Is Herbalife actually a Pyramid Scheme?

On our prior Herbalife thread, Tod implied that he wasn’t particularly interested in whether Herbalife itself was a pyramid scheme or not. But I am interested, so let’s try to answer the question if for no other reason than to reinforce the need for Ordinary Times management to be cautious about who they invite to write here.

Previously, I didn’t offer an opinion on Herbalife itself, but I study businesses, and Herbalife is a business, so I think I owe it to you to at least be willing to do some research, make a judgment, and stake my pseudonym on that judgment.

Somewhat surprisingly, I think there tends to be quite a lot of agreement about what Herbalife is, how it makes money, and who its customers are. What seems up for debate is what lies in the hearts and minds of its distributors.

Most new distributors don’t make much if any money, and the turnover among these low-volume distributors is about 90%. There are a lot more ex-Herbalife distributors than current distributors.

At best, Herbalife is a multi-level marketing company. Distributors (try to) earn money by selling their vitamins, herbal teas, and protein shakes.

They can also earn money by recruiting others to sell as well. The people they recruit become part of their “downline”. And if these downline distributers in turn recruit other sellers, they get a portion of those people’s sales too. “Multi-level” is a very good term for it. At Herbalife, your downline can have an indefinite number of tiers.

The only way to make serious money ($10,000+ per year) is to recruit a large number of distributors. Ideally, these distributors in turn recruit their own distributors, and they recruit more, and…

Some distributers operate a Herbalife “Nutrition Club”, of which there are 10,000 in the US. (Herbalife is a highly international company, but it’s reasonable to suspect that the FTC will be concerned with its US business.) Some of the nutrition clubs look like this; others are run from people’s homes where they earn less than minimum wage. You can argue that this is exploitative, but it isn’t illegal per se. These are people attempting to start businesses with no preexisting skills; not all of them are going to make it. Now, we have to address a few questions.

• What is a pyramid scheme?
• Why are pyramid scheme’s illegal?
• How is a pyramid scheme legally defined in the United States?
• Is Herbalife a pyramid scheme as defined by the US government?
• Do the things that make pyramid schemes bad in general apply to Herbalife in particular?

What is a pyramid scheme?

There are issues with using a definition from 1998 when I know others refer to more recent guidance, but here is a 1998 description from the FTC:

Pyramid schemes now come in so many forms that they may be difficult to recognize immediately. However, they all share one overriding characteristic. They promise consumers or investors large profits based primarily on recruiting others to join their program, not based on profits from any real investment or real sale of goods to the public. Some schemes may purport to sell a product, but they often simply use the product to hide their pyramid structure. There are two tell-tale signs that a product is simply being used to disguise a pyramid scheme: inventory loading and a lack of retail sales. Inventory loading occurs when a company’s incentive program forces recruits to buy more products than they could ever sell, often at inflated prices. If this occurs throughout the company’s distribution system, the people at the top of the pyramid reap substantial profits, even though little or no product moves to market. The people at the bottom make excessive payments for inventory that simply accumulates in their basements. A lack of retail sales is also a red flag that a pyramid exists. Many pyramid schemes will claim that their product is selling like hot cakes. However, on closer examination, the sales occur only between people inside the pyramid structure or to new recruits joining the structure, not to consumers out in the general public.

The FTC tells us how to distinguish multilevel marketing programs.

Some people confuse pyramid and Ponzi schemes with legitimate multilevel marketing. Multilevel marketing programs are known as MLM’s, and unlike pyramid or Ponzi schemes, MLM’s have a real product to sell. More importantly, MLM’s actually sell their product to members of the general public, without requiring these consumers to pay anything extra or to join the MLM system. MLM’s may pay commissions to a long string of distributors, but these commission are paid for real retail sales, not for new recruits.

