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FTC investigation could topple Herbalife's alleged pyramid scheme

FTC investigation could topple Herbalife's alleged pyramid scheme


An increasingly aggressive consumer protection agency is finally taking on its biggest — and most obvious — target

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Nearly 15 months ago, Wall Street hedge fund manager Bill Ackman placed a billion dollar Wall Street bet that Herbalife, the nutritional supplement company, was an illegal pyramid scheme. Despite a major publicity and lobbying campaign, the company continued to operate and Ackman’s fund lost as much as a half-billion dollars on the bet.

But last week, the Federal Trade Commission announced it was opening an investigation into Herbalife. This was a watershed moment for Ackman and others who followed his lead. The announcement of an FTC investigation seemed to show that his claims about Herbalife had merit, and that one of the biggest players in an often-criticized industry wasn’t merely in the sights of a hedge fund manager; it was also in the sights of the nation’s foremost consumer protection agency.

"A lot could change in the next 90 days."

Details about the investigation are scarce thus far. Herbalife issued a press release stating that the company had received a "Civil Investigative Demand" from the Federal Trade Commission — a formal request for documents. But so far the FTC, which has confirmed the investigation, has been mum about which documents it is seeking.

"This is like two people going into a room — FTC and Herbalife — to have a conversation, and everyone trying to listen in through a keyhole," says Bill Keep, dean of the School of Business at The College of New Jersey, who co-wrote an often-cited paper on pyramid schemes.

But picking through the FTC’s docket of historical pyramid scheme cases and recent decisions, a clear trend emerges: an increasingly aggressive FTC, which is beginning to assert itself after more than 30 years of relative passivity.

"A lot could change — about this industry, and certainly about Herbalife — in the next 90 days or so," Keep says.

The Amway decision

To understand what the FTC is looking for in its Herbalife probe, one has to look back at the FTC’s relationship with multi-level marketing schemes (MLMs). Way back in 1975, the FTC went after Amway — the biggest MLM player in the country at the time, with a sales structure virtually indistinguishable from Herbalife’s today. As the FTC saw it, Amway had two main problems in 1975: its distributors focused on recruiting new people into the sales structure rather than selling products, and distributors made dishonest promises about the riches that new distributors might earn by selling Amway.

The FTC’s eventual decision in 1979 kept Amway in business and set some basic MLM guidelines: the "70 percent rule" requires that a distributor must sell "at least 70 percent of the total amount of products he bought during a given month" at wholesale or retail price; the "10 customer" rule requires that distributors "must make not less than one sale at retail to each of 10 different customers that month"; and the "hypothetical" profit rule requires that MLMs must conspicuously disclose the amount of money distributors might actually make when they sign up.

But those guidelines are vague. They don’t stipulate, for example, who actually enforces the rules. A 2004 FTC Staff Advisory Opinion was ostensibly meant to clarify things, but it failed to; it implied, among other things, that the 70 percent rule doesn’t really matter. So companies such as Amway, Nu Skin, Avon — and Herbalife — have been free to adhere to the FTC’s rules in whatever way they see fit.

The big shift

But the era of vague MLM guidelines may be changing. In just over the past year, the FTC has made three major declarations about the importance of sales to customers outside the distribution networks of MLMs.

The first declaration came in January 2013, when a US district judge issued a restraining order in a pyramid scheme case brought by the FTC against Fortune Hi-Tech Marketing (FHTM). That restraining order prohibited the firm from paying compensation to participants "unless the majority of such compensation is derived from sales to persons who are not members" of FHTM’s distributor network.

Then, in April last year, in a case against BurnLounge, the FTC noted that compensation unrelated to retail sales was "the sine qua non" — the essential ingredient — "of a pyramid scheme."

And in December, in a case against an MLM called the Global Information Network, the FTC argues the company is a pyramid scheme because, "There are no sales of product or service to people outside GIN's network, so there cannot be any relation between retail (or external) sales and financial rewards paid in connection with recruitment."

Keep explains: "Whatever confusion the 2004 FTC Staff Advisory caused regarding internal consumption, FTC actions in 2013 make clear that MLMs need to have substantial retail sales … outside of the marketing program." He continues: "MLMs with unenforced policies regarding retail sales, those who fail to document retail sales, and those who conveniently try to redefine members of the marketing program as retail customers despite the fact that they joined under the twin offering of discounted products and a business opportunity are vulnerable to a pyramid scheme charge."

For that reason, Keep and others argue that the FTC’s Civil Investigative Demand last week likely demands that Herbalife come clean about its retail sales. While Herbalife’s promotional materials claim that the company "offers compensation that is directly linked to the generation of product sales," it hasn’t bothered to prove as much; it has, in fact, declined to publicly disclose information about retail sales.

The FTC, shut in a room with Herbalife, is likely asking why.