require the company to use data acquired by its rules to fully and adequately document, to the FTC, that all participants were in fact protected
Just having a set of 'rules' does not immunize a MLM from a pyramid charge. An affidavit from a distributor is merely the first step in a MLMs defense of its 'rules'. If the affidavit is not verifiable by an enforcement agency, in the context of issues such as 'inventory loading,' then it is worthless - or worse, deceptive.
I do not think that a distributor who files a false affidavit would feel comfortable if the matter of assisting in defrauding a Federal agency is raised.
The article referenced a legal requirement in the context of pyramid schemes, it is called "burden of proof' - there is a section on it. Check the legal language in the Gold Unlimited Case. Amway, sued as a pyramid, also recognized that it had to 'prove' to the court that its rules protected against abuses 'inherent' in pyramids. Take a look at the Koscot case cited in the article - it is still cited as controlling authority and is recognized as such in the Amway case - and states the reasons for a need for protections related to inventory.
Amway type rules require specific information, which is intended to show that product purchases were not primarily intended for the acquiring the right to recruit others and profit from their product purchases. If a company can't prove from data acquired via its rules that product purchased were primarily for retail, then it is, remains, a pyramid. That is the legal premise of 'burden of proof.'
Perhaps Herbalife has documentation required by its rules to prove that purchases were made in the context of actual retail sales. Perhaps not.
I should know better than to get into the middle of this, but Steadson’s point, regarding the Amway case,
stating that “the ALJ found that the buy­back rule, the 70 percent rule, and the ten customer rule are enforced, and that they serve to prevent inventory loading and encourage retailing” is at the heart of this entire matter. (I note the link to the Amway case in the article is no longer operative, the above link will lead to the Amway decision)
The Judge's findings on the “Amway Rules” are cited in the body of my article, copied from the Amway ruling. They recite the persons who testified on the rules, for example:
“73. To ensure that distributors do not attempt to secure the performance bonus solely on the basis of purchases, Amway requires that, to receive a performance bonus, distributors must resell at least 70% of the products they have purchased each month. (RX 331, pp. 16-B to 17-B) The 70% rule has been in existence since the beginning of Amway. (S. Bryant, Tr. 4086) Amway enforces the 70% rule. (Lemier, Tr. 192-93; S. Bryant, Tr. 4056-59; Halliday, Tr. 6497)”
My problem with the Judge’s conclusion is that it appears to be based solely on the testimony of Amway officers or employees. There is no indication of independent documentation or evidence that the rules, on an ongoing basis, actually work, and worked, as intended, i.e. resulted in the distributor retaining no more than 30% of the inventory purchased, a process intended to prevent “inventory loading” - as referenced in the opinion.
Normally a Judge would not take the testimony of a defendant as the primary, or sole, basis for declaring innocence and, concurrently, would recite the factual basis for his conclusion that “Amway enforces the 70% rule.” I have seen no evidence, from any source that would support this conclusion. My understanding is that distributor certifications of compliance with “Amway rules” (by Amway or other MLMs) is token at best and virtually non-existent, at least from the standpoint of preventing the victimization fully set forth in the Koscot case. Documentation to the contrary would be invaluable in resolving current disputes concerning retail sales and inventory loading.
In February of 2000, I made an explicit inquiry to the Chairman of the FTC on this point, i.e. whether the rules are enforced, on a continuing basis, and result in the intended prevention of “inventory loading.
This was not done, the only explanation provided me, in July 2000, by James Kolm, then an FTC attorney in the BCP Marketing Practices Division, recited pyramid cases brought by the Commission and stated that:
“The FTC continues to explore avenues for halting pyramid schemes that fleece millions of dollars from consumers, including the clarification of legal standards in this area.”
Given the fact that Judge Timony’s conclusion resulted in a declaration that Amway, sued as a pyramid, was not an illegal pyramid because of these rules, and their continuing existence and effective application, the basis for this ruling is at the heart of the current situation – where all MLMs, including Herbalife, have “rules” that purport to insulate them from prosecution under the Amway ruling. I have yet to see any independent documentary proof, normally the basis for a legal decision of this import, which indicates that the “rules” are actually enforced and work as intended by Judge Timony.