To paraphrase,

• pyramid scheme = product has no market, sold to network members and sitting in their basements, commissions paid for recruiting rather than retail sales
• Multilevel marketing = real product, sold to the public without the need to join the MLM system, commissions paid for retail sales rather than recruiting

Why are pyramid schemes illegal? Pyramid schemes are inherently fraudulent since those who join last will inevitably be left holding the herbal teabag.

If the primary way participants make money is by recruiting new members, this is unsustainable since eventually you will run out of new potential recruits. If, on the other hand, the primary way participants make money is by selling product, then you escape this problem since even a late-joining distributor could still make money by selling product to the general public.

How is a pyramid scheme legally defined in the United States?

This is a complicated matter because my understanding is that the definition largely hinges upon FTC guidance and case law rather than some widely-cited, definitive statute, and the FTC has only pursued 3 cases in the past 13 years, and even if there were more cases from which to draw on, IANAL. Bill Ackman of Pershing Capital seems to believe that the FTC will judge a business a pyramid scheme if participants in aggregate make more money in dollars off sales their recruits make than off their own sales.

There are a couple of crucial caveats to this, however. First, even if participants make more money off selling products to customers than off recruiting, the business could still be guilty of misrepresenting the opportunity to potential participants. Said differently, a company could be guilty of fraud while not being guilty of being a pyramid scheme. This post only addresses the is-it-a-pyramid question.

The second caveat is that as far as I can tell, the FTC has left squishy what “selling product to customers” excludes. If a distributor consumes her own product, I am not sure if the FTC would say that it doesn’t count as a sale to the public because the money comes from within the network or if it does count because when consuming the product, the distributors function as end customers.

Is Herbalife a pyramid scheme as defined by the US government?

Herbalife’s financial statements show that more money is made through retail sales than through recruitment commissions. Ackman provides good evidence to dispute the assumptions within these statements.

His strongest objection is that retail sales are assumed to happen at the suggested retail price. Ackman finds that eBay transactions occur at 40% discounts on average. Additionally, a number of websites offer Herbalife product at similar discounts (and with free shipping).

If that is a more accurate depiction of the retail environment, then “retail profits” largely evaporate and the only people making money would be the recruiters. That would help explain the below-minimum-wage nutrition club operators and the 90% turnover among lower-level distributors.

I share Ackman’s concerns about self-consumption within the network. If a distributor consumes product she bought for herself for $230-$300, the company still records that as $400 worth of retail sales and treats the difference as money in the distributor’s pocket. That seems inappropriate to me (though Herbalife itself gets the same amount of money either way). The company responds to this objection in an 8-K:

The percentage of product of any multi-level marketing company consumed by its distributors is substantial. This is not surprising since consumers who are enthusiastic about the products become distributors in order to purchase at a discount and possibly to share and sell the products to others. In addition, in order to minimize the risk of product being accumulated by distributors, the company has policies in place such as the 70% Rule, the Ten Customer Rule and the Buy Back policy.

That sounds to me like an admission that a significant portion of sales come from internal consumption. Yes, it also says it is no big deal because of their controls, but it still means their retail sales numbers are inflated since those sales are not being made at the full retail price. And that means that retail profits are probably overstated as compared to commissions on downline sales.

In 2004, however, the FTC downplayed [pdf] the importance of who does the consuming and focuses instead on whether a product or a business opportunity is being sold:

Much has been made of the personal, or internal, consumption issue in recent years. In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme. 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. A multi-level compensation system funded primarily by such non-incidental revenues does not depend on continual recruitment of new participants. In contrast, a multi-level compensation system funded primarily by payments made for the right to participate in the venture is an illegal pyramid scheme. [Vik: emphasis added]

[Update: James Kalcheim in the comments points to a 2007 court case that seems to contradict the FTC here and reaffirm the importance of internal consumption in determining whether a company is a Ponzi scheme.]

The same 2004 FTC letter warns that having a product doesn’t automatically mean you are not operating a pyramid scheme.

