In Letters to Senator Concerning Herbalife, FTC, SEC Cite Pyramid Scheme Authority

WASHINGTON—The Securities and Exchange Commission (SEC) and Federal Trade Commission (FTC) have declined to disclose to a U.S. senator whether they are investigating allegations that Herbalife Ltd. has engaged in unlawful pyramid scheme activities.

In letters to Sen. Edward Markey (D-MA), SEC and FTC noted their investigations are confidential. But the heads of the agencies made it clear they have authority to investigate and take action against pyramid schemes.

Markey has raised concerns that the marketer of nutritional products targets low-income consumers and offers a compensation system that favors distributors who sell products to other distributors rather than customers outside the network.

FTC Chairman Edit Ramirez said the agency was "carefully" considering concerns raised by Markey and told the senator to encourage his constituents to file complaints with the agency in English or Spanish. But FTC rules prohibit her from disclosing actions it may take in a particular case, she said in the Feb. 27 letter. 

SEC Chair Mary Jo White assured Markey "that we are giving your concerns every consideration."

Both agencies have prosecuted pyramid schemes in recent years.

Since 1996, FTC has brought 15 cases against companies that were masquerading as multi-level marketers and engaged in unlawful pyramid schemes, according to Ramirez. In the most recent case still in active litigation, FTC alleged a company and related entities made false claims that individuals could earn substantial income for selling a line of health and beauty products and communications and home security services. Most consumers incurred losses, and to the extent individuals earned income, it was mainly for recruiting, FTC has alleged.

Although SEC only has oversight over securities, the agency has authority to investigate pyramid operations that meet the definition of an "investment contract," White explained in the March 4 letter to Markey. Such a contract has been defined by the U.S. Supreme Court "to include the investment of money in a common enterprise, with the expectation of profits derived solely from the efforts of others," she wrote.

She also noted the FTC and Federal Bureau of Investigation (FBI) investigate pyramid schemes.

Last month, FTC confirmed meeting with a Latino group (League of United Latin American Citizens) that accused Herbalife of luring minorities with false promises of riches.

Herbalife effectively denied such claims in a Feb. 18 letter to Markey.

"We want to assure you in the strongest possible terms, as we assured your staff, that Herbalife does not 'target' members of minority or low-income communities, or any religious, social, or ethnic group," Herbalife CEO Michael Johnson declared.

Some lawmakers and minority groups have asked regulators to investigate Herbalife after hedge-fund manager Bill Ackman accused the company of operating an illegitimate enterprise that exploits minorities and achieves few actual retail sales.

Herbalife, whose net sales rose last year 18.5% to $4.8 billion, markets its weight-loss and nutritional products through a worldwide network of 3.7 million "members".

Ackman made a $1 billion short bet in the stock market that Herbalife would collapse. Instead, Herbalife's shares climbed last year as the company continued to exceed Wall Street's expectations. Ackman reportedly incurred paper losses totaling hundreds of millions of dollars.

Herbalife has repeatedly denied engaging in a pyramid scheme, which the SEC warns is an operation in which "money from new participants is used to pay recruiting commissions (that may take any form, including the form of securities) to earlier participants just like how, in classic Ponzi schemes, money from new investors is used to pay fake 'profits' to earlier investors."

In the letter to Markey, Herbalife cited a number of business practices to demonstrate the legitimacy of its operation and rebut claims that it exploits its vast network of distributors, leaving them with financial losses and heaps of inventory that they cannot sell to actual customers.

For instance, Herbalife cited the following policies for its members:

·        starter kits costing less than $90.00; 

·        a policy to refund 100 percent of the startup kit within 90 days even if it is not returned;

·        upon resignation of a member, a 100-percent refund on products that were purchased and unopened during the previous 12 months; and

·        information and disclosures about the costs and benefits of joining Herbalife as a member are provided to prospective members, including a statement of average gross compensation.

"We believe that Herbalife's model rewards an entrepreneurial spirit and supports the development of successful members, all while providing low risk and easy entry into and exit out of the business," Johnson wrote.

Markey's office did not respond to requests for comment on Herbalife's letter.

Ackman's pyramid scheme allegations against Herbalife are likely to be reiterated next week. According to national media reports, the billionaire investor is scheduled to make a presentation on March 11 in an effort to demonstrate that Herbalife is operating a pyramid scheme in China, where direct sales are booming and another direct marketer Nu Skin Enterprises faces government investigations.

China not only expressly prohibits pyramid schemes. Government regulations bar Herbalife (and others) from engaging in traditional multi-level marketing (MLM) in which distributors can earn compensation based on sales of products to other distributors who joined the network later.

Herbalife's MLM compensation model has been scrutinized by outsiders like Ackman. Yet 71 percent of the company's independent distributors have not sponsored another distributor, according to a statement of average gross compensation paid by Herbalife to U.S. distributors in 2012. According to Herbalife, 88 percent of U.S. distributors received no compensation from Herbalife in 2012, although the figures exclude any profits these "single-level distributors" may have yielded on retail sales to others.

Herbalife's most successful distributors earn more than $250,000 a year, but these partners represent significantly less than 1 percent of Herbalife's entire distribution network.