Herbalife's $4.1-Billion Question Debated

By Josh Long Comments
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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 presentation—that Herbalife is operating an unlawful pyramid scheme—cannot 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 percent 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 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 percent 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 percent 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.

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