On July 30, 2012, Herbalife posted two papers on the investor relations section of its web site, drafted by Anne T. Coughlan. The Economist quoted from one of Coughlan's Herbalife papers in its January 5, 2013 edition. For the reasons set out below, I believe that Coughlan's conclusions concerning the nature of Herbalife's multi-level marketing (MLM) business are not reliable. I am writing this article because I believe Coughlan's articles are misleading and deceptive, and that the MLM industry in general, and Herbalife in particular, should be required to disclose much more information concerning MLM business opportunities than current law requires.
I have been a practicing attorney for over thirty years, during which I have represented distributors and franchisees in cases across the country. I have represented distributors in class actions against MLM companies in about ten cases, including several class actions against Herbalife and some of its high level distributors. I was one of the attorneys for the class in Webster v. Omnitrition International, Inc., 79 F.3d 776 (9th Cir. 1996), which is the leading case on the standards for determining whether an MLM is operating as a pyramid scheme. I have represented or advised, on a pro bono basis, a number of consumer organizations devoted to educating consumers about deceptive MLM schemes. Since 1995 I have participated in the Federal Trade Commission's regulatory proceedings concerning the MLM industry and have advocated for better disclosure and regulation of MLM business opportunities. I have never invested in Herbalife (NYSE:HLF) or any other MLM stock. I have consulted with investment professionals concerning the MLM industry and various MLM companies, including Herbalife. I am not being compensated for publishing this article. I do not have an opinion about whether Herbalife or any other publicly held MLM is a good investment.
Coughlan is the J.L. & Helen Kellogg Professor of Marketing at Northwestern University's Kellogg School of Management. Prior to the two papers she published on Herbalife's web site she had authored a number of papers on MLM topics, as well as other areas of product distribution.
Herbalife's obvious purpose in commissioning these papers is to reassure investors that Herbalife is a "legitimate" MLM rather than an illegal pyramid scheme. Both papers include footnotes disclosing that they were "prepared with the financial and data support of Herbalife Ltd."
Coughlan's analysis is remarkably superficial, fails to identify back-up for many of her assertions, and in many instances is flat out wrong or misleading. These serious flaws are particularly distressing given her influential position at a leading business school.
My Comments on Coughlan's Article Entitled "FAQs on MLM Companies"
Coughlan's first Herbalife paper is a generic piece that does not refer to Herbalife. Rather, it is an effort to justify the typical practices of MLM companies, including Herbalife. Much of the article is similar to statements issued by the Direct Selling Association ("DSA"), which is the lobbying arm of the MLM industry.
The article follows a typical FAQ format. Key points include the following:
In her FAQ defining a "legitimate MLM", Coughlan defines "downline" distributors as those who are "recruited and mentored" by the upline distributor. The reference to mentoring is gratuitous and deceptive. Even if there were such a contractual requirement in Herbalife's distributorship agreement, it would be difficult or impossible to police or enforce. In Herbalife, as with every other MLM which I have examined, once the upline distributor has met the applicable purchase volume requirement for their level, they are entitled to receive commissions on the downline distributor's purchases. Two upline distributors with identically structured organizations and group volumes will receive the identical compensation, regardless of whether one actively "mentors" his or her recruits while the other remains passive.
Mythical "Retail Sales"
Coughlan recites the latest statistics from the DSA indicating that in 2011 there were 15.6 million MLM distributors in the U.S. who generated $29.87 billion in retail sales. She accepts these figures even though it is evident that Herbalife reports retail sales on the assumption that 100% of its sales to distributors are resold at suggested retail prices, even though this is manifestly untrue. Herbalife, like other MLMs, does not collect retail sales data from its distributors and therefore has no way of knowing how much of its products is sold at a discount, how much is personally consumed by distributors, how much is given away by distributors as product samples or how much is stockpiled by distributors who purchase to achieve or maintain their positions in the Herbalife marketing chain.