Excellent article. It's topic, Saturation, is one, as you state, which has been more or less ignored by the financial press and market analysts, even though geometric progression is at the heart of all MLM offerings. To some extent saturation has been delayed because of the substantial participant failure rates you mention, making room for new entrants that wouldn't be there if everyone was successfully retailing products. But, as you state, word is getting out.
I have a strong feeling that the market experts and press commentators are going to exhibit a much greater interest in this topic, and your data, in the near future. Neither want to be in a "Madoff" situation or one where the information was there but, for other reasons, was ignored. Sifting through the ashes after downfall is not where they want to be.
I'm wondering how the big discussion tonight will factor in the hard reality that two of the most prominent experts in the area of MLM/pyramid issues, former FTC economist and pyramid expert Dr. Peter Vander Nat
and colleague Professor William Keep. have both called for an explicit regulation dealing with pyramids.
Any FTC regulation, or modification of enforcement policy, which would begin to require specific documentation of critical issues such as 'retail sales' and some of the other "Amway Rules" would begin to bring some sunlight into these areas, which have remained in the fog for the past 30 years.
They could actually give the investment community some valuable information in respect to this particular type of offering and the advice they give their clients. Remember Madoff?
You recommend "proper and aggressive regulation" Amen. Your colleague, retired FTC economist and pyramid expert Dr. Peter Vander Nat, has recently made the same request. I take these comments as a rejection of the current FTC position that there cannot be a 'bright line' defining a pyramid and that cases should be brought only after the company in question has operated for a period of time sufficient to develop conclusive evidence of public harm. In the meantime, as indicated by Dr.Vander Nat, those not charged are presumed legal - as in his example that a traffic cop stops one speeder and the others drive by unhindered.
A law or regulation has to exist which enables the detection and prosecution of a pyramid offering at or near the time of commencement of business. This will require extensive investigative authority to examine, at inception, the structure of the business opportunity offered and the relevant nature of 'retail sales' and other exculpatory factors.
Failure rates in excess of 95% and 2 year 'churn' rates signify billions of dollars of loss at the hands of the millions of victims of these schemes, here and abroad - where 80% of business is currently conducted. It is hard to imagine a business practice which is in greater need of extensive and intensive regulation.
That stated, I have little confidence in the FTC taking such an enforcement stance on its own - it recently exempted MLM from its business opportunity rule, even though it is virtually the only non-franchise business opportunity in existence.
The Obama Administration, perhaps concerned that de-facto saturation could bring down this entire house of cards on its watch, may well conclude that more aggressive enforcement efforts are warranted, soon. Dr. Vander Nat, and you, have all the substantive evidence and expertise, developed over the past 20+ years, to support the enactment of such a regulation in the very short term. Doing nothing could well result in an outcome similar to the Madoff situation - except by an order of magnitude.
Questions concerning inherent illegality of MLM offerings, such as those raised by Mr. van Vlissingen, and the subject of your disagreement, are important- but not as important as the immediate need for a substantive regulation, the terms of which, hopefully, could prevent, to a meaningful extent, the massive losses incurred by victims around the world.
There are well meaning and competent people at the Federal Trade Commission, what they need is the support of the pubic, the press, and those within the Obama Administration who may well be concerned about the largest consumer fraud in history being dropped in their lap.
You cite Herbalife's 70% rule 18-C. This more or less matches one of the 'rules' Amway cited in its successful 1979 defense to the FTC charge it was a pyramid scheme.
In other words, Amway would have been an illegal pyramid scheme but for the existence, and enforcement, of these rules.
Herbalife rule 18-C states:
"If the Distributor fails to timely certify to Herbalife that they
have sold or consumed 70% of the product purchases made
that Volume Month, Royalty Overrides, Production Bonuses,
and other bonuses will not be paid to the Distributor."
Given the critical importance of these rules in shielding a company from a pyramid scheme charge, my question - to one who has done more in-depth research on this company than anyone else - is whether the company, or any enforcement agency, such as the FTC, has ever made any substantive inquiry into the existence of these 'certifications' to Herbalife - and their veracity?
This would seem to be a threshold issue in respect to any determination in respect to the important question of whether a company is a pyramid or not. I would assume that the investment market would deem this a critical matter in the context of recommending investment in the company.
