Herbalife's $4.1-billion question debated

Is Herbalife Ltd., the global multi-level marketer with $4.1 billion in annual sales, nothing more than an unlawful pyramid scheme? That question has been asked since the 1980s and resurfaced in December 2012 when William Ackman of Pershing Square Capital bet $1 billion that Herbalife exploits its network of 3.2 million distributors and is destined to fail.

Excluding a 2011 ruling from a Belgium court that is on appeal, Herbalife executives emphasized no court has ruled the company operates a pyramid scheme in its 33-year history.

"Our distributors know we're not a pyramid scheme," Des Walsh, Herbalife's president, told investors early this year in New York.

Paying for recruitment

But at least one federal judge implied in recent years that Ackman's central theme in a 334-page presentationthat Herbalife is operating an unlawful pyramid schemecannot be readily dismissed.

Crucial to the legal analysis is whether Herbalife forks over bonuses and other rewards to its distributors for recruiting others into the network when those rewards are "unrelated to the sale of the product to ultimate users." This element is the central prong of a pyramid scheme test the FTC outlined in a 1975 decision, In re: Koscot Interplanetary Inc.

"As is apparent, the presence of this second element, recruitment with rewards unrelated to the product sales, is nothing more than an elaborate chain letter in which individuals who pay a valuable consideration with the expectation of recouping it to some degree via recruitment are bound to be disappointed," Circuit Judge Robert Beezer of the U.S. Court of Appeals for the 9th Circuit, wrote 21 years later in the landmark case of Webster v. Omnitrition Int'l.

Most Herbalife distributors are consumers

Herbalife executives said most distributors purchase products, like its best-selling Formula 1 shake, for their own consumption rather than to make a killing as a business venture. According to a January 2013 outside study of 408 former distributors Herbalife commissioned, 73% of them joined the nutritional products manufacturer primarily because they wanted to obtain a discount on a product for their personal use, the company revealed during its investor presentation in January 2013.

"Ninety percent of our distributors who are buying our product buy it for one reason, and they buy it for self-consumption," Herbalife CEO Michael Johnson told CNBC in an interview.  

Johnson's remarks and the study by Lieberman Research Worldwide undermined Ackman's contention that Herbalife's distributors are victims of a scam.

"If distributors are purchasing the product with no intention of reselling it, then it's indicative of a legitimate retail sale," Kevin Thompson, a multi-level marketing lawyer with Thompson Burton, told Natural Products Insider in a phone interview. "Again, FTC wants to see sales to external customers to prove the products have true value."

But critics contended Herbalife is principally touting the business opportunities to its immense network of distributors. "My view is that the business is driven by the business opportunity it offers and not the consumer product it offers," said Robert FitzPatrick, the author of "False Profits," a book on multi-level marketing and pyramid schemes, and the founder of Pyramid Scheme Alert, a nonprofit consumer group.

Retail sales outside network?

Ackman contended few sales of retail products occur outside the distribution network. If distributors are selling more product to other distributors than to the public, that fact indicates the company is a pyramid scheme, according to FTC's "The Bottom Line About Multi-Level Marketing Plans and Pyramid Schemes," a fact sheet the agency released in October 2009. FTC also warned consumers against business models in which distributors' earnings hinge more on recruiting or "getting new distributors to pay for the right to participate in the plan."  

Herbalife executives acknowledged they don't track retail sales outside the network. Walsh told investors nothing is unusual about Herbalife's business-to-business model, and he dismissed as "myth" Ackman's claims that the company is only selling products to distributors.

Lieberman Research Worldwide found more than 5.5 million homes purchased Herbalife products during a three-month period following studies conducted in July 2012 and October 2012. Ninety-two percent of consumers who purchased the products were non-distributors, according to the Los Angeles-based research firm. Herbalife also declared 31% of its U.S. orders are shipped directly to consumers with an average order size totaling several hundred dollars.

"That's a pretty amazing statistic by itself," Thompson, the multi-level marketing lawyer, said. "Keep in mind that 30% doesn't factor the person-to-person sales that are occurring at the local level."

Professor: Pyramid scheme 'very unlikely'

Herbalife also pointed out distributors earn nothing if they simply recruit another person into the network without generating actual sales.

