On this thought-provoking Blog, English author, David Brear, guides us to the dark heart of a modern-day, totalitarian labyrinth and shines a piercing light on its manipulative rulers and manipulated inhabitants. First, he provides a spool of unbreakable thread so that we can all find our way safely home.
The Fact Herbalife Cannot Deny And The FTC Dares Not Name
By Robert FitzPatrick
Lack of a "pyramid scheme" charge has been cited for Wall Street's ignoring the FTC settlement and continuing to back Herbalife. Some accepted Herbalife's Orwellian claim it was "exonerated.".
The actual reason for Wall Street's and Herbalife's ridicule of the FTC is the agency did not confront the cause of Herbalife wrongdoing, its unlimited income promise with pay-to-play requirements.
The FTC's failure to acknowledge the root cause of Herbalife wrongdoing was a "tell" to investors that the FTC would not challenge the MLM lobby. They've bet on Herbalife's escape.
As cause for the FTC's silence in the face of Herbalife's and Wall Street's scorn some also note FTC Commissioners and officials using MLM as a lucrative post-government career destination.
Wall Street's bet against the FTC may be wrong if Herbalife must prove retail sales. The true facts about Herbalife's recruiting scheme could compel FTC law enforcement.
Three months have passed since the FTC presented its formal Complaint against Herbalife (NYSE:HLF), following a two-year investigation. The Complaint detailed pervasive deception and extensive consumer harm, i.e., unfair and deceptive trade practices under Section 5 of the FTC Act.
Beyond "Pyramid Scheme"
Some have focused on the absence of the term "pyramid scheme" in the FTC statement. Actually, the FTC vividly described the workings of a Herbalife pyramid scheme - payments related to recruiting, financial losses and churning rates of participants, false income promises, and absence of retail profits. Not naming or attempting to prove a pyramid scheme is a legal strategy, also recently used by the Dept. of Justice in criminal fraud charges against the CEO of the MLM, Zeek Rewards. Pyramid schemes are complex "long cons" and there is no federal law against them. Section 5 infractions are much easier to prove.
It was not the avoidance of "pyramid scheme" that is significant but rather the FTC's omission of the underlying foundation of a pyramid scheme, the well spring and the cause of Herbalife's deception and consumer losses. This underlying and uneconomic factor defeats, from the start, any chance of retail sales, and always produces 99% loss rates.
That factor is Herbalife's "unlimited income" promises based on its "endless chain" structure. The endless chain income promise, the most fundamental of all elements of a pyramid scheme, is the factor the FTC does not name because, officially, it endorses this endless chain proposition in its endorsement of "legitimate multi-level marketing", aka "MLM."
Not Denied, Not Even Hidden
Herbalife, for its part, does not - and cannot - in any way try to hide or deny its endless chain model. It is proclaimed as a legal and normal pillar of commerce, passing GAAP and regulatory standards. Herbalife defends the "endless chain" as the foundation of its pay plan and its recruiting activities and the hallmark of the business sector shared with hundreds of others of its type, "multi-level marketing."
In the FTC case against Herbalife, the archetype of MLM, deception and consumer losses were singled out for FTC action. Yet, because the unrestricted endless chain is permitted by the FTC in its endorsement of MLM, the agency dared not speak of the "causes" of Herbalife's global law breaking. The wrongdoing is named, but motive and opportunity are not referenced? Instead, Herbalife was said to be, in some unexplained way, endemicallyfraudulent, requiring "restructuring" to "start operating legitimately."
What then did cause Herbalife, among its MLM peers, to do such bad things and warrant FTC action? While the cause of the illegal practices was not named, the FTC did indicate what were not the causes. It was not due to a ringleader. None was named, like the CEO was in the MLM, Zeek Rewards. It was not accounting malfeasance, as in Crazy Eddy's and Enron. The SEC has not weighed in. It wasn't "rogue" salespeople or complicit managers, who took the fall at Wells Fargo bank. The Consumer Financial Protection Bureau remains silent. Herbalife's wrongdoing, the FTC stated, was embedded in its compensation formula and expressed in its core mission. For this premise to be true, Herbalife must be the ultimate "rogue" MLM, yet the FTC did not claim this either or argue that Herbalife was harming its fellow MLMs.
Exoneration not Condemnation!
Even though the operation of a "pyramid scheme" was not claimed and the causal factor underlying the FTC's list of Herbalife misdeeds was not named, it still would be reasonable that Wall Street analysts and the financial news media would dig deeply into the FTC's condemnations of Herbalife that led to a huge fine and major corrections.
As we know, none of that happened. Instead, Wall Street, and its news media minions, were captivated by Herbalife's stunning, Orwellian response that the FTC's Complaint-Settlement was not an order for fundamental restructuring at all but instead was a government exoneration and vindication of its existing"MLM" business model.
The FTC's litany of specific Herbalife wrongdoings and the punishing measures imposed on Herbalife for it to be allowed to stay in business, including disgorgement of $200 million, were ignored as if they did not exist.
The Fraud Whose Name Dare Not Be Said (by the FTC)
Astute observers have looked past Herbalife's mind-boggling but still predictable denials, and even the media's (also predictable) compliance. They wondered how and why the FTC would allow its own findings and official actions to be publicly negated, grossly misrepresented and misused by a company it had just prosecuted for deceiving consumers!
I submit that the explanation for Wall Street's defiant repudiation of facts and scorning of the FTC is the same factor that also accounts for the FTC's own self-destructive silence while its prosecutorial work is publicly trashed and the Defendant moons the Commission's authority.
The common factor is that the FTC did not and, apparently, feels it cannot address the main and central fraud involved in the Herbalife case, the endless chain income proposition. It is this position that undercuts the entire prosecution and has led some speculators to bet against FTC enforcement.
Indicators of Regulatory Capture
The FTC's revealing failure to acknowledge Herbalife's fundamental flimflam, on which is based its "infinite" structure and "unlimited" income promises, as well as being the root cause of the consumer losses was the "tell" for some on Wall Street of the government's unwillingness to cage the beast it had poked, the beast called "multi-level marketing." The FTC's failure to acknowledge the very nature of the scam gives evidence to some on Wall Street that the "settlement" will follow the FTC's historic - since 1980 - acceptance of MLM as politically insulated from law enforcement by "influenced" members of Congress and, besides that, because MLM is a lucrative career destination for some FTC Commissioners and officials.