As an ancillary question, does Herbalife claim that its business rules exist, and are enforced, in all the countries that it operates? Has this ever been verified?
I know this must be a naive question for an investor, which I'm not, but what are the motives of those who have taken the steps you outline in your articles?
Dave, excellent and well researched article.
As a footnote to your IRS data, the actual federal tax returns of all 192 Amway Direct Distributors, active in Wisconsin during 1979-80, were examined by a University economics expert as part of our Wisconsin case filed against Amway in 1982. They disclosed an average annual net income of minus $913. This was not a survey.
Significantly, this was after Amway had testified in the FTC case brought against it that its "Rules" protected against losses such as those documented in Wisconsin. To me, this raises significant concern about the efficacy of Amway style 'Rules' intended to protect against losses and the validity of the FTC's 1979 Amway decision.
Your research appears to confirm that financial failure of many "Leaders" is of continuing concern.
Primerica has one upstanding supporter of its marketing program, Timothy J. Muris, former Chairman of the Federal Trade Commission. He was, among others, successful in efforts to remove MLM from the Commission's Business Opportunity Rule.
casbus 7
A rhetorical question whether I was 'intentionally misleading' is not appreciated.
The quotes from Koscot reflected that Court's view of the law. Here are a few additional quotes from Koscot, some of which are from complaint counsel and which were affirmatively referenced by the Court as 'keen analysis'.
"Respondents' marketing plan contemplates upon the payment of consideration, participants would thereby acquire the right to engage in two income-producing activities, one of which contemplated the sale of similar rights to others for which substantial compensation would be paid, while the other contemplated the sale of products or services. Since implicit in the holding out of such rights is the representation that substantial rewards would be gained therefrom, and since the operation of such plan due to its very structure precludes the realization of such rewards to most of those who invest therein, such plan is inherently deceptive. Furthermore, such plan is contrary to established public policy in that it is generally considered to be unfair and unlawful and is by its very nature immoral, unethical, oppressive, unscrupulous, and exploitative Therefore, such plan was and is inherently unfair and the operation of the Koscot marketing plan by respondents, having caused substantial injury to the participants therein as well as to other members of the public, constitutes an unfair and deceptive act and practice and an unfair method of competition in violation of Section 5 of the Federal Trade Commission Act."
"The Commission has previously condemned so-called 'entrepreneurial chains' as possessing an intolerable capacity to mislead. Holiday Magic, Inc., Docket No. 8834, slip op. pp. 11-14 [84 F.T.C. 748 at pp. 1036-1039] (Oct 15, 1974); Ger-Ro-Mar, Inc., Docket No. 8872, slip op. pp. 8-12 [84 F.T.C. 95, at pp. 145-149] (July 23, 1974), rev'd in part 518 F.2d 33 (2d Cir. 1975). Such schemes are characterized by the payment by participants of money to the company in return for which they receive (1) the right to sell a product and (2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of the product to ultimate users. In general such recruitment is facilitated by promising all participants the same 'lucrative' rights to recruit.
As is apparent, the presence of this second element, recruitment with rewards unrelated to product sales, is nothing more than an elaborate chain letter device in which individuals who pay a valuable consideration with the expectation of recouping it to some degree via recruitment are bound to be disappointed. Cf. Twentieth Century Co. v. Quilling, 130 Wis. 318, 110 N.W. 173, 176 (1907)."
"Indeed, even where rewards are based upon sales to consumers, a scheme which represents indiscriminately to all comers that they can recoup their investments by virtue of the product sales of their recruits must end up disappointing those at the bottom who can find no recruits capable of making retail sales. [FN3]"
"At the very least we would conclude that a company which offers its distributors substantial rewards for recruiting other distributors, and charges them substantial amounts for this right, creates overwhelming barriers to the development of a sound retail distribution network and resultant meaningful retail sales opportunities for participants."
"What compels the categorical condemnation of entrepreneurial chains under Section 5 is, however, the inevitably deceptive representation (conveyed by their mere existence) that any individual can recoup his or her investment by means of inducing others to invest. That these schemes so often do not allow recovery of investments by means of retail sales either merely points up that there is very little positive value to be lost by not allowing such schemes to get started in the first place."
