By
Jon M. Taylor
:
With the hedge fund battle initiated by Bill Ackman's December
20 Sohn Conference presentation - calling Herbalife (
HLF
) a "pyramid scheme" - one point has been overlooked. He was way
too kind in his criticisms of the company and of the multi-level
marketing ((
MLM
)) industry, of which Herbalife is a top player.
As a consumer advocate with four decades of teaching, writing,
entrepreneurship, and consulting related to the field of home
business opportunities, I have analyzed approximately 500 MLMs
(multi-level marketing programs) over the past 18 years and written
three books on the subject. I would have to rank Herbalife near the
top of the list of questionable MLMs.
Ackman concluded his presentation by charging that 1.9 million
Sales Leaders for Herbalife have lost $3.8 billion since the
company's founding in 1980. In my opinion, this is a gross
underestimate. Let's look more closely at the numbers.
Calculating the harm done by Herbalife
I agree with Ackman that the products are too expensive to be
competitive with retail alternatives and that little selling occurs
to persons who are not participating in the program. And no one
makes the "residual income" held out to prospects without building
a sizable downline of distributors beneath them. Careful study of
the compensation plan confirms this. And why would anyone attempt
to sell overpriced products, when they can be bought much cheaper
online and when the plan offers huge rewards for recruiting,
compared to a pittance for selling direct to non-participants?
To build a downline is expensive and getting more so, as
hundreds of MLMs are saturating U.S. and overseas markets. So
Herbalife must "re-pyramid" (rebuild new pyramids) into market
after market to compensate for what Ackman calls the "pop and drop"
phenomenon, as each market reaches saturation and impending
collapse - with no sustainable retail base of non-participating
customers. The company's entries into obscure markets does not
represent real growth, but merely re-pyramiding to replace
declining markets for its bogus "income opportunity." Herbalife's
nutrition clubs and ubiquitous "work from home" ads are merely
efforts to maintain its income stream by recruiting a revolving
door of new recruits, each investing their hard-earned dollars
before giving up.
Ackman cites evidence that the cost of becoming a Sales Leader
is at least $10,000, and my own one-year test of a similar program
(Nu Skin) suggests that the cost of conducting a successful MLM
recruitment campaign is actually much more. A review of Herbalife's
"Statement of Average Gross Compensation of U.S. Supervisors -
2011" shows that only 3.5% of "Total Leaders" are paid commissions
exceeding $10,000, making it possible for them to realize a net
profit after expenses. These are at earnings levels labeled "Get
Team," Millionaire Team," and "President's Team."
The Statement claims that 25% of Distributors reach the level of
"Supervisor" and above ("Leader"). Dropouts are not counted in its
statistics, which hugely skews the calculations of average incomes
to appear to suggest a far more favorable success rate. The company
also claims that it has improved its retention rate, bringing it
from approximately 43% to 48.9% in 2011. If we (1) assume a 50%
dropout rate, (2) include the 75% of distributors who did not reach
Leader status, (3) project the 50% dropout rate over a ten-year
period, and (4) subtract costs of recruiting a downline, we get a
loss rate of approximately 99.88%. In other words, about one
distributor out of 813 realizes a significant profit after
expenses. And if we exclude those few who hold the top spots in the
pyramid of distributors (which also hugely skews the averages), the
odds of new distributors earning significant profits is less than
one in 10,000 - essentially zero. Recruits are being sold a ticket
on a flight that has already left the ground.
Now let's look at the number of Herbalife distributors that have
been recruited (and victimized) since the company's founding in
1980. By 1996, the company reported sales of $1 billion, and by
2011, it reported 3.15 million distributors selling a total of $4.3
billion. If we conservatively estimate an average of at least one
million distributors and average sales of at least $1 billion per
year since 1980 (allowing for a minimal amount of sales to
non-distributors), the total number of distributors cycled through
the program during those 32 years would be roughly 32 million, with
a total of about $32 billion in sales. Since 99.88% lose money, the
total recorded as sales for the company could be considered an
estimate of the losses for the downline distributors who provide
the vast majority of the company's revenue from their failed
investments. This is roughly eight times the losses reported by
Ackman.