Smart money took note that two former FTC Commissioners and one high level official are now on the Herbalife payroll:
Pamela Jones Harbour, Commissioner
Jon Leibowitz, Commission Chairperson
Eileen Harrington, FTC Bureau of Consumer Protection (1987-2009), "with direct responsibility for the FTC's enforcement and regulatory oversight of business opportunities like Herbalife."
Other FTC Commissioners and officials have worked as lobbyists or consultants for MLMs, before or after leaving the FTC:
Timothy Muris, Commission Chairperson (Primerica)
Jodie Bernstein, Director, Bureau of Consumer Protection (Amway)
J. Howard Beales, Director, Bureau of Consumer Protection (Primerica)
David Scheffman, Director of the Bureau of Economics (Equinox)
The appearance, at least, of revolving door and other, potentially, close connections between former FTC Commissioners and officials and MLMs involve intermediary law firms:
FTC Commissioner Julie Brill recently resigned to join the law firm of Hogan and Lovells, a firm that lists Amway and the Direct Selling Association among its clients, and in which partner Deborah Ashford is General Counsel to the DSA "Education" Foundation of which former FTC Commissioner and now Herbalife employee, Pamela Jones Harbour, is a board member. Hogan and Lovells, where Commissioner Brill now works, also filed an amicus brief,opposing the FTC in its case against the MLM, Burnlounge.
FTC, Director of the Bureau of Competition, Richard Feinstein, returned to the law firm, Boies Schiller Flexner, soon after the firm was retained by Herbalife in 2012. Feinstein was appointed to his position at the FTC in 2009 by Commission Chair, Jon Leibowitz, who is now on Herbalife's payroll. Feinstein has moved back and forth between the Boies Schiller and the FTC several times. Boies Schiller recently helped Herbalife fight revelations by short-seller Pershing Capital and to secure a quick and minuscule cash settlement in the most recent consumer class action case of pyramid scheme charges against Herbalife.
Heart of the Pyramid
The "endless chain" is the genesis of all pyramid and ponzi schemes and various other swindles. In the world of "business opportunity" solicitations a perpetual endless chain income promise is equivalent to what a perpetual-motion-machine would be in patents and inventions. Unlike the complex factors involved in a "pyramid scheme" racket, the fraudulence of a perpetual endless chain income promise is pure and recognizable. By its very nature, it meets the conventional definition of fraud: deliberate deception to secure unfair or unlawful gain.
At Herbalife, in classic MLM fashion, this recruiting-based proposition is codified in a contractual agreement with participants of advance-fee collection (fees and quotas of product purchases) with promised rewards (bonuses and royalties) payable upon the perpetual recruiting of new contractors under the same terms, with the new investments serving as funds for the promised reward to the recruiters. This proposition is then marketed as a viable livelihood for millions of people.
In its Complaint and Settlement, the FTC went beyond choosing not to prove Herbalife is a pyramid scheme. It chose to leave out any reference to the source of the racket from which all the itemized wrongdoings and abuses flow, including a definable status of "pyramid scheme." Ignoring the beating heart of the Herbalife scam - the continuous endless chain income promise - gave this classic tool of fraudsters the status of a legal, normal and matter-of-fact business "incentive."
Like Herbalife's astonishing claim of FTC exoneration, the FTC's treatment of the Herbalife "endless chain" created its own reversal of reality. Omission implied legitimacy and viability to this classic trickery. Thus, to bring charges against Herbalife, the FTC had to claim Herbalife had misused the endless chain pay plan and structure of "legitimate MLM", as if a continuous endless chain income promise to all could possibly operate honestly and fairly and really could deliver its promised benefits to all who pay and participate!
Never Denied, but Always Disguised
As an almost magical force capable of mesmerizing millions, the MLM version of the endless chain promise is never denied by Herbalife, but its shifty and voracious countenance is prudently covered with a mask, called "direct selling." In this disguise, the siphoning of money from doomed participants at the bottom is sanitized through product purchases to mimic ordinary consumer transactions and divert attention from the "incentivizing" role of the endless chain promise. The products operate like chips in Las Vegas or a form of crypto-currency, like Bitcoin. Between 35% and 55% of the price of the chips (products) is transferred to the chain of recruiters, with the majority of that total allocated by formula to those in the top 1% of the chain.
With two years of fact-finding, aided by whistle-blowers, independent researchers and consumer activists and with the whole world watching, the FTC had a historic opportunity to escape its political leash by merely acknowledging and describing the foundation of Herbalife's business model. It could have explained and illustrated how the endless chain income proposition itself compels the marketing program toward recruiting and thereby snuffs out retail sales potential. It could have shown how it produces by design, 99% consumer loss rates year after year and necessitates cover-up "disclosures." Instead, the FTC chose to treat the "infinity" aspect of the proposition, an economic Unicorn, as if it really exists, while condemning its effects, as if they were preventable.
Gallery of Endless Chains
To put the MLM endless chain proposition into perspective, it is useful to consider other areas of commercial activity where the endless chain income proposition, under certain conditions, can be legal and permissible or even harmless. These include lotteries, securities and chain letters. Lotteries, chain letters and securities-trading - due to their inherent risk and their win-lose nature and even when they are abused and operate criminally - do not portray themselves as viable Main Street "income opportunities" to replace higher education, trades, jobs and other business ventures. MLMs do exactly this.
Due to the near total losses that lotteries must cause among virtually all participants, state governments oversee or directly operate them. Actual odds to win must be published. Accounting of revenue and rewards is strictly monitored. Most important, lotteries present themselves as games of chance, never as livelihoods to replace jobs. MLMs do exactly this.
Securities must be registered with the SEC. The nature of a security in which value is dependent on future actions of other parties define them as "speculative", and thereby require government oversight. The floating value of a security, based ultimately on what the latest investors believe and will pay, without limit, and always vulnerable to manipulation, is offset by disclosure requirements, government monitoring, and independent analyses of revenue, earnings, book value, and the performance of comparable companies. Security-trading, even under regulation, disclosure rules, monitoring and analysis, does not portray itself as a replacement for jobs for millions of people. MLMs do exactly this.
