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Herbalife (HLF) Denouement: Nothing Is What It Seems...

|Includes: Herbalife Nutrition Ltd. (HLF)

The Herbalife (NYSE:HLF) grind is becoming tiresome. No one can predict the outcome of the current conundrum, and until then the market is necessarily in limbo, supported mostly by the artifice of the current share buyback program. Meanwhile Herbalife is now borrowing one from the Amway playbook, and sending their own demonstrators to DC, while analysts are paying attention to the fact that Herbalife may be becoming a case of "the lady doth protest too much," when instead they could simply address the issues. Hayman Capital seems to be opportunistically trading in and out, reminding us not too read too much into the actions of some. And the insider blogger TheSkeptic21 seems to have been de-fanged.

The longs look at the reported numbers, take them at face value, and assume that thirty years of inaction by regulators is a virtual guarantee of immunity of the Herbalife business model. Some of them even seem to be Herbalife distributors, who have an obvious ax to grind.

The shorts insist on looking under the hood, and questioning the business model (which the longs think is not a decent thing to do). The shorts tend to think that the stellar top-line financials simply are prima facie evidence that something is too good to be true. Then they try to find what is wrong, all of which at this point boils down to trying to second guess the regulators and law-enforcement who are currently investigating the company. Given forty-plus years worth of obfuscation by regulators and subsequent jurisprudence, the odds of any more clarity resulting are low, though an attempt may be in the works.

MLM has been a troubled business model. Completely aside from the question if HLF individually should be found legal or be shut down, it is much more important for the market that clarity of regulations be provided, as Prof. William Keep et al continue to argue. Prospects of that happening remain dim. A lot of valuable critical work has been done, starting with the presentations by Pershing Square, and various other analysts including some on this site. Inevitably, a lot of other solid analysis can be found by those who search.

The franchise law workaround

Many MLMs, particularly of the "pay to play" variety, go to great lengths to circumvent franchise laws, which would come, among other things, with disclosure requirements they don't like. The only reason not to like disclosures is because you have something to hide. A variety of MLM-constructs are around, typically with some initiation fee, usually below $500, to the point of ridiculousness, like $499, and monthly fees, annual renewal fees, etc. In short, companies raise as much as a thousand or more in first year "fees" per sign-up, just not at sign-up, and that seems to keep them below the radar screen of the franchise laws. Plus, they know that 9 out of ten fail to renew the first year, and write it off, so in effect they have statistical certainty to raise $10,000 in fees for every first year renewal, and still remain under the radar, though Fortune High Tech Marketing was one venture in this vein that came to grief, and there is a class action cum RICO suit pending against Ignite/Stream, a Texas based energy company.

In Herbalife's case, it's different, and they may have negotiated themselves into a corner with some of the changes they have made in an attempt to forestall regulatory problems. The initial fee has been relabeled "membership," as if people were buying into a discount buying club, and they now get a 25% discount. As has been pointed out by many, this appears to be somewhat pointless since the products are widely available at steeper discounts from a variety of online sources. The fallout from this is, that it then becomes very clear that the "opportunity" begins only with the $3,000 "supervisor" position, which would be clearly above the $500 limit, though it is not a fee, but "only" a necessary condition for the "benefits" of the supervisor position, not to mention that it is inventory loading. Similarly, the start-up cost of the "nutrition clubs," could face problems with the franchise laws. These constructs potentially cross the line into the franchise arena, and therefore legal requirements, beginning with disclosure requirements. The nutrition clubs represent a somewhat significant investment, and were an erstwhile Herbalife approved "business method," although they now took themselves out of the business of "approving" methods.

In short, if regulators do not act decisively this time, and in effect leave Herbalife and the industry in limbo, this issue of circumventing franchise laws is quite likely to be tested at some point. Herbalife's own actions may have set them up for that challenge.

Legal MLM or Illegitimate Pyramid Scam

The FTC definition of the distinction between the two is relatively useless. The SEC clarification is hardly that either. These sites tell you some trouble signs to look for, but do not give clear guidance, or any definitive line of demarcation between legit and illegitimate. Clearly they are still confused, or at least still making up their minds, and until then everything remains open to interpretation. The given state of regulation and jurisprudence does not give them much of an option.

The FBI weighs in on pyramid schemes also (see comments under advance fee schemes, and pyramid schemes). But again, for the most part, the consumer is left guessing. Nothing is clear-cut and definitive, although there are some definite no-no's.

From the past forty years of regulatory attempts and jurisprudence, a number of marker issues have arisen which may or may not be relevant, depending on circumstances. There are issues like the 70% retail sales (from the '79 Amway ruling), or whether or not personal consumption counts (Koscot, Omnitrition, Burnlounge). There are other issues of associated fees, that can be hidden under different business entities, like the tool scam in Amway, and "lead generation" schemes for Herbalife and others. The legal notion of "independence," provides cover here, and this is where RICO statutes have sometimes been invoked.

