Crime

An Insider Explains Why the FTC Can't Put an End to Pyramid Schemes

They're starting from zero on every case, the former official says

"A police officer can only stop one speeder while all the others race by," says ex-FTC official. He wants a federal rule.

Photographer: Fuse via Getty Images

When BurnLounge was launched in 2004, it was sold as a mix of iTunes, MySpace, and PayPal. With celebrity endorsements from Justin Timberlake and Shaquille O'Neal, "independent sellers" peddled it as a place to buy and sell music—and make heaps of cash. 

But in the age of the iPod, BurnLounge was built to use Windows Media Player. And when musicians and concert attendees were approached by the BurnLounge sellers, they weren't offered a product. Instead, they were shown a complicated sales model in which they, too, could sell BurnLounge for an annual fee ranging from $29.95 to $429.95.

In 2007, the U.S. Federal Trade Commission accused BurnLounge of operating a pyramid scheme, a company designed to sell the opportunity for recruitment more than the opportunity to buy a product. Yet it took the FTC seven years to shut BurnLounge down. In the meantime, as many as 30,000 salespeople had been roped into the scam. According to the FTC, almost 94 percent of them lost money

Peter Vander Nat was the government’s testifying expert in BurnLounge and similar cases. He was a senior economist for the FTC who helped shut down 15 of them. He has one thing to say about the system designed to close and prevent pyramid schemes.

There ought to be a law.

Peter Vander Nat
Peter Vander Nat
Source: Peter Vander Nat via Bloomberg

It's been nearly a year since the FTC opened an investigation into Herbalife, its biggest announcement about a suspected pyramid scheme in decades. Herbalife is a nutritional supplement company that sells protein shakes, healthy snacks, and vitamins. It also is the publicly traded, multilevel marketing company that activist investor Bill Ackman has accused of being an illegal pyramid scheme since December 2012. 

Vander Nat, who retired last summer, has some suggestions on how to improve the procedure.

“It is a process in which the prosecution takes so long that the deterrent effect is insufficient,” he says, comparing it to people speeding on the highway. “A police officer can only stop one speeder while all the others race by.”

It isn’t fair to the companies under scrutiny either, forcing them to wait, sometimes for years, for regulators’ follow-up announcement about their investigation or an exoneration. If it's a publicly traded company, like Herbalife, investors can get jumpy, sending the stock on a wild ride, and lose large sums.

What we need, says Vander Nat, 68, is a clear federal rule establishing the circumstances under which a multilevel marketer—a company whose salespeople earn income from recruiting other salespeople as well as from selling the product—becomes a pyramid scheme. At the FTC, Vander Nat worked on all the major pyramid-scheme investigations in the country going back to the mid-'90s and has published intricate economic studies about multilevel marketing and pyramid schemes in peer-reviewed journals. 

The FTC declined to respond to a specific request for comment about Vander Nat's suggestions. An Herbalife spokesman declined to comment. Herbalife has denied allegations that it operates a pyramid scheme.  

Bill Keep, dean and marketing professor at the College of New Jersey, has written multiple economic papers on pyramid schemes with Vander Nat. He has testified as an expert witness on pyramid schemes for the Department of Justice, the states of Kentucky and Florida, and the Securities and Exchange Commission. He believes the FTC’s failure to establish such a rule has been harmful to consumers.

“From a policy perspective, in terms of sending clear signals to the industry, the FTC has done worse than nothing since 1979,” Keep says. “It sends confusing signals that have in no way helped us understand how to identify a multilevel marketing company that may be a pyramid scheme.”

A federal rule would create as a matter of policy the notion that pyramid schemes can exist, and that when they exist, they can do a lot of harm, Keep says.

“In advertising, we won’t tolerate it if a single source hands out a marketing message that is deceptive,” he says. “So why should we tolerate it if 10,000 people hand out marketing messages that are deceptive? We could be talking about that many or more when we look at the multilevel marketing industry as a whole. And the FTC has just been unwilling to take that on.”

In December 2012, Ackman placed a $1 billion bet that Herbalife's shares would eventually become worthless. The shares, which trade on the New York Stock Exchange, fell 22 percent in two days, to their lowest price in two years. 

Between December 2012 and January 2014, the stock tripled, peaking at more than $81. The FTC announcement on March 12 of last year served to temper Wall Street’s optimism about investor Carl Icahn and others defending the company with their wallets; the stock dropped to $49. After a brief uptick, the shares soon began to fall again and have been in a steady decline since July 2014, trading at midday today, Feb. 27, at $32.18 per share.

The FTC goes after suspected pyramid schemes on a case-by-case basis, Vander Nat explains. Complaints come in to the office and investigators look at them individually before bringing cases that seem egregious to a Ph.D. economist such as Vander Nat. 

“That approach has been successful in shutting down pyramid schemes,” Vander Nat says. “However, each case is extremely resource-intensive.” He cites the FTC's seven-year pursuit of BurnLounge and says it is “not atypical.”

The lack of a federal rule means every case brought by the FTC begins from scratch. The commision is forced to explain not only why it believes a company is a pyramid scheme but also why it believes it hurts consumers.

“We’re starting from square zero,” Vander Nat says. “That takes an immense amount of time.”

In his retirement, Vander Nat is consulting with the U.S. Securities and Exchange Commission, so he won’t speak specifically about any ongoing investigations, especially into Herbalife. But the FTC's probe of Herbalife might have taken a matter of months, instead of a year or longer, if a rule had been in place, he says.

There’s a precedent for what Vander Nat is suggesting. There is a federal rule, for example, that establishes funeral home practices. A funeral home must offer casket price lists to grieving customers and open discussions about alternatives to burial. Otherwise it could be prosecuted. 

“Almost every rule is about disclosures, so that the consumer understands context,” Vander Nat says. 

The BurnLounge case is important, he says, citing a key phrase in the decision: “The promise of lucrative rewards for recruiting others tends to induce participants to focus on the recruitment side of the business at the expense of their retail marketing efforts, making it unlikely that meaningful opportunities for retail sales will occur.”

That’s central to what Vander Nat believes a federal pyramid scheme rule should say.

“What is the primary purpose of the organization? Is it to recruit others and to let others make money from recruitment? Or is it about retailing goods and services to the general public?” he says. “That fundamental understanding of a pyramid scheme would be announced in a rule, laid down once and for all: That’s what a pyramid scheme is.”

To Bill Keep, the college dean and pyramid-scheme expert, the federal rule should begin at a fairly simple place, established by the BurnLounge decision.

“What this decision says to me is that when compensation to participants relies primarily on distributor purchases in the absence of identifiable consumer demand, there is a very good chance we are looking at a pyramid scheme,” he says.

What does that mean for Herbalife?

Herbalife has said the BurnLounge decision "rejects Bill Ackman's fundamental thesis against Herbalife."

Vander Nat won’t say whether he agrees, but Keep thinks the BurnLounge decision spells trouble for Herbalife.

To him, BurnLounge indicates that “the court wants to see ‘consumer demand for merchandise.’” The safeguards Herbalife has set in place don’t establish that, Keep says.

Herbalife adheres to two basic guidelines: Distributors must sell at least 70 percent of their products to other people. They must also sell to 10 customers each month. These guidelines are "completely ineffective," Keep says, because they allow "each individual distributor ... to determine the amount of product that they hold for resale. As a result, the 70 percent that a distributor ‘must sell to retail customers’ can apply to zero percent of a distributor's inventory."

Before it's here, it's on the Bloomberg Terminal. LEARN MORE