"A discussion of 'inherent' illegality and capacity to deceive may seem pointless given the more than 4000 pages of transcript detailing the actual deception and injury in which the Koscot plan resulted. Nothing could be further from the truth. It is regrettably clear that responsible authorities, including this Commission, have acted far too slowly to protect consumers from the manipulations of respondents and others like them. "
At the time Koscot came down there was little doubt that the offerings described in the decision, as previously quoted - including the 'consummated' sales requirement - were illegal and 'inherently deceptive".
The matter was considerably confounded by the FTC's 1979 Amway case, which held that certain internal rules could absolve a pyramid from the 'illegal' label. That case led to confusion about retail sales and other purported exculpatory factors. It also led to 34 years of an ambiguous legal status, fostered by the FTC and within which the MLM industry prospered. This status has yet to be formally resolved by the FTC. This topic is for another article, but it is clear that the Koscot case, often currently cited as the fundamental ruling, said what it meant and meant what it said.
For the most part it has been ignored, except for the narrow language cited.
Ben N
"So, if I may sum up your point ... You agree that the 2nd prong of Koscot must be met first and the burden of proof is on the accuser, and once that burden of proof is satisfied, then the defense might be able to convince the court that the MLM has rules in place to prevent inventory loading and a buy back program that sufficiently protects participants.
In that, we agree."
Actually we don't agree. Koscot said the only sales which would exempt a direct seller from pyramid status would be 'consummated' retail sales to non participants. This consummated element would have to be reflected in company documents as the method of compensating distributors, or, at a minimum, via a formal process of corporate retention of all consummated sales to non-participants. That's why Koscot said that this process could be 'readily monitored'.
You clearly point out, accurately, "The call for Herbalife to provide all retail sales records to "prove" they are not a pyramid scheme is nonsense." If that is the case, and it is - Herbalife has no records - then either the Koscot court was dead wrong in its conclusion that the retail issue could be 'readily monitored' or the method of monitoring it had in mind was one involving corporate procedures and readily available consummated sales records.
Since you, and most experts, rely on Koscot it would seem reasonable to conclude that it had a meaningful enforcement mechanism in mind, rather than 'nonsense'. You can't have it both ways.
On the issue of documentation and the retail sales question, there is an excellent article on SA today, by Robert Fitzpatrick, on that point. For some reason it is not indexed for HLF subscribers. It is definitely worth viewing
see my reply to Nimaj, above
Ben Nimaj
"As you know, the 2nd prong of koscot (the Sine Qua Non of a pyramid scheme) must be first be proven for an MLM's structure to be found to be a "pyramid structure" and the burden of proof lies with the accuser. Should a court rule that the 2nd prong has been satisfied, then the defense might be able to convince the court that the MLM has rules in place to prevent inventory loading and a buy back program that sufficiently protects participants."
Here's the full statement in the Koscot ruling
“Such schemes are characterized by the payment by participants of money to the company in return for which they receive (1) the right to sell a product and (2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of the product to ultimate users. In general such recruitment is facilitated by promising all participants the same 'lucrative' rights to recruit.”
This statement was codified in the Koscot court's injunction, par. 2, p.1186
" "2. Offering, operating, or participating in, any marketing or sales plan or program wherein a participant gives or agrees to give a valuable consideration in return (1) for the opportunity to receive compensation in return for inducing other persons to become participants in the plan or program, or (2) for the opportunity to receive something of value when a person induced by the participant induces a new participant to give such valuable consideration, Provided, That the term 'compensation,' as used in this paragraph only, does not mean any payment based on actually consummated sales of goods or services to persons who are not participants in the plan or program and who do not purchase such goods or services in order to participate in the plan or program."
In other words, an offering as described above is an illegal pyramid unless 'compensation' is based on "actually consummated sales of goods or services to persons who are not participants" Since all MLMs that I know of pay compensation to upline participants on the wholesale purchases of their downlines, not on ‘consummated retail sales’, they are presumptively illegal pyramids. A prima facie case on the part of the government as soon as it shows, from company documentation, that compensation is paid on downline wholesale purchases. That is why Amway was sued, from the start, as an illegal pyramid. It fit within the Koscot prohibitions - and that is why it was up to Amway to prove that it had protective devices in place that actually prevented participant injury.
