Last week when I wrote about Youngevity being the MLM Scam of the Week, I was mostly joking. I don’t really expect to have a noteworthy MLM article every week. However, I couldn’t resist this week. A company losing 3 billion dollars is significant. It’s not often that the Wall Street Journal or Business Week write about an MLM company. However, that was the case with HerbaLife earlier this week.

Let me start off by saying that I’m not very familiar with HerbaLife. They’ve been mentioned in connection with my MonaVie and Nerium articles, but I haven’t researched them like those other companies. With that understanding in place let’s get to the news.

Earlier this week HerbaLife (ticker:HLF) announced their earnings and had a conference call. The earnings for the quarter were down a little, but the outlook for the future was raised. The consensus was that it was more or less business as usual at HerbaLife. However, during the call Greenlight Capital president David Einhorn asked a few pointed questions:

“First is, how much of the sales that you’d make in terms of final sales are sold outside the network and how much are consumed within the distributor base?”

“What is the incentive for supervisor to sign somebody up to become a distributor as opposed to – if they’re just going to consume for themselves as opposed to just selling them the product for the markup. How does the distributor – how does the supervisor come out better?”

“When you had your previous 10-K, you disclosed three groups of distributors at the low-end. You called 29% self consumers, 57% small retailers, and 14% potential sales leaders and then that disclosure did not repeat in the subsequent 10-K. So, I got two questions, first of all how do you track that and how do you characterize and know which ones are which? And second, why did you stop disclosing that in the last 10-K? Is that something that you stopped tracking or just stopped disclosing?”

These questions put the stock in a free-fall. Over the last 5 days it lost 35% of its value dropping from $70 a share to 46. I read some of the business blogs and they didn’t seem to know what make of these questions. For example, MarketWatch just blamed it on the fact that Einhorn was asking them. HerbaLife responded by saying:

“The fact that recognized short seller David Einhorn asked questions on the call put pressure on Herbalife’s stock price. Mr. Einhorn’s questions raised no new subjects or concerns. Our business fundamentals are very strong and we are confident in our financials, our disclosures and our network marketing business method.”

So we are to ignore the questions themselves and just chalk it up to who is asking what their motives are? “I don’t think so… Homey don’t play dat!”

There are two fishy things going on here.

First, within hours of the call, the Law Offices of Howard G. Smith announced and investigation on behalf of shareholders of Herbalife. That was pretty quick. I think Einhorn already knew that it was in the works and this was the reason for his questions. This would mean that Einhorn isn’t the cause, but in fact just a messenger. Very few news outlets reported on this investigation. (The other side is this is that maybe the Law Offices of Howard G. Smith just jumped on the hot button issue very quickly to get some business. I think the former is more likely.)

Second, the point of the questions, even though it isn’t explicitly expressed is determine if HerbaLife is a pyramid scheme. You can look at the questions and there’s nothing in there that says “pyramid scheme.” It’s not a surprise why much of Wall Street missed it and didn’t make the connection. CNBC did a segment with analyst Tim Ramey at D.A. Davidson:

As you can see the interviewer (I forget his name) says the questions are about the margins of selling the product at retail or wholesale. Tim Ramey corrects him and says that it really isn’t about margins at all. Tim Ramey upgraded the stock after the sell-off and suggested that people should buy it hand-over fist. Ramey brings up the issue of customers vs. distributors saying (paraphrased), “If you are customer, you aren’t very smart, you should become a distributor to get that discount. The people who just want to buy the product become preferred customers at NuSkin/Usana or distributors at HerbaLife. There’s nothing wrong with that by the way.”

I beg to differ with Tim Ramey. There’s nothing wrong with being a preferred customer, but if the MLM consists of all distributors and not preferred customers there’s a lot wrong with that… at least according to the FTC:

“Not all multilevel marketing plans are legitimate. Some are pyramid schemes. It’s best not to get involved in plans where the money you make is based primarily on the number of distributors you recruit and your sales to them, rather than on your sales to people outside the plan who intend to use the products.

… Avoid any plan where the reward for recruiting new distributors is more than it is for selling products to the public. That’s a time tested tip-off to a pyramid scheme.

