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Greenberg: Why Investors in Herbalife and Nu Skin Should Read This Paper

By: Herb Greenberg | 02/21/14 - 03:11 PM EST

Stocks in this article: HLF

SAN DIEGO (TheStreet) -- A just-published academic paper on multi-level marketers supports the notion that the multi-level marketing industry has a serious unresolved issue or two.

Before you go dismissing this as just another academic paper, consider the authors: FTC senior economist and pyramid scheme expert Peter Vander Nat and Bill Keep, dean of the business school at The College of New Jersey.

In 2002 they co-authored a highly regarded paper explaining what differentiates a legitimate multi-level marketer from a pyramid scheme.

In this piece, which doesn't pick on any company in particular, Vander Nat and Keep give an exceptionally well-spelled-out history of multi-level marketers, but then dive into the deep-in-the-weeds legal decisions and "continuing concerns."

Perhaps nothing in the paper is more compelling to multi-level marketing aficionados as their discussion of internal consumption. This is when distributors get compensated for sales to themselves and other distributors. A key issue in the debates on Herbalife (HLF), Nu Skin (NUS) and others is how much compensation comes from internal consumption vs. genuine external sales.

It's such a critical issue that last year Nu Skin, on its Web site, included the question of whether internal consumption "indicates a business is a pyramid scheme" among FAQs on its Web site. As part of the answer, video of showcasing Joseph Mariano, president of the Direct Selling Association -- the industry trade group -- dispelled the concerns.

Beneath the video is a paragraph from a 2004 FTC staff letter in response to an "internal consumption" question raised by the Direct Selling Association. This paragraph is pointed to by the industry and individual companies when the issue of internal consumption arises. I certainly received it from Herbalife when I was doing research for my CNBC.com documentary, Selling the American Dream.

According to the letter:

Much has been made of the personal, or internal, consumption issue in recent years. In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme. The critical question for the FTC is whether the revenues that primarily support the commissions paid to all participants are generated from the purchase of goods that are not simply incidental to the purchase of the right to participate in a money making venture.

As it turns out, Vander Nat and Keep reference the letter, too, but a different part of the letter. According to their paper:

The Advisory continues by characterizing an MLM pyramid scheme as an organization whose primary purpose is recruitment and is funded by monthly product purchases that are qualifiers for recruitment rewards. This part of the Advisory is often ignored." Also ignored is the court's warning in Omnitrition; i.e., the firm's permission that its "70% rule" can be satisfied by a distributor's purchase for personal use is certainly not a meaning consistent with Koscot. The court directly states: "Plaintiffs have produced evidence that the 70% rule can be satisfied by a distributor's personal use of the products. If Koscot is to have any teeth, such a sale cannot satisfy the requirement that sales be to ultimate users" (Omnitrition, Part II C, 1996).

Omnitrition and Koscot are two ground-breaking legal cases that have set precedence for subsequent multi-level marketing lawsuits.

They conclude (emphasis mine):

Without a significant external customer base, internal consumption by an ever-churning base of participants resembles neither employee purchases nor a buying club. The MLM industry now appears to be heavily reliant on selling to itself - raising the retail question to ever greater urgency.

Reality: The industry can spin this paper any way it wishes -- and I'm sure it will work overtime doing so, as will many bulls on the stock. But given that one of the authors is among the foremost experts on pyramid schemes at the FTC -- whose declarations have been included in the agency's most recent cases -- it would be foolhardy for investors to dismiss this as just another attack by short-sellers. If for no other reason -- it's not! Regulators and lawmakers may never lift a finger on the multi-level marketing debate, but as this paper shows, the risk is always there that they may have good reason to.

P.S: I'll be doing a live meet and greet and Q/A at TheStreet's New York headquarters this Wednesday. It's in conjunction with my new Reality Check newsletter. It's invitation only. For more information contact ChairmansRSVP@thestreet.com.

Herb Greenberg, editor of Herb Greenberg's Reality Check, is a contributor to CNBC. He does not own shares, short or trade shares in an individual corporate security. He can be reached at herbonthestreet@thestreet.com.

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