"There is no compensation in a legitimate MLM company for just recruiting," Anne Coughlan, a professor with Northwestern University's Kellogg School of Management, who was retained by Herbalife to investigate its business, told investors. "Even if you recruit a number of people, if they didn't sell and didn't buy, you make no commissions."

Other indicators of a pyramid scheme include exorbitant registration fees, a requirement to buy large amounts of inventory, the inability of a distributor to return product to the business when quitting, and scant evidence a company is investing in infrastructure and products, she said. Coughlan and Herbalife maintain none of those factors are present in Herbalife's business.

"Conversely, if you don't see these things, how likely is it that what we're looking at is a pyramid scheme? Very unlikely, in fact," the professor told investors.

Federal judge shows skepticism

A federal judge in California wasn't so quick to dismiss allegations that Herbalife runs a pyramid scheme. In a 2009 lawsuit Herbalife brought against former distributors, the defendants including Robert E. Ford filed a counterclaim, alleging their former employer operated an illegal pyramid or so-called endless-chain scheme in violation of California law.

"Herbalifes entire business model appears to incentivize primarily the payment of compensation that is 'facially unrelated to the sale of the product to ultimate users because it is paid based on the suggested retail price of the amount ordered from [Herbalife], rather than based on actual sales to consumers,'" U.S. District Judge Gary Allen Feess wrote in an August 25, 2009, memorandum and order denying Herbalife's motion to dismiss the counterclaim, quoting the 9th Circuit case Omnitrition.

Herbalife enacted rules to ensure inventory is not gathering dust in garages and actually reaching consumers. The "10-Customer Rule," for instance, requires distributors who are eligible for bonuses and other rewards sell to at least 10 retail customers each month. Jacqueline Miller, a former Herbalife executive, stated in a 2009 deposition that the rule was enacted in the 1980s following an investigation into Herbalife. Miller confirmed the rule doesn't require a minimum purchase, and only applies to distributors who are seeking bonuses and additional payments referred to as "overrides." 

Herbalife's "70-Percent Rule" requires 70% of the product purchased by distributors to be sold to other distributors "downline" or other customers, Miller explained. But her deposition made clear there was no requirement that any percentage of sales reflect purchases outside the distributor networkwhat Herbalife critics such as Ackman might consider legitimate retail sales. And the rule only applied to distributors seeking bonuses and overrides, she confirmed. Herbalife didn't respond to an emailed request for comment on the rules.

Paul Greenberg, then senior legal counsel with Herbalife, explained in a 2009 deposition the 10-Customer and 70-Percent rules date back to an FTC decision involving Amway. FTC felt those rules and other requirements were effective in preventing a finding of "inventory loading," said Greenberg, who now serves as senior vice president of the company, according to a LinkedIn profile. 

But these rules only apply to about 15% of Herbalife's distributors, according to a 2011 decision from the Commercial Court in Brussels.

In the case filed against Herbalife distributors, defendant Bruce Roth claimed Herbalife never trained him and his wife on the 70-Percent Rule, and he said he didn't understand the 10-Customer Rule.

"I know that Herbalife has created the 10 Retail Sales Rule and the 70-Percent Rule, but looking at the record, I have serious question as to whether or not those are not exalting form over substance and aren't just there for the purpose of creating the impression that the second element of the Koscot test has been met," the federal judge Feess observed during a hearing on June 1, 2009. 

"As I look at the information that's been provided to me, it appears to me that in the end, what Herbalife is interested in is generating sales to its downline distribution chain," the judge said. "It doesn't keep any records of the sales volume of product to people outside of its distribution system and report on that. They do have this process where they have their distributors provide them with sales data, and they provide periodic audits of that, but in the end, looking at their annual report, it's plain that what is relevant to corporate success is simply the moving of product out of the Herbalife warehouse into the hands of its distributors. And at that point, their rewards to their distributors are essentially based on the volume of their distributors, not necessarily retail sales."

A lawyer representing Herbalife, Chuck Patterson, gave a clever response to the judge: He said the 9th Circuit's concerns expressed in the 1996 case of Omnitritionpresumably that most distributors are bound to be disappointed in their inability to recoup their investment through recruitmentare not present because most Herbalife distributors are simply buying the product and using it for themselves.

But Roth claimed Herbalife business model for distributors isn't viable.

