SEC responds to Sen Markey regarding Herbalife Ltd. (NYSE:HLF); for more background see here.
H/T Herb Greenberg
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WASHINGTON, D.C. 20549
March 4, 2014
The Honorable Edward J. Markey
United States Senate
218 Russell Building
Washington, DC 20510-2107
Dear Senator Markey:
Thank you for your January 23, 2014 letter requesting that the Securities and Exchange Commission (the “Commission” or”SEC”) investigate the business practices of Herbalife, Ltd. to determine whether it is acting in accordance with the federal securities laws. Inparticular, you raised concerns overreports that Herbalife may be a pyramid scheme.
The Commission’s investigations are confidential, and the Commission generally neither confirms nordenies the existence of an inquiry or investigation unless and until made a matter of public record in proceedings instituted before the Commission or in court. We do this to protect the integrity and effectiveness of our investigative process and to preserve the privacy ofthe individuals and entities involved. Accordingly, we cannot comment on whether SEC staffhas investigated, or is currently investigating, matters related to Herbalife. Nonetheless, we appreciate your letter and the concerns you raised. Ican assure you that we are giving your concerns every consideration.
In your letter, you asked for information in response to several questions. While specific responses are provided below, it is important at the outset to note some general information regarding the Commission’s authority to enforce the federal securities laws as they relate to illegal pyramid schemes and legitimate multi-level marketing (“MLM”) companies.
The Commission’s Division of Enforcement is responsible for investigating possible violations ofthe federal securities laws, including unregistered offers and sales ofsecurities and false and misleading statements in connection with the offer, purchase, and sale ofsecurities. The antifraud provisions of the federal securities laws prohibit fraud, in the offer or sale, or in connection with the purchase or sale, of securities. “Securities” include, among other things, acompany’s stock and investment contracts offered by a company or promoters. Generally, the Commission’s jurisdiction is limited to investigating and prosecuting misconduct involving securities as defined by the law and interpreted by the courts.
The Division of Enforcement regularly investigates the accuracy of disclosures by companies that offer or sell securities. In these cases, Enforcement staff reviews corporate statements, whether found in SEC filings, in statements by corporate officers, or elsewhere, to investigate whether such statements are materially false or misleading. For example, the Division may investigate whether acompany or others misrepresented the company’s business as having tributes of a legitimate MLM company when, in fact, the company does not have those attributes.
The Division ofEnforcement also regularly investigates whether promoters offer or sell securities, and, if so, whether the offerings of securities are registered with the Commission in accordance with federal securities laws and regulations. In these offering cases, SEC staff reviews the representations made by the promotersto determine whetherthe interestoffered is a security.
For example, the Division may investigate whetherpromoters offered and/or sold to investors securities in the form of investment contracts. Under certain circumstances, an interest in a pyramid schememay be an investmentcontract, and, therefore, a security subject to the Commission’s jurisdiction. Whether an interest is an investment contract depends on the particular facts and circumstances as applied to the law. The Supreme Courthas defined an “investment contract” to includethe investmentofmoney in a common enterprise, with the expectationof profits derived solely from the effortsof others. SEC. v. W.J. Howey Co., 328 U.S. 293,298-299 (1946).
In the securities law context, a so-called”pyramid scheme” is not a defined term, but rather generally refers to a type of scam in which fraudsters may pitch as legitimate a business opportunity intheform of MLM programs. SEC staffhasissued an investor alert to warn thepublic of these scams, titled Beware ofPyramidSchemes Posing as Multi-Level Marketing Programs, available at www.sec.gov/investor/alerts/ia pvramid.htm. In this alert, the staff warns that pyramid schemes masquerading as MLM programs may violate the federal securities laws, such as laws prohibiting fraud and requiring the registration ofsecurities offerings and broker-dealers. The alert explains that, ina typical pyramid scheme, money from new participants is used topay recruiting commissions to earlier participants —justasinclassic Ponzi schemes, where money from new investors isused topay fake “profits” to earlier investors. Recently, the Commission has sued alleged operators oflarge-scale pyramid schemes for violating the federal securities laws by falsely representing these scams to be legitimate MLM programs.
For example, in SEC v. CKB168,13 Civ. 5584 (E.D.N.Y. 2013), Lit Rel. No. 22846 (Oct. 17,2013),1 the Commission filed charges to stop an alleged pyramid scheme. In addition, in an adjudicated settled action, SEC v. Rex Venture Group, 12 Civ. 519 (W.D.N.C. 2012), Lit Rel. No. 22456 (Aug. 22,2012),2 the Commission shut down a $600 million fraud that duped approximately one million Internet customers through a complex investment scam involving aPonzi scheme promoted as adaily profit-share pool and a pyramid scheme pitched asa legitimate MLM company.
