All posts from in,

Herbalife Key Documentation Regarding “Deception” Left On Sidelines [Part II]

Continued from Part I...

What constitutes an illegal pyramid scheme?

While many surrounding the issue appear to have conflicting interpretations, a source close to Herbalife Ltd. (NYSE:HLF) told ValueWalk their version of truth on the issue of regulatory clarity on the "pyramid" scheme issue was that the rules are generally clear:

Pyramid schemes are illegal because they are inherently deceptive and therefore illegal under Section 5(a) of the Federal Trade Commission Act (unfair or deceptive act or practice). The legal definition has been clear and unchanging since 1975 (the Koscot Test): "Such schemes are characterized by the payment by participants of money to the company in return for which they receive (1) the right to sell a product and (2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of the product to ultimate users.” They are inherently deceptive because they inevitably collapse because they depend for their very survival on continuous exponential recruitment of new participants (each of whom hopes to benefit from still more continuous exponential recruitment of new participants). Like a chain letter, the day when the last person becomes or rejects becoming a participant is the day that the scheme collapses and everyone who has money invested in the scheme loses that investment. In contrast and as reaffirmed in the BurnLounge decision (2014) and FTC’s guidance (Staff Advisory Opinion, 2004), an MLM whose products are purchased -- whether by participants or nonparticipants -- because buyers want the products for consumption or resale does not depend for its survival on continuous recruitment of new participants because those purchases will continue and cash will continue to flow to the sales organization and the company even without further recruitment. To determine whether a company is operating a pyramid scheme requires a court to determine how its business operates in practice. (Koscot, Amway 1979, Omnitrition 1996, BurnLounge 2014). Although the definition and standards are well established, facts matter.

Amway decision illuminates

While Herbalife supporters may be satisfied by the legal and regulatory clarity on the issues, a recent Amway ruling may provide additional guidance.

The multilevel marketing company Amway was not considered a pyramid scheme under the Koscot test in part because it enforced anti-inventory-loading safeguards, including: (a) a requirement that distributors sell at wholesale or retail at least 70% of the products bought in a given month to receive a bonus for that month (the “70% rule”); (b) a requirement that sponsoring distributors buy back from any person they recruited any unused, marketable product if the recruit left the business (the “buy-back rule”); and (c) a requirement that distributors submit proof of retail sales made to at least ten different customers to receive a bonus for that month (the “ten customer rule”). In re Amway Corp., 93 F.T.C. 618, 716 (1979). The Amway safeguards were found to be effective as a matter of fact, not law, and thus are not one-size-fits-all. Omnitrition, 79 F.3d at 783. But “[t]he key to any anti-pryamiding rule . . . is that the rule must serve to tie recruitment bonuses to actual retail sales in some way.

"The decision nicely recognizes the in 1979 the Amway rules served a certain purpose, which was to help demonstrate that whatever rule 'must serve to tie recruitment bonuses to actual retail sales in some way,'" Keep told ValueWalk.

It is also instructive to consider where the FTC focused on in the Vemma case -- deceptive claims -- a key point made in the Parloff article about defining a fraud. The FTC charges against the Vemma pyramid center on unattainable income claims, focusing on recruitment, and complex agreements that confuse prospective distributors.

While Herbilife has made changes on the edges of their business, critics say the business model is fundamentally the same. The distributor agreement is comically complex, as was the Vemma agreement, and "despite all of the ballyhooed changes under Michael Johnson, the Herbalife compensation structure is fundamentally the same today as it was a decade ago," an Herbalife critic told ValueWalk. "People at the top make all of the money while the vast majority at the bottom make essentially nothing."

While the definition of an illegal Pyramid scheme clearly focuses on deception in the sales cycle, oddly discussing evidence of deception in the sales cycle wasn't a primary focus of analysis in the Parloff article.

Parloff focuses on deception, but doesn't document a key point when the word "deception" was used in sales training

If there is a key takeaway from the Parloff article it is that deception can play a key role in defining an illegal pyramid scheme. The intent to deceive is often correlated to documented knowledge that the act in question was known to be illegal or unethical, a key point regulators sometimes cite as a trigger to aggressively tackle a case. If indications exist that a participant in a fraud was aware that their actions were potentially illegal or unethical, and such knowledge can be documented, yet they proceed nonetheless, points to a cold logic to violate the law.

Parloff didn’t focus on the awareness of potential fraud and the documented evidence that exists to the same degree as might have been warranted, but instead focused on the concept of deceit:

There is no federal statute defining “pyramid scheme.” For years MLM critics have begged the FTC to draw some bright-line rules—but in vain. Such schemes are usually prosecuted by the FTC as an “unfair or deceptive act or practice.” If an MLM or its distributors have merely made some misleading claims, the FTC may fine the company and let it live to see another day. But if the commission finds that an MLM is a pyramid scheme—which is considered inherently deceptive—it must shut it down. The best definition of pyramid scheme emerged from a 1975 case in which the FTC shuttered a cosmetics marketer called Koscot Interplanetary. The key feature is that a...