Editorial: Building Pyramids
As Wall Street theater goes, hedge-fund manager Bill Ackman’s broadside last month aimed at Herbalife Ltd. was about as entertaining as it gets.
Herbalife, a seller of fitness and weight-loss supplements, is a pyramid scheme, Ackman claimed in a three-hour PowerPoint presentation. The bulk of its revenue, he said, comes from customers who pay to join the Herbalife marketing network along with the supplies they are obligated to buy. When the company runs out of people willing to become distributors, he argued, it will fail. Herbalife is telling investors that Ackman doesn’t know what he’s talking about. Other investors are betting against Ackman.
The real issue is why there’s a debate in the first place. For that, we can thank the Federal Trade Commission, which for three decades has punted on regulating businesses known as multilevel marketers.
Companies such as Herbalife, Amway Corp., Nu Skin Enterprise Inc. and hundreds of others don’t necessarily deserve to be lumped together with the likes of Bernard Madoff. Madoff’s operation was a Ponzi scheme, plain and simple: Early investors were paid outsized returns from the money of later investors. When the pipeline of new customers dried up, the edifice collapsed. Multilevel marketers start with a product, whether beauty aids, home decorations or, in the case of Herbalife, vitamins and dietary aids. Distributors make money both by selling products to consumers and by receiving commissions based on sales by the other distributors they recruit — often friends and family.
These commissions are the main reason so many multilevel marketers tout themselves as “unlimited business opportunities,” or words to that effect. The more distributors there are in a network, the more money those higher up the chain can make in the form of commissions.
Those at the very top — usually the founders — can make millions. Most of those further down don’t fare so well. The industry doesn’t supply estimates, but Jon Taylor, a consumer advocate, says he has studied roughly 500 multilevel marketers and estimates that 99 percent of participants lose money.
So what distinguishes a legitimate company from a pyramid scheme? In a 1979 administrative ruling that has guided much of the FTC’s subsequent enforcement and regulatory actions, the agency said only companies that pay for recruiting new distributors are illegal scams. To avoid getting tagged as an outlaw, the FTC said, a company also must prove that the majority of its sales consists of products sold to consumers outside the network and that each distributor makes 10 verifiable sales a month to such consumers.
One hitch: Companies often don’t bother with the required documentation, and the FTC doesn’t do the needed checking.
The agency seems to lack the will even to try. Figuring out if a company is a pyramid “entails a complex economic analysis,” according to a 2010 FTC staff report. “There is no bright-line disclosure that would help consumers identify a fraudulent pyramid scheme.”
After thus throwing up its hands, the agency exempted the industry from disclosures that might help consumers better discern the line between legitimate and shady operators.
That was a serious mistake. The agency should require multilevel marketers to say how long the average distributor stays in a network, how much distributors earn on average after expenses, and the status of any lawsuits that distributors file against the company.
As for Ackman, he said the stock will fall to zero and has sold Herbalife’s shares short, a way to profit should the stock decline. His bet seems to be based on the assumption that the 32-year-old company will soon either be shut by the FTC or will run out of potential new distributors.
A quick check of Herbalife’s financial statements, however, shows that as of last year it operated in 79 countries. Its biggest markets now are China and other Asia-Pacific countries. No shortage of opportunities for growth there.
As for the FTC, its job should be to ensure that consumers have access to the information they need to make smart decisions. That may not aid Ackman’s cause or Herbalife’s. But at least it might help those who join a multilevel marketer to understand why the promised riches always seem just out of reach.