Only in the MLM version is the endless chain proposition permitted without registration, regulation, oversight and no disclosure requirements of any kind. Only in MLM is the endless chain allowed to be portrayed as a rational replacement for jobs for millions of people. Only in MLM is the investment in an endless chain proposition allowed to be to be called "risk free".
MLM's endless chain marketplace, called the MLM "industry," is not studied by universities and its data are not gathered or monitored by any government agency. There are no independent data beyond those promoted by MLM's own PR and lobbying group, the Direct Selling Association, repeatedly shown to be skewed, exaggerated or at best "anecdotal." There are no independent analysts examining factors of saturation, competition, or historical performance for the investors (participants).
If the MLM "distributorship" were a security, it would be an unregistered penny stock hyped in a boiler room by unlicensed brokers, manipulating the price and lining up buyers and sellers to kite the price.
If MLM were a lottery it would be selling tickets to yesterday's drawing.
If MLM were a chain letter, the persons at the top of the list would never be taken off as more people signed at the end and sent money to those listed above.
The Endless Chain Detonator:Pay to Play
The endless chain in business is potentially toxic by design and, history shows, if not regulated and monitored, it can destroy whole markets or even nations and it can lead individuals to insane and self-destructive actions. By its nature as a transfer, there is no equitable exchange of value. If you profit from it, someone else on the chain or perhaps many others did not.
However, if no money is required to participate, the illusions and fantasies conjured by the income promises of an endless chain become only fanciful and rather innocent. Chain letters, the original endless chain schemes, exemplify this principle. When they charge money for participation, they are illegal in the United States. Why? It is their impossible reward promise based on an illusory "endless" structure. They are fraud per se.
Herbalife's structure and income promise are based on that same model, understood to be inherently deceptive in a chain letter. Yet, at the press conference on Herbalife, the FTC suspended recognition of the inherentlydeceptive nature of Herbalife's structure and related income promise, and FTC officials lamented only that Herbalife did not fulfill its impossible income promises to participants.
When chain letters do not charge money, but only solicit participants to sign on and then send the letter to potential new participants, they become harmless parlor games promising good fortune or offering the chance to spread a wise or silly admonition. The activating spark that makes an endless chain financially lethal is the "pay-to-play" component, sometimes called "payment of consideration."
Yet, besides being unable to acknowledge Herbalife's dangerous endless chain proposition at its core, the FTC also could not take notice of the long and brightly colored fuse attached to the Herbalife explosive, the pay-to-play components built into the MLM pay plan. Herbalife, like all MLMs, is steeped in and totally dependent upon pay-to-play charges.
The legal prohibition against chain letters charging money should be the guide for how the FTC can summarily stop Herbalife's law-breaking: prohibit Herbalife from charging money to participate in its illusory reward planbased on "endless" recruiting.
Among Herbalife's pay-to-play costs are registration fees, but those are just the start and not the main ones. The modest registration fees for "startup kits" may be outside the reward plan and not exceed their base costs. The important pay-to-play charges are product purchase quotas to "qualify" for receiving recruiting-related rewards under the pay plan, then monthly maintenance of the qualifying purchase quotas. Personal buying can fulfill or top off the quotas. There are escalating purchase quotas for higher rewards which if not met, result in penalizing lower rates and lead to significant purchasing to avoid the penalty. Add to these, back office and website charges, shipping costs, marketing material purchases, seminar registrations, books, videos, and more. MLM's pay-to-play costs add up to thousands or tens of thousands of dollars for those who bite the hook attached to the end of the chain.
Defusing the MLM Bomb
The simple solution to deactivating MLM's financial IEDs is presented in twoSeeking Alpha articles, one by me, and one by attorney Douglas Brooks. The articles explain that to remove the danger the FTC would just need to prohibitpersonal purchases from being used as qualifiers or measures for recruiting-related rewards. Buying for personal use or for retail marketing purposes or for any other reason would be unaffected, but personal purchases would never count toward the buyer's own quota related to recruiting-related rewards. Everyone on the chain would be free to buy the goods, but personal buying would not help or hurt the buyers themselves regarding their future-oriented, recruiting-related rewards.
With the fuse to the bomb removed, the FTC would then have no need to monitor "retail selling" rates, which is an after-effect of pay-to-play recruiting and which is impossible to do anyway. FTC monitors would just need to read the terms of the MLM's pay plan and enforce the prohibition against any pay-to-play provisions.
Endless Chain Math and Geometry
Just as whistle-blower Harry Markopolos asked the SEC when he famously and unsuccessfully presented that agency with Madoff's impossible ROI data, consumer activists asked the FTC to look at Herbalife's math. The Herbalife income proposition is based upon continuous exponential expansion without regard to saturation. The promised success of each new MLM participant's investment is based upon a mathematical impossibility. "Infinite" expansion and the promise of "unlimited income" are obviously pseudo-economic phenomena. If the FTC had only recognized the implausible claims along with Herbalife's historical recruiting and payout data over multiple years, the investigation would be finished in short order. As Markopolos noted when he realized Madoffs' trading records had to be bogus, it only takes about 5 minutes to see such fraud.
As we know, Herbalife's business, despite the absurd promises and the devastating data, or perhaps because of them, befuddle many people. I have explained and presented to countless journalists the runaway numbers in a typical MLM plan based on each participant recruiting just five others. After the 13th recruiting cycle, the earth's entire population is enrolled, if the chain is not broken. The numbers are indisputable, yet because the MLM scheme endures and continues to recruit, the numbers don't penetrate some minds.
At that point, I turn to pyramid geometry and the work of the recently retired expert on pyramids at the FTC, Peter Vandernat. Dr. Vandernat left the agency with a trove of precise declarations including an explanation of the design of endless chains showing that financial disaster for millions of participant-investors is pre-ordained by the model itself.
He wrote,"In a pyramid scheme the large scale failure to obtain the proposed rewards is not postponed until market saturation. For as long as a successful recruitment pattern is maintained, the names of the most recent recruits change over time, but the percentage of members constituting the most recent layers of recruits does not appreciably change. At whatever enrollment the program may be considered, whether the total membership be large or small, saturation or not, the rules and implementation of the program ensure that the vast majority of members are not in a position to obtain the proposed rewards. For the promoters of the scheme, this feature always limits the liability for required payouts, while also favoring relatively few participants who are at or near the top of the structure. This description is typically true for all stages of recruitment, including those stages that are still far from market saturation. Also, in a pyramid scheme the number of people who lose money increases exponentially for as long as a successful recruitment pattern is maintained. From the perspective of consumer protection, it is always better that a pyramid scheme fail sooner rather than later."
