More on Herbalife, Bill Ackman, and Law Enforcement

As we patiently wait for Herbalife’s “analyst and investor meeting” on January 10 to address the pyramid scheme allegations made by short seller Bill Ackman, there is plenty of good discussion of HLF around the world wide web.

Kid Dynamite said Bill Ackman is wrong about Herbalife, citing that:

  • HLF  is not a pyramid scheme because commissions are paid based on sales of products, not recruitment (Wrong. Commissions are paid largely based on required minimum purchases of products by recruits.)
  • Herbalife has not committed accounting fraud in reporting their product sales. (I’m not so sure about that. The numbers as reported are deliberately and materially misleading.)
  • Few people make purchases of Herbalife products to fulfill volume requirements to receive commission checks. (He is so wrong on this. The minimum purchase requirements are the heart of multi-level marketing companies, and I have seen distributors make these purchases in huge numbers. The minimum purchase requirements exist because they induce distributors to buy products unnecessarily, boosting the MLM’s revenue substantially.)

Kid Dynamite more recently suggested that regulators haven’t taken on HLF because they are using a “I’ll know it when I see it” approach to the pyramid scheme allegation. I think he’s right about the approach, and that regulators are 100% in the wrong by using that approach. MLMs design their systems very cleverly to avoid being blatant pyramid schemes. It takes a great deal of understanding of the MLM scam, and lots of analysis of intentionally incomplete disclosures by the MLMs to determine that the are pyramid schemes. By turning a blind eye to pyramid scheme allegations simply because the fraud is not obvious, regulatory and law enforcement agencies are shortchanging consumers.

Robert Chapman of Chapman Capital is on the opposite side of Bill Ackman, essentially saying that Ackman will lose because no regulatory or law enforcement agency in the United States will take action against Herbalife. And I think Chapman is right about that. The Direct Selling Association markets itself as a trade group for direct selling companies. The real truth is that they’re a lobbying organization.

The DSA spends millions lobbying lawmaking bodies and regulatory agencies to 1. not create new laws to regulate MLMs, and 2. not enforce existing laws against MLMs. They have been incredibly effective.  Read this fine piece of work by DSA lawyers illustrating the goal of not regulating MLMs.

This theory is largely backed up by Bruce Craig, a former consumer fraud litigator for the Wisconsin Department of Justice. First, he says the whole issue of MLMs and pyramid schemes is too much of a gray area for regulators:

Unfortunately, it is my belief that the Commission’s definitions and description of pyramid schemes fall far short of the necessary legal sufficiency required for an intelligent decision on the part of an investor or investment adviser. By doing so, these governmental agencies have unnecessarily placed the investor at risk.

Bruce correctly points out that federal regulators have simply chosen to take no action against most multi-level marketing companies. And any “retail sales” standards that have come out of legal cases involving MLMs are also too gray, leaving companies great latitude in setting up systems that appear to require a retail sales component:

None of the pyramid style companies that I am aware of collect or report any direct and verifiable information about retail sales, since their records reflect only wholesale purchases from listed distributors. Given this, it is difficult to understand how an enforcement agency such as the FTC could obtain the data necessary for it to conclude, from an enforcement oversight standpoint and in accord with its standards, that a company using pyramid recruiting methods is not a pyramid scheme. Further, whatever the standards, it should be the obligation of a company using the pyramid mechanism, not the Commission, to fully document legalizing retail transactions, as to all its wholesale distributors, as a prerequisite of rebutting the presumption that it is an illegal pyramid scheme. The Commission should not have to prove a negative.

So why is there so much investor interest in Herbalife? Pyramid schemes are highly profitable for those who run them, which is why the stock of HLF has historically done so well. There is big money in conning consumers out of their money by promising them an “income opportunity,” all the while knowing they are almost guaranteed to lose money.

Because of little to no government intervention, companies like HLF are free to perpetuate their schemes against unsuspecting consumers into infinity. I know, I know. If companies like Herbalife were really pyramid schemes, they would have collapsed by now. The sad truth is that so many consumers know nothing about MLM or pyramid schemes, and companies like Herbalife, Mary Kay, Amway, Avon, and MonaVie do everything in their power to convince people they’re not pyramid schemes. They have compelling presentations about this issue because they’re professional con men.

So Herbalife will have its dog and pony show in New York next week, giving everyone the warm fuzzy feeling that the company cares. What do I think will go on at this analyst and investor meeting? A whole lot of nothing. Sure, Herbalife will let people try the products and will have some pretty slide shows and graphics. But there will be little real substance. The “substance” will likely include:

  • We’ve been in business 30+ years, so we must not be a pyramid scheme
  • The FTC hasn’t taken much action against us, so we must not be a pyramid scheme
  • The court in Belgium that deemed us a pyramid scheme was wrong, so we must not be a pyramid scheme
  • We recruit lots of people, so we must not be a pyramid scheme

They still won’t answer important questions like these (which I first wrote about here):

  • 2.7 million distributors are highlighted in the most recent 10-K. At what point in time is this for? How was the number calculated?
  • How many new distributors were recruited in 2011 and 2012?
  • How do you define “active” distributors? How many distributors were active at the end of 2011 and 2012?
  • How many non-terminated distributors were there at the end of 2011 and 2012?
  • 548,000 sales leaders were mentioned in the most recent 10-K. At what point in time is this for? How was the number calculated?
  • How many distributors became new sales leaders during 2011 and 2012?
  • How do you define “average active sales leaders” and how many were there at the end of 2011 and 2012?
  • What was the average monthly retail purchase per distributor in 2011 and 2012?
  • What was the average monthly retail purchase per sales leader in 2011 and 2012?
  • What were the total retail purchases by sales leaders in 2011 and 2012?
  • What were the total retail purchases by non-sales leaders in 2011 and 2012?
  • The 2011 10-K cites 548,000 sales leaders at 12/31/11, but shows only 318,000 at 2/28/11. Were 230,000 new sales leaders added in 10 months? If so, that equals 23,000 per month when only 29,000 sales leaders were added in January and February 2011 (or 14,500 per month). Please explain the discrepancy.
  • Why did you stop disclosing the turnover rate for distributors after 2005?

Multi-level marketing companies have a vested interest in limiting the information they disclose That’s not an accident. It is intentional.

And while there may be nothing legally wrong with failing to disclose these numbers (i.e. the SEC and other regulatory bodies don’t require it), the failure to disclose ensures that investors and potential distributors can’t make an informed decision. Companies like Herbalife claim they’re all about transparency, when really there is nothing transparent about them because they don’t disclose enough facts and figures for anyone  to get to the bottom of the recruiting and pyramid issues.

Similar Posts:

Tags: , , , , , ,

Trackback from your site.

Leave a comment

Expert Fraud Investigation
Lifestyle Analysis in Divorce Cases
CPA's Handbook of Fraud and Commercial Crime Prevention
Essentials of Corporate Fraud
© 2013 Sequence Inc. Forensic Accounting. All rights reserved. View our privacy policy here.