Recognizing Pyramids - Without A Lawyer, An Economist, Or The FTC

| About: Herbalife Ltd. (HLF)
This article is now exclusive for PRO subscribers.

You shouldn't need a Boston attorney to spot a pyramid selling scheme. You shouldn't have to be a Wall Street quant to recognize a direct selling business that is an "endless chain." And you shouldn't have to wait for the FTC to tell you whether or not a particular multi-level marketing (MLM) company is "unfair and deceptive" when millions of people are being solicited. There are market-based, reasoned and well-researched tools and assessments available for individual investors, analysts and consumers to answer questions of MLM legality and sustainability. This article presents some of them.

The diverse or diametrically opposing views unleashed by questions and claims of hedge fund managers David Einhorn and William Ackman about the iconic multi-level marketing company, Herbalife International (NYSE:HLF), and the related spikes in share prices of other MLM companies, such as Nu Skin (NYSE:NUS), Usana (NYSE:USNA), Medifast (NYSE:MED), Blyth (NYSE:BTH) and others, bear witness to a widely experience blind spot regarding multi-level marketing and pyramid schemes.

From the perspective of my work and involvement in multi-level marketing since the mid-90s, I observe that decades of confusing data, lack of transparency, inconsistent and lax law enforcement, cleverly diverting arguments, and outright false information about pyramid schemes and multi-level marketing have led to a broad decline in the ability of millions of people to recognize pyramid schemes. An "extraordinary popular delusion" regarding pyramid schemes has spread across the land, not unlike the confused thinking that accompanied the dot-com and housing/mortgage bubbles.

In recent years, I am frequently sought out professionally by Wall Street analysts who are now trying to understand multi-level marketing. Until recently, few had even recognized MLM as a distinct business sector with a common financial product, the famous MLM "business opportunity." Many tell me they concluded that the MLM sector is rife with deception but, if it keeps growing, they have a "fiduciary responsibility" to profit from it. Some tell me candidly that whether MLM is illegal or not is a moot point as long as regulators take no corrective action. Others admit, despite years of business experience, to being utterly perplexed by MLM's business model, compensation plan and marketing practices.


The MLM industry's promise of a "safe haven" from recession and a rescue from unemployment and its hallmark claim of "unlimited" income have a mesmerizing effect on Main Street. A similar effect is created on Wall Street by MLM claims of a business capable of rocket-like growth, debt-free cash flow and outsized profits, without need of R&D or even advertising.

The business media too can be dazzled. INC Magazine, for example, in 1996 named the multi-level marketing company, Equinox International as #1 on its "INC 500" list of the fastest growing privately held companies. In that year, Equinox claimed 100,000 distributors, a growth rate of more than 35,000% over a five-year period and annual sales approaching $200 million, selling ordinary vitamins, water filters and household items. That 1996 edition of INC featured the company founder on the magazine's cover, a glowing interview with him and an article touting the MLM sales model.

Then, in August 1999, the FTC and eight states prosecuted Equinox International alleging that Equinox was an illegal pyramid scheme. The settlement resulted in shutting down the company, restitution of about $40 million to victims, and the banning of the company founder from the MLM business forever.

Too Complicated for Experts to Understand?

Pyramid schemes are well known as inherent frauds based upon deception, robberies of Peter to pay Paul, endless chain scams, and closed market swindles. So, why should it be so difficult to spot a pyramid fraud among sales companies that are all over Main Street and are being promoted by friends and family?

One would also expect that Wall Street could deftly identify a pyramid scheme whose stock is listed on a major exchange. This is especially true since pyramids are easier to identify than Ponzis are. In the Ponzis, the reality of an unsustainable money transfer can be concealed by a clever perpetrator who secretly solicits new investors to pay earlier ones. Bernard Madoff proved this. A pyramid selling scheme, on the other hand, openly sends current participants on an income-seeking mission to recruit new participants to do the same, ad infinitum. To investors, it candidly reports that profits depend on the continued recruiting, and it dutifully lists under "risk factors" in SEC filings the potential of the company being charged with pyramid fraud.

Yet, the heated debates on the legitimacy of the MLM, Herbalife, show that Wall Street appears to be as flummoxed by multi-level marketing as Main Street is.

