Last week the U.S. District Court for the Eastern District of Kentucky issued some important definitions regarding pyramid schemes and orders for a multi-level marketing company some compare to Herbalife Ltd. (NYSE:HLF). The ruling came in a case the Federal Trade Commission and the states of Illinois, Kentucky, and North Carolina filed against Fortune Hi-Tech Marketing, Inc.
Activist investor Bill Ackman and his fund Pershing Square Capital Management have been accusing MLM company Herbalife Ltd. (NYSE:HLF) of being a pyramid scheme for about a year and a half now. They’ve put together a comparison between Hi-Tech and Herbalife, alleging that by the court’s definition, Herbalife could also be subjected to some of the same orders.
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Court defines MLM sales
One of the key pieces of the ruling against Fortune Hi-Tech relates to what the order refers to as a “prohibited marketing program,” which it defines as “any marketing program or plan in which any participant pays money or valuable consideration in return for which the participant receives the right to receive rewards in return for recruiting other participants into the program or plan, which are unrelated to the sales of products or services to ultimate users.” It further states that “sales of products or services to ultimate users” don’t include “sales to other participants or recruits or to the participants’ own accounts.”
This ruling sets this sort of sales model apart from the “multi-level marketing program,” which, among other things, for a fee, grants participants the right to “receive payment or other compensation that is based, in whole or in part, upon the sales of those in the participant’s downline, tree, cooperative, income or similar program grouping.”
In other words, sales to those who participate in a marketing plan can’t count toward a company’s retail sales or basis for upline compensation. According to the court, very few of Fortune Hi-Tech’s products are ever sold to anyone other than the distributors. Herbalife Ltd. (NYSE:HLF) has said it doesn’t track this statistic because it doesn’t believe it matters to investors.
If this ruling against Fortune was applied to Herbalife—which, by the way, is under investigation by regulators—the company could be forced to track this number in order to determine if it is in violation of the court order against Fortune. While currently not applicable to Herbalife, the order does set a precedent for future cases brought against alleged pyramid schemes. If Herbalife Ltd. (NYSE:HLF) does face a court case filed by regulators, then this could be a weak area in its case, potentially, as it has no defense because it claims that it doesn’t track this number. Some argue that Herbalife doesn’t track it because it already knows this is a problem and thus doesn’t want to have a number on it.
Herbalife’s misrepresentations defined
Like Fortune Hi-Tech, Herbalife Ltd. (NYSE:HLF) has also been criticized for misrepresentations allegedly made by some of its distributors. The misrepresentations of which Herbalife has been accused are pretty similar to those set out in the ruling against Fortune Hi-Tech and the other defendants in the case. The defendants in the case have been barred from misrepresenting several items in its marketing to potential distributors.
Among those items are how much money consumers can “reasonably” expect to make, the amount of money participating consumers have “actually achieved, and that consumers can “reasonably expect to recoup their investment.” Other items include whether “all or most of the people who fail to make significant income failed to devote substantial or sufficient effort” and how likely consumers are to “receive substantial income.”
So what does all this mean for Herbalife Ltd. (NYSE:HLF)? Nothing yet, but Pershing Square has drawn enough comparisons make it worth considering, particularly because the FTC is looking into Herbalife.