The Federal Trade Commission And The Need For Investigations Into Pyramid Schemes

Includes: HLF
by: Bruce Craig

Recent news items have reported a possible investigation by the FTC into pyramid schemes. Open record requests by the New York Post recently disclosed 197 complaints filed with the FTC against Herbalife (NYSE:HLF) in the past seven years. Herbalife's web site indicates that it has more than 2.5 million distributors in over 80 countries.

This does not seem to be a significant number of complaints, given the number of distributors involved. As I have stated in an earlier article, the number of complaints against a company should not be the primary basis for enforcement activity by an agency charged with protecting the consuming public. The reason for this, in this context, is that distributors who failed were told, and preconditioned to believe, that the failure was their fault for not working hard enough. It was not the company's fault since it was legal and not a pyramid scheme. The real question for the FTC should be the extent of damage done to persons that participate in pyramid schemes, not the number of complaints filed.

It is important to note that the victims of these offerings are not sophisticated investors but are often persons hoping to improve their lot in life and who may well invest savings or borrow the money to participate. This includes the use of microloans such as those offered by the Grameen Foundation. Also to be considered, are the victims in the many other countries that accept these business offerings because they are considered legal in the United States and, in fact, are listed on the major US stock exchange. Reliable reports indicate a failure rate among victims in excess of 90%, certainly an indication of considerable injury worthy of further investigative inquiry.

The extensive discussion of the Ackman - Herbalife dispute has documented, if nothing else, that the legal definition of a pyramid is far from clear. Some states, such as New York, have a relatively distinct definition as "a sales device whereby a person, upon a condition that the person make an investment, is granted a license or right to recruit for profit one or more additional persons who also are granted such license or right upon condition of making an investment and may further perpetuate the chain of persons who are granted such license or right upon such condition."

The Federal Trade Commission, on the other hand, has stated "the critical question for the FTC is whether the revenues that primarily support the commissions paid to all participants are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture." Other recent Federal Court interpretations have expanded this concept somewhat, but the focus has been primarily on whether the company in question is involved in paying commissions for "retail sales" that are not solely compensation for purchases made to qualify for the right to recruit others.

While there is considerable speculation whether Herbalife, or other companies, are the subject of current FTC investigations, the critical question has to be asked why in-depth threshold investigations have not been conducted over the past 30 years? There certainly has been enough external evidence of the potential for considerable consumer damage, well into the billions of dollars. The Commission's recent case against Fortune High Tech involves a company that had been in business for about 11 years, why did it take so long to reach the conclusion that it was a "massive pyramid scheme"? Amway was sued for operating a pyramid scheme, and then legalized, in 1979, because it proved it had 70% retail sales, a ten customer rule, and a buy back program. In 2000, I asked the Commission to use its investigative authority to determine whether these ostensibly legalizing elements were actually implemented by the company and effective in protecting participants in the manner contemplated in the Commission's ruling. This request was denied.

The FTC has considerable investigative authority. It would seem a relatively basic task to ask companies involved in this disputed area whether they have the capability to document, and in fact do document, that they have the 'retail sales' necessary to comply with the Commission's standards. This is not to say that these standards are adequate, but at least it would be a start in determining the extent and consequence of these marketing methods. Of course, it has been reported that these companies do not have actual records of retail sales, since they deal only in wholesale transactions. This would be one avenue of inquiry for the Commission's investigative attempt to determine whether adequate records exist and whether the Commission's legal standards are capable of objective determination sufficient to protect the public. This investigative effort should take place soon after a pyramid style company begins business not, as with Fortune High Tech, eleven years after it started business and 100,000 distributors were left in the lurch. It did not become a "massive pyramid scheme" overnight.

The Federal Trade Commission is not meeting its obligations to potential victims or to investors, who are entitled to have some confidence that the stocks they buy are not tainted with illegal conduct. It is time it got serious with an industry with $28 billion in annual sales and a checkered past.

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.