Pyramid scheme or not: Herbalife to pay $200M

Herbalife - Pyramid SchemeThe nearly four-year battle between the FTC and Herbalife has come to an end.  In mid-July, Herbalife agreed to pay $200 million to compensate consumers to settle charges that Herbalife “deceived consumers into believing they could earn substantial money selling diet, nutritional supplement, and personal care products,” the FTC said in a recent press release.  Even still, while the fight with the FTC may be over, questions linger about whether Herbalife is or is not a pyramid scheme.

Controversial History of Herbalife

Herbalife was founded in 1980 by entrepreneur Mark Hughes, and today employs more than 7,800 workers worldwide.  Hughes, partnering with Dr. Richard Marconi, developed an herbal weight-loss line of products, which the two branded as Herbalife.  Initially, Hughes and Marconi sold the Herbalife line out of their cars.  The Herbalife plan devised by Hughes and Marconi instructed individuals to eat only one meal a day.  That single meal was then to be supplemented by up to 20 vitamins and supplements.

During the early years of Herbalife, the company experienced increasing success, with gross revenue topping $500 million a year by 1985.  However, in 1984, the U.S. Food and Drug Administration (“FDA”) released a report setting forth complaints against Herbalife, including complaints that the company was operating a pyramid scheme.  Herbalife responded by filing a lawsuit against the FDA and U.S. Health and Human Services Division for defamation, which the FDA countered with a lawsuit of its own.  The FDA’s lawsuit, targeted at Hughes personally, blamed Hughes for the five deaths associated with the use of Herbalife products.

Hughes ultimately settled the FDA’s lawsuit in 1986.  As part of the settlement, Herbalife was banned from continuing to produce certain of its products and/or substitute some ingredients that had been linked to death or illness.  Following the settlement, Hughes and Herbalife pushed forward through the nineties and into the two thousands.  By 1993, Herbalife had some $700 million in sales.  By 2003, those numbers had grown to nearly $1.3 billion.

Hedge-Funder Willam Ackman Complains Herbalife is a Pyramid Scheme

In 2012, trouble found Herbalife again, when hedge-fund manager William Ackman publicly accused Herbalife of operating as a pyramid scheme.  Ackman was so confident in his claims that Herbalife was a pyramid scheme that he and his firm, Pershing Square Capital Management LP, bet almost $1 billion that Herbalife’s shares would fall.  However, not everyone sided with Ackman in the Herbalife debate.  Billionaire Carl Icahn and Post Holdings Inc. Chairman William Stiritz, both investors in Herbalife, have supported the nutrition giant, claiming that the business practices of Herbalife do not represent those of an illegal pyramid scheme.  Icahn is Herbalife’s largest investor, owning 17 percent of the company’s stock, while Stiritz holds 7.4 percent of the Herbalife shares.

FTC Issues CID to Herbalife in 2014

In response to Ackman’s accusations, as well as a request to investigate Herbalife’s business practices by Senator Edward Markey (D-MA), the FTC served Herbalife with a Civil Investigative Demand (“CID”) in early 2014.  At the time, Herbalife said it welcomed “the inquiry given the tremendous amount of misinformation in the marketplace.  We are confident that Herbalife is in compliance with all applicable laws and regulations.”

Herbalife Agrees to $200M Settlement, as well as Other Stringent Restrictions

Now, more than two years after being served with a CID, Herbalife has agreed to settle charges with the FTC that deceived consumers about their ability to earn substantial money through the sale of Herbalife products, and that Herbalife’s compensation structure was unfair because it rewarded its “distributors for recruiting others to join and purchase products in order to advance in the marketing program, rather than in response to actual retail demand for the product, causing substantial economic injury to many of its distributors,” the FTC said.

FTC’s Allegations Against Herbalife

According to the FTC’s complaint, Herbalife made promises that, if people agreed to sell their product, they could “expect to quit their jobs, earn thousands of dollars a month, make a career-level income, or even get rich.”  The FTC said that, in reality, Herbalife’s claims were untrue, and that “the overwhelming majority of distributors who pursue the business opportunity earn little or no money.”  By way of example, the FTC set forth in its complaint that more than half of Herbalife’s distributors received less than $300 in rewards payments in 2014.  Herbalife’s own study revealed that “Nutrition Club owners spent an average of about $8,500 to open a club, and 57 percent of club owners reported making no profit or losing money.”

The FTC’s complaint says that the small minority of Herbalife distributors that make large sums of money do so by recruiting other distributors, without regard to whether those newly recruited distributors will actually be able to sell the products they are encouraged to buy from Herbalife.  Because many of these new recruits find it hard to sell Herbalife’s products, they abandon Herbalife.  In fact, “[t]he majority of [distributors] stop ordering products within their first year, and nearly half of the entire Herbalife distributor base quits in any given year,” the FTC says.

The Terms of the FTC’s Settlement

Under the settlement with the FTC, Herbalife is required to restructure its compensation system in order to reward actual retail sales to consumers, as well as eliminating the current incentives that reward distributors primarily for recruiting.  According to the FTC, the settlement “mandates a new compensation structure in which success depends on whether participants sell Herbalife products, not on whether they buy products.”

