Herbalife (NYSE:HLF) investors are aware that the company is under investigation by numerous regulatory agencies around the United States.
Specifically, FTC expert Dr. Peter Vander Nat is likely pouring over the details of the Herbalife Marketing Plan to determine whether or not "in practice" this incentive system is a pyramid scheme.
In the late 1970s and early 1980s Faberge Organic Shampoo ran a series of television commercials that were somewhat unforgettable. Heather Locklear was hired as the spokesperson for the product and starred in this commercial from 1981.
"I told two friends, and they told two friends, and so on and so on and so on…"
Q. What does Heather Locklear have to do with Herbalife?
The answer has to do with mathematics, probabilities and outcomes.
Ms. Locklear's television commercial accurately describes the recruitment pattern in a type of pyramid scheme. Another term that is used to describe this pattern is a binary recruitment pattern.
The pattern starts at the Top and then progresses as the first person recruits two friends who then recruits two friends and so on and so on and so on…
Sounds simple, yes?
Q. What does FTC expert Dr. Vander Nat have to say about this sort of geometric progression?
To find out, all we need to do is search for his expert testimony in historical pyramid scheme prosecutions. Particularly interesting is Dr. Vander Nat's analysis in the FTC v. SkyBiz case.
Sky Biz was shuttered as a pyramid scheme. Embedded in Dr. Vander Nat's Appendix was a mathematical analysis of how Binary Compensation plans are structured in such a way that the vast majority of participants are mathematically doomed to fail at the business opportunity.
This result is not arbitrary - it is predetermined by design.
Investors like Mr. Icahn and Mr. Stiritz would do well to listen to Ms. Locklear. Perhaps she will prompt them to inquire more robustly into the real, lottery-like mechanics that lurk beneath the veneer of legitimacy Herbalife offers day in and day out.
Statistical evidence that the vast majority of people who now pursue the Herbalife business opportunity fail is readily available in the company's 10ks, Regional Key Metrics Disclosures, Statements of Annual Average Compensation. The turnover in the salesforce is certainly not a mystery. The data, actually, is plain as day.
The question that needs to be asked is "Why are they failing?"
Let's ask this question a different way.
"Why do so many people who buy lottery tickets fail to win the jackpot?"
People who play the lottery often have their favorite numbers or individual superstitions. The faithful seem to believe that the numbers produced weekly are not a result of some random mathematical outcome with readily ascertainable probabilities. In delusional fashion, lottery players think that their own efforts or ideas have some influence over their chances of "winning". Unfortunately, the lottery is a rigged game. There is only one Jackpot winner. Everyone else who plays loses. The House keeps the difference.
In like manner, pyramid schemes are rigged games. The mathematics are different but the result is the same.
Consider what Dr. Vander Nat has to say in his Sky Biz testimony which can be found here. If you haven't bothered to read it, I suggest you read it closely.
In practice, Sky Biz' compensation plan functioned just like a lottery. Results for participants are not arbitrary. Rather:
Dr. Vander Nat writes:
" A pyramid scheme is an organization in which the participants obtain their monetary benefits primarily from the recruitment of new members and not from the sale of goods and services to the public. The proposed rewards set forth in a pyramid scheme are tied primarily to an ongoing ability to recruit others into a stated program and, thereby, a situation is created in which the proposed rewards cannot come true for the vast majority of participants. As recruitment continues, the number of people who are at or near the base of the recruitment structure grows very rapidly, often at an exponential rate for as long as a successful recruitment pattern is maintained. At whatever enrollment level new recruitment ceases, a number of layers of the most recent recruits cannot qualify for the proposed benefits precisely because their own "downlines" are either empty or have insufficient numbers. Moreover, given the nature of the recruitment pattern, these same people (those who are at or near the base of the recruitment structure) comprise the vast majority of participants. The resulting losses are not accidental; they are determined by the structure of a compensation plan that ties most of the proposed rewards to a participant's ability to recruit others into the program."
"Every pyramid scheme is a transfer scheme, but each pyramid has its own specific rules whereby the transfer takes place."
In a footnote the FTC expert writes:
"There are known examples of this type of phenomenon. Many magazine subscriptions are sold via sweepstake programs that offer a large jack-pot, and many people buy a subscription in the hope of obtaining a prize. (If this were not so, one may trust that the promoters would not undertake the substantial costs of such a program.) The difference for the Sky Biz program, however, is that a lottery and its related odds are not disclosed; the program is sold as a "business opportunity."
He goes on to write:
"32. I am aware that in the above analysis I have not addressed the value of the product. I have no expertise in evaluating the technical characteristics of a web site, and I have not reached a conclusion about the market value of the Sky Bizweb pack. For purposes of this declaration, I tacitly allow the assumption that the web pack may have some positive market value. I explain below why a pyramid conclusion does not hinge on the market value of the company's product.
33. If a pyramid uses a product that is generally worth what the company claims, it may seem all the more plausible to general participants that the operation is a legitimate business and that, ostensibly, the rewards are being funded from the sale of the product. But such a view misunderstands the funding mechanism that a pyramid uses. Unbeknownst to general participants -and whatever the product may or may not be worth- the terms of the pyramid compensation plan secure the result that the vast majority will fail to obtain monetary rewards, so that the company can use the net monies paid by those who are not entitled to rewards and give that money to those who are entitled under the same plan. If, in addition, the pyramid promoters also misrepresent the value of the product and can thereby extract additional funds from the participants, the net transfer becomes all the greater for the "winners," while the losses for others increase correspondingly. In my opinion, the value of the product addresses the extent of harm, not whether a pyramid exists."
