The Herbalife Scandal: A Pyramid Scheme or Legitimate Multi-Level Marketing?

In December 2012, a famed activist hedge and fund manager, Bill Ackman publicly accused a company named Herbalife as an abusive pyramid scheme. The accusation alarmed many investors, given the popularity of Herbalife as a globally recognized nutrition product distributor and its massive size with annual sales exceeding $4 billion. Ackman believed that Herbalife had been operating fraudulently with unfair and deceptive practices behind the veil of legally approved multi-level marketing (MLM) practice. It was also known that he undertook a $1 billion short position on Herbalife’s common stock, in anticipation of the company’s shutdown when regulators eventually confirmed his allegation. Herbalife fought back, refuting that their business model is sound and Ackman’s intention was to manipulate the market for his own profit. The battle has thus ensued and prolonged for the next four years.

As the dispute became intensive, the Federal Trade Commission (FTC), a regulatory agency overseeing such matters, finally stepped in and launched a formal investigation. In June 2016, the commission announced that Herbalife’s compensation structure was unfair by rewarding distributors for recruiting others to join and purchase products in order to advance in the marketing program. However, the commission also declared that Herbalife is not a pyramid scheme, and it allowed the business to continue with partially injunctive order and $200 million settlement. The order required a fundamental restructuring of its compensation structure and regular independent oversight(The Federal Trade Commission, 2016). Ackman believed that once the business restructuring was fully implemented, Herbalife was destined to fail as it cannot survive without maintaining a predatory practice.

In this paper, I would like to provide clarity on the issues surrounding the MLM industry and Herbalife itself. With all the complexities revealed in the Herbalife case, I affirm that the company is not a pyramid scheme as Ackman claimed. As the claim hinges on distinguishing between the legitimate MLM and a deceptive pyramid scheme. I will begin with an analysis of the fundamental difference between the two.

Multi-Level Marketing vs. Pyramid Scheme

Multi-level marketing (MLM) is a type of direct selling technique commonly expressed in opposition to the traditional brick-and-mortar stores. This technique also differs from online direct retailers like Amazon which do not rely on independent contractors’ marketing channels. Under the MLM, products are typically distributed via proprietary networks formed by independent contractors. Compensations are normally based on sales, but it is also granted according to the recruitment activity, especially when the new members provide upfront fees upon enrollment. The practice encourages the network to expand, forming a pyramid-looking structure when the relationship multiplies.

The problem arises when the compensation from recruitment becomes more dominant than sales. Under such circumstances, participants would be encouraged to focus more on branching out the network rather than making sales and expropriating profits at the expense of their recruits. Late-comers would subsequently turn to their own downline in order to recover expenses among other things. Consequently, it becomes a money-circulation game in which whoever is at the bottom line incurs loss whereas profit is collected by those at the top. Indeed, it is normally designed to make the bottom 70~80% of the pyramid to suffer the loss for the sake of remainders(Valentine, 1998). Regulators have long recognized this harm and banned it as an illegal pyramid scheme.

The challenge is to single out those pyramid schemes from legitimate MLMs. While there is no settled distinction, two notable guidelines have been developed in the U.S. over the past decades; first is the Koscot Test which was introduced in 1975 as part of the FTC vs. Koscot Interplanetary case. During this time, the FTC devised a test rule that affirmed its allegation and eventually obtained the injunction against Koscot’s entire business practice. Second, is the Amway Safety Rule which also arose as part of the FTC allegation (FTC vs. Amway). Unlike the Koscot Test, it was proposed by Amway as a defendant in an attempt to prove its legitimacy to which the FTC finally agreed(Valentine, 1998). Although these two rules are different in specifics, they both have served as a barometer of MLM’s minimum industry standard and propose the following principle. If a company compensates more on recruitment that are unrelated to sales and rely on the money paid by the distributors rather than sales, it should be considered a pyramid scheme. Accordingly, a legitimate MLM should compensate more on the sales and limit the scope of reward from recruitment. Among many symptoms to verify this principle, three attributes have been acknowledged as the key testaments. They are 1) plan structure, 2) market validity, and 3) misrepresentation.

These three aspects were also the key items over which the Herbalife case was acutely disputed. Ackman basically asserted that Herbalife passed none of these criteria: it has distorted its policy to resemble that of a pyramid scheme, does not have valid market that supports its revenue, and has misled its participants into an abysmal loss. All of them were strongly denied by the Herbalife management. I will now discuss each of them based on Herbalife’s policies and conducts.

