Pyramid Schemes Are Illegal... but Herbalife's Still at It 

HerbalifeHerbalife is back in the news again...

On Nov. 7, comedian and HBO's "Last Week Tonight" host John Oliver went after its uncanny resemblance to a pyramid scheme.

We last wrote about Herbalife Ltd. (NYSE: HLF) back on Aug. 14, 2014, when we noted that activist investor Bill Ackman "was going to deliver a 'deathblow' to the company with a presentation on HLF's predatory business model."

Not much has changed since then...

What Is a Pyramid Scheme?

It's called a pyramid scheme quite aptly -- when you visualize the scam, it is structured like a pyramid...

The founder of the scam, called the "initial recruiter," sits atop the pyramid. The initial recruiter then drafts a second person. This person is required to "invest" a certain amount, which is paid to the initial recruiter. In order to make his or her money back, the second person must then, you guessed it, draft more people... and so on.

This process is repeated as new recruits pay the people who recruited them, the base of the pyramid growing larger and larger.

Must Read: What is a Ponzi scheme? Click here for our infographic...

As the Federal Trade Commission (FTC) states, "they [pyramid schemers] promise consumers or investors large profits based primarily on recruiting others to join their program, not based on profits from any real investments or real sale of goods to the public."

That seems to be how Herbalife operates...

What Is Herbalife?

Herbalife develops, markets, and sells supplements for nutrition, weight management, sports nutrition, along with other personal care products. Current CEO Michael Johnson is poised to step down from his position in June 2017; he's to be succeeded by COO Richard Goudis. Under Johnson's 13-year leadership, HLF saw annual net sales more than quadruple to $4.5 billion as it expanded operations around the world.

The announcement to transition Goudis into the CEO position came on Nov. 1, 2016 -- the same day the company reported Q3 profits fell 6% to $87.7 million, or $1.01 a share. And four months earlier, Herbalife paid a $200 million settlement to federal regulators due to allegations of being a pyramid scheme.

But even post-settlement, Herbalife's still at it. Here's how the company has been able to remain in operation so far -- despite its questionable practices and a clash with the feds...

Here's How Herbalife Remained in Operation Despite Its Pyramid-Like System

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Herbalife is considered to be a "multilevel marketing company" (MLM). According to the FTC, MLMs "have real products to sell... they sell their product to members of the general public... [employees are] paid for retail sales, not for new recruits." Meaning the distinction between a pyramid scheme and an MLM is the ability to sell a product -- and not recruitment.

For instance, an MLM might have a line of products that are inexpensive to produce in mass amounts; it then promotes employees based on monthly sales figures. In contrast, a pyramid scheme will have fantastical promises about revolutionizing an industry or introducing a "miracle product" -- and a business model that emphasizes the process of recruitment and promotion over the actual sale of a product.

What's suspicious about HLF -- and what's caused people like Bill Ackman and John Oliver to criticize the company - is the way the company makes its sales.

As we mentioned, in July 2016 the FTC filed a complaint against Herbalife. As John Oliver put it, the complaint "walked right up to the line of calling it [Herbalife] a pyramid scheme."

The complaint stated Herbalife's "compensation program incentivizes not retail sales, but the recruiting of additional participants who will fuel the enterprise by making wholesale purchase of products."

This means Herbalife sold its products within the company, which looks like this:

pyramid scheme herbalife

As a result of the FTC settlement, Herbalife promised to "revamp its compensation system so that it rewards retail sales to customers and eliminates the incentives in its currency system that reward distributors primarily for recruiting. [The FTC settlement] mandates a new compensation structure in which success depends on whether participants sell Herbalife products, not on where they buy products."

Per the settlement, within a 10-month period that began tolling in July, the company must have:

  • At least two-thirds of its rewards paid to distributors be based on retail sales that are tracked and verified by an Independent Compliance Auditor that will report to the FTC
  • At least 80% of its product sales be comprised of sales to legitimate end-users. Otherwise, rewards to distributors must be reduced

Under the new FTC restrictions, Herbalife's future is uncertain, since distributors are now being forced to make a majority of their money from "legitimate end users." Whether it can stay in business with the forced change to its business model remains to be seen...

Herbalife stock currently trades at $52.26 per share. It's lost 2.46% so far in 2016 and 11.42% since the FTC settlement in July:

To get more up to date news on the suspicious things companies do, follow us at @moneymorning or on Facebook.

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