Finally, in the Appendix, the FTC's expert produces a Mathematical Formula that shows how a binary recruiting plan articulated so well by Heather Locklear effectively locks late entrants up in the bottom tiers of the structure mathematically dooming them to financial failure not by happenstance but rather by mathematical design.
This is the mathematical fallacy that is described so well in Koscot. This is how Money Transfer schemes like Herbalife function "in practice."
Think of it this way. Compensation plans like Herbalife's are well-designed games. When followed by the participants or players the result is predetermined. Cash injected into the game at the bottom of the pyramid is transferred to those who design and sponsor the game at the top.
This is the same mathematical outcome we see with lotteries, Black Jack tables, Slot Machines, and Craps. In the long run "The House" (or if you prefer the Upline) always wins.
Herbalife can wrap its game around a product like Formula 1 or an athlete like Cristiano Ronaldo or a Professional Sports Team like the LA Galaxy or send missionaries to Washington to lobby congress about what a great company they are.
Unfortunately, none of these behaviors by a firm flush with free cashflow changes the math for the poor suckers trapped at the bottom of the pay plan.
And so, just like a lottery, the marginal entrants into the scheme fail.
Legitimate Multi Level Marketing Plans tie commissions to the sale of products to real retail customers.
Prohibited Marketing Schemes pay participants commissions for recruiting new participants. Whether or not inventory loaded onto the books of these new recruits is ultimately sold to retail customers or not doesn't change the mathematical outcome for those pursuing the business opportunity.
As upline participants continue to proliferate an endless chain of new recruits/income seekers and push out the number of levels in the multi-level hierarchy the majority of the participants in the scheme have to fail. Meanwhile, the "Winners" continue to get paid as long as this recruiting cycle proliferates. Isn't this what the likes of Susan Peterson have figured out? Why else is she always recruiting?
The MLM uberazzi have made a living trying to obfuscate the essence of what a pyramid scheme is and what it isn't. Their efforts, by design, are intended to "Move the Show" or "Wag the Dog" in such a way so as to draw attention away for the sinister mathematics of a professionally structured confidence game.
Fortunately for society, the FTC has experts like Dr. Keep and Dr. Vander Nat who understand this mathematics all too well and exactly how they work.
Herbalife is a recruiting company that uses a deliberately designed incentive system that is a pyramid scheme to expand its reach. The further this reach expands, the more new people get victimized.
Why else do we see such massive year over year turnover in the bottom levels of the pay plan Mr. Hempton? Surely you don't think it is because participants are just getting skinny and moving on.
Let's get real! Participants pay $59 - $100 to join and then get paid recruiting rewards when new recruits sign-up for the business and select a "Membership Level" in the pay plan. The most lucrative commission level for the recruiter is SUPERVISOR. Participants inventory load to either buy a higher status level or buy a higher discount or both. Of course to earn royalty overrides too, SUPERVISOR is the place to be.
What is the road to riches?
- Duplication or if you prefer recruiting.
If you build out your downline and your downline builds out their down line and "so on and so on and so on…"
Two things become true:
- Those at the Top get richer
- Those at the Bottom get churned
Herbalife might just be the most sophisticated pyramid scheme in the history of the world. Certainly, the hubris of its management team and Board of Directors and Top Recruiters is staggering.
Engineering a massive recapitalization of the balance sheet simultaneously gutting the company's estate of proceeds for restitution takes brass.
Then again, Herbalife has been breaking the law for 34 years. Why stop now?
Heck - they've even recruited Carl Icahn into their ruse. Mr. Stiritz has attached his reputation to this carnival game too.
Gentleman, I beg of you, please review Dr. Vander Nat's testimony more clearly. The math is undeniable.
To close, Herbalife tells the world that it sells a business opportunity that is the "solution for these tough economic times".
Mathematically, this statement is an outright lie for the vast majority of participants who languish at the bottom of the pyramid.
What's the harm?
Let's read what Dr. Vander Nat had to say about Sky Biz.
"Regarding the harm caused by the Sky Biz program, I point out that this harm is not postponed until saturation has been reached for potential participants. The company's materials envision and advocate a binary recruitment scenario: each participant purchases a web pack and enrolls (at least) two others who do the same.
As shown in the mathematical appendix, at whatever size the organization may be considered -whether fairly small at 2,000 total members (corresponding to n = 10),or fairly large at some 131,000 total members (n = 16), or at any other level to which the scenario is extended- more than 87% of members are in the bottom three levels of the recruitment structure (levels n -2, n -1, and n); moreover, these same levels fail to achieve any "pay step."
Also, given the monetary amounts associated with paysteps, some 94% of participants will either earn nothing or not recoup $100. This failure does not depend on the particular time frame over which the program may be considered, nor on whether saturation has been reached for potential participants."
Put another way - the sooner the FTC shuts down Herbalife the better.
One has to applaud the engineers of Herbalife's short squeeze and recapitalization. The stock trades $65 today and life has been uncomfortable for Pershing Square for sure.
Mind you, Dr. Vander Nat and his PHD has yet to finish pushing the buttons on his calculator.
Longs who do not hit the bid before he does may be in for a shocker.
When you think of Herbalife's Pay Plan as a Casino Game v. a Commission System you start to get the picture.
Disclosure: The author is short HLF. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.