Substantial Expenses Incurred by Distributors
Coughlan states that "an entrepreneurial individual" can participate in MLM without incurring the overhead costs assumed by the company. Among the costs which she claims are assumed by the company are taking product returns and handling customer service inquiries. At least as to Herbalife this is factually inaccurate because the Herbalife distributor agreement requires its distributors to take on these tasks. It is noteworthy that Herbalife states in its 2011 Form 10-K, "our distributors bear the majority of our consumer marketing expenses and sales leaders sponsor and coordinate a large share of distributor recruiting and training initiatives." Further insight into the expenses incurred by MLM distributors is provided in Item 7 of Herbalife's 2011 Form 10-K:
"If a distributor wants to pursue the Herbalife business opportunity, the distributor is responsible for growing his or her business and personally pays for the sales activities related to attracting new customers and recruiting distributors by hosting events such as Herbalife Opportunity Meetings or Success Training Seminars; by advertising Herbalife's products; by purchasing and using promotional materials such as t-shirts, buttons and caps; by utilizing and paying for direct mail and print material such as brochures, flyers, catalogs, business cards, posters and banners and telephone book listings; by purchasing inventory for sale or use as samples; and by training, mentoring and following up (in person or via the phone or internet) with customers and recruits on how to use Herbalife products and/or pursue the Herbalife business opportunity."
MLM Targets the Unemployed
Coughlan notes that the MLM opportunity is especially attractive to unemployed and underemployed persons. It may be literally true that MLM opportunities are attractive to financially distressed people, but Coughlan's statement begs the question of whether these is a legitimate opportunities, and whether these persons have adequate funds to pay not only for their inventory and the type of expenses outlined in Herbalife's 10-K.
Mythical Motivations to Join MLMs
Coughlan recites a list of motivations for people to participate in MLM, including purchasing at wholesale, sharing the products with others, short term income goals, augmenting earnings from other sources, building a full-time MLM career and "finding recognition for one's achievements and a sense of community." Coughlan asserts that many MLM distributors are satisfied with small or no commission income. The DSA makes similar, self-serving arguments, and has put forth a similar list of motivations. Coughlan does not cite to any authority for this proposition nor to any study or other formal analysis which would indicate the percentage of persons in each of these categories. One has to wonder whether the financially distressed individuals who are attracted to MLM opportunities really want or need "recognition" or "a sense of community" in lieu of income.
Deceptive Definition of Pyramid Schemes
Coughlan purports to distinguish between pyramid schemes and legitimate MLMs. She references the 1979 Amway decision for the proposition that pyramid schemes require "headhunting fees" and commissions based on mandatory product purchases by "new recruits." This is an oversimplified and deceptive misreading of the Amway case. Amway avoided the pyramid scheme charge because the administrative law judge found that its retail sales rules (the 70% rule, 10 customer rule and buy back policy) were actually enforced and effectively prevented inventory loading by distributors. Coughlan also makes the remarkable statement that "a true pyramid scheme causes all later participants to lose money on the scheme" (emphasis in original). There is no legal support this statement.
According to Coughlan, you can distinguish between a legitimate MLM and an illegal pyramid scheme because "an illegal pyramid scheme awards payments to participants for mere recruiting." This is another deceptive oversimplification. As an informal FTC staff advisory letter dated January 14, 2004 states, "Modern pyramid schemes generally do not base commissions on the outright payment of fees, but instead try to disguise those payments to appear as if they are based on the sale of goods or services. The most common means employed to achieve this goal is to require a certain level of monthly purchases to qualify for commissions." Coughlan asserts that in a legitimate MLM, "the distributor earns income only when sales happen." This begs the question, sales to whom? Is a retail sale required (that is, a sale to someone who is not part of the marketing scheme) or is it simply a sale to another distributor?
Personal Use of MLM Products by Distributors
Coughlan devotes several FAQs to justifying the inclusion of a distributor's personal use in an MLM's "retail sales." One of the more remarkable arguments she makes is that "[b]ecause many or most new MLM distributors were enthusiastic consumers of the products before registering as a distributor, it is natural that MLM distributors are also end-user consumers of the respective MLM firm's products." This is contrary to the typical MLM recruitment scenario, in which the prospect is recruited into the business opportunity shortly after or simultaneously with their first "sampling" of the product. It would be deceptive to refer to such a recruit as an "enthusiastic consumer" before they became a distributor. Coughlan does not reveal the source for her assertion.