Plan Structure

As mentioned earlier, legitimate MLMs should not design their policies to excessively reward recruitment over sales. While it may seem easy to verify, only few MLMs are solely dependent on the recruitment fees in an outright manner, presumably due to the increasing awareness of reputational risk. However, they may continue to collect money internally from many different ways. One example is to offer a discount on the retail price based on the membership level, which is again determined according to the amount of purchase. The discount effectively induces the members to pile up inventories in the hope of selling later, even when the actual demand is not confirmed. If the sales do not materialize as expected, they end up with unused packages and have to absorb the loss - a phenomenon commonly known as ‘Inventory Loading’. Regulators consider this to be a strong indicator of a pyramid scheme and require companies to avoid promoting such behaviour by policy (The Federal Trade Commission, 2018).

Herbalife faced the same accusation. According to its compensation structure, there are nine levels of membership hierarchy determined mostly by the purchases of their own and downlines. Each level is offered the discount, ranging from as low as 25% to up to 50% off the retail price. The level five or above is eligible for the 5% royalty overrides, which is determined by their downline’s purchases(The siege of Herbalife, n.d.). The plan appears to provide a strong incentive for an inventory loading and to emphasize recruitment as a significant source of their compensation.

Herbalife denied such notions. The company claimed that inventory loading is well prevented by other rules incorporated in the plan. One example is its buy-back policy, offered for up to 100% of the purchase since 2012 (it was 90% before). This policy is one of the most generous rules in the industry, it plead, along with its 100% reimbursement policy for the return shipping cost. Herbalife further argued that the members’ consistently low buy-back rate at only 0.1% is a strong indicator against the inventory loading(Herbalife Nutrition, 2018). If the original purchase was not sold, they would have simply returned it.

Yet the low return rate in itself is insufficient to prove the absence of inventory loading. For example, if the company created an environment in which the utilization of such options is strongly discouraged, the return rate would remain very low even when the products are becoming obsolete as inventory. To fully comprehend the distributor behaviour, we would need to verify the market validity, which is the second attribute of our analysis.

Product/Market Validity

Many illegal pyramid schemes do not actually earn much revenue from their own products, but mostly via recruiting channel. In this case, products are usually presented as a red-herring to maintain the appearance of market availability. One recent example is Vemma Nutrition Company which originally purported to be an energy drink seller as an MLM. The FTC later determined that its revenue was not really contributed by its products but was sourced mainly from recruiting fees. The commission then proceeded to halt Vemma’s entire operation(The Federal Trade Commission, 2015). It signalled that, to be considered legitimate, companies must be able to attest to the validity of their products as demanded by customers outside the network.

Market validity is hard to prove. Most MLMs’ end-user purchases are not recognized as revenue. They are normally the margins earned by the final selling distributors, not the company. With respect to Herbalife, Ackman alleged that there is no real market supporting its products, which was again outrightly dismissed by the company. The problem is that none of their arguments could be easily supported with evidence.

A survey method was therefore suggested as an alternative, and three different agencies were hired between 2012 and 2013. The results turned out to be surprisingly in favor of Herbalife, since all of them indicated that more or less than 90% of its products are purchased by consumers outside the network (see table below). This empowered Herbalife’s claim that its products reach beyond the scope of network and the margins must have been earned by those selling them to the retail customers. Ackman dismissed the survey as too small to be authoritative, but did not provide any data to support his allegations.

[Herbalife Survey (The siege of Herbalife, n.d.)]

Agency

Survey Period

Sample Size

Percentage of those of household outside the network

Lieberman Research Worldwide

3 months to October 2012

2,000

(conducted twice)

90% of 5.5 million American household estimated to have used the products

Nielsen

3 months to May 2013

10,500

87% of 8 million consumers estimated to have purchased the products

Walter Vandaele

June 2013

1,349

(distributors)

97% of the Herbalife product volume purchased by distributors represents retails sales for end-use consumption

Misrepresentation

MLMs are required not to mislead their members with respect to its business opportunity and product validity. Most of the pyramid scheme victims, however, arise from their deceiving statements regarding potential financial benefits from the membership. It may come in the form of an advertisement clip or individual testimonial at the off-line conference meeting, where a few successful top-tier marketers are showcased with lavish lifestyles being enjoyed. Such opportunities of course rarely materialize for most people.