NOTE: My methodology and calculations were validated by five
financial experts, but readers can examine this for themselves by
reading chapter 7 of my free eBook
The Case (for and) Against Multi-Level Marketing
.
So what is a pyramid scheme - and are all MLMs pyramid
schemes?
Ask ten regulators (from the FTC, SEC, and state AG offices) to
define a pyramid scheme, and you get ten different answers. About
the only thing they (and Ackman) agree upon is that if revenues are
derived primarily from recruitment, rather than from product sales,
it's a pyramid. But even then, some would say that most sales must
be to non-participants, while others would not even make that
distinction. In fact, it is hard to get agreement on a good
definition of "multi-level marketing."
The problem with most pyramid definitions is that they focus on
beha
vioral characteristics
, rather than on the underlying
structure
of the scheme. Ackman posits six "indicia of pyramids" - all
behavioral:
- Exaggerated earnings claims
- Inflated prices and need to sell to other members
- Emotional sales pitch - the "Dream"
- A history of lawsuits
- Targeting the financially unsophisticated
- Complex compensation plans
Note that none of these addresses the fundamental structural
flaws in all MLM programs. Let me try to summarize an entire
chapter in my eBook in which I define what is and what is not MLM
and on what constitutes a pyramid scheme.
To gain a good grasp of this definitional issue, one can benefit
from looking at the features of a classic, 1-2-4-8 no-product
pyramid scheme, such as the "Airplane Game," which was active in
the late 1980s. The nomenclature of the various levels of the game
involve participatory levels such as 'passenger', 'flight
attendant', 'co-pilot' and at the top, 'pilot'. Typically, a new
recruit would pay $1,000 to enter at the level of passenger, in the
hopes of receiving a $14,000 payout when one 'piloted out' at the
top of the scheme. When the downline of 14 participants have each
paid their money to the pilot at the top, the pyramid matures and
the pilot departs with his booty, allowing the next person to move
up to his spot and those at the bottom to continue the recruiting
process in hopes of each reaching the top and receiving the cash
reward. Because of the endless chain of recruitment, the pyramid
ultimately saturates a given market, and those at the bottom levels
(93.3% of participants) are caught in a losing position. The loss
rate of participants averages about 90% (between 87.7% and 93.3%,
depending on the percentage of pilots who have continued to
initiate new pyramids after reaping the reward).
The fundamental flaw in all pyramid schemes is the assumption of
an infinite market, since they are structurally built up on an
endless chain of recruitment. It is assumed that they will
inevitably reach market saturation and collapse. The only way to
get to the top is to recruit others into the scheme. There is a
requirement for an investment ("pay to play") in order to
participate. And all the money goes to the top.
MLMs, which evolved from classic, no-product pyramid schemes
(and chain letters) are what I call "product-based pyramid
schemes." They operate structurally on exactly the same principle,
except that they disguise or launder the investment in the pyramid
with the purchase of products (usually "pills, potions, and
lotions"), and the pyramid may be many more levels deep, as with
Herbalife. Typically, they spread rapidly through recruitment of a
whole network of endless chains of participants (a.k.a.,
distributors, associates, agents, etc), with thousands, or even
millions of participants in an ever expanding mega-pyramid of
participants. And instead of a loss rate of approximately 90% as
with classic 1-2-4-8 pyramid schemes, the loss rate for MLMs is
closer to 99.9%. So participants in a classic, no-product pyramid
scheme are 100 times more likely to profit as are participants in a
product-based pyramid scheme. And in fact the likelihood of
receiving the promised rewards by getting to the top of a classic,
no-product scheme are at least 1,000 times as great as in a
product-based scheme/MLM.
