Herbalife Ltd. (NYSE:HLF)’s motion to dismiss a lawsuit against it has been denied by a U.S. District Court. Plaintiff Dana Bostick has accused Herbalife of being a pyramid scheme. Previous allegations of racketeering, so-called RICO charges, have been dismissed and Herbalife was hoping that it would be able to end the whole affair without having to go to trial. A guilty verdict could encourage other people who have had bad experiences with the company to also press charges.

Herbalife

Herbalife pyramid scheme

The decision cites the Koscot Test which has been used by the Federal Trade Commission and previous judges to determine whether a company is a pyramid scheme. “The Koscot test specifies that a pyramid scheme is ‘characterized by the payment of participants of money to the company in return for which they receive the right to (1) sell a product and (2) receive in return for recruiting other participants into the program rewards which are unrelated to sale of the product to ultimate users.”

Herbalife Ltd. (NYSE:HLF) tried to get the case dismissed because Bostick conceded that it’s possible for someone to become a supervisor without actually buying and selling Herbalife products, which would seem to put the company outside the definition of a pyramid scheme, but Judge Beverly Reid O’Connell explained that the situation isn’t so straightforward, citing the landmark case Webster v. Omnitrition.

Herbalife’s product distribution

“The considerable discounts and advantages offered to supervisors presents the same risk of a recruitment focus present in Omnitrition… [Herbalife] contend that distributors should be classified as ultimate users, Omnitrition points out that “[i]f Koscot is to have any teeth, [a sale for a distributor’s personal use] cannot satisfy the requirement that sales be to ‘ultimate users’ of a product.” Id. at 783. Therefore, downline distributors are not ultimate users for purposes of the second element of the Koscot test.  Accordingly, Plaintiff has adequately alleged that supervisors pay money to receive recruitment rewards which are unrelated to the sale of products to ultimate users.”

Just to be clear, O’Connell isn’t ruling that Herbalife Ltd. (NYSE:HLF) meets the Koscot test criteria, only that the plaintiff has made a strong enough argument that it can’t be dismissed out of hand.

Bostick — Order Denying Motion to Dismiss by ValueWalk.com