Modern pyramid schemes generally do not blatantly base commissions on the outright payment of fees, but instead try to disguise those payments to appear as if they are based on the sale of goods or services. The most common means employed to achieve this goal is to require a certain level of monthly purchases to qualify for commissions. While the sale of goods and services nominally generates all commissions in a system primarily funded by such purchases, in fact, those commissions are funded by purchases made to obtain the right to participate in the scheme. Each individual who profits, therefore, does so primarily from the payments of others who are themselves making payments in order to obtain their own profit. As discussed above, such a plan is little more than a transfer scheme, dooming the vast majority of participants to financial failure. [Vik: emphases added]

That first sentence I bolded? It applies to Herbalife. They do have minimum purchase requirements to qualify for commissions. (Perhaps these are the people dumping product at a discount on eBay.)

That second bolded sentence might not apply to Herbalife though. Ackman has shown that some people indeed receive money from those who are making purchases solely to obtain their own commissions, but he hasn’t convinced me that payments come primarily from these sources. I am not a lawyer, but Kevin Thompson is, and he offers this commentary:

If a company has a forced inventory requirement, it’s an immediate red flag because it’s an indicator that the product is serving as a subterfuge of the money transfer scheme. Additionally, it’s an indicator that the product lacks marketability and that the business depends upon constant recruitment of new participants to engage in the inventory requirements. Imagine a company that sold $1,000 bottles of lemonade and required its distributors to purchase a product a month. Clearly, the bottles of lemonade would be considered token products designed to conceal the money transfer scheme.

Herbalife strikes me more as a $7 protein shake than a $1000 lemonade. Some buy it because they actually want a protein shake, but others buy it because they want to get rich off recruiting others who also want to be rich.

The Herbalife-is-not-a-pyramid-scheme argument is that they do have a real product that is sold to the public through one of their 10,000 Nutrition Clubs without the need to join the MLM system, and commissions are paid for retail sales rather than for recruiting. All true things.

The Herbalife-is-a-pyramid-scheme argument is that a bunch of the sales happen within the network, and retail profits seem minimal compared to recruitment-derived profits. Also true things.

Some investors look at these facts, and see the pyramid as half full; others don’t. The case law apparently suggests that the company needs proper controls to ensure that substantial sales to the public are being made. There is no statute that specifies what controls are considered proper and which are insufficient. We know Amway’s rule that 70% of sales come from outside of its network passes. We know that asking distributors to sign a piece of paper certifying that they made retail sales doesn’t pass muster.

The FTC does say that profits need to primarily come from retail sales rather than recruitment, and Herbalife doesn’t directly pay for recruitment. But do commissions earned on downline retail sales count as retail sales profits or recruitment commissions? Ackman believes these are indeed recruitment commissions hiding in sheer lingerie*.

Do the things that make pyramid schemes bad in general apply to Herbalife in particular?

Absent clearer guidance from the FTC, I think it makes sense to go back to why pyramid schemes are bad in the first place. They are bad because they unavoidably defraud those who are last to join.

Ackman has not yet convinced me that Herbalife does this. He has convinced me that trying to become an Herbalife distributor is not likely to make you rich. Additionally, he provides evidence that the opportunities are exaggerated and that distributors are sometimes not given a clear picture of how unlikely they are to be successful. But Burt says the same of law schools, and they are still around.

Perhaps selling an unlikely, inflated dream should be illegal, but it isn’t yet. Perhaps these complaints will eventually form a class-action lawsuit. But none of that means that Herbalife’s system is inherently fraudulent by design.

My predictions

• The FTC will not find that Herbalife is a pyramid scheme.
• Contrary to Ackman’s claim, Herbalife will not go to zero soon. I expect the company’s US business will still be around five years from now.

Not predictions, but things I would recommend Herbalife do

• Change how end-customer retail sales are reported to shareholders to provide a more realistic view of retail sales.
• Alter its compensation scheme to provide retailers with more profit as compared to recruiters.
• Limit the number of downline tiers of distributors that recruiters can be paid for to two.

* not pictured

Disclaimer: Don’t be silly. This is not investing advice. I have no position in Herbalife.