Inadequate Retail Sales Rules
Coughlan then addresses the question of how MLM firms can be sure that distributors are actually consuming or retailing the products they purchase. She first states that the MLM firm cannot observe every transaction the distributor makes. This may seem to be a reasonable statement, but in fact, an MLM firm can - as Herbalife does in its distributor agreements - require distributors to maintain retail sales receipts for every transaction. Herbalife, however, to my knowledge, does not take advantage of this contractual right and does not collect this important source of retail sales data. Coughlan fails to mention this but goes on to state that MLM firms have rules to discourage inventory loading. Interestingly, she does not cite the 70% Rule or 10-Customer Rule which have been adopted by almost every MLM firm (including Herbalife). Instead, the only rule she references is the practice of buying back unsold inventory, which includes clawing back compensation previously paid to the upline distributors based on the sale of that inventory to the distributor. Even though this is the only rule she actually discusses, she refers to "rules" in the plural, and references the possibility of enforcement. Presumably enforcement refers to the rules which impose obligations on the distributors - like the 70% rule - as opposed to the buy-back rule, which imposes an obligation on the MLM firm. But she does not mention these rules. In its correspondence with the SEC last summer, Herbalife disclaimed reliance on the 70% rule and did not mention the 10-Customer Rule.
Conflicting Inferences from Ordering Patterns
She also discusses the possibility of monitoring distributors' ordering patterns, as a means to ensure retail selling. She assumes that a distributor with "reasonably consistent order quantities and order frequency over time" is most likely selling or consuming what is ordered, while a distributor with "infrequent or sporadic ordering of large quantities of product" may indicate inventory loading. The first of these assumptions is questionable. Consistent order patterns may indicate that a distributor is simply ordering enough product to ensure that volume requirements to receive commissions are met. A good example of this was identified by Pershing Square in their analysis of ordering patterns by a Herbalife distributor. Consistent patterns may also indicate that the distributor has signed by for "automatic" monthly orders which are generally pegged at an amount sufficient to maintain qualifications to receive commissions.
Another remarkable assertion made by Coughlan is that "a legitimate MLM offers the exact same business opportunity to all distributors," by which she means that a "newer arrival" can build just a strong a business as "early joiners." Again, it would be interesting to learn the basis for her statement. In fact it is highly doubtful that later entrants to an MLM really have the same opportunity as earlier entrants. This is a testable proposition - one could examine the attrition rates among distributors at the highest level, and compare with attrition rates at the lower levels. In 2005, the last year for which Herbalife provided relevant data, the attrition rate was highest at the lower levels. One could also examine the relative frequency of new distributors achieving different levels of the MLM firm's plan. In mature MLM firms it is likely that the percentage of new distributors at the highest levels is much lower than the percentages of new distributors at lower levels. Typically, however, MLM firms do not disclose their attrition rates and Herbalife has not done so since 2005.
Coughlan's Chart of "Good" MLM Business Practices
Coughlan includes a chart listing business practices followed by "legitimate" MLMs that would be inconsistent with illegal pyramid schemes. In fact, none of the practices is inconsistent with being a pyramid scheme:
- Low enrollment fees are quite common among MLM firms, primarily to avoid coverage by the FTC Franchise Rule (with its threshold of $500 within the first six months) and similar state business opportunity laws.
- R&D expenses enable the MLM firm to claim that its products are so special that they justify the substantial price premium over similar products available through traditional retail channels. Even if Coughlan's point were valid, it does not apply to Herbalife, since Herbalife's R&D expenses are such a tiny percentage of revenues.
- The willingness of an MLM firm to buy back unsold inventory says very little about whether it is a pyramid scheme, since most MLM firms strive to follow the Amway Rules, which included a buy back provision, and some state laws require MLM firms to buy back inventory. Moreover, many MLM firms include restrictions which make these buy back rights illusory. Herbalife, for instance, requires distributors who wish to return inventory to resign their distributorships, imposes a claw back provision under which distributors must forfeit commissions paid on inventory which is ultimately returned, and includes a contractual term which gives it the right to refuse to pay refunds on inventory which was supposedly sold under its 70% rule. Moreover, buy back provisions do not reimburse distributors for the substantial expenses they incur in operating their distributorships.