Specifically, the settlement imposes the following requirements on Herbalife:

  • The company will now differentiate between participants who join simply to buy products at a discount and those who join the business opportunity. “Discount buyers” will not be eligible to sell product or earn rewards.
  • Multi-level compensation that business opportunity participants earn will be driven by retail sales. At least two-thirds of rewards paid by Herbalife to distributors must be based on retail sales of Herbalife products that are tracked and verified. No more than one-third of rewards can be based on other distributors’ limited personal consumption.
  • Companywide, in order to pay compensation to distributors at current levels, at least 80 percent of Herbalife’s product sales must be comprised of sales to legitimate end-users. Otherwise, rewards to distributors must be reduced.
  • Herbalife is prohibited from allowing participants to incur the expenses associated with leasing or purchasing premises for “Nutrition Clubs” or other business locations before completing their first year as a distributor and completing a business training program.

FTC Requires Herbalife to Pay for Independent Compliance Auditor for Seven Years as Part of Settlement

As part of the settlement, Herbalife will be required to pay for an Independent Compliance Auditor (“ICA”).  The ICA will be responsible for monitoring Herbalife’s compliance with the settlement’s restructuring plan.  The ICA will be in place for seven years, and will report directly to the FTC.  In addition to the restructuring and imposition of the ICA, the settlement also prohibits Herbalife from making misrepresentations regarding distributor’s potential or likely earnings from selling Herbalife products.  Finally, the settlement “imposes a $200 million judgment against Herbalife to provide consumer redress, including money for consumers who purchased large quantities of Herbalife products (such as many Nutrition Club owners, among others) and lost money.”

FTC’s Statements Regarding Settlement with Herbalife

In conjunction with the settlement, FTC Chairwoman Edith Ramirez issued the following remarks:

With this settlement, Herbalife has agreed to restructure its business, transforming it from an organization that pays its distributors based on their own wholesale purchases and those of their downlines, to one where compensation is calculated based upon verifiable retail sales. Significantly, in order to pay compensation to distributors at current levels, the order requires Herbalife to verify, through receipts and other reliable methods, that its business is driven by retail sales and that at least 80% of its sales are made to legitimate end-users. Otherwise, it must reduce rewards to lower levels. Under the order, an independent compliance auditor will review and assess Herbalife’s compliance with these structural provisions for a period of seven years. Herbalife is also barred from misleading distributors about their earnings potential and must pay $200 million in consumer redress.

In addition to providing significant relief to consumers who may have been harmed by Herbalife’s practices and protecting consumers who may join Herbalife in the future, this settlement also serves as an important reminder to multi-level marketing firms. They should ensure that income representations are not false or misleading, and that compensation structures do not incentivize recruitment and wholesale purchases unrelated to retail demand. Put simply, the structure of a multi-level marketing business should present a viable retail opportunity. We are pleased that this order will require Herbalife to base rewards on tracked and verified retail sales and recommend that all multi-level marketing companies likewise take sufficient steps to ensure their practices are not unfair, false, or misleading.

Icahn and Herbalife Respond to Settlement: Icahn Declares Herbalife is not a Pyramid Scheme

Following the announcement of the settlement, Carl Icahn issued a statement.  In his statement, Icahn said in pertinent part:

The FTC settlement announced today, coming after a two-year investigation also concluded that Herbalife is not a pyramid scheme – a conclusion that obviously vindicates our research and conviction.  While Bill Ackman and I are on friendly terms, we have agreed to disagree (vehemently) on this subject.  Simply stated the shorts have been completely wrong on Herbalife.  Now that the Company has reached a settlement with the FTC, it is time to consider a range of strategic opportunities, including potential roll-ups involving competitors, as well as other strategic transactions.

Similarly, Herbalife has said of the settlement:

After more than two years of working with the FTC (Federal Trade Commission), I think we understand the terms of the settlement agreement very well.  We would not have settled unless we had the greatest confidence in our ability to comply with the agreement and grow our business and we believe this will be proven out over time.

While Icahn and Herbalife celebrate the settlement, William Ackman has said he plans to maintain his bet against Herbalife shares, and will push foreign regulators to investigate Herbalife further.  This means that Herbalife’s fight to remain unbranded as a pyramid scheme.  According to Ackman, “Herbalife has been shut down by the FTC — it just doesn’t know it yet.”  Time will tell if Ackman’s bet against Herbalife will come to fruition.

The Message Sent to the Multi-Level Marketing Industry by the Settlement

While Herbalife’s problems with the FTC may have ended, the settlement should worry others in the multi-level marketing industry.  Besides the $200 million fine, the more stringent part of the settlement is the consent decree Herbalife signed as part of the overall settlement.  Essentially, the consent decree requires Herbalife to provide going forward that it is not operating as a pyramid scheme, even if the FTC failed to use the actual term pyramid scheme in its complaint and/or settlement documents.  Under the terms of the consent decree, Herbalife must show that its products are being sold to actual customers, which was at the heart of Ackman’s complaints about Herbalife going back to 2012.

FTC Chairwoman Edith Ramirez said the FTC would soon be issuing guidance for multi-level marketers in light of the settlement with Herbalife.  While that guidance is likely welcomed throughout the multi-level marketing world, consent decrees like that entered into by Herbalife may be too onerous for other multi-level marketing companies.  Such stringent consent decrees may force many smaller multi-level marketing companies out of business if they are required to ensure that all of their sales are made to legitimate consumers.  Thus, without calling Herbalife a pyramid scheme directly, the FTC has sent a clear message via it settlement with Herbalife that pyramid scheme type businesses will not be tolerated, and will face stiff financial and other penalties if they operate as a pyramid scheme.

* Photo Cred.: finance.yahoo.com

Copyright 2016