Applying his description to the "each get just 5" chart, it shows that the hapless and unprofitable recruits in the bottom two levels make up 96% of the total downline! Yet, even with the math calculations and Dr. Vandernat's explanation, the mystifying capacity of the MLM endless chain scheme to endure leads some otherwise perceptive individuals to swallow the "direct selling" narrative and ignore the recruiting reality.
The Secrets of Saturation and Breakage
The math projections and the pyramid's malevolent design are often overwhelmed by reports of continued recruiting, pious denials of wrongdoing by well dressed MLM executives and scenes of ecstatic new recruits pouring into "extravaganza" recruiting rallies. The mind cannot easily hold those apparently positive images alongside the gruesome facts of 99% "losers", perjury about retail sales and 50-80% annual churn of "quitters." MLM persistence becomes an unfathomable mystery to some people.
As in the Wizard of Oz or a Tony Robbins "fire walk", the explanation for the mystery is behind the curtain and through the smoke. In the MLM case, the saturation of whole populations that the recruiting model would seem to lead to is mitigated and managed - for the MLM enterprise - by Factor X, the undisclosed or obscured rates of quitting. In the "biz", the quitting pattern is called "breakage."
Insiders understand breakage as the key to a MLM enterprise's longevity and a windfall to top recruiters. As lower-level recruiters finally quit, whatever residual revenue they may have created from recruiting flows to the levels above. At Herbalife, 66% of all rewards wind up in the hands of the top 1% of recruiters. This is no accident, but the planned result of a carefully formulated top-loaded reward plan with the upward transfer compounded by "breakage" which the plan's authors fully anticipate.
Ironically, the fitful and profitless migration of millions of unwitting consumers joining and quitting MLMs constitutes MLM stability. The quitting keeps the MLM from imploding. The churn and loss rate are not signs of abuse of the MLM model but an integral and necessary part of it. The model is based, as all endless chains are, on transferring money within the chain from later participants to earlier ones. Each "winner" requires many losers, which leads to large-scale quitting.
The fabled MLM income plan dazzles the new recruits with visions of an explosively growing downline - 5+25+125+625 = 780 in just 4 cycles! In reality, 70-80% of new recruits quit within a year as "failures" and most are unable or unwilling to recruit others. The entire chain turns over at a 60% rate. Recruiting often does not keep up with quitting. Only by invading more geography is the MLM enterprise able to show continued "growth". This "growth" is not from building upon a base but is only the net gain of relentless recruiting over constant quitting. Huge troughs of saturation and decline in established areas are papered over with "growth" in new areas, the classic "pop and drop."
If it can replace its 60% of quitters, the MLM enterprise itself does not face "saturation." But the hundreds of thousands joining each year at the end of its "endless chain" are robbed blind by it. For any significant number among that huge base of new recruits to build large "downlines" is mathematically, demographically and economically impossible. They are doomed by design, and fated to lose from the start, as Dr. Vandernat explained.
Saturation may be a distant forecast for the MLM enterprise itself, as long it can keep replacing quitters and expanding globally. The baffling and brutal consequences of saturation are "externalized" by the MLM scheme to all new recruits soon after the scheme is launched. Any significant number of recruits at the end cannot possibly "duplicate" the recruiting numbers of the "winners" on the extravaganza stage. Saturation for the participants is not a far-off event. It is the immediate andpermanent MLM state. Constant "breakage", experienced as loss, disappointment, and self-blame among millions of "losers", is how the MLM manages saturation, while it proclaims another year of "growth."
There is a critical data point that no one has ever seen and the FTC did not report, despite two years of fact-finding with subpoena power. If known, it would instantly reveal the savage impact of saturation on Herbalife recruits and the ill-gotten profit to the company and its top promoters.
The data point may be expressed in this analytical question: How many people, in the USA for example, have ever become paying contractors (distributors) for Herbalife since it opened its doors in 1981? Out of all those millions of individuals, how many ever gained any net profit?
If only 1% can be shown to be profitable during one year, the percentage of profitable participants among all who paid in over the last 35 years would be infinitesimal. The 1-percenters remain in place year after year while the 99-percenters churn and accumulate. The actual winners, stated as a percentage of the true total would be as close to zero as one could graphically illustrate.
Could it be that the FTC does not know about the inherent fraudulence of anyendless chain allowed to operate unregulated and unmonitored?
Does it really not have data on the historical destructiveness of MLM income propositions and "business opportunity" solicitations?
Is it really unaware that MLM's "incentivize" personal purchases with recruiting-based rewards as stated in the compensation plan?
Does it not see how its enforcement policies since 1980 have created a protected haven for the nation's only "endless chain" enterprise without regulation, disclosure or oversight?
Does it really not know that the endless chain will, by geometric design, always produce massive loss rates, and that MLM schemes survive by churning and replacing 60% of the participants every year?
Could it be that the FTC believes most MLMers make money from retailing? Does it think MLM retailing is even feasible, when the MLM enterprise perpetually inundates all areas with competitive "salespeople" and offerswholesale pricing to anyone breathing?
Or could it be that the FTC - and many of us too - have forgotten? Are we like people under a dictatorship who forget what free speech and assembly are? Have we forgotten that an endless chain income proposition is inherently deceptive? Did we forget that law enforcement used to stop this kind of virally-spreading fraud from infecting commercial markets?
Fortunately, there are some who do remember and there are statutory records to reference, laws still on the books that just need dusting off after years of lack of use. Consider the language prohibiting " chain distributor schemes in Wisconsin :
"Unfair trade practice: The promotional use of a chain distributor scheme in connection with the solicitation of business investments from members of the public is an unfair trade practice under 100.20 Stats. When so used the scheme serves as a lure to improvident and uneconomical investment. Many small investors lack commercial expertise and anticipate unrealistic profits through use of the chance to further perpetuate a chain of distributors, without regard to actual market conditions affecting further distribution and sale of the property purchased by them or its market acceptance by final users or consumers. Substantial economic losses to participating distributors have occurred and will inevitably occur by reason of their reliance on perpetuation of the chain distributor scheme as a source of profit."