Regulatory Threats

Though MLM's volatility and complexity can produce extraordinary capital gains opportunities and attract high-rolling speculation, this general state of confusion is not good for investors. Just one regulatory action can bring down a multi-level marketing business like a house of cards. This happened in 2008 with the publicly traded MLM company, Your Travel The Direct Selling Association awarded YTB membership status and its seal of approval for meeting the industry's standard for "ethics" and legality. YTB had a "sales force" of over 340,000 in the USA. It drew 20,000 participants to its annual meeting in St. Louis in 2007. It was the fastest growing travel agency in America. In 2008, the number of YTB "agents" grew 67%. Its 2008 annual convention featured a 130-foot replica of the Statue of Liberty, weighing 50,000 pounds. YTB's stock had climbed to above $4 a share and there had never been a federal regulatory action against the company.

Then in 2008 the California Attorney General prosecuted YTB as an "endless chain" banned under California law. The state prosecution stated, " operates a gigantic pyramid scheme that is immensely profitable to a few individuals on top and a complete rip-off for most everyone else." The prosecution was followed by class action lawsuits brought by consumers. The YTB stock collapsed totally and is now at virtually zero in value.

The End Is Near, or Not?

Absent a regulatory action, investing in a business that is financially unsustainable is a classic folly - in the end - and especially so if the investors don't know when the end will come. Apart from speculations about collapse, if MLM businesses are so opaque and complex or operate so near to illegality that hedge fund managers cannot agree as to their legality or sustainability, what are less focused investors to do?

But what is bad for Wall Street is even worse for Main Street. Millions of ordinary people are being solicited to invest in these MLM companies not as shareholders but even more directly as participants in the MLM's advertised "income opportunities." Their individual financial stakes may appear small from the heights of Wall Street but, for many, they represent their last best hopes for economic survival. Making a last ditch investment into what turns out to be a pyramid scheme is a financial death blow. When this happens to hundreds of thousands of people, it is a national tragedy.

Pyramid Detection Tools

Referencing some of the most common points of contention, here are salient facts and business-based insights for developing the all-important skill set of pyramid detection.

Business or Bunco?

It can't be a pyramid. It's a business. It has good credit. No debt. It's profitable and growing and has been running for years now. For heaven's sake, my brother-in-law is in it!

A pyramid scheme can definitely look just like a business, and investors, promoters and endorsers may be trusted figures. This was the case for Enron. Bernard Madoff's hedge fund looked above reproach too. So how can you identify the scams, unless you are a Boston lawyer or a Wall Street quant?

In fact, the most telltale sign of pyramid selling fraud is actually the most obvious. Anyone can see it by just believing their own eyes. Applying the simplest definition of a pyramid scheme informs us that any business in which profit is based upon the investor-participant's success at recruiting more investor/participants is plainly and simply, an endless chain. It may be popular, glitzy and fast growing. Your favorite sports star may give it his (paid for) blessing. And in the absence of regulatory oversight, call it legal or illegal. It's pretty much your call.

But, by design and by definition, if income and profit existentially depend on the salespeople recruiting more salespeople, it is a pyramid scheme or endless chain. Endless chains, of course, are not really endless. Markets for products and for recruits are finite, and they inevitably saturate. If someone invests either as a shareholder or a participant on the premise that earlier growth will continue, and their income chances are as good as those who invested earlier, they must be deceiving themselves.

Retailing or Recruiting

Distributors can also be customers. They count as retail buyers.

The recent uproar surrounding Herbalife was provoked when hedge fund manager David Einhorn asked Herbalife managers what percentage of company products are resold by the distributors to retail customers. This seems like an innocuous question. In fact, it is loaded. This is because repeated court rulings have affirmed that MLM rewards to recruiters must be derived from retail sales revenue, not from purchases of other salespeople. Moreover, the courts have plainly defined retail purchasers as those who are not involved in the pay plan, i.e., not salespeople/distributors or those who signed sales contracts that offer recruiting rewards. In the ensuing years, those court rulings led to a war of words over what is a retail sale, how much retail revenue is enough for legality and whether a purchase by a wholesale distributor at contract price constitutes an open market retail sale.

It must be remembered that the presence of retailing does not change the inherently fraudulent and harmful nature of an "endless chain" income promise. However, it may reduce the harm, since some of the participants might be able to recoup at least some of their costs by successful retailing, even if they would still inevitably fail to gain the promised recruitment-based rewards. Retailing does not redeem an endless chain from fraud, but it may reduce its egregiousness somewhat.

