Court's ruling on illegal pyramid scheme turns spotlight on Herbalife

05-Jun-2014 - Last updated on 06-Jun-2014 at 16:43 GMT

Related tags Multi-level marketing Pyramid scheme

A recent ruling by an appellate court judging a multi-level marketing organization to be an illegal pyramid scheme puts the spotlight on the legality of network marketing companies active in the dietary supplement and nutrition businesses.

In the case of BurnLounge Inc. vs the US Federal Trade Commission, the Ninth District Court of Appeals the court ruled that BurnLounge was an illegal pyramid scheme by applying a metric laid out in a previous ruling, the so-called Omnitron test. BurnLounge operated from 2005 to 2007 and recruited participants to sell online music and related merchandise.

The Omnitron test of whether an MLM business in an illegal pyramind scheme consists of two considerations. In the court’s words: “a pyramid scheme is ‘characterized by the payment by participants of money to the company in return for which they receive (1) the right to sell a product and (2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of the product to ultimate users.’ Not all MLM businesses are illegal pyramid schemes. To determine whether a MLM business is a pyramid, a court must look at how the MLM business operates in practice.”

Paying for recruitment

The court ruled that BurnLounge’s business model was based primarily on recruiting new members and getting them to purchase ‘packages’ that started at about $30 and ranged up to several hundred dollars. In return, participants could set up their own web pages to sell music and merchandise. This constituted one prong of the argument, that is that BurnLounge partipants had to pay for the priviledge of selling a product. Another prong is that users had to pay to receive higher commissions on the recruitment of new members, and this promotion of the scheme as opposed to the retail product (in this case the music and related merchandise) fulfilled the second prong of the Omnitrition test. Indeed, after a preliminary injuction prevented BurnLounge from requiring the purchase of packages to earn commissions on recruitment, revenues for the company basically vanished, meaning very little actual music and related merchandise was being sold.

How this relates to the biggest network markeing company solely in the nutrition business, Herbalife, is a matter of conjecture. (Other large network marketing companies active in the sector include Amway, Usana and MonaVie.) Herbalife has been under extreme pressure in the financial markets for several years, as activist investor Bill Ackman, a principal in the firm Pershing Square, has taken a huge short position on the company’s stock, a position valued at times up to $1 billion. Ackman is betting that the current FTC (and a reported FBI) investigation into Herbalife will result in a similar outcome to BurnLounge.

Herbalife rejects comparison

Herbalife has countered these claims on several fronts. First, the company asserts that pyramid schemes by their nature are ephemeral, and Herbalife has been in business and growing for decades. Second, while it is true that Herbalife requires new distributors to purchase a kit to start their businesses, the compensation structure is weighted toward the sales of products, not the recruitment of new distributors. After Ackman’s initial attack, Herbalife made changes to the way it refers to distributors in an attempt to differentiate between sales associates pursuing a busniness opportiunity and people who enrolled simlply to get ‘discounts.’ (How much product is sold at the theoretical asking price is unclear.) The company halted the practice by one of its highest-profile sales leaders of selling leads to the members of his sales network, a practice that presumably could have been viewed as fulfilling the second prong of the Omnitron test. Herbalife also adopted at that time a mantra of referring to the ‘daily consumption’ of its meal replacement shakes and supplement products as the core of its business model, emphasizng that the sale of products to end users was the overriding goal of the company.

“It’s an issue of concern with all MLMas. The core of concern in a Ponzi scheme is that the company always makes money but not so most of the members if they have to rely on recruitment and not sales,” said Marc Ullman, an attorney with the firm Ullman, Shapiro & Ullman.

“It can be tricky because the very nature of an MLM means you are recruiting people. People using this business model must be very vigilant and there are experts who work with MLMs to make sure they address these concerns.

“Whether these questions about Herbalife have any merit it is simply a result of all the noise that Ackman has made is something we don’t know. Herbalife tends to be a very careful company in my experience,” he said.

Herbalife has had no trouble selling its products. The company's troubles on the stock market and with the FTC have not affected the company’s growth or profitability. Herbalife reported sales of $1.3 billion in its first quarter 2014 earnings statement, which represented a 12% year-over-year growth.

Outside of those developments, Herbalife has maintained a strict silence on the subject of its regulatory challenges. “We do not intend to make any additional comments regarding any of these matters unless and until there are material development,” CEO Michael Johnson said during a recent earnings call with analysts.