The basics are simple:

  • Everyone understands what a Ponzi-scheme is, because it is an investment, and principal is callable. A Ponzi blows up so spectacularly once suspicions set in, withdrawals rise and overwhelm the non-existent or at least underperforming core business.
  • Nearly nobody can clearly explain what an illegal pyramid scheme is, except that it clearly is like a Ponzi, except it is wrapped around a product. Also, in terms of not being an investment proper, it lacks the aspect of "withdrawals," though "refund" programs may be needed, as we have seen with Herbalife. The only claim consumers have is not about principal, but about the expectation of a business opportunity, which may have been fraudulent. That is a fuzzier claim. It also comes with a slower, and more widely dispersed (in time and space) pattern of failure, as I have described in an earlier article on "The Fractal Nature of Failure." This makes pyramid scams harder to detect.
  • Everyone understands what a chain letter is, and why it produces a few winners and a lot of losers.

It is my belief that the difficulty of grappling with illegal pyramid scams comes from the fact that people have put the emphasis on the wrong word. The problem is not in the word "pyramid," but in the words "illegal" and/or "scam," and the "pyramid" structure just creates a multiplier.

If regulation is to go anywhere, we'll need clear and explicit definitions of "pyramid scam," and "legitimate MLM," and related issues. The recent paper by Prof. William Keep, and Peter vander Nat of the FTC is an attempt to lay the ground work.

No harm, no foul

To put it differently, no harm no foul. If a company provides fair value, provides full disclosure, and it's sales force is paid by an MLM-type compensation, there are no victims, and hence no crime. There are customers, who are maybe not interested in selling the product, and there are other customers who elect to try to sell the product, either part time or full time. As long as there is no intent to deceive, and full disclosure, there could not be a problem. It is then purely a customer choice to become a representative or not. The problems come in when there are fraudulent misrepresentations involved in promoting the opportunity, and people end up being bilked out of their money for something where they can only fail. When the focus is put on the "pyramid" structure, fuzziness enters, unclear definitions of the problem result, and people then overlook the fact that the real question must be: is the basic proposition fraudulent or not?

Likewise, the 70% rule may be relevant only if there is an issue of people becoming "garage qualified," i.e. they are buying product in order to qualify for bonuses, and it is backing up on them. Channel stuffing is no good for obvious reasons. The question of personal consumption is likewise irrelevant. Many programs are built around the idea that what matters is that you eat your own dog food. That "self-consumption is a legitimate sale for the company and for the person who made it. If the purpose is to market product, there is nothing wrong with the idea that a customer could opt to resell a product they believe in. If there is deceit, lies, fraudulent claims about a product, or the opportunity, those are an issue. The problem is more likely the forced buying in excess of personal consumption, which then again leads to "channel stuffing," and folks becoming "garage qualified."

Prima facie evidence: tail wagging dog

The first indication of trouble which is clear from some of the websites of various regulators (SEC/FTC), or law enforcement (FBI), is if the opportunity justifies the product. That is a feature which sets up an evident money game, dressed up as a product sale, but no one in their right mind would buy a commodity product at three times the going rate, unless they were buying into the opportunity to earn money on reselling the same deception to others.

In short, if the product is ho-hum and the "opportunity" is the only reason for buying the product, you are entering a world of make-believe opportunity. If on the other hand the product provides fair value, that means you have happy customers. Then, if it is sold by a network, some of whom are part time, and some full time, and there was no deception in recruiting these reps, there is no damage, no victims, and no issue.

The obvious form of this problem which is relatively well understood is the issue of "paying for recruiting" as opposed to product sales. The fuzziness comes back in the HLF scenario, if indeed the prospects of "supervisors" are based on fraudulent misrepresentation, and de facto their only hope of making money on their new found opportunity is to deceive others in turn, the forensic accountants argue that never mind what the label says, this constructively amounts to paying for recruiting. There's nothing else to do but recruit if the product is unsalable.

What the end will be like

You wish I would tell you, but I won't. I already said that at the outset. We are in limbo for now with the stock drifting upwards with artificial support, and everyone waiting for the other shoe to drop.

One of the obvious industry problems is that the DSA (Direct Selling Association) has been giving cover to too many scoundrels, and has fought the FTC on the business opportunity rule. At that point they are enabling abuse, not effectively self-regulating, as they pretend to do. No doubt this was a missed opportunity.

The question remains if might HLF be shut down altogether, or given unwelcome restrictions that could undermine their prospects, or they might walk away unscathed. The latter seems unlikely, but anything is possible. Again, the only thing that matters is if clarity for the industry results. If that opportunity is missed once again, we remain stuck in the casuistic jurisprudence where everything is open to interpretation, which is good for lawyers, but not for investors, or entrepreneurs.

This article was based on developments, but could be equally relevant to other publicly traded MLMs, such as (NYSE:BTH), (NYSE:JE), (OTCBB:LFVN), (NASDAQ:MTEX), (NYSE:NUS), NYSE:PRI), (NASDAQ:RELV), (NASDAQ:USNA) or even to private ones.

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.

Additional disclosure: I have been an observer of MLM since ca 1990, an intermittent participant, including at one time developing a business plan for a company based on an MLM concept, working with a top industry consultant. My outlook is that MLM is overrun by fraud, but it does have a legitimate role to play. Clearly, self-regulation by the DSA is a joke, and regulators have tended not to make things any better.