"Distributors have to purchase product from Herbalife each month in order to obtain their paychecks," he asserted. "Under this system, we would not be paid any money or commissions from the sales by people in our business organization in a given month unless we purchased products from Herbalife during that month. Herbalife products became almost impossible to retail because the pay-for-your-paycheck Herbalife product was being dumped on eBay for much less than we could sell it for."

Earnings are modest for most Herbalife distributors

Most Herbalife distributors earn little coin. In 2011, Herbalife paid on average just $2,900 annually in gross compensation to its "Leaders." Most distributors earn even less than that figure because three out of four distributors don't ascend to a status that would qualify them as a leader, according to Herbalife's own statistics.

FitzPatrick of the Pyramid Scheme Alert cited an extraordinarily high turnover rate within Herbalife's distribution network. In an annual Securities & Exchange Commission filing dated March 14, 2005, Herbalife revealed more than 90% of its distributors who were not supervisors stopped selling the products. Supervisors are those individuals who qualify for Herbalife's 50% discount.

It's a tough business even for supervisors. More recently, Herbalife disclosed a 52% retention rate among its "sales leaders" in 2012 while a whopping 151.3 million distributors were demoted from that status because they did not meet the requalification requirements to maintain their 50% discount on products and remain eligible for bonuses.

"Distributors who purchase our product for personal consumption or for short-term income goals may stay with us for several months to one year," Herbalife revealed in a regulatory filing.

This raises yet another question: Are droves of distributors leaving Herbalife's business due to failed expectations or because they no longer want the products for their own consumption?

Belgium court finds pyramid scheme

In a 2011 decision, a Belgium court didn't specifically answer this question, but said it disapproved of Herbalife's business model.

"The fact that entry into the system as a distributor does not in fact satisfy a genuine capacity and desire for responsible entrepreneurship is after all evident by the high distributor turnover; within a year, 50% of them drop out and are replaced, and only the sponsors of these distributors (the 'full-time' salespeople as they are referred to in the conclusion of Herbalife) make money directly or indirectly and, therefore obviously, remain stable," the court observed in an opinion, holding that Herbalife operates an unlawful pyramid scheme. "This cannot and should not be allowed to be the aim of independent entrepreneurship."

Herbalife is appealing the decision and emphasized the ruling has had no substantial impact on its business in Belgium. Again, company execs say it's the only decision in 33 years that has found Herbalife is a pyramid scheme. But FitzPatrick doesn't think that makes much difference.

"Enron was not charged with anything [before its collapse.] It doesn't mean anything," he said.

The Securities and Exchange Commission(SEC) is said to be investigating Herbalife. In a regulatory filing, Herbalife disclosed SEC has requested information on its business and financial operations after it requested a meeting with SEC staff. Herbalife says it is cooperating and maintains it has nothing to hide.

"We believe, based upon the advice of experts and prior guidance from FTC in this area, that our network marketing program is compliant with applicable law," Herbalife stated in the filing.

Unless U.S. regulators accuse the company of wrongdoing, there is scant evidence Herbalife will stop growing at least in the near term. In February, the company posted fourth-quarter earnings per share that beat analysts' consensus by a few pennies as net sales ($1.1 billion) climbed 20% over the year-ago period.

Some Wall Street analysts have brushed aside the allegations against Herbalife.  

"Questions concerning this multilevel marketer have been asked and answered to our satisfaction. Many times over," wrote Timothy Ramey, an equity analyst with D.A. Davidson & Co., who rates Herbalife's stock a "buy," in a Jan. 2 research note sent to institutional investor clients. "We are confident the Herbalife compensation system should not make a regulator conclude that an illegal pyramid scheme exists."

But Herbalife is clearly aware it could do more to shed light on its business model. It has revealed plans to make name changes that will distinguish its active distributors and sales leaders from what it dubs "wholesale customers" distributors purchasing Herbalife's products for their own consumption.

"What we, of course, know from our research is that a very significant percentage of people who become distributors do so in order to receive a wholesale price on Herbalife products because they are avid Herbalife users," Walsh told analysts during its fourth-quarter earnings call. "So what we want to do is simplify matters by breaking out that group and identifying them separately so that they're clear that this is a group that are not distributing product, but rather are engaged as wholesale customers."