Lost in this legalistic and semantic debate about retailing and retail levels are basic economic realities that under gird why the court was addressing this seemingly non-legalistic factor in the first place. Retail sales are addressed by the courts because, without them, the plan unequivocally becomes a closed market swindle. If all or nearly all the money paid in to the multi-level marketing company comes from purchases of the contract salespeople themselves and each salesperson gains rewards only by bringing in other salespersons who do the same, then there can be only one way for the participants (salespersons) to make a profit; that is to endlessly expand the sales chain. Company profit would, therefore, necessarily be based on recruiting more salespeople who hopefully recruit more salespeople, forever. Of course, such a model is impossible, and it could not operate at all without deception of the recruits, the majority of whom are doomed by the plan's design.

Whether most of the salespeople want to recruit and make a profit or not, the plan could not fulfill its promise to those who do want to make money. It must doom those at the bottom of the recruiting chain, and the bottom will always be the majority of all who are trying. Any claims about "unlimited income" and "opportunity for all" must be false. Such a closed market system, the courts have affirmed, is inherently "unfair and deceptive."

The impossibility of a closed market/non-retailing model to fulfill income promises and the certainty of its inflicting losses can be seen in the simple illustration of 10 people each paying in $10 to participate in the pay plan. $100 is total revenue. If there is not an outside source of revenue - equivalent to retail sales revenue - for even one of the 10 to gain more than his initial $10, at least one of the others must lose. If one or several are to make a large return on their $10, all or most of the others must lose. This is the classic zero sum game.

Unless most salespeople make most of their money from retailing, then recruiting remains the core of the business model, placing it in regulatory and financial jeopardy. Unfortunately, few MLMs offer data on retailing levels and they are not required by the SEC or the FTC to do so. Investors must therefore make their own assessments.

These following, non-legalistic assessments can aid in making a valid determination of whether the company is retail (sales) based or (pyramid) recruiting based:

Retailing 101

  • Does the MLM company advertise or are its products already well known by the general public? Unknown, unadvertised products are far more difficult to retail.
  • Does it offer a product that is unique, differentiated and demonstrably superior to comparable products so as to justify person-to-person selling? Commodity products are difficult to retail personally. No one needs a personal sales rep for a commodity product.
  • Are the retail prices competitive to similar products offered by other sales channels such as stores or on the internet? Overpriced products are far more difficult to retail, especially if they are not unique or command brand loyalty.
  • Is the gross profit margin offered to the retailers sufficient to cover the high selling costs of personal retailing? This gross retail profit margin must be sufficient to cover not only the retailers' business costs but also the extreme time and labor investment. Few MLM companies offer as much as a 50% gross margin and in those cases, usually only for those making largest inventory purchases or who have already reached a large "group volume" threshold, based on the purchases of their recruits.
  • Is the sales force stable enough to build a base of repeat retail customers? A churning sales force means inconsistent customer service and loss of continuity in relationship building.
  • Do the incentives for retailing and the income potential from it outweigh the rewards for recruiting a "chain" of other salespeople? If the MLM company offers greater rewards to those who recruit, this is a flaming red flag. For some companies, average retail profit margin is around 25% while the commissions tied to recruiting total often as much as 355-50% of the wholesale price. More, per sale, is paid to recruiters than to the person making a sale. The great majority of that higher reward also flows to the 1% at the top. This is an enormous incentive to try to get to the top, which means recruiting, not retailing. The recruiter is also able to leverage the efforts of many others, while retailers must produce all revenue from their own sales efforts.

One more factor is all important in assessing retail activity. Like the first and main evidence of an endless chain, this retailing factor also is in plain sight, and only requires a willingness to believe one's own eyes and judgment. This fatal flaw is fundamental and intrinsic and, when present, would determine whether the company is retail-based.

Does the company offer every salesperson rewards for recruiting yet more salespeople, with no limit in any geographic area? If it does and the rewards for recruiting overshadow those of retailing, how could any single retailer survive unlimited numbers of competing retailers being continuously added in his/her sales area? With more rewards offered for recruiting, why would anyone even try? More sales outlets offering the same product means fewer sales for each. Continued inundation of each area with more and more retailers violates the first requirement of profitable retailing: a limited number of competitors for the limited number of customers.

Fortune or Folly?

Everyone has the same chance. If you work hard, anyone can do it.

It is now well known that the loss rates (failure to make a profit) for participants in multi-level marketing companies are huge, 90% to 99% or even more. The odds to make the advertised big bucks are too small to graphically illustrate. This is not denied. William Ackman's claims about minuscule income chances for salespeople in Herbalife are based on Herbalife's own disclosure. But there is much confusion about the cause of these losses. In the current Herbalife/Ackman/Einhorn debate, for example, one side says that the income claims are false and misleading. The other side says most people join just to get a product, not to make money, so they choose to not make money, but could if they wanted to.

