Herbalife – Starting From Zero

After the statement of the FTC was released on FTC v. Herbalife International of America, I wondered why the FTC agreed to a settlement at all. Their press statement asserted several findings on Herbalife (NYSE:HLF) that would logically draw one to conclude that it is indeed a pyramid scheme.

The SEC defines the classic “pyramid scheme” as participants attempting to make money solely by recruiting new participants into the program.

The hallmark of these schemes is the promise of sky-high returns in a short period of time for doing nothing other than handing over your money and getting others to do the same.” – SEC

According to Wall Street Journal and other news outlets, Herbalife will simply pay a fine of $200M and, in return, the company will not be classified as a pyramid scheme. However, when FTC Chairwoman Ramirez was asked if Herbalife was therefore freed from the pyramid scheme label, she replied: “I do not agree with that statement.” She later asserted that “they were not determined not to have been a pyramid scheme.”

On the surface, this settlement hints that Herbalife won. And that is exactly how Herbalife touted the ruling.

The FTC settlement is an acknowledgment that our business model is sound and underscores our confidence in our ability to move forward successfully, otherwise we would not have agreed to these terms.” – Michael O. Johnson, chairman and CEO of Herbalife.

However, a deeper dive into FTC documents and examination of government bureaucracy tells another story.

A good matador doesn’t go after a fresh bull. He sticks him, makes him bleed a little bit, and then goes for the kill.”

Former senior economist for the FTC, Peter Vander Nat, has asserted that the “process [in judging pyramid schemes] in which the prosecution takes so long that the deterrent effect is insufficient.” He alludes to another pyramid scheme, BurnLounge, that took the FTC seven years to shut down. As there is no established rule or precedent in judging these cases, the FTC is effectively starting from zero on every case.

It was this statement that tipped me into investigating the merits of the FTC injunction. My theory is that Herbalife aggressively negotiated away the label of “pyramid scheme,” and in exchange, conceded to the highest level of injunctive action imaginable. Certainly, Herbalife coordinated a massive PR campaign the day of the press statement.

Pic 1

Perhaps they even leaked false headlines to news outlets.



And of course, Dow Jones later corrected their statement (at Friday in the afternoon), when nobody was paying attention. As my colleague pointed out, nobody reads Dow Jones – not even Dow Jones.

“Buying a diet shake from a Herbalife distributor will now be harder than buying a gun.” – Matt Levine, Bloomberg View

In return for conceding the “pyramid scheme” label, the FTC is now given every authority to essentially break down Herbalife’s business in the US. In fact, the FTC statement affirms that Herbalife is, by definition, a pyramid scheme.

In fact, only a small minority of distributors have made anything near what the company promises, and they have done so mainly by recruiting a “downline” of distributors who buy the product at wholesale. Indeed, for years, Herbalife’s business model primarily compensated members for recruiting new distributors to purchase product, not for selling product at retail to users outside of the Herbalife network. As described in the complaint, this structure led many members to purchase an oversupply of product and rewarded only the tiny percentage of distributors with large downlines. As a result, according to the complaint, a large majority of distributors made little or no money and a substantial percentage lost money.”

Circling back to my theory that the FTC chose the path of least resistance, I reviewed the injunctive actions ordered by the FTC.

Here’s a summary of the FTC’s orders:

  • Limitations on Multi-Level Compensation
  • Collection of Retail Sales Information
  • Verification of Retail Sales and Preferred Customer Sales
  • Limitations on Thresholds, Targets, and Requirements
  • Required Training for Business Opportunity Partners
  • Prohibited Misrepresentations
  • Prohibition Against Material Omissions and Unsubstantiated Income Representations
  • Compliance Monitoring by Defendants
  • Independent Compliance Auditor
  • Customer Information

If you don’t want to pour through the specifics of the order, Matt Levine from Bloomberg succinctly summarizes the effects of this injunction: “Buying a diet shake from a Herbalife distributor will now be harder than buying a gun.” Moreover, restrictions are put on “Nutrition Clubs” such that it becomes more difficult than opening a McDonald’s. Under these constraints, it is almost impossible for any distributor to realize retail profit in a heavily competitive industry in which Herbalife sells at a significant premium.

The higher you are, the harder you’ll fall

All pyramid schemes, by the rules of simple mathematics, must come to an end. Such schemes are certain to fail because there is a limit to the number of new participants and the probability of success decreases for each new recruit. Once a top distributor leaves, the house of cards will surely collapse. It’s just a matter of time.

I’d like to conclude with an excerpt from a blog post on the FTC’s website:

“We’re glad to be returning $200 million to consumers. (Details about the refund program will be available soon.) But another key goal is to dismantle the alleged deception and unfairness built into how Herbalife does business. As the company rewrites its advertising claims and restructures its compensation system, we’ll be watching. The Auditor will be watching. And consumers should be watching, too.

My Short Thesis

HLF Summary PDF