Herbalife Ltd., the multilevel marketer of nutritional products, and its adversary Bill Ackman engaged in a new debate this week: whether or not a June 2 court ruling supports Herbalife’s position that it is a law-abiding company rather than a pyramid scheme.

The ruling from the U.S. Court of Appeals for the 9th Circuit dates back to a 2007 case the FTC brought against BurnLounge, Inc., a marketer of music and music-related merchandise.

The panel of three appellate judges found BurnLounge was a pyramid scheme because its members paid for the right to sell products and the company paid the rewards for—and members were motivated to earn cash through—recruitment.

The rewards “were primarily in return for selling the right to participate in the money-making venture—the Mogul program," Circuit Judge Morgan Christen, who was appointed to the bench in 2012 by President Obama, wrote on behalf of the appeals panel. “The merchandise in the packages was simply incidental."

Differing Perspectives

Herbalife declared the ruling undermined the position of its adversary Ackman. The billionaire hedge fund manager has accused the company of running a pyramid scheme that exploits minorities and achieves few retail sales outside its gargantuan network of members. Ackman’s firm has bet $1 billion against Herbalife and stands to profit handsomely if the company implodes and its stock price plunges.

Although Herbalife doesn’t track retail sales outside its network, the company has said most members formerly known as distributors purchase its weight-loss shakes and nutritional products for their own consumption. Founded in 1980, Herbalife’s net sales last year rose 18 percent to $4.8 billion.

The 9th Circuit’s decision “validates product consumption by participants as a legitimate measure of demand for multi-level marketing companies and rejects Bill Ackman’s fundamental thesis against Herbalife," the company asserted Monday in a statement. “This ruling from one of the country’s most influential courts is consistent with Herbalife’s position that the widespread demand Herbalife has demonstrated for its products, by members and non-members alike, confirms that it is a multi-level marketing company with proper business practices."

The 9th Circuit is the same court that handed down a landmark decision 18 years ago on pyramid schemes, Webster v. Omnitrition, Inc. That case laid out a two-part test for determining whether a multilevel marketing operation is an unlawful pyramid scheme, with the central prong of the test analyzing whether the business is defined by “recruitment with rewards unrelated to product sales."  

Pershing Square Capital Management, L.P., Ackman’s hedge fund, characterized Herbalife’s interpretation of the BurnLounge decision validating its business model as “absurd."

“The case certainly does not support Herbalife’s position that sales of products to distributors who tried – but failed – to succeed in their pursuit of the Herbalife business should be regarded as true retail sales," Pershing declared in a statement Tuesday.

Sales to End Users

In cases in which the FTC has alleged pyramid scheme activity, American courts have looked at whether products are actually sold to end users and whether participants in a multilevel marketing program have the right to receive compensation for recruitment when the rewards don’t relate to such sales.

BurnLounge argued that its recruits became ultimate users when they purchased packages and the packages were related to the sale of products to actual users. FTC maintained such sales didn’t count as sales to ultimate users.

The 9th Circuit rejected both arguments.

“BurnLounge is correct that when participants bought packages in part for internal consumption (to obtain the ability to sell music through BurnPages and to use the package merchandise), the participants were the ‘ultimate users’ of the merchandise and that this internal sale alone does not make BurnLounge a pyramid scheme. But it is incorrect to conclude that all rewards paid on these sales were related to the sale of products to ultimate users," Christen wrote. “Whether the rewards are related to the sale of products depends on how BurnLounge’s bonus structure operated in practice. In practice, the rewards BurnLounge paid for package sales were not tied to the consumer demand for the merchandise in the packages; they were paid to Moguls for recruiting new participants."

In support of its finding that BurnLounge paid rewards for recruiting, the 9th Circuit noted members needed to recruit to earn cash rewards and said the company’s scheme was designed to motivate members through the chance to earn cash.

Motivation for Sales  

Ackman has accused Herbalife of luring members with false promises of soaring to vast wealth through recruitment. Herbalife has countered that it is forthright about the risks and opportunities, disclosing to prospective members the average compensation of individuals in its member network. Only 62,374 individuals, or roughly 12 percent of Herbalife’s U.S. members, earned compensation last year from the company, and more than half of Herbalife’s sales leaders with a downline, or 40,120 members, brought home a modest $1,000 or less, according to Herbalife’s statement of average gross compensation. The company noted the figures excluded any compensation its members may have earned through retail sales to non-members.

A number of state and federal authorities including the FTC are investigating Herbalife’s business practices. The probes likely include a thorough investigation into whether or not opportunities to earn compensation that Herbalife touts are driving orders rather than legitimate consumer demand for its products.

In the BurnLounge case, the 9th Circuit believed the opportunity to earn cash is what motivated Moguls, not the content of the music and merchandise packages.

BurnLounge’s plummeting sales after it discontinued its Mogul program also supported the lower court’s decision that the company paid rewards for recruitment that were not related to sales, the judge added. Revenues plunged from $476,516 in June 2007 to $10,880 in August 2007.

Amway

The 9th Circuit distinguished the facts in BurnLounge from a 1979 case in which the FTC found Amway was not a pyramid scheme.

“Though Amway created incentives for recruitment by requiring participants to purchase inventory from their recruiters, it had rules it effectively enforced that discouraged recruiters from ‘pushing unrealistically large amounts of inventory onto, recruits," Christen stated.

But BurnLounge “had no rules promoting retail sales over recruitment," she noted.

Herbalife distributors must sell to at least 10 retail customers each month in order to remain eligible for bonuses and other rewards, according to 2009 court documents. Herbalife also requires that 70 percent of the products distributors purchase are sold to other distributors “downline" in the same network or other customers, the documents said.  

The FTC felt in the Amway decision that the 10-Customer and 70-percent rules and other requirements were effective in helping to prevent loading of inventory, a lawyer for Herbalife said in a 2009 deposition.

Ackman has argued many Herbalife members incur significant losses after purchasing inventory that they are unable to sell. Herbalife has countered that it explicitly discourages members from purchasing more inventory than they need for personal consumption or existing sales.

In an appeals ruling overturning a decision that had found Herbalife was a pyramid scheme, a Belgium court cited an absence of documentation showing that Belgium distributors are saddled with too much inventory.