Similar clearly-worded state statutes are in North Carolina and in California among others. Additionally, there are attorneys, regulators and economists to help with memory recovery. The author of the Wisconsin statute and regulations, Bruce Craig, retired Asst. Attorney General, continues to offer his experience and insights to the FTC, universities and the business media.
Despite the FTC's conspicuous omission of the source of Herbalife's wrongdoings - its endless chain structure and compensation plan and the incendiary factor of "pay-to-play" purchasing - the FTC Settlement with Herbalife is a game-changer in one important way. Herbalife is to be required to show that 80% of all its sales are made to people who are not part of the pay plan, true end-users, outside the chain. Herbalife's model and reward plan are based on a closed market that focuses on recruiting and transferring money among the recruits inside the chain. Any significant level of bona fide retail sales have never been documented.
Most important under the Settlement terms, Herbalife, not the FTC, must bear the burden of proving the existence of these mythical retail sales. Until now, the FTC carried that impossible responsibility of searching for what did not exist, and proving the absence of retail sales by extrapolating data among millions of churning individuals who are "independent" of the offending MLM enterprise.
End Game Scenarios
Could it be that Wall Street's reading of the FTC "tell" is wrong? Many observers were so skeptical of FTC's prosecutorial-will they expected the two-year investigation to conclude with a shameful white wash. They were happily proven wrong and have acknowledged the FTC for breaking a 30-year precedent in taking on Herbalife.
There is also a plausible case to be made that the FTC has soberly recognized its historical dilemma and the impossible mission of "proving" retail sales as the anti-dote for an inherently deceptive endless chain business model, now called "multi-level marketing." And, rather than take on the MLM lobby directly and its paid friends in Congress, the FTC will just let the facts of Herbalife - the poster child of MLM - come to light and serve as a mandate and guide for law enforcement on all MLMs.
If that is true, it is no wonder Herbalife has gone into full-blown denial. In the reality-based world where Unicorns, perpetual-motion-machines and "endless chains" don't exist Herbalife has no other option.
Herbalife has less than a year to prove to the FTC that its US business is based on sales to distributors with Retail Customers who purchase products at prices that generate real profits.
We consider the buying patterns of a small and highly influential group of Herbalife’s top distributors who account for an outsized share of the company’s sales.
We find standing qualification orders, phony accounts, collapsing pyramids of qualification buyers, millions of dollars of products donated to charity and thousands of dollars spent on storage space – all suggesting top distributors lack Retail Customers.
By the way, Herbalife would prefer if you didn’t call these top distributors to ask them about how their businesses operate.
Remember those Herbalife (NYSE:HLF) buttons? "Earn What You're Worth." It's time to find out what that really means.
On July 15, the Federal Trade Commission (FTC) imposed new requirements on Herbalife Ltd. and its payment of commissions. In a Stipulated Order for Permanent Injunction and Monetary Judgment, the FTC and Herbalife agreed that after May 2017, Herbalife must principally pay rewards on three types of transactions: (1) sales by a distributor to a Preferred Customer (a distributor who signed up with Herbalife in order to buy the products at a discount for personal consumption but who is not pursuing the business opportunity), (2) sales to Preferred Customers in a distributor's downline organization, and (3) Profitable Retail Sales by Supervisors in a distributor's downline to Retail Customers outside the Herbalife distributor network.
In yesterday's article, we discussed why we think Herbalife will fall short when it comes to Preferred Customers. We looked at a proxy for Preferred Customers and determined that less than 2% of Herbalife's US sales are attributable to distributors who signed up only to consume the product at a discount.
Now we consider the other 98% - sales to distributors who signed up with Herbalife in order to pursue the business opportunity. What are these distributors doing with the products they purchase? Do the majority resell products to Retail Customers? For Herbalife's US business to survive the FTC settlement, they have to.
FTC Sees Insufficient Retail Demand
While Herbalife continues to insist that the vast majority of its products end up in the hands of Retail Customers, the FTC disagreed. The agency found little retail demand for Herbalife products and certainly not at resale prices that generate material profits for distributors. The FTC mentioned this several times in its Complaint for Permanent Injunction and Other Equitable Relief, which was filed in Federal Court on July 15, 2016 and publicly released alongside its proposed settlement agreement with Herbalife:
If all this is true, how is it that Herbalife's top distributors are running successful businesses? If they can't retail the product themselves and the huge number of people they recruit can't retail the product, what exactly are they doing with it?
One group of Herbalife distributors is key to answering this question. These are members of the TAB Team and higher, a tiny but influential group. They make up the Millionaire Team, President's Team, Chairman's Club and Founder's Circle and are Herbalife's highest paid distributors, receiving tens of thousands or even millions of dollars a year in commission and bonus checks.
In our previous article, we used various data sources, including the recent FTC complaint, to determine how much of Herbalife's US sales can be attributed to purchases by various categories of distributors, including those in the TAB Team or higher:
As the table above shows, "TAB Team or Higher" members account for just 0.7% of all distributors, but as a group purchase 13.5% of Herbalife products sold. We also estimate that these distributors each purchase about 40,000 volume points per year. That's the equivalent of around 1,670 canisters of Formula 1 a year, or 140 canisters a month.
How can we possibly square this with the FTC's statements that there is no real retail opportunity for Herbalife products? What in the world are these top distributors doing with the products?
One way to get to the bottom of those questions would be to simply ask top distributors about their businesses. But Herbalife is discouraging this approach.
Here's a message the company sent to TAB Team members shortly after the FTC settlement was announced:
Here's another message, posted by an influential Herbalife distributor who also runs a business helping Hispanic distributors in the US with accounting and tax issues:
It's interesting that HerbaTax encourages Herbalife distributors to turn down $300-$400 "for answering some questions," while the FTC found that half of Sales Leaders average only $5 per year in net profits.
We haven't tried to reach any of these distributors since the FTC settlement was announced, but based on the above, we suspect trying to interview members of this group won't be a fruitful exercise.
That doesn't mean we can't find clues to how top distributors operate their businesses.