Coughlan's speculations concerning high turnover among MLM distributors
Finally, Coughlan disputes that high turnover is an indication of a pyramid scheme. She asserts that "there is no accepted criterion for classifying turnover as "high" versus "low." Since most members of the MLM industry assiduously avoid disclosing attrition rates, Coughlan's statement may be literally true, but deceptive. The data concerning attrition rates, both as compared from one MLM firm to another, and among different levels of distributors in an MLM firm's compensation structure, would be very revealing as to the nature of the scheme.
Coughlan asserts that there are "many reasons" why there might be high turnover among MLM distributors, but cites only one - that a distributor may join in order to meet "short-term goals." This is a common refrain among the DSA and its members. It would be interesting to learn how many "short-term" distributors have actually had a positive return on their investments. If there really are any "short-term" distributors, the number that actually earn a profit commensurate with the time they spend is likely to be quite low. The hypothetical "short-term goal" distributor would have to earn their profits solely based on retail selling, because earning commissions requires a longer time commitment and a larger investment in inventory. But direct selling (i.e., person-to-person selling away from a fixed retail location) also requires a substantial time commitment. While some sales to friends and family may be relatively easy, once these avenues are exhausted the distributor must spend a great deal of time and energy learning how to pitch the products, obtaining sales leads and making sales calls.
My Comments on Coughlan's article entitled "Assessing an MLM Business: Herbalife as a Legitimate MLM"
In this piece Coughlan undertakes to apply the "framework" from her FAQ piece to Herbalife. Not surprisingly she concludes that Herbalife is a legitimate MLM.
Misleading Analysis of Herbalife's "Retail" Sales
Coughlan asserts that compensation for Herbalife distributors is based on retail sales rather than recruitment. She offers merely conclusory statements to back up this assertion.
For instance, she describes the ways distributors can earn money - retail sales plus various types of commissions - and then states "None of these components are earned without product sales behind them, and all are directly linked to the amount of product sales." By "product sales" does she mean Herbalife's sale to the distributor or the distributor's sale to a retail customer? She doesn't explain, and as an author of an 'academic' paper on this subject this is an unacceptable omission. Moreover, her use of the term "product sale" rather than "retail sale" is misleading and deceptive. Is she claiming that retail sales don't matter? If so, she is contradicting decades of FTC case law.
Nonsensical "cap" on commissions
She also makes the rather odd argument that since Herbalife "caps" commissions at 44% of product sales revenue, "compensation [to distributors] cannot rise without limit or be greater than the company's sales revenue." I find it difficult to understand exactly what she is trying to say here. Would Herbalife only be a pyramid scheme if distributor commissions exceeded Herbalife's sales to distributors? Does she really think that any MLM, whether or not it is an illegal pyramid scheme, would ever pay out more in commissions than it collected in wholesale purchases by distributors?
Inadequate Discussion of Herbalife distributors' expenses
She then posits that Herbalife's low enrollment fee - the Herbalife Mini International Business Pack (NYSE:IBP) at $57.75 or the full IBP at $95.55 - is a badge of legitimacy. Her argument ignores the fact that low enrollment fees protect Herbalife from being subject to the FTC Franchise Rule and most state business opportunity laws. It also ignores the much higher costs for Herbalife distributors who wish to advance to the level of Supervisor and qualify to earn commissions on their downlines, which includes recruits who have joined in order to recruit others and earn those commissions.
Herbalife's immaterial research and development expenses
Coughlan then discusses Herbalife's expenditures on R&D, "technical operations, scientific affairs, quality assurance and quality control, product safety, and compliance efforts" (a combined $25 million in 2011) plus an additional $11 million spent on "nutrition affairs, product licensing, and strategic sourcing." Coughlan does not explain or break out the amounts of these expenses, but claims that these expenses are another proof that Herbalife is legitimate. She does not attempt to calculate these expenses as a percentage of Herbalife's revenues or expenses. In 2011 Herbalife's gross profits were $2.774 billion and selling, general and administrative expenses were $1.074 billion. Accordingly, the non-pyramid scheme expenses identified by Coughlan were a very modest 1.3% of gross profits and 3.35% of total expenses. Notably, Herbalife's 2011 Form 10-K stated that its research and development costs were "not material."
