Mansions, private jets not pictured.

Photographer: Patrick T. Fallon/Bloomberg

Herbalife Will Have to Live Without Mansions and Private Jets

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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I don't know anything any more. Here's CNBC:

The Federal Trade Commission settled with Herbalife on Friday, effectively determining that the nutritional supplement marketer is not a pyramid scheme.

Here's Herbalife Chief Executive Officer Michael O. Johnson:

"The settlements are an acknowledgment that our business model is sound and underscore our confidence in our ability to move forward successfully, otherwise we would not have agreed to the terms."

Here's the FTC's complaint against Herbalife, filed today with the settlement:

Most Herbalife participants earn little or no profit, or even lose money, from retailing Herbalife products.

In the absence of a viable retail-based business opportunity, recruiting, rather than retail sales, is the natural focus of successful participants in Defendants’ business opportunity.

Thus, participants’ wholesale purchases from Herbalife are primarily a payment to participate in a business opportunity that rewards recruiting at the expense of retail sales.

Here's a definition of a pyramid scheme, from the FTC's website

Pyramid schemes now come in so many forms that they may be difficult to recognize immediately. However, they all share one overriding characteristic. They promise consumers or investors large profits based primarily on recruiting others to join their program, not based on profits from any real investment or real sale of goods to the public. Some schemes may purport to sell a product, but they often simply use the product to hide their pyramid structure. 

Here's a case that the FTC brought last year against Vemma, a multilevel marketing company that it shut down as an alleged pyramid scheme. From the Vemma complaint:

Defendants promote participation in Vemma, which has a compensation program based primarily on providing payments to participants for the recruitment of new participants, not on the retail sale of products or services, thereby resulting in a substantial percentage of participants losing money.

Defendants' promotion of this type of scheme, often referred to as a pyramid scheme, constitutes a deceptive act or practice in violation of Section 5(a) of the FTC Act.

Paying primarily for recruitment, with a substantial percentage of participants losing money, is the "type of scheme often referred to as a pyramid scheme," says the FTC. Herbalife pays primarily for recruitment, with a substantial percentage of participants losing money, says the FTC. The FTC couldn't have been clearer that it thinks that Herbalife is a pyramid scheme, without actually using the words "pyramid scheme."

But it didn't use the words "pyramid scheme"! And it didn't shut down Herbalife like it did Vemma. Instead it agreed to a settlement in which Herbalife will pay $200 million to the FTC and make a bunch of changes to its disclosure and business model. For those accustomed to the "neither admit nor deny" settlements in the financial industry, it's fun to see a settlement where the two sides so openly and vehemently disagree. The FTC thinks that Herbalife is ... well ... arbitrarily close to being a pyramid scheme, anyway. Herbalife thinks that its business model is fine, and "believes that many of the allegations made by the FTC are factually incorrect." They'll split the difference and call it $200 million.

The basic thesis of the complaint is that Herbalife is primarily in the business of selling business opportunities to gullible customers on false premises, and it works out poorly for those customers:

The overwhelming majority of Herbalife Distributors who pursue the business opportunity do not make anything approaching full-time or even part-time minimum wage because the promised retail sales to customers simply are not there.

And:

Analysis of Defendants’ own Distributor purchase data shows that, even under favorable assumptions about Distributors’ market reach and sales price, the overwhelming majority of Herbalife Distributors who pursue the business opportunity make little or no money from retail sales. Under these assumptions, and assuming no costs other than an individual’s total payments to Herbalife, half of Distributors whom the Defendants designate as “Sales Leaders” average less than $5 per month in net profit from retail alone, and half of these Distributors lose money.

But while the actual business opportunity is bad, Herbalife tells potential recruits that it is very good indeed. The complaint is full of quotes from Herbalife presentations that wildly oversell the business opportunity:

[H]ow many of you would like to make at least a million dollars a year in income? I gotta tell ya, every extra million dollars, I find, comes in handy. OK? You know? Then you get 2 million, 5 million, you know, and with the increases of 20%, 25%—

Even now, you can put into your mind—like, if you made a hundred thousand dollars last year, and your income went up proportionately, an extra twenty thousand dollars? That’s pretty cool, huh? Couple thousand a month? You make five hundred thousand dollars, would an extra hundred thousand dollars come in handy? And we’re gonna go through how to make it happen.

And:

I can remember when I was new, and I didn’t know anything, I didn’t know anybody, didn’t have any sales or marketing experience, I didn’t know, how was I ever gonna get successful? ...