While the policy and product/market validity seem to support the case for Herbalife, misrepresentation was indeed the most grey and continuous claim against it. During one of his presentations, Ackman played Herbalife’s official video clip that introduced one of its chairman’s club-level distributors showing around his Beverly Hills house and the Ferrari, the Bentley etc. The video said that he “was just working two or three hours a week, and yet after his very first calendar year, his income hit $350,000.” In his second year, he turned 30 and his income hit $1.1 million(The siege of Herbalife, n.d.). however, the video was dismissed on an account that it was outdated – the clip was made in 2003, almost a decade before Ackman’s allegation in 2012 - and significant improvements have since been made regarding its presentation. In fact, Herbalife’s then CEO Michael Johnson has implemented a few active gestures to address potential misrepresentation issue, including 1) voluntary disclosure of the average gross compensation paid to the distributors and 2) disclaimer requirement for income testimonials.

Another misrepresentation charge has recently been raised by a group of its former distributors, which could involve more than 100,000 plaintiffs and might mean as much as $1 billion in damages(ANDERSON, 2018). It is too early to tell where this would be headed given that no sufficient amount of facts appears to be publicly available yet. However, it is unlikely that the suit would seriously dent Herbalife’s sustainability even in the event that the damage become fully materialized. As of October 12, 2018, Herbalife’s enterprise value was estimated at over $ 9 billion, nine times of the damage the company is being sued. Nevertheless, it is also worth mentioning that the FTC is unlikely to shut down the business solely based on misrepresentation charges, unless the degree of such behaviour is excessively malicious and large enough that the entire model becomes deceptive. Given Herbalife’s ongoing compliance with the partial injunction imposed earlier, I do not expect the FTC to revert its original decision that Herbalife is not a pyramid scheme.

Conclusion

I have briefly reviewed the Herbalife case based on the three distinct metrics, all of which do not strongly suggest that the company is a pyramid scheme. One question remains as to Ackman’s original allegation, in which he claimed that 88% of the participants were never paid a commission and more than half of all money paid to distributors went to the top 1%. This claim might have stemmed from misreading the MLM’s revenue recognition as briefly explained earlier. Most of the MLM participants join to buy products at a discount, either for their own use or selling at a retail price. While some do earn modest income from retail sales, such amount is not included in Herbalife’s compensation disclosures, given it is not money paid by Herbalife.

As of October 12, 2018, Herbalife’s market cap is currently valued at over USD 8 billion, a 60% higher since the Ackman allegation. Its equity is held by many household name funds such as Carl Icahn’s Icahn Associate holdings (22.4%), The Vanguard Group (6.3%), and Fidelity Management (3.86%). The company’s outstanding debts are also widely financed by those big banks including Bank of America and Citigroup. To Ackman’s dismay, Herbalife’s business model does not appear to be wholly disapproved by many investors in the Wall Street.

References

ANDERSON, C. (2018, August 22). Lawsuit says Herbalife events promising riches misled product distributors. Retrieved from Portland Press Herald: https://www.pressherald.com/2018/08/21/lawsuit-says-herbalife-events-promising-riches-misled-product-distributors/

Herbalife Nutrition. (2018, February). Annual Report 2017. Retrieved from Herbalife: http://annualreports.com/HostedData/AnnualReports/PDF/NYSE_HLF_2017.pdf

The Federal Trade Commission. (2015, August 26). FTC Acts to Halt Vemma as Alleged Pyramid Scheme. Retrieved from The Federal Trade Commission Release: https://www.ftc.gov/news-events/press-releases/2015/08/ftc-acts-halt-vemma-alleged-pyramid-scheme

The Federal Trade Commission. (2016, July 15). Herbalife Will Restructure Its Multi-level Marketing Operations and Pay $200 Million For Consumer Redress to Settle FTC Charges. Retrieved from The Federal Trade Commission : https://www.ftc.gov/news-events/press-releases/2016/07/herbalife-will-restructure-its-multi-level-marketing-operations

The Federal Trade Commission. (2018, January). Business Guidance Concerning Multi-Level Marketing. Retrieved from The Federal Trade Commission: https://www.ftc.gov/tips-advice/business-center/guidance/business-guidance-concerning-multi-level-marketing

The siege of Herbalife. (n.d.). Retrieved 10 15, 2018, from http://fortune.com/2015/09/09/the-siege-of-herbalife/

Valentine, D. A. (1998, May 13). Pyramid Schemes. Retrieved from The Federal Trade Commission: https://www.ftc.gov/public-statements/1998/05/pyramid-schemes