Herbalife Ltd. (HLF) – Regulators As Financial Partners: Multilevel Marketing And The House Of Cards

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Herbalife – Regulators As Financial Partners: Multilevel Marketing And The House Of Cards


Regulatory enforcement complements but does not substitute for regulatory oversight and reporting.

Will 2016 be any different for the MLM industry and the ongoing problem of pyramid schemes?

No independent evidence indicates a decline in the incidence of pyramid scheme victims.

Since the 17th Century a “house of cards” meant something “shaky, or in constant danger of collapse.” The popularity of the Netflix series of the same name gave the term additional meaning, one less tenuous and more aggressive: “The series deals primarily with themes of ruthless pragmatism, manipulation, and power.” Oddly, both meanings may be relevant to the MLM industry.

Day-in-and-day-out regulators impact the ability of companies to make money. The impact comes through rules that impose costs (e.g., compliance reporting, testing and product safety requirements, etc.), enforcement actions that punish and deter specific behaviors (e.g., General Motors, BP, Goldman Sachs, and soon Volkswagen), or both. If such actions affect a company’s bottom line, then the absence of regulatory oversight in the presence of misrepresentations and fraud can have the opposite outcome-putting money in the pockets of under-regulated companies and their owners.

For more than thirty-five years the MLM industry has managed to avoid federal regulatory oversight while successful prosecutions have had little apparent impact. Why? And more importantly, whom has it benefited and whom has it harmed?

CAN THE LACK OF OVERSIGHT be attributed to the Federal Trade Commission ((NYSEARCA:FTC))-the federal regulator most responsible for consumer protection-perceiving little or no consumer harm in the industry? No, evidently not: “The Commission has not made a finding that there is little or no evidence of fraud within the MLM industry; to the contrary, it has specifically recognized, through its own law enforcement experience, that some MLMs may be pyramid schemes in masquerade and may make false and unsubstantiated earnings claims.” (Federal Register, Vol. 76, No. 236, p. 76823; December 8, 2011)

In most industries a company that engages in false and unsubstantiated claims risks regulatory action because other members of the industry find it in their best interest to complain to regulators and/or bring legal action. But what happens in an industry where major firms and the lead trade association stand against regulatory oversight, as the MLM industry did regarding the Business Opportunity Rule? What happens when over time companies with no regulatory reporting requirements admit to being unable to control the marketing message of their contractual representatives, and monitoring fraudulent marketing messages remains for decades beyond the reach of FTC?

CAN THE LACK OF OVERSIGHT be attributed an unclear understanding within the FTC or the courts as to what constitutes an pyramid scheme? No. That does not appear to be the case given the string of MLM companies closed in the face of a pyramid scheme charge brought by the FTC, cases consistent in their legal arguments and analytical approach. Neither the courts nor the FTC appear to be confused about what constitutes a pyramid scheme.

CAN THE LACK OF OVERSIGHT be attributed to the FTC’s confidence in the deterrent impact of successful prosecutions? Yes, but paradoxically only if the FTC fails to understand its own research. A superficial understanding of three FTC Fraud Surveys could lead one to believe that the incidence of pyramid scheme victims declined nationally from 2003 to 2011. However, anyone with rudimentary statistical skills recognizes that, in fact, the FTC surveys show that any perceived difference in the incidence of victims can be attributed to either one or both of two factors: small sample sizes (and the resulting large confidence intervals) and a definitional change as to what constitutes a pyramid scheme victim.

Further, despite of and even during a successful string of FTC prosecutions, other companies that would eventually also face pyramid scheme charges operated with impunity. In 2007 the FTC accused BurnLounge of operating a pyramid scheme. Over the next seven years both a lower court and the appellate court agreed that this company was a pyramid scheme. During those same years both Fortune Hi-Tech Marketing (FHTM) and Vemma operated openly, the first one with two former Attorneys General and a member of the Direct Selling Association (DSA) Hall of Fame as advisors and the second (still under court order) targeting youth. In both instances the FTC benefited from external research before finally bringing a case. In FHTM the Commonwealth of Kentucky acquired a considerable amount of data before contacting the FTC, and in Vemma the non-profit Truth in Advertising (TINA.org) accumulated complaints and evidence.

Like a Ponzi scheme, a pyramid scheme can be shown to create victims of more than 95% of participants and both schemes are prone to collapse, hence the apt label of a house of cards. However, as demonstrated by Bernie Madoff and decade-old pyramid schemes, a collapse can be delayed by expanding geographic markets (i.e., victims) and/or revitalizing interest through superficial changes.

If the FTC knows that “some MLMs may be pyramid schemes,” and that even in the face of enforcement efforts other pyramid schemes operated for many years, and further knowing that continued enforcement has not measurably reduced the incidence of pyramid scheme victims, why then does this industry still have no regulatory oversight?

The answer may rest with the newer meaning of a House of Cards-ruthless pragmatism, manipulation, and power. When the FTC decided not to include MLM companies under the Business Opportunity Rule in 2011, it did so because (as it stated) “the overwhelming majority of the approximately 17,000 comments argued that the IPBOR [Initial Proposed Business Opportunity Rule] failed to differentiate between unlawful pyramid schemes-which the Commission intended to cover-and legitimate companies using an MLM model.” (Federal Register, Vol. 76, No. 236, p. 76819; December 8, 2011). Notably, the referenced 17,000 people represented 0.1% (not 1%) of the number of “U.S. Direct Sellers” in 2011 according to DSA data.

The lead regulator responsible for consumer protection with a successful record of consistent pyramid scheme prosecutions punted in the face of comments from a miniscule percentage of industry participants that overwhelmingly reflected a single view. And the FTC’s own research showed pyramid scheme victims to be far less likely to complain than the victims of the remaining nine top forms of consumer fraud. A cynic might further question the impact of former FTC managers defending the industry’s position.

The recent Vemma case highlights the muddle created by the lack of regulatory oversight. The DSA presented Vemma with an award for its innovative product launch, “a model for the highest standards in business practices and ethics.” Of course this comes from the same trade association that: a) claims to have perfected the definition of a pyramid scheme, b) commissioned an “independent” report that applied a gross misunderstanding of pyramid scheme case law and a woeful economic theory, and c) no longer refers to members of the direct selling industry as direct sellers.

Pyramid scheme analyses show that top “distributors” in pyramid schemes garner the lion’s share of ill-gotten gains. The lack of FTC regulatory oversight for the past thirty-five years benefited these distributors and harmed consumers. Three years ago Bill Ackman’s short position coupled with a subsequent long position taken by Carl Icahn and others further placed the FTC between a rock and a hard place. Prosecute Herbalife (NYSE: HLF) and benefit Ackman and his investors or do nothing and benefit investors long on Herbalife. The Herbalife battle illustrates the deeper question of insufficient regulatory oversight: has the FTC already acquiesced to be more of a financial partner than a regulator? In 2016 the agency has an opportunity to redress this situation. How? Do what integrity requires: stop the House of Cards and affirm the FTC’s role as the nation’s premier consumer protection agency.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have received no compensation from any parties associated with the Herbalife controversy and have no known financial position associated with any firm mentioned.

Herbalife – Regulators As Financial Partners: Multilevel Marketing And The House Of Cards by William Keep, Seeking Alpha


Herbalife Ltd. (HLF) – Regulators As Financial Partners

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