And make no mistake about it, ’cause it happened for me, I’m living proof that it can happen, and all the people down here in this floor here, and the people behind you, all of us are, you know—I’m a multi-millionaire, but, you know, all of us are getting groomed to become multi-millionaires. That is an awesome opportunity.

Now, you can take advantage of it, or you may only want to make sixty thousand, a hundred thousand, a couple hundred thousand.

Again: The normal profit is more like $5 a month.  "Notwithstanding Defendants’ express and implied representations that Herbalife offers a retail-based business opportunity," says the FTC, "in truth the only way to achieve wealth from the Herbalife business opportunity is to recruit other Distributors" -- again, basically the definition of a pyramid scheme.

Nobody exactly denies this; it's hard to explain away the presentations, or to claim that everyone who tries hard enough to sell Herbalife shakes becomes rich. (Herbalife does compare its business to Uber and Airbnb, as an "opportunity to generate supplemental income with low barriers to entry and the flexibility to work on their own terms." ) Instead, the core pro-Herbalife position is that most of the people who sign up to be Herbalife "distributors" and don't make money mostly aren't trying to make money. Instead, they just want the diet shakes, and the most efficient way to get the diet shakes is to sign up to be a Herbalife member, which gets you both discounts on the shakes and a social support network for your dieting. So people are just signing up to be members to get a bulk discount, but due to an accident of history, Herbalife refers to its members as "distributors." But they never meant to distribute anything. It is all a misunderstanding

This is actually not a trivial argument, and John Hempton, the most interesting and thoughtful Herbalife bull, has spent a lot of time going out into the world and documenting evidence both that it is true and that it works -- that Herbalife customer-distributors do benefit from the membership model. But the FTC isn't buying it:

Although Defendants heavily promote their business opportunity, in recent years Defendants have begun to claim that most consumers who sign up to be Distributors are merely customers who purchase the product only for their own consumption and are not interested in pursuing the Herbalife business opportunity.

Defendants do not offer a separate “customer” or “discount buyer” status for consumers who are uninterested in pursuing a business opportunity and thus do not systematically track or distinguish Distributors who might be “discount buyers” from Distributors who are pursuing a business opportunity.

Herbalife claims that only 27 percent of "Distributors" are actually distributing product to make money; the rest are just consumer/members. The FTC disagrees:

When observable Distributor behavior from Defendants’ data is analyzed, the percentage of Distributors who are attempting to earn income from the Herbalife business opportunity readily exceeds the 27% in Defendants’ claims. Such behaviors include, for example, purchasing promotional literature and sales and recruiting aids from Defendants.

Anyway, the complaint goes on and on like this, in terms that are probably familiar to you if you've followed Bill Ackman's endless crusade against Herbalife. From its tone and contents, today's complaint could almost have been written by the authors of Ackman's multihour presentations about Herbalife, or the curators of his antiHerbalife website. The FTC seems to agree with Ackman on essentially everything except his final conclusion -- that regulators should shut down Herbalife. 

And yet in a weird way the settlement is a vindication of Herbalife's business model. Herbalife is a company that sells two things: weight-loss shakes, and the prospect of achieving fabulous wealth by selling weight-loss shakes. The weight-loss shakes seem to work, insofar as weight-loss shakes can work. The fabulous wealth is mostly a mirage. If you think that Herbalife is mostly in the business of using a direct-sales mechanism to sell weight-loss shakes, it seems fine. If you think that Herbalife is mostly in the business of selling business opportunities, it seems bad. But if you think that Herbalife is only in the business of selling business opportunities, that it is just a pyramid hidden under a thin dusting of protein powder, then it is so bad that it can't be fixed. If you get rid of all the naughty overpromising of fabulous wealth, you are left with just protein powder and herbal tea. Is that enough?

Ackman's thesis for his bet against Herbalife was that the naughty overpromising was the core of the business, and that if Herbalife reformed its selling practices its business would vanish: It couldn't possibly make money just by legitimately selling its weight-loss products to people via direct-sales channels. And for a long time, there was a pattern in which Ackman would point out some awful-sounding thing that Herbalife did, and Herbalife would deny it, and then Herbalife would fix it anyway. And each time, Ackman would say something like this :

“By becoming legal, they die,” he said of the nutrition clubs. “Why? Because we don’t think there’s fundamental demand for the product.”

He said that in July 2014, shortly before Herbalife announced its second-quarter earnings. The second quarter of 2014 is still the high-water mark for Herbalife's revenue and net income, so it's possible that all of the Herbalife reforms prompted by Ackman's goading have had a negative effect on the business. But not that much of an effect. Revenue didn't go to zero. (It went from $1.3 billion of net sales in the second quarter of 2014 to $1.1 billion in the first quarter of this year.) Even after fixing the worst pyramid-y practices that Ackman focused on, Herbalife was basically fine.

