Herbalife Ltd. (NYSE:HLF) has so far been beating activist investor Bill Ackman on Wall Street. The company’s financials have been good, and investors have mostly ignored Ackman’s claims that Herbalife is a pyramid scheme. However, company management—and investors too—should be waiting to hear the outcome of a case that is currently pending in the Ninth Circuit Court of Appeals.

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Herbalife affected by FTC vs. Burnlounge

Writing on the Financial Times’ Alphaville blog, Dan McCrum points us to the case between the Federal Trade Commission and a company called Burnlounge. He thinks the FTC will wait to hear what the court has to say on that case before it decides to change some guidance which will affect all multi-level marketing companies. In fact, that ruling could be very damaging to Herbalife Ltd (NYSE:HLF)’s business model.

The guidance the FTC may be considering changing deals with internal consumption of products at a multi-level marketing company. One of Ackman’s biggest complaints about Herbalife Ltd (NYSE:HLF) the indications that so much of its sales come from the distributors themselves, who have no intention of selling the product but would rather just use it themselves. The FTC has already said it is launching its own investigation of Herbalife Ltd. (NYSE:HLF) as a possible pyramid scheme, so the outcome of the Burnlounge case could have a huge bearing on the outcome of that investigation.

Of course the FTC could lose that case against Burnlounge entirely, or the decision could end up being somewhat mixed.

Background on the case

According to McCrum, the FTC filed a complaint against Burnlounge in 2009, alleging that it is a pyramid scheme. Burnlounge is an online music company which sells music through what it calls “burnpages.” The company gets most of its money by charging for premium services. These services allow members to earn cash for recruiting new members to the service. Five years after the case was filed, an appeals court ruled against Burnlounge and levied a $17 million judgment against the company.

However, the case is up on appeal again, this time because of a one in the final judgment. The court defined exactly what it meant by the term “pyramid scheme.” The line highlighted by McCrum is: “For purposes of this definition, ‘sale of products or services to ultimate users’ does not include sales to other participants or recruits or to the participants’ own accounts.”

What could happen to Herbalife?

If the Ninth Circuit Appeals Court accepts that statement as part of the legal definition of what a pyramid scheme is, it would be a major blow to Herbalife Ltd. (NYSE:HLF) and the rest of the MLM industry. It would provide a specific test which requires all MLMs to make most of their sales to customers who are not inside their network of distributors.

Herbalife Ltd. (NYSE:HLF) and many other MLMs probably wouldn’t pass such a test because today the industry largely involves companies which just sell to themselves through internal consumption by distributors who pay in large amounts of the companies’ revenues.

Herbalife says it is legitimate

Herbalife Ltd. (NYSE:HLF) has continued to defend its business model, but so far, it has not specified exactly what percentage of sales are to people outside its network. In fact, the nutritional supplements company has said that the metric isn’t even important enough to track. It does admit, however, that most of its distributors are customers who sign up just so that they can get a discount on its products. But Herbalife isn’t the only company which sees this sort of setup as an OK way to do business.

According to McCrum, well-known industry lawyer Jeffrey Babner has argued that the statement in the court document is overreaching by the court on the topic of personal consumption. He said if this sort of language is applied to the MLM industry, it “could easily create legal challenge to many of the world’s leading direct selling companies, many in business for decades and some even publicly traded on stock exchanges.”

We should hear a ruling on this case against Burnlounge later this year, and it will certainly be an important one for the MLM industry as a whole.