Fortunately, math and a basic business model analysis can provide a diligent observer with facts, not opinion. Regardless of the alleged motives of participants, an endless chain recruitment plan, in which profit and income depend on continued recruitment, requires that only a few can be profitable. This is true whether most want to be make money or not. The skewed loss rates are pre-determined. The participants could all be as wise as Warren Buffett; the loss rates would be exactly the same.

The cause for these losses is in plain sight. It is the model itself. If an individual participant's profit requires, for example, the enrollment of at least nine more people who similarly join up and pay fees and buy products, then only one in 10 can ever be profitable. 90% must always lose because, at all times, collectively, there must nine seekers for each winner. The 90% loss rate, based on the ratio of those who pay and those who get paid, is immutable and will be true whether 100 people are in the plan or 100 million are.

Products or Ponzi?

Products are sold and payments are based on sales, so it can't be a pyramid scheme.

A disguised pyramid or Ponzi may involve the buying and selling of stocks in South Sea Island real estate, Dutch tulips, miracle vitamin pills or ordinary household soap. Actually, most any product will do. This is because the factors that make a business an endless chain or pyramid scheme are not related to the presence or absence of products. All the MLM companies prosecuted by the FTC sold products of some kind.

The basic pyramid model and how it can be disguised can be more clearly observed in one of the most notorious non-product pyramid schemes to sweep through America and Canada, and continues to do so, repeatedly. This pyramid scheme is called a "gifting club." Gifting clubs have been prosecuted in more than 30 states and have operated widely in Canada. Millions of people have joined them. The most popular ones targeted women and claimed to offer a remedy against job discrimination and support for stay-at-home moms. In fact, at least 90% who join always lose, by design. The Gifting Clubs have no products to sell, but they do have a story to disguise the endless chain and the money transfers. The story has successfully duped millions of people.

The basic model has one person at the top, two others in the next level, followed by a four-person level and then eight people at the bottom. Each new participant in the eight-member positions at the bottom "gifts" (not pays) $1500 to the top person and then "invites" (not recruits) new people to also "gift." As more people join the club, each participant moves up the four-level endless chain eventually to the top position. When all eight positions fill, the top person has received $12,000 in gifts and exits the club. The recipients of the eight gifts can also re-enter at the bottom and repeat the cycle as long as the recruiting process continues, which is believed to be forever. After the eight positions are filled, two below the top then assume top positions of two new clubs. The two clubs each solicit eight new people or 16 in total to fill their respective bottom positions. When they are enrolled, another 32 are needed, etc. For every person that "receives" the money, at least another eight had given "gifts" and not yet received anything.

The pyramid is in plain sight, and the endless (and impossible) expansion is easily grasped. (10 cycles of eight people each recruiting eight consumes the earth's population at the 11th cycle.) Yet millions of people fail to see it. Instead, they focus on the "story" of club members happily giving money to and receiving money from each other, and they are diverted by the lure of an 800% return that could be gained in as little as a week and then repeated forever! Most were also solicited to join by a trusted friend of family member, lowering the threshold of diligence. The scheme's leaders assure recruits that the club is not illegal because the participants are not "paying to join" or "gaining rewards for recruiting" (referring to explicit prohibitions in the wording of the anti-pyramid laws). They are only "giving" and "receiving." So it's legal! Besides, just look around. Do the people that are involved look like criminals?

Buying products or start-up kits as part of "qualifying" for rewards and then gaining "commissions" when new recruits similarly buy products to qualify can function for pyramid selling scams just like the giving/receiving cover story does for the gifting pyramids. Both schemes can claim they escape the defining words of anti-pyramid laws. Words, perhaps, but not meaning. Both will inflict the same level of losses on participants. Both will have deceived the losers, who usually do not ever suspect illegality.

Behind the Disguise

Products or not, gifts or payments, or whatever disguise may be employed, there are two main factors that make an alleged business or club a pyramid scheme.

  1. The payments to gain the right to recruit and receive rewards tied to recruiting others who gain the same right by also paying, even if that payment also includes buying a product
  2. Receipt of rewards (usually money but can also be "points" that are exchanged for money) that is tied to recruiting more participants who also pay, i.e., buy products as part of gaining or maintaining the recruiting rights, forever and ever.

Products can be merely a vehicle for transferring money, part of a disguise to make it appear that everyone inside the pay plan is just happily buying and selling consumer products - but mostly just to each other.

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.