MLMs are not even shaped like a classic 1-2-4-8 pyramid scheme -
which is so named because it looks like pyramid scheme with one,
then two, then four, then eight participants stacked atop each
other in the four levels of the pyramid. But most MLMs have far
more levels, and by the time a 6th or 7th level in an MLM is
reached, the number of participants is extremely wide, making the
structure look more like a pancake (with a bump in the middle for
the "upline") than a pyramid. An MLM like Herbalife could more
appropriately be called a "pancake scheme," with a much larger base
at the bottom losing money.
So I conclude that Ackman's claim that Herbalife is a pyramid
scheme is an extreme understatement - way too kind. My research
convinces me that MLMs like Herbalife are a form of white collar
crime that is far more damaging than are classic no-product pyramid
schemes, by any measure - loss rate, aggregate losses, or number of
victims.
As a flawed business model, MLM is unfair, deceptive,
viral, and predatory
As if Herbalife by itself did not do enough harm to consumers
struggling to stay afloat, it should be noted that Herbalife is one
of hundreds of similar MLM programs with a loss rate I calculate to
be upwards of 99%, several of which are publicly traded - Nu Skin (
NUS
), Medifast (
MED
), PrePaid Legal (PPD), USANA (
USNA
), Mannatech (MTEX),Tupperware (TUP) etc.). In the aggregate, tens
of millions of MLM victims worldwide suffer losses of tens of
billions of dollars every year.
In my opinion, Ackman errs in suggesting that Herbalife stands
out as a "bad MLM," choosing to compare it to Avon. While it is
true that Avon was once a legitimate direct selling company, they
recently changed their program and are much more
recruitment-driven, like other MLMs. I will grant that some MLMs
like Herbalife and Nu Skin are worse than others, in that they are
more highly leveraged; i.e., leveraging the losses of a huge
downline of participants (victims) to the benefit of a few at the
top of the pyramid. Looking at the industry as a whole, there are
hundreds of MLMs with compensation plans (the root of all the
problems) that are built on the same flawed assumptions that drive
Herbalife.
Of approximately 500 MLMs I have analyzed, ALL assume an
infinite market, which does not exist in the real world. ALL assume
a virgin market, which does not exist for long. ALL suspend the
laws of supply and demand, rewarding unlimited recruitment of a
whole network of endless chains of participants - who are the
primary customers. ALL hold out a false hope of income that is only
possible for those at or near the top, who are usually the first
ones in. And I have identified over 110 typical misrepresentations
that are used in MLM recruitment campaigns. In fact, ALL of the
MLMs I have studied are extremely unfair and deceptive and (as
endless chain "opportunity" recruitment schemes) both viral and
predatory as well.
Ackman is right in concluding that society would be better off
without Herbalife. But Herbalife could be included in a multitude
of MLMs that sap the most vulnerable among us of much-needed
resources, and I would argue that that society would be far better
off without all MLMs that follow the same endless chain recruitment
model.
Most MLM recruits spend a few hundred dollars but find the
selling of overpriced products and the pressure to recruit too
formidable, so they drop out. They are the lucky ones. Others
believe the MLM hype and become more committed, spending the family
fortune or going deep in debt. Prospective MLM recruits should be
given the warning: "the more you spend, the more you lose" - which
is true of any scam.
Don't join Herbalife - gamble!
Let's look at it another way. Using the calculations above, you
are 24 times more likely to profit from a single bet on snake eyes
in a roll of the dice in a game of Craps in Las Vegas as you are to
profit as a Distributor for Herbalife. And this is without risking
one's social capital - the friends and family that resent your
efforts to recruit them and may even shun you as
loved-one-turned-recruiter.
It should also be noted that the personal losses from MLM
participation often far exceed financial losses. From reports we
have received, I conclude there are many thousands of divorces,
estranged extended families, bankruptcies, lost homes, diverted
careers, and even suicides. Some become addicted to the "easy
money" allure of MLM to the point that they can no longer work at
an honest job, but keep moving from one MLM to another in hopes of
finding "the right program" for them. We refer to these victims as
"MLM junkies."
So where is law enforcement in all this?
