The government is finally closing in on Herbalife. Herbalife will fight back hard.

Why It’s So Hard to Bust Herbalife for Being an Alleged Pyramid Scheme

Why It’s So Hard to Bust Herbalife for Being an Alleged Pyramid Scheme

Moneybox
Commentary about business and finance.
May 9 2016 5:48 AM

Herbalife’s Endgame

The government may be close to cracking down on the multilevel marketing company. Here’s how it will fight back.

Signage stands outside of the Herbalife Ltd. Plaza in Torrance, California, U.S., on Sunday, May 1, 2016. Herbalife Ltd. is scheduled to release earnings figures on May 5.
Herbalife and the FTC have been in talks since earlier this year, and a monetary settlement could hit $200 million—possibly the biggest fine ever levied by the agency.

Patrick T. Fallon/Getty Images

For the past three years, activist investor Bill Ackman has criticized the nutritional supplement company Herbalife to anyone who will listen—and on April 27, his audience happened to be a group of U.S. senators. “Herbalife is causing enormous harm” to the people who sign up as sellers for the company, he said, even though he’d been summoned to Capitol Hill so legislators could grill him on an entirely unrelated topic—his investment in the troubled drug company Valeant Pharmaceuticals. He wondered out loud: Why not hold a hearing on Herbalife? 

Seriously, why not? The Federal Trade Commission has been probing Herbalife for more than two years on charges that the multilevel marketing company is in fact a pyramid scheme, an inherent fraud in which salespeople are primarily incentivized to recruit others into the scam. Right now, Herbalife is giving the U.S. government a long-overdue opportunity to redress the damage that more than three decades of deregulation and money-fueled political pressure have allowed the MLM industry to inflict. As Ackman, who has a $1 billion short on Herbalife, knows all too well, the sad truth is that the vast majority of the aspirants who sign up for an MLM—18.2 million in the U.S. in 2014 alone—will lose their money trying to make a go of a business opportunity that is, in fact, simply too good to be true. 

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In many MLMs, high-pressured salespeople convince participants to join in, dangling riches before their eyes as they’re led to make big, upfront purchases of pricey products, then try to recruit others under them to do the same in the hopes of earning big commissions. At Herbalife, the costs of renting space for recruiting venues known as nutrition clubs, along with fat fees for “university” classes and pep-rally conferences known as “extravaganzas,” make it even harder for salespeople to make a profit as a saturated market becomes almost impenetrable. Last year, the top 1 percent of Herbalife’s 545,160 so-called “members” in the U.S. made almost 90 percent of the earnings—and that group rarely lets in new names. 

Aside from Herbalife investors, insiders, and its paid supporters, most people can see that the company is engaged in unsavory practices, whether they’re deemed illegal or not. Even Charles Munger, the vice chairman of Warren Buffett’s Berkshire Hathaway, which owns the MLM Pampered Chef, said this week on Fox Business News that Ackman is “totally right” about Herbalife. “It’s a disgusting company that lures poor people into buying product with too much hope it’ll pay off,” he said. 

Herbalife and the FTC have been in talks since earlier this year, and last Thursday the company said that those discussions are in an advanced stage, causing its stock to rally. But buried inside the company’s quarterly financials are indications that it’s way too soon for Herbalife investors to cheer. According to those documents, a monetary settlement could hit $200 million in addition to “injunctive and other relief.” That “relief” likely means mandated changes to Herbalife’s compensation model to ensure salespeople aren’t primarily being paid for recruiting, as the FTC has done recently with alleged pyramid scheme Vemma. Such changes could deal Herbalife a crippling blow, with the company admitting in its financials that the outcome could have a “material adverse impact” on its business. Not surprisingly, Herbalife also said it could still end up in court with the FTC, as several “material open issues” remain unresolved. “If discussions with the FTC do not continue to progress, it is likely that litigation would ensue,” it said.