In this respect, pyramids are comparable to Ponzi schemes, they are illegal on their face. The Amway case confused this issue in the sense that a defendant pyramid would be permitted to show that it had ‘rules’ in effect that precluded participant injury. As much as I disagree with this ruling, the fact remains that Amway held that it is the defendant pyramid’s burden of proof to show an absence of consumer injury, not the government’s.
To further clarify Koscot, the court indicated it’s reasoning in respect to the "consummated’ sale requirement, at pp. 1183-84, by stating “requiring that compensation for recruitment be based in all cases upon retail sales by those recruited, the order provides a readily monitored means to ensure that recruitment of distributors is based on market demand, which is the goal of any legitimate business enterprise. [FN4] “
An MLM/pyramid offering can thus be “readily monitored” simply by examining the company’s compensation plan. Amway’s plan paid on downline wholesale purchases, not consummated sales, and that is why it was sued as an illegal pyramid.
This is not to say that the FTC has fully followed this analysis, although it indicates that Koscot is the primary ruling on the matter. For some reason, it has taken it upon itself to prove each pyramid case through documented consumer injury - as it did in the recent FHTM case, 10 years after the company commenced business and 350,000 victims recruited.
It is well time that the FTC re-evaluate its enforcement policy in respect to pyramid schemes.
The full Koscot statement is quoted below,at pp. 1183-84
" Miscellaneous
Complaint counsel urge that Paragraph I(2) of the law judge's proposed order be reformulated so as to prevent in all cases the use of bounty-seeking 'headhunters,' individuals who would receive compensation based upon the number of others they could induce to participate in respondents' sales program. As now formulated, the law judge's order would permit respondents to enlist certain individuals as headhunters, provided they were not required to pay a valuable consideration for that right. The revised order would still permit payment of compensation to headhunters provided it was based upon actually consummated retail sales by recruits.
Respondents have not objected to this change and we believe it is warranted under the circumstances. As complaint counsel point out, while the order prevents respondents from requiring an initial payment for participation in a plan, it does not prevent participants from making initial inventory purchases if they so desire. Thus there remain incentives for indiscriminate recruitment by headhunters, and incentives for headhunters in any program to ignore other requirements of the order designed to ensure that recruitment is undertaken honestly. By requiring that compensation for recruitment be based in all cases upon retail sales by those recruited, the order provides a readily monitored means to ensure that recruitment of distributors is based on market demand, which is the goal of any legitimate business enterprise. [FN4] "
to Ben Nimaj
"The reality is that anyone claiming that Herbalife is a pyramid scheme will have to show that Herbalife satisfies the Koscot/Omnitrition test. Since internal sales CAN be a valid sale to the ultimate consumer, the data that Ackman, and evidently you, demand is in fact is NOT relevant."
Actually, if a MLM has a pyramid structure it is it's obligation to prove to enforcement authorities that it, in fact, has rules in place to prevent inventory loading and, through buy back procedures, a buy back program -both of which effectively prevents participant loss.
While I disagree with the conclusions in the FTC Amway case, it clearly held that Amway would have been found to be a pyramid save for the fact that Amway 'proved' that it's retail sales rules and buy back provision were demonstrably effective in preventing participant loss. I have yet to see any MLM/pyramid document with actual sales records, as Amway purportedly did, that its 'rules' are effective in preventing the consumer damage well documented and spelled out in the Koscot case.
I don't really know why this information hasn't been requested of all major MLMs - I'm assuming that it is currently being sought from HLF and that a couple of studies won't do the trick.
Given all the uncertainty here, it would seem a good idea that this documentation be requested of all MLMs as soon as practically possible, and not wait another another 34 years.
It is important to note that New York’s Attorney General Eric Schneiderman has a potential conflict similar to General Harris’, according to reports by Michelle Celarier in the New York Post
Louis Flores in Progress Queens
and a recent article in Seeking Alpha by Rogier van Vlissingen.