Herbalife's Inadequate Retail Sales Rules
Herbalife's buy-back policy, according to Coughlan, is another indicia of legitimacy. She does not mention the genesis of this rule in the Amway decision, nor the various state laws which require MLM firms to have a buy-back policy. And she does not mention Herbalife's rules which discourage distributors from seeking to return their unsold inventory, including the provision that precludes a refund for products that were previously certified as sold pursuant to the 70% rule.
Coughlan asserts that Herbalife discourages inventory loading by distributors, but studiously avoids mentioning the 70% Rule and 10-Customer Rule. Rather, she cites a rule that provides that "Products purchased from the Company are intended to be sold and distributed to retail customers and downline Distributors, or used for Distributors' and their immediate families' own personal consumption." This quote is from Rule 18-A of Herbalife's distributor rules. The 10 Retail Customer Rule is set forth in Rule 18-B and the 70% Rule is set forth in Rule 18-C. Evidently Coughlan is arguing that the simple prohibition of inventory loading in Rule 18-A is sufficient to ensure that all products are retailed or personally consumed by distributors. She does not address any enforcement mechanism nor does she indicate whether Herbalife's prohibition of inventory loading is actually effective in preventing inventory loading, as required by the Ninth Circuit's Omnitrition decision.
Deceptive Discussion of Distributor Consumption
Finally, Coughlan asserts that the amount of consumption by non-distributors is only relevant "if it is also established that the product for sale has little or no value and that sales are driven only by a money-making program based on recruitment." There is simply no legal support for this proposition. She then concludes that Herbalife's compensation plan is legitimate because it is "based on retail sales" and because of its "no-inventory-loading policies." As discussed above, she has failed to cite any evidence that Herbalife's prohibition of inventory loading is actually enforced or effective. Her proposition as to retail sales is also fact-free, as she immediately acknowledges that Herbalife does "not have an end-user product- and quantity-specific database that would permit precise measurement of the proportion of sales made to non-distributor end-users." As discussed above, the absence of such data results from the choice Herbalife has made to refrain from collecting the retail sales receipts that it requires its distributors to maintain. Coughlan does not comment on why Herbalife does not collect information concerning actual retail sales from its distributors. Despite the lack of actual retail sales data, Coughlan concludes that there is sufficient retailing based on the following:
- She uses the mysterious phrase "other traditional direct sales methods for in-home consumption." She fails to offer any explanation of what this means. Could she be saying that it is "traditional" for direct selling companies to rely on personal consumption by distributors? Or could she just be referring to the type of non-distributor consumption that theoretically happens if the distributors are actually retailing the products? Either way, she offers no data or even an estimate as to the amount of such consumption.
- She cites to the Herbalife's estimate that 34-41% of its sales are driven by "daily consumption methods," mainly Nutrition Clubs. Herbalife has repeated this 34-41% figure in recent investor presentations, with the explanation that it is "estimated using various techniques including number and size of orders per month," based on a 2010 study by the company, which has not been publicly disclosed.
The entire focus of Coughlan's articles is directed to the issue of whether Herbalife is a legitimate MLM as opposed to an illegal pyramid scheme. The assumption appears to be that if Herbalife can avoid being cast as a pyramid scheme its troubles are over. There is no discussion of whether any other legal issues are implicated by Herbalife's distributor compensation plan, such as whether the earnings claims made by Herbalife and its high level distributors are deceptive.
Coughlan's Herbalife papers are not of the quality which is worthy of a prominent professor from a leading business school. They certainly should not be relied upon by investors who want to understand the true nature of Herbalife's business. Herbalife could answer most of the serious allegations against it by collecting and reporting actual retail sales data from its distributors, by reporting the attrition rates of its distributors at various levels in its marketing plan, and by collecting and reporting data concerning the business and operating expenses incurred by its distributors. Instead, Herbalife has commissioned a business school professor to publish a set of papers which contain statements which are deceptive, misleading, unsupported or downright false.
Disclosure: I 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.