FTC declares Herbalife a Pyramid Scheme in All But Name

The company and its biggest critic both declare victory.
By William McConnell ,

Herbalife Ltd.'s (HLF) shares briefly spiked Friday after the activist-embattled company reached a settlement with the Federal Trade Commission that will force the company to dramatically alter its U.S. business operations and pay $200 million to compensate individuals who the FTC said were deceived by the company into believing they could earn substantial money investing in rights to sell its diet and nutritional supplements and other products.

After an initial spike from an Friday opening of $66.29 to $71.05, cooler heads prevailed and the shares lost value, dropping to around $64.50 through late mid-afternoon trading.

The settlement was good news for Herbalife, at least in the short run, because the company won't be shut down by the feds as has been argued by activist investor Bill Ackman, whose Pershing Square Capital Management had engaged in a multi-year $2 billion short-selling campaign asserting that Herbalife was a "Ponzi scheme" with a worthless stock that should trade at zero.

In the long-run, however, Herbalife must comply with tough new restrictions on how it runs its business. After the FTC settlement was announced Ackman continued to argue that the company will soon collapse even if the feds don't order operations to cease.

"We expect 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," Pershing Squared said in a statement.

Although Herbalife's most prominent supporter, Carl Icahn--also an activist investor--declared immediately after the settlement was announced that the FTC "concluded that Herbalife is not a pyramid scheme," the truth is that the commission's allegations make it clear Herbalife's business tactics are largely identical to those of other companies that have been tarred with the label.

In a press conference Friday morning FTC Chairwoman Edith Ramirez said the FTC purposefully avoided using the term "pyramid scheme"  in order to reach a settlement with Herbalife and avoid protracted litigation with the company. By settling now the FTC could more quickly deliver restitution to individuals who invested money in Herbalife distributorships on the mistaken belief that they could earn a reasonable income selling the company's products and to force the company to restructure its business. She said people can draw their own conclusions about what Herbalife should be called.

Regarding Icahn's contention that the FTC concluded that Herbalife is not a pyramid scheme, Ramirez said, "I don't endorse that statement."

Under the terms of the settlement, Herbalife must revamp its compensation system so that it rewards sellers for retail sales to customers and end its current system of rewarding distributors primarily for recruiting new sales people. Compensation Herbalife pays to distributors must be based on retail sales that are tracked and verified. Furthermore, unless at least 80 percent of Herbalife's product sales are made to legitimate end-users rather than new sales recruits the company will have to reduce its rewards to distributors.  An independent monitor funded by Herbalife will oversee the company's compliance.

Although Icahn cited the settlement as a reason to increase his ownership limit from 25% to 34.99%, another multi-level marketer facing similar restrictions is fighting vehemently to escape them. In September a federal judge barred Vemma Nutrition Co. from paying commissions, recruiting new members, offering rewards for purchases and tying sales to multi-level marketing in response to an FTC lawsuit filed last month seeking to stop what the government says is an illegal pyramid scheme. That case remains in litigation.

The most prominent case against a multi-level marketing was brought by the FTC against Amway Corp. in the 1970s. In that case, the FTC actually did rule that Amway was not a pyramid scheme, but ordered Amway to cease price fixing and cease misrepresenting the apparent success achieved by the average distributor.

Many pyramid scheme cases have been fatal to the targeted companies. Fortune Hi-Tech Marketing (FHTM) multi-level marketer that recruited individuals to sell consumer goods and services was shut down in 2013. In 2007 BurnLounge, Inc., a multi-level marketing online music store ceased operations and was forced to return $1.9 million to people who had lost money getting into the business. 

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