One Of Herbalife's Greatest Risks

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

In a Seeking Alpha article posted on January 17, 2013, I predicted that Herbalife would have to start cracking down on the recruitment methods used by its high ranking distributors as a result of the attention drawn to these practices by Bill Ackman's presentation in December. This prediction has proved accurate, as Herbalife has evidently been reviewing its distributors' sales methods and has determined that the vast majority of previously approved lead generation systems are unacceptable. Tuesday, the New York Post reported that Herbalife (NYSE:HLF) "has cut ties with a controversial group of online recruiters who promise to help new salespeople build their own Herbalife businesses with pitches such as 'be your own boss' and 'stay home with your kids.'" These "online recruiters" are actually high level Herbalife distributors who not only earn royalties from Herbalife for purchases made by their "downline" distributors but also make money by selling "lead generation systems" to their downline distributors. According to the article, in 2010 there were 29 such systems, which had been approved by Herbalife. As of February 15 the number has decreased to two. This is more than just housekeeping; this is a radical restructuring of the relationship between Herbalife and its top ranking distributors, who collectively control large portions of Herbalife's distributor force.

What are Lead Generation Systems?

The term "Lead Generation Systems" (LGS) is used within Herbalife to refer to distributor-developed promotional systems, including the use of mass mailings, Internet and telephone solicitations, sign-posting, sales scripts and other techniques designed to increase recruitment of new distributors.

The use and impact of similar systems in Amway, the largest MLM seller, has been documented in books such as Amway Motivational Organizations: Behind the Smoke and Mirrors and Merchants of Deception . These writers demonstrate how high level Amway distributors can make more money selling lead generation systems to their downlines than they make in the commissions paid by Amway. Of course, in Amway as in Herbalife, the vast majority of distributors lose their investments and drop out.

In some MLM systems distributors must exclusively use company-developed promotional materials. This provides some protection to the company, since there is less likelihood that materials which have been vetted by its in-house attorneys and marketing professionals will be found to be deceptive or unlawful. On the other hand, MLM distributors often want to develop and use their own promotional materials because the company-produced materials are perceived as too bland or not sufficiently aggressive.

Herbalife Has Long Known of the Risks of Distributor-Produced Promotional Systems

Herbalife distributors began developing lead generation systems in the 1990's. In a 2001 letter to President's Team distributors, Herbalife's then CEO, Francis X. Tirelli, stated that the purpose of lead generation systems is to take advantage of "21st Century communications vehicles" such as the Internet and computerized mailing and telephone systems. This letter is quoted in a class action complaint which I drafted in a case involving several Herbalife lead generation systems (the case has since been settled). Tirelli went on to write that lead generation systems were "[o]ne of our greatest opportunities [but] also one of our greatest risks." Tirelli characterized LGS as one side of the "Golden Triangle of Success" (the other sides being "products" and the "Home Office") and noted that he had been communicating this message at every corporate and distributor event he had attended. Tirelli stated that "Herbalife is committed to take full advantage of all the collective innovative and creative solutions in the marketplace with respect to Lead Generation Systems." Tellingly, Tirelli warned that "LGS should be an augment to the Herbalife mission and business and should not become more important economically than the Herbalife opportunity."

Herbalife Retains the Power to Approve or Disapprove Distributor-Produced Sales Materials

Under Tirelli, Herbalife adopted a series of guidelines, effective January 1, 2002, governing the use of Lead Generation systems. These guidelines included review by Herbalife of every system to ensure compliance with legal regulations, industry standards and Herbalife's own standards (although Tirelli emphasized that he would be personally involved in all decisions and was committed to the "innovative and creative use of LGS"); a requirement that at least 50% of every LGS should be focused on Herbalife's products; an understanding that the purpose of LGS was to "augment the Herbalife mission and business and should not become more important economically than the Herbalife opportunity;" and a requirement that "all LGS should stay within the Chairman's Club lineage."

The 2002 guidelines were addressed to the actual kinds of problems Herbalife was already recognizing that it had with Lead Generation systems. When Tirelli referred to LGS as "one of our greatest risks" he was in my opinion referring to the adverse impact of regulatory scrutiny and exposure to civil lawsuits which would likely be prompted due to the use of deceptive LGS promotional materials and the emphasis on recruiting new distributors over retail selling. My belief is that MLM companies like Herbalife and Amway permit distributor-produced promotional materials and lead generation systems as a way of preserving plausible deniability as to deceptive earnings and product claims made by their distributors. Allowing the use of these materials also enables high level distributors to earn more money and encourages them to stay in the system.

Conclusion - Risk Becomes Reality

The New York Post article quotes an unidentified Herbalife spokesperson as saying that, "some distributors did create online business systems that involved lead generation in the 1990s, but added that 'very few are still using those methods.'" I doubt that the use of Herbalife lead generation systems is as insignificant as Herbalife's spokesperson suggests. On the contrary, it appears that at least one of Herbalife's LGS systems generates enough money to fund the purchase of millions of dollars worth of promotions on radio talk shows.

The substantial reduction in the number of approved Herbalife lead generation systems indicates that Herbalife has weighed the risk of having implicitly approved deceptive promotional systems against the risk of alienating an influential group of high level distributors and has concluded that it simply cannot afford the regulatory and litigation risks created by lead generation systems. I predict that Herbalife's actions will have a material impact on distributor recruitment and retention. Moreover, since Herbalife had previously approved the now-disapproved lead generation systems, and since those systems were used to recruit hundreds of thousands of distributors who have lost untold millions of dollars, Herbalife is still facing serious regulatory and litigation risks.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.