Inaddition to the SEC’s efforts, other federal agencies also seek to combat illegal pyramid schemes. See, e.g., www.consumer.ftc.gov/articles/0065-multilevel-marketing (describing the FTC’s use offederal consumer protection laws to combat pyramid schemes) and http://www.ibi.gov/scams-safetv/fraud (listing pyramid schemes asa common scheme that the FBI investigates).
With this general information in mind, below are responses to your specific questions.
1) There is agreat deal ofopacity surrounding Herbalife’s system ofcompensation,
a) Typically, how many compensation system levels do multi-level marketing companies have? Is itcommon to see amulti-level marketing company have
1 Sgg http://www.sec.gov/Iitigation/litrelcases/2Q 13Zlr22846.htm.
2 See https://www.sec.gov/litigation/litreleases/2012/lr22456.htm.
more than a half-a-dozen? Also, how many compensation system levels does the typical pyramid scheme have?
b) Hypothetically, if an entity had a turnover rate in excess of 5% each quarter in its lowest tier, would that be grounds for an investigation into whether the entity is a pyramid scheme? What if the turnover rate was in excess of 10%?
What if it was in excess of 50%?
The SEC does not maintain specific data regarding the typical number of compensation levels or turnover rates at eitherMLMcompanies or pyramid schemes. As statedabove, the Division of Enforcement’s investigations include disclosure and offering cases, and each investigation depends onitsparticular facts and circumstances. In disclosure cases, we investigate whether any statements made about the business are materially false ormisleading, including statements regarding the compensation levels orthe turnover rates. In offering cases, we investigate whether the interest acquired bythe investor was a security, and the compensation level and/or turnover rate might be relevant to that analysis. However, compensation and turnover rates would bebut two ofmultiple facts and circumstances used todetermine whether Enforcement should conduct an investigation.
2) How a company structures its operations typically provides insight into whether a company is a pyramid scheme.
a) Is it accurate to state thatthe more complex a structure and the longer it takes to rise through it, the more likely it isa company is a pyramid scheme?
b) Can you provide mewith information about the pyramid schemes that the Commission has prosecuted with the least complex structures, including information about the minimum amount of time it took a distributor who entered an entity to rise through each of the entity’s compensation levels?
Whether a firm isoperating an illegal pyramid scheme inviolation ofthe federal securities laws depends on the particular facts and circumstances, including the complexity ofits structure and its disclosures concerning the structure. Although we do not have detailed information on the minimum amount of timefor distributors to risethrough compensation levels, the following Commission enforcement actions exemplify pyramid schemes involving limited complexity: SEC v Universo Foneclub Corporation, 06 Civ. 109040 (D. Mass.), SEC Lit Rel. No. 19715 (Jun. 1, 2006) (two levels);3 SEC v. Lane, 07 Civ. 1920 (M.D. Fla.), SEC Lit Rel. No. 20393 (Dec. 11, 2007) (four levels);4 and SEC v. West, 09 Civ. 1419 (M.D. Fla.), SEC Rel. No. 21182 (Aug. 21, 2009) (four levels).5 In each action, the defendants purported to operate legitimate MLM companies.
3 See http://www.sec.gov/litigation/litreleases/2006/lrl 9715.htm.
4 See http://www.sec.gov/litigation/litreleases/2007/lr20393.htm.
5 See https://www.sec.gov/litigation/litreleases/2009/lr21182.htm.
3) There have been inconsistent estimates of sales outside Herbalifc’s distributor network (i.e. to people who are not distributors). Typically, the more sales occur within a distributor network in which the products are not purchased by those who would be expected to ultimately consume them, the more likely a company is to be a pyramid scheme.
a) Have you investigated the fact that Herbalife’s statements changed materially over time about the percentage of sales outside the network?
i) May 1,2012 Conference Call – Pres. Des Walsh: 70% or higher
ii) May 2,2012 – 8K: We don’t keep track
iii) Dec. 19,2012 – CEO Michael Johnson: 90% of customers are outside the network – “Absolutely”
b) Do you have any idea what the accurate number of sales outside the networks as a percentage of total sales was for each of the last five years?
As stated above, the Commission’s investigations are confidential and the Commission generally neither confirms nor denies the existence of an inquiry or investigation unless and until we bring charges against someone involved. Accordingly, we cannot comment on whether the Commission has investigated, or is currently investigating, matters related to Herbalife.
Thank you again for your letter Please do not hesitate to contact me at (202) 551-2100, or have your staff contact Tim Henseler, Director ofthe Office of Legislative and Intergovernmental
Affairs, at (202) 551-2010, if you have any questions or comments.
Mary Jo White