Bill Ackman’s short against Herbalife Ltd. (NYSE:HLF) is in the news again now that the Federal Trade Commission has decided to investigate allegations against the company, but Ackman isn’t content to attack the company only in the US. He has also claimed that Herbalife’s recruitment and compensation policies violate Chinese law.

Bill Ackman herbalife

While pyramid schemes are illegal in most countries, the rules that distinguish between a pyramid scheme and a legitimate multi-level marketing business vary from place to place, so a business that is deemed legit in one country might be breaking the law in another. Ackman points to four restrictions in China that are different and arguably stricter than the equivalent laws in the US.

First, only licensed direct sellers can recruit other people into a multi-level marketing process; individuals cannot recruit new sellers on their own, and recruitment can’t require new sellers to pay fees or buy products up front. Compensation has to be based on the direct sales from a distributor to consumers, not on the sales of his or her down line as is Herbalife Ltd. (NYSE:HLF)’s normal practice in other countries. Compensation can’t surpass 30% of sales volume, and it can’t be based on recruitment activities.

Ackman retains OTG to investigate

“For competitive reasons, I don’t want to disclose our compensation program other than to say that we are abiding by all local regulations. We have a very competitive marketing plan for our distributors…obviously, there’s a limit in the payout,” said Herbalife Ltd. (NYSE:HLF) COO Rich Goudis (CFO when he made the statement), which Ackman sees as a red flag that something is wrong.

To find out what Herbalife Ltd.’s (NYSE:HLF) compensation program looks like he retained OTG Research Group to interview dozens of Herbalife distributors in Shanghai, Guangzhou, and Hefei. OTG found that Herbalife had three levels of participation in China: preferred customer, business representative, and distributor. Becoming a preferred customer requires a 100 RMB purchase (about $16). Moving up from there to business representative requires the accumulation of 100 volume points (12 RMB per point), and it take 5000 volume points within a three month period to reach distributor status.

Distributors are further divided into five groups according to volume and receive hourly consulting fees based on which group they are in. “Earning 30% of retail profits is not very much. But the consulting fee paid by Herbalife is very high,” said one distributor, Mr. Hu in Hefei.

Herbalife responds to Ackman’s allegations

Herbalife says that Ackman’s presentation on its operations in China show his “continued failure to fundamentally understand” the company’s business model, and that it “regularly partnered with local, regional, and national Chinese government officials in seeking out and penalizing those who violate Chinese laws and Herbalife (China)’s rules.”

The company says that 150,000 preferred customers buy Herbalife Ltd. (NYSE:HLF) products for their own use, not to resell, and that the company’s nutrition clubs have the proper licenses to recruit new sellers.