The Petersons' Standing Order
Susan Peterson is one of Herbalife's top distributors. She has frequently been named the #1 Herbalife distributor in the world and is one of a handful of distributors who are part of Herbalife's Founder's Circle.
We get a glimpse into how Susan Peterson manages her business in a document filed as part of a legal dispute over assets jointly owned by her and her late ex-husband John Peterson.
These documents describe the operation of numerous companies and accounts jointly owned by the Petersons. Included in the documents is one detailing the operation of J&S Vision Marketing, Inc. - a company that is 50% owned by John Peterson's estate and 50% owned by Susan Peterson, which operates the couple's Herbalife distributorship.
According to the document, J&S Vision Marketing has contracted with an administrator to oversee aspects of the business. Among the administrator's responsibilities is to monitor sales volume and purchase 2,500 volume points of products from Herbalife every month without fail:
Under Herbalife's compensation plan, distributors need to purchase 2,500 volume points a month in order to qualify for the maximum commission on their downline Supervisors' purchases. Herbalife also counts purchases made by non-Supervisors immediately underneath the distributor toward this threshold.
We have no idea how many non-Supervisors Susan Peterson has in her organization at any given time, though one would expect there to be many if Peterson continues to actively retail, recruit and teach recruits. One would also, of course, expect Susan Peterson to have developed and maintained a substantial base of her own loyal retail customers over the decades that she's worked as an Herbalife distributor.
Instead, the standing order makes no mention of existing Retail Customers and recognizes that the purchases by non-Supervisors in the Petersons' organization can't be counted on. Therefore, the standing order has been established to assure that the Petersons' distributorship earns its maximum commissions every month.
This is qualification buying, and Susan Peterson has outsourced it to an office manager so she doesn't even have to think about it.
$8 Million in Donated Product
The Petersons aren't the only ones at the top of the Herbalife marketing plan who engage in qualification buying. Sometimes that qualification buying is more complex and involves multiple accounts, as the FTC noted in its complaint:
Not only was this distributor buying products for which he or she had no Retail Customer demand, the distributor also was buying for numerous accounts in his or her downline organization for which there was no underlying Retail Customer demand.
When a distributor sets up multiple accounts, buying product under those accounts and earning commissions, this is known as "stacking." Each account allows the distributor to reach further down into the pyramid, taking multiple commissions on the massive churn that occurs as people attempt the business opportunity.
Stacking is prohibited under Herbalife's compensation plan and so is qualification buying. Yet both have clearly been used with impunity by those at the top of the marketing pyramid to qualify for layers of commissions.
Kim's Collapsing Pyramid
Sometimes qualification buying extends to an entire organization, and Korean Chairman's Club members Tai Ho Kim and Hyun Mo Koo provide us with an excellent example. They are among Herbalife's most successful distributors and, like Susan Peterson, are members of the exclusive Founder's Circle.
Herbalife inadvertently revealed some details about Kim's business in an email sent by an Herbalife executive to the head of the Herbalife Family Foundation, in support of Kim receiving the Foundation's annual Humanitarian Award in 2013. The email appeared on the Foundation's website.
In the email, the Herbalife executive tells a story of how Kim's business, which was generating $500,000 a month in Herbalife commission payments, collapsed after Herbalife's now late founder Mark Hughes postponed the opening of the Korea market.
If Kim's organization had been composed of distributors with actual Retail Customers, his downline would have continued to purchase product even after the news of the delayed market opening. Distributors in his downline might have been disappointed by the loss of recruiting opportunities, but they wouldn't have stopped buying products from Herbalife altogether. The problem was that their purchases were driven by a desire to reach a high position in the marketing plan ahead of what was expected to be a dramatic expansion in the number of potential recruits in Korea. That's called qualification buying.
Doran Andry's Storage Space
Another one of Herbalife's most successful distributors is Chairman's Club member Doran Andry. We get a glimpse into how Andry's business works thanks to details provided in his ongoing divorce battle in California. Filings in that case include financial information for Andry's Herbalife distributorship, which is run through a company called HB International Group, Inc.
In 2014, HB International reported $2.6 million in commission and bonus payments from Herbalife. Yet, the business reported just $15,700 in revenue from product sales. It seems that while Andry earned huge commissions on the volume purchased by people recruited into his organization, his own retail business was a disaster.
HB International generated just $15,730.43 by selling products (which we assume to be Herbalife products), while also reporting that it spent $142,557.55, in two separate line items, to buy what we assume are Herbalife products. (We believe F.S.S. stands for Financial Success Systems, another company owned by Andry.)
If these goods were in fact Herbalife products, then Andry bought products with a Suggested Retail Price of around $284,000 and made just$15,700 selling them.
This wasn't a one-time problem either. In 2013, HB International reported revenue from product sales of $32,419.99 and product purchases of $196,699.68, the equivalent of $394,000 in Herbalife products at the Suggested Retail Price.
Why does Andry buy product that he can't sell? In 2014, his purchases helped to qualify Andry for $2.6 million in commissions, and in 2013, the product purchased by Andry and his downline distributors unlocked $2.9 million in commission payments.
What in the world does Andry do with all the products that he doesn't sell?
One of HB International's larger expenses is an item called "Public Storage," which amounted to $55,113.00 in 2014.
We don't know what Andry's Herbalife distributorship is storing in all that space, but it sure would hold a lot of unsold Formula 1.
Missing Retail Demand
Will Herbalife's top distributors be able to meet the FTC-imposed thresholds and show that the vast majority of their organization's purchases are made by Preferred Customers or by distributors with actual Retail Customers? Top distributors have cheated in the past and will surely try in the future. We've already heard that some top distributors believe it will be easy enough to use the names of friends and relatives to create fake accounts and to place orders on behalf of these individuals. But going forward there will be an outside monitor reporting to the FTC checking up on them.
As it stands, we believe there is substantial reason to doubt that Herbalife's most successful distributors will be able to honestly prove they have armies of Retail Customers.
It appears, given her standing instructions to an administrator, that Susan Peterson can't count on Retail Customers or her downline distributors' Retail Customers to come up with even 2,500 volume points a month; that's about 100 canisters of Formula 1.
