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Greenberg: What to Expect from Herbalife Probe

By: Herb Greenberg | 03/13/14 - 01:26 PM EDT

(This column originally appeared on Herb Greenberg's Reality Check)

SAN DIEGO (TheStreet) -- So much for those who laughingly insisted the FTC would never launch an investigation into Herbalife (HLF).

An investigation is underway. It won't be over anytime soon and the outcome is uncertain.

But in the meantime, what to expect?

Beyond the broad and deep request for documents, which is likely to be part of a civil investigation by the FTC, the bigger issue is what the ramifications are for Herbalife and the entire industry, regardless of whether the investigation from Herbalife's perspective is a win, lose or draw.

In two years of researching the industry, I've been struck by how multi-level marketers, as a whole, have slipped through regulatory cracks.

Fast-forward to the FTC's Herbalife investigation, which Herbalife disclosed Wednesday. It's the first probe of a major, multi-level marketer in more than 30 years.

The difference now is a mostly different FTC, and for what it's worth -- and for better or for worse -- different politicians.

Amway Set a Roadmap

Much of what I've heard through the course of my reporting is that the FTC gave multi-level markers a pass, and roadmap, in 1979 when it ruled that Amway was not a pyramid scheme.

Notably, in that case the commission cited Amway's 70% Rule, which requires that distributors must "resell" at least 70% of their products every month in order to receive performance bonuses. According to the commission, the 70% Rule -- combined with another rule that requires the sale of product to 10 different customers each month -- "deters unlawful inventory loading."

Since then, the 70% Rule has taken on a life of its own, with each company, including Herbalife, putting its own spin on it.

And that gets to the heart of what the Herbalife and alleged pyramid-scheme controversy is all about and what regulators are likely to seek answers to:

1. What constitutes a genuine retail sale?

2. Most importantly, do distributors make more money by way of commissions and bonuses by selling product or by recruiting other distributors?

It's really that simple, or complicated, depending on your perspective, knowledge and access to company internal documents.

Industry May Not Emerge Unscathed

Herbalife, for its part, insists it isn't an illegal pyramid scheme. So do all other multi-level marketers. But I believe no matter what the FTC ultimately decides in the Herbalife probe -- and whether it even goes beyond the investigation phase -- Herbalife and the industry may very well not emerge unscathed.

While Amway wasn't deemed a pyramid scheme, it was cited for a number of business practices that it had to clean up.

And unlike Amway, this is an investigation, not a lawsuit.

Even if the FTC doesn't file a formal complaint, there is the bigger risk that it may decide the industry needs to be reeled in, especially given the proliferation of multi-level marketing since the Amway case. We're not just talking about the likes of Herbalife, Nu Skin (NUS) and Usana (USNA), perhaps best known among public companies, but an unknown number of private companies that generally fly under the radar.

Why Investors Should Be Concerned

If I were an investor in a multi-level marketer, these are the three possible outcomes that would concern me:

First, a revisit of the Amway case by the current FTC, especially the 70% Rule, which is an Amway rule not a regulatory requirement. What may have worked, on paper, when Amway was smaller has taken on a life of its own under the guise, by many companies, to prove they're not a pyramid scheme.

Even Amway has since stretched the meaning of rule, according to its own published guidelines, to say: "For purposes of this Rule, a reasonable amount used for personal or family consumption or given out as samples can contribute to the 70% average."

Reasonable amount used for personal or family consumption? The obvious question is "what's reasonable?"

 "The term reasonable amount is not defined and apparently left to distributor discretion," is the way the FTC's pyramid scheme expert Peter Vander Nat and College of New Jersey business school dean William Keep put it in a just-published paper on the history of multi-level marketing. (This should take on added significance given Vander Nat's history with pyramid schemes at the FTC.)

Should Distributors Sell to Themselves?

That gets to point No. 2: internal consumption. Should sales by distributors to themselves be counted as genuine retail sales for the purpose of commissions and bonuses? I can't stress the importance of this. The industry has embraced the the idea that sales by distributors to themselves for personal use count as retail sales.

The internal consumption issue is so hotly contested that in 2004, in response to a question from the Direct Selling Association, the FTC issued a staff advisory that has been widely interpreted by the industry to suggest that internal consumption was acceptable. The advisory is ambiguous at best, but is still often served up by multi-level marketers to show that internal consumption, for the purpose of being counted as retail sales is well within its rights. They may very well believe it is, but during research for my CBNC.com documentary Selling the American Dream, I spoke to the advisory letters author, James Kohm. He told me the letter has been "grossly mischaracterized" by the industry.

A string of court cases over the years specifically dismiss internal consumption as retail sales. In declarations to recent smaller FTC pyramid scheme cases, Vander Nat has left a trail of breadcrumbs that provide a window into the FTC's current thoughts on internal consumption. Hint: It's not in keeping with the 2004 letter.

Did the Industry Really Dodge a Bullet?

Finally, the FTC could revive the question of whether multi-level marketers should be included in the very-deep-in-the weeds Business Opportunity Rule, which would have required extensive disclosure to potential distributors. Multi-level marketers were front and center in the rule's original proposal. By getting excluded in the final rule 2012, after five years of lobbying -- as I wrote at the time -- the industry dodged a bullet.

I would also keep an eye on whether the FTC puts a limit on how many so-called downline levels a distributor can have. At Herbalife, and many other multi-level marketers, it's unlimited. At struggling direct-seller Avon, the downline is limited to three. And in an era when product and inventory tracking is more the rule than the exception -- in the very least to know who received products in the event of a recall -- the FTC could require multi-level marketers to track actual retail sales, something Herbalife has said it doesn't do.

Reality: If regulators do nothing more than eliminate internal consumption as retail sales, the result could likely be a hard reset of the business models of multi-level marketers operating in the U.S., not unlike the reset at for-profit education companies after the government changed the rules related to them.

And while it may seem arcane, don't dismiss the significance of the Business Opportunity Rule and the possibility that multi-level marketers could be looped back in. When the rule first surfaced, Herbalife warned in its 2006 10-K "The proposed rule, if implemented in its original form, would negatively impact our U.S. business."

Even after multi-level marketers were excluded from the rule, pro-industry attorney Jeffrey Babener -- while cheering -- ended a blog entry on this cautious note:

"Unfortunately, the new Final Rule language does not match the 'staff' commentary. And unfortunately, staffs come and go...and administrations come and go. And commentaries are just that...commentaries. In the end, it is the actual Rule that reigns. And the actual language of the Final Business Opportunity rule opens the door to significant enforcement of the Rule to the MLM/Direct Selling/Network Marketing industry should a future staff so choose. In that regard, the Industry, in the absence of clarification of the Rule, should not sleep quite as peacefully as it would like. And it may take limited comfort in the FTC staff commentary and good rapport that exists between the Industry and the FTC at the time of adoption of the Final Business Opportunity Rule."

I don't know about "good rapport," but what I do know is that with the FTC's investigation of Herbalife, everything is back on the table, not just for Herbalife but for the industry. In the end, with its lobbying dollars and political might, the industry might once again prevail. But this is for sure: if it doesn't, this industry will never be the same.

-- Written by Herb Greenberg in San Diego

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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