The Federal Trade Commission is supposedly the nation's consumer
watchdog, charged with protecting consumers against "unfair and
deceptive acts or practices in the marketplace." (Section 5 of the
FTC Act.) Unfortunately, investigators working for the agency have
assumed that any pyramid will reach saturation and collapse. They
also assume that if MLM fraud was widespread, it would be reflected
in a large number of complaints. They are wrong on both counts.
Let's look at the first issue. The assumption that pyramid
schemes ultimately lead to saturation and collapse misled
prosecutors involved in the 1979 FTC v. Amway case. Amway attorneys
argued that though the company had been active for 20 years, it had
not even captured 1% of the market - far from a saturated market -
and therefore was not a pyramid scheme (assuming certain "retail
rules" were enforced). But no distinction was made between
total saturation
and
market saturation
. Why would a city of 100,000 people need 100,000 distributors?
Five may be plenty, with each new distributor finding it more
difficult to get customers. So total saturation is absurd. It is
market saturation
that is at issue, and that happens very quickly. No MLM market can
sustain itself, since there is no significant base of actual
customers who are not participating in the scheme. MLMs like
Herbalife get around this problem by "re-pyramiding" into new
markets and/or by introducing new products and programs. Ackman's
presentation of the "pop-and-drop" syndrome in one country after
another demonstrated the need for such aggressive re-pyramiding in
order to survive and grow.
And why do victims remain silent?
This is one of the most insidious facets of the MLM problem.
Even MLM victims who have lost thousands of dollars almost never
file complaints with either state or federal authorities. They
blame themselves for their "failure" since MLM promoters claim that
their programs are perfectly legitimate and that success is assured
for those who work hard. But worldwide feedback from victims and
their families convinces me that a greater factor for the silence
of victims is
fear
. Since all MLMs are endless chains, every major victim is of
necessity a perpetrator, having recruited as many people as they
could in hopes of covering their expenses and eventually profiting.
They fear self-incrimination, and they fear consequences from or to
those they recruited, which likely includes close family and
friends. So they remain silent. And since in law enforcement, the
squeaky wheel gets the grease, nothing gets done.
Of course, one could complain to the Better Business Bureau. But
the BBB includes among its "corporate sponsors" some leading MLM
companies. In fact, the BBB gives an A+ rating to Amway - which
says more about the BBB than it says about Amway.
The FTC caves to the DSA/MLM lobby
In 2006, the FTC proposed a "Business Opportunity Rule" which
would have required that business opportunity sellers disclose
average incomes, any legal actions against the company, refund
provisions, a list of references, and that a 7-day waiting period
be required before investing in the program. The Direct Selling
Association ((DSA)), the lobby for the MLM industry, appealed to
millions of MLM participants and got over 15,000 MLM participants
and 84 congressmen (influenced by money and votes) to write in and
complain that MLM (re-branded "direct selling") be exempted. The
FTC officials caved and exempted MLMs from compliance! What is
needed to tackle the MLM issue are a cadre of Eliot Spitzer-style
regulators, with the skill and the will and the resources to stand
up to the DSA/MLM lobby (a.k.a. "the pyramid lobby").
The influence of the powerful DSA/MLM lobby over the FTC is
detailed in a 200-page report I just completed titled:
REGULATORY CAPTURE: The FTC's Flawed Business Opportunity
Rule,
which can also be downloaded free of charge from my web site.
Conclusion
Where Ackman's short attack on Herbalife will wind up, no one
knows. But I do know this. Daniel Loeb, Carl Icahn, and others who
are betting long on the stock either don't understand the business
model, or they don't care that millions of struggling families are
impoverished by its tentacles, and our society is worse for
allowing such unfair and deceptive practices to sap our resources
and corrupt our markets. Bernie Madoff was a stain on Wall Street
and the SEC. MLMs like Herbalife are a stain on Main Street and the
FTC.
Disclosure:
I 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.
See also
Two Harbors Is Likely To Cut Its 2013 Dividend
on seekingalpha.com