The charitable donor described above, almost certainly a Founder's Circle or Chairman's Club member, not only relies on a charity to create "demand" for the products he or she purchases but appears to have used controlled downline member accounts to simulate even more demand.
Kim built a business that paid him $500,000 a month in commissions, yet his entire organization collapsed when the demand for qualification volume was pulled out from under the business by the delayed opening of the Korea market.
Chairman's Club member Doran Andry bought product with a retail value that is 10 to 20 times higher than the amount his business generated through product sales.
The problem for Herbalife's top distributors going forward is that fake demand or qualification buying won't count toward earning commission checks after May 2017. The FTC was quite clear that in order for product purchases to count toward commissions, the products must be sold in "Profitable Retail Sales." That means distributors must sell to real customers who pay full Retail Price or close to it and provide their names and contact information to the company. Volume that is donated or is part of a standing order, that ends up at a charity or in a storage locker won't count either.
Combine this with the fact that a deminimis amount of product is being sold to Discount Buyers, and Herbalife is going to have major problems clearing the FTC-imposed hurdle on paying commissions.
In this sense, Herbalife may be right to discourage top distributors from wasting their time taking calls from curious investors. The button may still say: "Earn what you're worth," but if Herbalife's top distributors are going to continue to get the same checks they received in the past, they need to find an awful lot of real Retail Customers and they need to find them soon.
For All The Hype About Herbalife's Discount Buyers, We Estimate They Account For Less Than 2% Of U.S. Sales
By Christine Richard
Herbalife has less than a year to show the FTC that the vast majority of its products are sold to people who have no interest in its business opportunity.
To do this Herbalife must prove that legions of people sign up with the company only to buy the product at a discount for personal consumption.
Herbalife’s disclosure regarding so-called Discount Buyers has been self-serving and misleading since the company came under scrutiny.
We estimate the number of current Discount Buyers, based on Herbalife’s disclosures, past and present, and the FTC’s findings, and discover that they account for less than 2% of Herbalife’s US sales.
The clock is running for Herbalife Ltd. (NYSE:HLF). The company has until May 15, 2017 to show the Federal Trade Commission (FTC) that the vast majority of its products are purchased by consumers, not by distributors who buy Herbalife products to qualify for and generate commissions. Qualification buying is a red flag of a pyramid scheme.
Starting in May, Herbalife will be required to show that two types of individuals account for most of its sales: 1) a newly created category of individuals called Preferred Customers, who sign up with Herbalife just to get a discount on the products for personal consumption and have no interest in pursuing the business and 2) distributors who are pursuing the business opportunity and can verify that they sell the products they buy from Herbalife to Retail Customers at a profit.
In this article, we estimate how many individuals make up the first group, Preferred Customers, and how much product they're consuming. To do this, we reconstruct a metric that the company stopped regularly disclosing in 2012 - the percentage of distributors Herbalife considers to be "Discount Buyers" or people who signed up just to get the product as a discount.
When it stopped including this information in its filings with the Securities and Exchange Commission, management said it believed the information was not valuable to the business or to investors. In fact, this data may be one of the single most important pieces of information for determining whether Herbalife operates as a legitimate direct selling business in the US and whether Herbalife's US business will be able to survive the FTC settlement.
For years, Discount Buyers were little more than an aside, with Herbalife management focusing on distributors who signed up for the business opportunity. Discount Buyers were part of a group of distributors referred to as Non-Sales Leaders (individuals who didn't purchase sufficient product from Herbalife in a year to be eligible for commissions). There were two other categories in this group: Small Retailers, who were happy limiting their business to selling to a few friends or family members, and Potential Supervisors, distributors who were working on building a more substantial business but weren't there yet.
In 2012, Herbalife stopped breaking out Non-Sales Leaders in its filings. Then, in 2013, as Herbalife came under intense scrutiny over the deceptiveness of its business opportunity and the high failure rate of its distributors, management revived its discussion of Discount Buyers and suddenly this group dominated the business. A survey Herbalife commissioned found that Discount Buyers made up nearly two-thirds of its distributors.
With the benefit of evidence obtained in the course of its two-year investigation, the FTC concluded certain Herbalife-commissioned surveys were "flawed and unreliable." It noted, for example, that one survey classified people as becoming distributors primarily to obtain product discounts even when those same individuals reported leaving Herbalife because "finding new customers was too difficult and/or time consuming" or that "the business was harder than [they] originally believed."
Here's how Herbalife's disclosure regarding the relative importance of Discount Buyers evolved:
"We have two core, two core businesses. We have a business opportunity, which is why most of our distributors come here. They come here to look for a business opportunity."
- CEO Michael Johnson, 2005
"[D]iscount buyers . . . who have signed up as distributors to enjoy a discount . . . are approximately 29%."
- 10-K for 2010
For "complete transparency," for the full year 2011, "discount buyers were 27 percent."
- 8-K filed May 2, 2012
"Fact: 73% of Former Distributors Joined for Product Discounts."
- Jan. 10, 2013 (Investor Day)
"90% buy for one reason - self-consumption."
- Jan. 10, 2013 Michael Johnson Interview on CNBC
How is it possible that Discount Buyers went from 27% of Non-Sales Leaders in 2012 to 90% of all distributors less than two years later?
This remarkable shift was certainly convenient. The higher the number of Discount Buyers in Herbalife's ranks, the stronger the company's defense against critics who said Herbalife's own US Statement of Average Gross Compensation indicated that only a tiny fraction of distributors earn any money.
The company insisted that Discount Buyers, though included in the compensation table, didn't sign up with Herbalife to make money; they were consumers, not business opportunity seekers, so attempts to analyze Herbalife's business opportunity with these individuals in the data were guaranteed to skew the analysis toward the erroneous conclusion that most people signing up with Herbalife failed at the business. The presence of a large number of supposed Discount Buyers in the data made it impossible to draw conclusions about the business opportunity.
Thanks to some additional information about distributor buying patterns provided by the FTC in its complaint, we believe we can come up with a realistic estimate of the number and importance of Discount Buyers, and by extension, a realistic estimate of the number and importance of Herbalife's future Preferred Customers.
Counting Discount Buyers
We start by creating a table with six categories of distributors. Three of these categories are for Non-Sales Leaders, which includes the category we are most interested in - Discount Buyers - as well as Small Retailers and Potential Supervisors.