Now the FTC wants to strip out a lot more practices that it views as pyramid-y. The stipulation in this case -- the order that the FTC and Herbalife agreed to -- is quite far-reaching and comprehensive. It requires Herbalife to do a lot more to demonstrate that it is really in the business of selling diet shakes, not just get-rich-quick schemes. Higher-level distributors in the pyramid can't get paid just for lower-level distributors buying lots of product for their personal use; there need to be real retail sales to earn payments. Herbalife has to distinguish between "Preferred Customers," who just sign up to get discounts on the products, and "Business Opportunity Participants," who sign up hoping to make money, instead of its previous practice of signing everyone up as "Distributors" and then claiming that the ones who don't make money never wanted the business opportunity anyway. 

And it has to collect real data on retail sales, which was pretty slippery before. Buying a diet shake from a Herbalife distributor will now be harder than buying a gun; distributors will have to record and submit to Herbalife information including "the first and last name of the purchaser" and "contact information for the purchaser, including at least two of the following: telephone number, address or e-mail address."

Herbalife has also agreed to a lot of new restrictions on how it can market its business opportunity. People won't be allowed to start a Herbalife Nutrition Club -- which is a big commitment, requiring them to lease space and run a business -- until they have been selling Herbalife for at least a year, completed a training course and written a business plan that might actually result in profit, unlike the majority of nutrition clubs now. Herbalife won't be allowed to say "that participants will or are likely to earn substantial income," or make false claims about "the reasons participants do not earn significant income, including but not limited to representations that participants fail to devote substantial or sufficient effort."

There is even an antihelicopter clause, prohibiting Herbalife from marketing itself using:

Statements that participants can “quit your job,” “be set for life,” “earn millions of dollars,” “make more money than they ever have imagined or thought possible,” “realize unlimited income,” or any substantially similar representations; and

Descriptions or images of opulent mansions, private helicopters, private jets, yachts, exotic automobiles, or any substantially similar representations.

If you think that Herbalife's business relies on flashing pictures of yachts at suckers until they part with all of their money -- a plausible thing to think, based on the presentations collected by Ackman and the ones cited by the FTC -- then these changes will be, practically speaking, the end of Herbalife. That is (still) Bill Ackman's view; Pershing Square issued a statement today saying that "once Herbalife’s business restructuring is fully implemented, these fundamental structural changes will cause the pyramid to collapse as top distributors and others take their downlines elsewhere or otherwise quit the business."

If you think that Herbalife's business relies mostly on selling diet shakes to people who want to diet, and that the yachts are an unfortunate sideshow -- a plausible thing to think, based on John Hempton's field investigations of Herbalife's operations -- then these changes will be no big deal, a minor clean-up of the worst excesses that will allow Herbalife to focus on its thriving core business.

That's obviously Herbalife's own perspective. "The Company agreed to new procedures and enhancements to some policies that already exist," it says. "Many of the terms agreed to were either already being contemplated by the Company or are extensions of practices already in place and will be implemented over the next 10 months." "While some of the additional terms do not have significant impact on the Company, these provisions will improve policies throughout the industry." More importantly, the market seems to agree. Herbalife's stock was up about 8.6 percent as of 2:30 p.m. today, suggesting that investors think that Herbalife will be able to handle these changes just fine.  

There is an alternative possibility, which is that these restrictions really will cripple Herbalife's business, but that it won't matter much because they'll only cripple Herbalife's U.S. business. Intriguingly, Herbalife mentions that possibility in its own press release: "The terms of the settlement apply only to the Company's sales in the U.S., which comprise approximately 20% of total net sales." I suppose it will be awkward if, a few years from now, Herbalife has cracked down on fake sales and helicopter-based pitches in the U.S. and seen its U.S. business wither, but is still making money by going hard on the private helicopters abroad. Awkward, though not necessarily much of a financial problem for Herbalife.

But I prefer to be optimistic. The positive view of this settlement is -- well, weirdly, it's a huge victory for Bill Ackman. He has been banging on for years to any regulator who would listen about Herbalife's practices that he thinks are sketchy, and he seems to have completely convinced the FTC -- the most important pyramid-scheme regulator -- that those practices really are sketchy. Not only that, but Herbalife has agreed to fix all those practices. At least in the U.S., no one will be tricked into blowing their last dollar on a Herbalife business opportunity by misleading promises of luxury and leisure. No one will fork out thousands of dollars to run a nutrition club with no hope of making a profit. Herbalife in the U.S. will become a low-key social weight-loss concern, not a high-pressure get-rich-quick scheme. Bill Ackman launched his short-selling crusade against Herbalife, not just to make money -- he promised to donate his personal profits to charity -- but to save people from being victimized by Herbalife. He seems to have accomplished just that.