… Another sign of a pyramid scheme is if the money you make depends more on recruiting — getting new distributors to pay for the right to participate in the plan — than on sales to the public.”

The FTC says a whole more in a bunch of other documents. I’ve summmarized a few of the key documents and they all say, “MLMs must focus on sales to outside participants.”

Is HerbaLife a Pyramid Scheme?

With this piece of information, it is worth deeper at Einhorn’s questions – but I’m most interested in the first one. You can listen to the audio of the call here (scroll down to the video box) or read a transcript of it here.

When looking at that first question it becomes clear that when Einhorn asked, “How much of the sales that you’d make in terms of final sales are sold outside the network and how much are consumed within the distributor base?” he was really asking, “Is HerbaLife a pyramid scheme?” It is a very fair question and one that the FTC says you should ask of any MLM to make sure it isn’t a pyramid scheme.

HerbaLife’s response was “So, David, we have a 70% custom rule which is basically says that 70% of all products sold to consumers or actually consume my distributors for their own personal use.”

I’ve read HerbaLife’s response a number of times and it’s not helping me answer Einhorn’s questions. As best I can tell 70% of the product is sold to a combination of consumers who may be distributors or the general public. Who knows what happens to the other 30%… I guess it’s thrown in the trash? (For those who really know about MLMs, the 70% is not a random number that HerbaLife picked out of a hat, it is the percentage of retail customers a company should have as defined in a big FTC-Amway law case at the end the 70’s.)

Tim Ramey in the CNBC video above makes a good point. HerbaLife doesn’t really know where these sales are going. That’s tough poop for HerbaLife. They were the ones that created the compensation system. They need to be able to ensure compliance or change the compensation plan. I offer some advice here: How an MLM Can Show It Isn’t an Illegal Pyramid Scheme. The idea is simple. Don’t pay people for product sold to other distributors, but only those who are preferred customers not in HerbaLife. This ensures that outside sales are made and that it isn’t an endless chain recruiting system, which is what the FTC is looking for.

A day later after having time to think about it, HerbaLife had a more specific answer for Einhorn’s questions:

“The company said that at the low end of its distributors, 27 percent were people who bought products for their own use; 61 percent used the products personally and sold modest quantities to friends and family; and 12 percent signed up with the intention of seeking a promotion in the distributor hierarchy.”

Notice how the response is qualified to address the low end of its distributors. What about the high end? Is their reward for the recruited distributors more than their sales to the public? In every MLM I have looked at it is. And that would be a “time tested tip-off to a pyramid scheme” from the FTC quotes above.

Continuing on with HerbaLife’s response, they once again don’t give a clear answer to where the product is being sold. In fact shouldn’t the 27% “who bought product for own use” be included in the 61% “who used the products personally…”? This shouldn’t be a brain teaser. Some percentage of people buying the product are distributors and the rest are not.

I give analyst Gary Albanese at Auriga USA credit as he said Einhorn was asking how much product was being sold through to customers, and the company was giving an answer of how much was being consumed by distributors themselves.

My best analysis of this answer is that the 27%, the 61% and the 12% are all effectively sales to distributors within HerbaLife and not to end customers with the except of the “modest quantities sold to friends of family.” That modest quantity does not fit with the FTC’s repeated requirements of focusing a majority of sales to customers outside of the company. Therefore, the only conclusion I can draw is that HerbaLife is indeed a publicly traded pyramid scheme.

Finally, it is worth noting that late last year, a court in Belgium ruled that HerbaLife was indeed a pyramid scheme. Belgium’s laws for pyramid schemes aren’t too different than the United States.

Further Reading: If you are weird like me and find this kind of thing fascinating I suggest you should check out the full story on: MLMs Vs. Pyramid Schemes.

More Further Reading:

Days after I published this CNBC caught on to the what Einhorn was getting at published this article. It’s a very good read.

Fraud Files covers this Herbalife issue in depth as well.

Finally a court in California said that HerbaLife might be and endless chain scheme (PDF):

Moreover, in the Court’s view, Herbalife’s entire business model appears to incentivize primarily the payment of compensation that is “facially unrelated to the sale of the product to ultimate users because it is paid based on the suggested retail price of the amount ordered from [Herbalife], rather than based on actual sales to consumers.'”