“Attorney General Schneiderman's reported investigation of Herbalife is taking place as other prosecutorial or regulatory offices are investigating the company for questionable business practices, including allegations that Herbalife operates as a pyramid scheme. To push back against the investigations, Herbalife has retained a national law firm, public relations firms, and other consulting firms to lobby prosecutors and regulators. One of the consulting firms retained by Herbalife is SKD Knickerbocker, the consulting firm that employs Attorney General Schneiderman's ex-wife, Jennifer Cunningham, who remains a close adviser to Attorney General Schneiderman. Herbalife claims that Ms. Cunningham does not work on the Herbalife account at SKD Knickerbocker. However, government reform advocates question how Ms. Cunningham's firm could represent a company that is accused of operating as a pyramid scheme when she herself is advising the state's top law enforcement official.” (Quote from Progress Queens)
In conjunction with this is the recent article by Eric Lipton of the New York Times concerning the extensive lobbying influence exerted on Attorneys General in other states as well.
"In my experience, those who served on staffs in state AGs office studiously avoid the law when leveling accusations. A sad state of affairs in this country, no doubt."
Mr. Casbus7, No bad at all. Thanks for the support. In my 30 years in an AG's office it was a real challenge in bringing a number of major cases while studiously avoiding the law when leveling these accusations. We need more informative comments such as yours to help the public understand how we public servants do our job.
Whatever else is going on, this does not look like a company whose primary concern is helping obese people around the world. I don't understand all the discussion about the recent press release concerning CEO Johnson but it does seem that he is spending a lot more time and energy on PR than on the obese victims in Cambodia, Vietnam, or Queens.
Fan, well stated. I understand this is an investment site and not one for Mother Theresa and her ilk, but at some time one has to take a look at what is happening.
"Churn" may be a financial term but it reflects a massive number of persons, here and abroad, who saw the Cadillacs, the "Universidad", big homes etc and spent savings, maxed credit cards, recruited family members, left jobs, and ultimately, at a rate of 99%, failed - economically and personally.
My only claim in this spat is that I was around when it started in 1968, and nothing has changed. Our 1982 Wisconsin Amway case documented, from tax returns not surveys, that the top !% of Wisconsin distributors (200 of 20,000) had annual incomes of -$900. At the time, I spoke to a number of victims, or members of their families, and learned first hand the damage done.
There is now an abundance of evidence that pyramid style offerings are inherently destructive and deceptive. In addition to the personal impact involved, those retailers and others marketing similar products are faced with competition based on an 'inherently deceptive' market concept - to the tune of $150 billion each year.
According to Stewart, the metrics are beginning to show the saturation inherent in a chain offering. Unfortunately, this could take a while and, in the meantime, more victims will fail. It really is time for government enforcement to take an unequivocal stand on this matter.
Ms. Richard, I'm impressed. This article, and the one your wrote in September,
provide a picture of a company that utilizes practices which should raise significant questions about the integrity of the balance of its business operations - a critical matter given annual revenues well over $4 billion and the fine, but ambiguous, line currently drawn between 'inherently' illegal pyramid offerings and MLM operations.
As a former enforcement attorney that dealt with a number of these companies, my legal approach has focused on the premise of saturation, one adopted by early FTC cases such as Koscot - which continues to be cited as controlling in current litigation. A focus on foreign operations, such as Venezuela, highlights the fact that 80% of current MLM business is done overseas, with China as a major, and unpredictable, participant. I was troubled to learn that HLF operates in Cambodia, where the GDP per capita is under $1000
US business has shifted to ethnic minorities, such as Latinos. 60% of HLF US customers are Latino but they make up only 17% of the population. Where are all the Anglo customers, other than those at the top of the heap?
Shifting to new markets, and an ambiguous Federal enforcement attitude, can delay saturation, but my sense is that some of the extreme measures you document are a sign that things may be changing and evidence of efforts to maximize revenues for those at the top before things crumble.
Nice job.
"Edith Ramirez has been friends with Michael Johnson for years and she heads the FTC and Obama is friends with HLF as well"
This a quote of yours from a comment to an article posted yesterday
This is a serious matter and I had asked in a comment to this article for some documentation of this relationship. I received none, so I am asking again. Where did you get this information.