It certainly isn’t easy for the FTC to take on Herbalife, whose $4.5 billion in annual sales make it the third-largest MLM in the world. The Los Angeles company, now loaded with political operatives including a former chief of staff to Joe Biden and heavy-hitting attorneys from Boies Schiller and Gibson Dunn, has already spent more than $100 million defending itself while running attack ads on Ackman. It is also laying the groundwork to fight back against any action the FTC takes, whether through the courts or in Congress. There, the MLM industry has lined up 43 members to support its cause and, according to two individuals close to the situation, is quietly preparing legislation that, if it were to become law, would make it virtually impossible for the FTC to protect the public against most MLMs.*

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Herbalife and companies like Nu Skin and Mary Kay have been under the microscope ever since Ackman famously called Herbalife a pyramid scheme in 2012 and lobbied heavily for the current FTC investigation. Since then, with the help of activists like the League of United Latin American Citizens, more than 1,200 individuals, many of them Latinos—and often undocumented—have filed complaints with the FTC, detailing losses that sometimes totaled more than $100,000 and which also included broken marriages, lost dreams, and court records show, even alleged threats of physical harm.

So if things are so sketchy in the MLM world, and at Herbalife specifically, why hasn’t the FTC acted? Well, it’s complicated.

Proving an MLM is a pyramid scheme is an arcane legal matter, one clouded by the rhetoric of free-market economics. One person’s victim of fraud, after all, is another’s sore loser in the sweepstakes of capitalism. It is perhaps no surprise that several of the Republican candidates for president this year—Donald Trump, Ted Cruz, Jeb Bush, and Ben Carson—have had ties to MLM companies. In the Democratic camp, Hillary Clinton has several high-profile supporters (Madeleine Albright, Hilary Rosen) who are advisers to Herbalife.

Ever since the biggest MLM, Amway, which sells everything from vitamins to laundry detergent, made inroads with the Christian Right in its early days, the industry has amassed political power to protect itself—and for good reason. Critic and Pyramid Scheme Alert president Robert FitzPatrick says the industry is “built on sand,” given the constant turnover in the ranks, which he says makes it deeply unstable and always on the defensive.*

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Today there is more at stake than ever for MLMs, which have mushroomed into a $34 billion a year industry in the U.S. after a 1979 administrative judge gave the green light to Amway, which the FTC had charged was a pyramid scheme in 1975. While no federal law defines a pyramid scheme, over the years, the courts and the FTC have concluded that a pyramid is a company whose salespeople make more money recruiting other salespeople than selling products to consumers, even if the recruiting is disguised as the sale of a product. The much-debated question has come down to what constitutes a consumer. The FTC and decades of case law say that people who have signed up as salespeople may well consume products, but that so-called internal consumption doesn’t count when it comes to the recruitment-compensation calculation. MLM attorneys disagree and say that by that standard, few MLMs, if any, would be legal, if tested by regulators. But they seldom are. To try to get around the issue after Ackman came along, Herbalife simply renamed its distributor salespeople “members,” claiming that most people who sign complex agreements to join Herbalife (which include giving up the right to sue the company) have no interest in running a Herbalife business and just want to buy the outrageously expensive products at a discount. The company even commissioned a survey that drew the same conclusion. But if the FTC had been convinced by that argument, it seems likely that the probe would have been closed by now.

In the event of a bad outcome in the Herbalife case, the industry’s lobbying arm, the Direct Selling Association, has been drafting legislation that would count internal consumption in the calculation, making virtually every MLM that sells a product (which is most of them) beyond the reach of the pyramid law. “It would make pyramid schemes legal,” says Brent Wilkes, executive director of LULAC, which he promised would lobby against the bill and doesn’t think it will ever go anywhere. “It would legitimatize a game of people losing their savings and maybe going on public assistance. Who wants to vote for something that puts people on welfare?”

A similar bill was introduced in 2003 following an important court case, but it never got out of committee. However, several states have passed legislation that says compensation derived via internal consumption is appropriate as long as the company has a generous refund policy, and those laws are believed by both supporters and critics alike to be the blueprint for what’s being attempted now. Those critics, including former FTC economist Peter Vander Nat, who took down numerous pyramids while at the agency, also happen to want a law. But they have something quite different in mind. Writing in support of a pyramid law for the blog of consumer group Truth in Advertising, Vander Nat said the first thing such a law would make clear, is that, “In an MLM context, an organization is a pyramid scheme if it rewards participants primarily for recruitment, while the firm’s product is incidental to the proposed business opportunity; moreover, the incidental nature of the product is chiefly evidenced by the payment of recruitment rewards having no cognizable or substantive relation to retail sales; i.e., sales to consumers who buy the product for their own end-use and are not incentivized to buy product for the sake of the business opportunity.”