There are also three categories of Sales Leaders (distributors who buy enough product from Herbalife in a year to qualify for commissions). These include Inactive Sales Leaders, distributors who bought enough to qualify for commissions but aren't regular buyers; Active non-TAB Team members, distributors on the lower end of the Sales Leader ladder who buy regularly; and Active TAB Team members, the highest-ranking Sales Leader who make regular purchases.
Herbalife's 2015 US Statement of Average Gross Compensation disclosure table along with its 10-K give us enough information to estimate the total number of distributors in the US and to break that into the number of Non-Sales Leaders and Sales Leaders, as follows:
Herbalife's more detailed 2011 U.S. Statement of Average Gross Compensation, shown below, provides the basis for breaking Sales Leaders into different categories.
By applying this breakdown to the absolute numbers of Sales Leaders for 2015, we can determine the absolute numbers of Sales Leaders in each of our categories:
To determine the breakdown for non-Sales Leaders, we go back to Herbalife's May 1, 2012 earnings call when hedge fund manager David Einhorn phoned in with some questions, including: Why did Herbalife stop breaking out the various categories of non-Sales Leaders in its 2011 10-K?
Here's part of the answer, which the company filed in an 8-K:
We did not include the percentages from the 2011 Form 10-K in our more recent filings because we do not view the information as valuable to the business or to investors. For complete transparency, however, the full year 2011 information is as follows:
· Discount buyers were 27%
· Small retailers were 61%
· Potential supervisors were 12%
By applying these percentages to 2015 sales, we can fill in all the categories of non-Sales Leaders, including Discount Buyers.
The result: Discount Buyers in the US totaled 117,771 in 2015 and made up 21.6% of all US distributors.
That's significantly lower than the figure Herbalife disclosed in 2012 when it said it 27% of its distributors fell into the Discount Buyer category. It's also a very disappointing number given the statements Herbalife has made in recent years about the vast majority of its distributors signing up just to get a discount on the products.
But let's keep going, because what we really want to know is how much of Herbalife's U.S. sales were made to these 117,711 Discount Buyers.
Discount Consumer Purchases
The FTC provided a crucial data point in its complaint that allows us to add volume composition to our table. The FTC stated that Sales Leaders purchaseat least 75% of Herbalife's products while non-Sales Leaders purchase less than 25%.
We add this information to the table.
The FTC also provided a second piece of information in its complaint that allows us to break down the distribution of product purchases within the Sales Leader category. The agency noted that TAB Team members buy about 8x the amount of product purchased by lower level Sales Leaders.
This will be helpful once we can establish how much Inactive Sales Leaders are purchasing. By consulting the Marketing Plan, we can make a reasonable estimate. We know they must be purchasing at least 4,000 volume points a year in order to be considered Sales Leaders. But they can't be purchasing 7,500 volume points or more or they would be considered Active Sales Leaders. So we estimate purchases of 5,000 volume points per year for each Inactive Sales Leader and add it to the table below.
Now, we can estimate that those in the TAB Team or Higher are buying on average 40,000 volume points a year because the FTC said that the average TAB Team member or Higher purchases about 8x the amount purchased by lower level Sales Leaders. We add the 40,000 volume points to the table.
By multiplying the volume points per distributor by the total number of distributors in each category, we come up with the total volume points being purchased by these two groups of distributors:
Now we can plug in the missing values for Active Non-TAB Team, and we've established everything we need to know about the Sales Leader groups:
This leaves us to determine Non-Sales Leaders, including the crucial Discount Buyers - the individuals who interact with Herbalife solely to get a discount on the product and who must exist in substantial numbers in order to legitimize Herbalife's business in the eyes of the FTC.
In the 8-K Herbalife filed following David Einhorn's question back in May 2012, the company not only revealed the breakdown in Non-Sales Leaders by motivation, but it explained how it arrived at these various categories. The groups correspond to distributors who have achieved various levels in the marketing plan, which entitle them to different discounts on products:
· Potential Supervisors were buying at a 42% discount, putting them at the "Success Builder" level in the marketing plan.
· Small Retailers were buying at a 35% discount, making them "Senior Consultants."
· Discount Buyers were buying at a 25% discount, which is the discount available to "Distributors."
Using the marketing plan, we can estimate, on average, how much Potential Supervisors, a/k/a Success Builders, are buying. A Success Builder is defined as a distributor who has purchased 1,000 volume points in a month or 2,500 volume points over three months. If the distributor had purchased 4,000 volume points over a one-year period, he or she would have advanced to the higher level of Sales Leader. We therefore conservatively estimate that Potential Supervisors buy on average 2,000 volume points a year.
Again, using the marketing plan, we estimate that Small Retailers, a/k/a Senior Consultants, are buying on average 600 volume points a year. To reach the Senior Consultant level, an Herbalife distributor needs at least 500 volume points, but with more than 1,000 volume points in a month or 2,500 volume points over 3 months, the distributor would be bumped up to a Success Builder.
Using these estimates, we can now fill in the total amount of product purchased by these two groups of Non-Sales Leaders:
We now only need to plug in the missing values for Discount Buyers.
The result: Discount Buyers purchased 18 million volume points in 2015, accounting for just 1.6% of U.S. sales.
Let's review: The FTC says sales to Preferred Customers and to distributors who sell on to Retail Customers must account for two-thirds of Herbalife's sales, if the company is to continue to pay the same level of commissions to its distributors. We considered one category in this article - Preferred Customers - and estimated the size and importance of this group by reconstructing the ranks of Discount Buyers, a metric Herbalife stopped regularly disclosing in 2012.
Recall that Herbalife set our expectations very high for this group, with periodic claims such as CEO Michael Johnson's statement in 2013 that 90% of distributors sign up for one reason only - to consume the product.
Discount Buyers are vital to legitimizing Herbalife's U.S. business because they have no interest in pursuing the business. They are a testament to the underlying demand for the products. These individuals are so pleased with Herbalife products that they are willing to make an upfront payment in order to get discounts on future purchases and they're willing to go through the hassle of signing a contract in order to get that discount. They are what one might call "loyal customers."
The problem is that they make up only 22% of all distributors, and they buy less than 2% of the product Herbalife sells in the US.