It's rough that he's lost so very much money doing it though.

  1. Similarly Business Insider, the New York Post, the Wall Street Journal ("a settlement with the Federal Trade Commission that will enable the company to avoid being classified as a pyramid scheme"), etc.

  2. He says "settlements" because there's also a $3 million settlement with Illinois.

  3. It's from a 1998 speech given by then-FTC general counsel Debra A. Valentine. She goes on:

    There are two tell-tale signs that a product is simply being used to disguise a pyramid scheme: inventory loading and a lack of retail sales. Inventory loading occurs when a company's incentive program forces recruits to buy more products than they could ever sell, often at inflated prices. If this occurs throughout the company's distribution system, the people at the top of the pyramid reap substantial profits, even though little or no product moves to market. The people at the bottom make excessive payments for inventory that simply accumulates in their basements. A lack of retail sales is also a red flag that a pyramid exists. Many pyramid schemes will claim that their product is selling like hot cakes. However, on closer examination, the sales occur only between people inside the pyramid structure or to new recruits joining the structure, not to consumers out in the general public.

    Here is a Securities and Exchange Commission explanation:

    Multi-level marketing ("MLM") programs are promoted through Internet advertising, company websites, social media, presentations, group meetings, conference calls, and brochures. In an MLM program, you typically get paid for products or services that you and the distributors in your "downline" (i.e., participants you recruit and their recruits) sell to others. However, some MLM programs are actually pyramid schemes -- a type of fraud in which participants profit almost exclusively through recruiting other people to participate in the program.

    The basic hallmark is paying participants primarily for recruiting, not for real sales.

  4. Bill Ackman's Pershing Square Capital Management, which has waged a long-running campaign against Herbalife, responded: "While it appears that Herbalife negotiated away the words 'pyramid scheme' from the settlement agreement, the FTC’s findings are clear."

  5. The settlement has the money going to the FTC, though the press release says that it will eventually be allocated "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."

  6. The FTC similarly thinks that Herbalife's Nutrition Clubs -- in which customers lease space to operate Herbalife clubs where they can charge membership fees to let people sit around drinking diet shakes -- are mostly a ruse:

    According to Defendants, the Nutrition Club is supposed to be a neighborhood gathering place to promote health and wellness, and to provide income for the Nutrition Club owner. In practice, Nutrition Clubs operate primarily as a tool for recruiting new members rather than as a method for profitably retailing Herbalife products.

    And:

    In fact, Defendants’ own telephone survey of 433 current and 69 former Nutrition Club owners in February 2013 paints a discouraging picture of the experience of many Nutrition Club owners. Fifty-seven percent of Nutrition Club owners reported that their clubs made no profit or lost money. Club owners reported spending an average of about $8,500 to open their club.

  7. From the press release:

    The American economy is full of people searching for supplemental income and those who choose to sell Herbalife products are no different. Companies like Uber, Airbnb and Etsy all offer industrious people the opportunity to generate supplemental income with low barriers to entry and the flexibility to work on their own terms. In the United States alone, there are more than 18 million direct sellers and more than 156 million consumers who purchase products from these individuals. The very essence of the entire $35 billion American direct selling industry is to provide individuals with the opportunity to be their own boss, to set their own schedule and to make their own decisions. The Company believes this settlement will strengthen and improve this important industry.

  8. He said this specifically about Herbalife's nutrition clubs, but as I said two years ago, "this was his theory about inventory loading too, and about lead generation. He finds a problem and says that it can't be fixed without crippling the business. Herbalife denies that it's a problem and also promises to fix it. Herbalife's revenue keeps going up."

  9. I can't resist citing the Mitch Hedberg "receipt for a doughnut" routine here:

    I just cannot imagine a scenario where I'd have to prove that I bought a doughnut. Some skeptical friend? "Dont't even act like I didn't get that doughnut. I've got the documentation right here."

    That will now literally happen, only for diet shakes.

  10. The fact that Herbalife also entered into an agreement with Carl Icahn allowing him to buy as much as 34.99 percent of Herbalife's stock, and mentioned its interest in "exploring strategic business opportunities," might also have excited shareholders.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net