Is there any documented support for the claim that "Edith Ramirez has been friends with Michael Johnson for years and she heads the FTC" ? This is an extraordinary allegation.
user 2050... "i mean, what a joke--in the era of incredible data-mining hlf cant sort out their retail data!"
to retrieve my cred from the window, the reason retail sales can't be verified is because they take place outside the company's domain - all the company does is sell at wholesale. Maybe it drop ships some retail. Reports from its hundreds of thousands of independent contractors, if they exist at all, are unreliable in that the contractor must claim retail sales in order to keep his position. Most importantly however, it is impossible for enforcement authorities to verify whether the retail reports are accurate. This is why the FTC Amway decision is flawed - but that's another story.
Is the FTC going to send inspectors out to each of the thousands of distributors and take a statement under oath, ask the kids, or look in the garage for unopened bottles of shake mix? Maybe rely on a company funded survey? Impossible is the word - with cred. And all this would happen after several years of uninterrupted business operations.
That's why the emphasis on an absence of retail sales, even though it would show the presence of a pyramid style offering, is so difficult as an enforcement standard - it can't be verified. This becomes particularly true when the company says that its distributors are retail consumers. How is this verified? Check for opened bottles, empty garages, ebay sales efforts? If they're happy customers why does the entire sales force churn every two years. The only retail sales recognized by FTC decisions are those 'consummated' at the time a distributor places an order with the company - verified by an actual, and concurrent, sales contract.
At some time it will be necessary to establish clear legal standards intended to regulate, or prohibit, these offerings. Otherwise things will stay more or less the same.
About 18% of Herbalife's business is presently done in North America. If it purports to clean up its act here, and retains general government approval and NYSE listing, isn't it possible that these same reforms will not implemented in other countries, where the implicit US and NYSE seal of approval gained Herbalife entry in the first place?
If the majority of its profits could still be earned via practices which Herbalife has agreed to cease here, wouldn't it make sense to cut a deal in the US in return for an open season as to the remaining 82%? Given the ambiguity of legal standards and reticence of US authorities to act over the past 30 years, it would seem highly unlikely that, for instance, Cambodia is going to implement its own enforcement efforts - even if these reforms, in name, are supposed to be in place there.
I assume US enforcement agencies do not have any legal authority to mandate business practices elsewhere, much less the ability to effectively monitor them. It has been impossible to obtain meaningful data on, for instance, retail sales in this country, how could any similar oversight be effective overseas?
If these marketing practices are in the category which the FTC has labeled as "inherently deceptive", as it did in the Koscot case, what value will there be in closing a series of barn doors after many billions of dollars have already been lost by their victims. Unless, of course, a full refund program for prior participants is contemplated by enforcement authorities as part of their current response.
An excellent article, by one who has spent the past seventeen years examining the underlying elements of a business proposal which now annually grosses $150 billion.
The substantive arguments and factual presentations made in the article make a compelling case for meaningful regulation and enforcement response. They also make a case for parallel analysis by the widely acknowledged high-ranking professional analysts in investigative journalism, law, regulatory policy, marketing, and finance. These professed experts have been notably silent, or, rather, focused more on the perceived antics of hedge fund titans than on the underlying massive losses incurred, here and abroad, by those invisible victims with no political currency or public traction. Wm. Keep and a few others excepted.
Among this group of silent witnesses, I include ProPublica, the Investigative Reporting Program at the Graduate School of Journalism at UC Berkely, the New York Times, the law school at Harvard which enabled the Amway program in the Harvard School of Business without, to my knowledge, informative due diligence analysis, all traditional business publications, the Federal Trade Commission, and all university marketing departments.
I find it stunning that a $150 billion/yr business proposal which has been substantively questioned as to its legality, and evidenced consumer losses for 99% of its participants, has not warranted more than passing comment.
Whether you agree with Mr. Fitzpatrick or not, you owe it to yourselves to read this article and ask why no meaningful answers to the issues raised have surfaced over the past 30 years.
At some time, there exists the real possibility that pyramids will fall from their own weight, government involvement or not. When, and if, this happens there will be a lot of questions why none of the leading journalists, experts, and academics spoke authoritatively on what may well be the largest consumer fraud in history.
here's the link to the Pitofsky letter, but there seems to be a problem with it. Hope this works