Decades ago, Amway beat back the FTC by arguing it had safeguards to limit the focus on recruiting, like forcing distributors to provide names of 10 customers a month and mandating they get rid of 70 percent of their product before ordering more. A look at the court record shows that the judge accepted Amway execs’ statements at face value. The so-called Amway rules become the standard policies that MLMs said they adopted (but were never forced to prove) as the country moved into the deregulatory Reagan era and the companies were allowed to grow, largely unimpeded. In fact, an attempt by the Food and Drug Administration to shutter Herbalife in the early 1980s was stopped by Utah Sen. Orrin Hatch, who headed the committee responsible for the FDA’s budget, according to the oral exit interview by the agency’s former enforcement head. In 1986, Herbalife signed a consent decree with the state of California that mandated it provide a system for detailing retail selling if asked, but the terms do not appear to ever have been enforced. Then, the Direct Selling Association convinced the FTC to exempt MLMs from a new “business opportunity rule” by arguing somewhat incredibly that it would put too big of a strain on the companies to comply. MLM critic Bill Keep, the dean of the School of Business at the College of New Jersey, called the FTC’s decision an “erroneous conclusion” that was “naïve.” The rule was adopted in 2011 to protect individuals from unscrupulous work-at-home businesses. Timothy Muris, who was head of the FTC during the Bush era, along with J. Howard Beales, the director of the FTC’s Bureau of Consumer Protection during the same period, lobbied for the exclusion as representatives for Primerica Financial, an MLM that sells insurance. 

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With government seemingly captured by MLMs, the industry touched 1 in 7 American households by 2014, reaching people from all walks of life beset by economic uncertainty. Even doctors, who are getting squeezed by insurance companies, have gotten into the MLM business, with companies selling everything from anti-aging creams and protein shakes to jewelry, legal aid, and pots and pans. More salespeople in crowded fields don’t add up to greater sales, and saturation makes recruiting harder as well. Some 87 percent of Herbalife’s members didn’t earn a dime in commissions from the company last year. “The deck is stacked against newcomers,” says Keep.

But the endgame is approaching. Herbalife had said in February that it was in talks with the agency and threatened to fight back if the FTC tries to take it to court. A civil suit could seek a preliminary injunction to shut the company down immediately; alternatively, the FTC could simply sue Herbalife for deceptive practices and go to trial for a permanent injunction or other relief. While a year and a half ago, Herbalife was telling investors it expected to be exonerated, it appears to be hoping for a negotiated settlement with manageable fines and no substantive changes to its business practices. That is now looking very unlikely.

If the FTC presses Herbalife to accept a new type of compensation system—the one mandated last fall by a federal judge in the pyramid case against Vemma, which is still winding through the courts—the company is likely to spin any such deal as a win. But over time a Vemma-like solution—in which members could not receive commissions on sales to other members unless outside customers represented more than half of their own organization’s sales—could virtually end the business if it were designed and enforced properly.* The Vemma case was so significant for what it portended for the industry that soon after action was taken against the MLM, the Direct Selling Association announced the creation of its very own legislative caucus

By letting the MLM industry spin out of control for three decades, the FTC made its own job more important, but harder, than ever. No matter how it all plays out, one thing is clear: Herbalife and the rest of the MLM industry will fight for their right to entice more and more people with all the muscle and cunning they’ve displayed for decades.

*Correction, May 9, 2016: Due to an editing error, this article originally misstated that the MLM industry had lined up 41 members of Congress to support its cause; there are 43 members of the Direct Selling Caucus. (Return.) Also due to an editing error, it misstated how the compensation system to which the company Vemma recently agreed works. The system doesn’t mandate that members cannot receive commissions on sales to other members unless outside customers represented more than half of the company’s sales; outside customers must represent more than half of the sales within a member’s own organization—that is, the tree of sellers beneath him or her. (Return.) Finally, the article originally misidentified Robert FitzPatrick as a former MLM participant. He is not one. (Return.)

Michelle Celarier is a contributing writer to Fortune and New York magazine. She previously was the senior business reporter at the New York Post, where she reported on hedge funds and finance. Her work has also appeared in the New York Times Dealbook.