FTC confirmed it was investigating Herbalife in 2014. The questions surrounding Herbalife’s business practices centered on whether the company’s business model constituted a legitimate network marketing company or an illegal pyramid scheme, as has been publicly (and loudly) claimed by investor Bill Ackman, who through his firm Pershing Square several years ago took a $1 billion short position on the company’s stock. Today’s settlement puts that question to rest—Herbalife is a legitimate business—but to get into FTC’s good graces the company agreed to make significant changes to the way it interacts with its distributors in addition to paying the $200 million to compensate distributors whom FTC claimed it defrauded.
You spin your way, I’ll spin mine
There was a markedly different spin on the import of the settlement from the two sides. FTC said that the company “deceived consumers into believing they could earn substantial money selling diet, nutritional supplement, and personal care products.” The agency went on to say that, “the multi-level marketing company’s compensation structure was unfair because it rewards distributors for recruiting others to join and purchase products in order to advance in the marketing program, rather than in response to actual retail demand for the product, causing substantial economic injury to many of its distributors.”
““This settlement will require Herbalife to fundamentally restructure its business so that participants are rewarded for what they sell, not how many people they recruit,” FTC Chairwoman Edith Ramirez said. “Herbalife is going to have to start operating legitimately, making only truthful claims about how much money its members are likely to make, and it will have to compensate consumers for the losses they have suffered as a result of what we charge are unfair and deceptive practices.”
But Herbalife CEO Michael Johnson saw things differently. In commenting on the FTC settlement and the resolution of a separate investigation by the Illinois Attorney General that included payment of an additional $3 million fine, Johnson said, “The settlements are an acknowledgment that our business model is sound and underscore our confidence in our ability to move forward successfully, otherwise we would not have agreed to the terms.”
Overselling the dream
FTC was critical of how Herbalife pitched its business opportunity to prospective distributors. Marketing materials for the company featured imagery such as people posed near luxury automobiles parked in front of mansions, and pictured people aboard cruise ships. FTC asserted that the messaging was essentially fraudulent. “Herbalife claims that people who participate can expect to quit their jobs, earn thousands of dollars a month, make a career-level income, or even get rich. But the truth, as alleged in the FTC complaint, is that the overwhelming majority of distributors who pursue the business opportunity earn little or no money,” the commission said.
The truth, FTC said, is something different. More than half of those distributors who qualified for compensation (known as ‘sales leaders’) in 2014 received $300 or less. FTC was also critical of Herbalife’s recent emphasis on Nutrition Clubs as a way for distributors to build their businesses (this is something Ackman has harped on, too). In this model, the distributor rents office space, often in storefronts, as a platform to attract new consumers and distributors. It hasn’t worked out well for most distributors, many of whom lacked the business experience to judge the costs and benefits of such a transaction, FTC alleged.
“According to a survey Herbalife itself conducted, which is described in the complaint, Nutrition Club owners spent an average of about $8,500 to open a club, and 57% of club owners reported making no profit or losing money,” the commission said.
Flattening the pyramid
The line that separates a legitimate network marketing company from a pyramid scheme is determined by whether the business exists as a way to sell a product or a service for which there is demand in the marketplace, or if it is simply a vehicle to sign up new members who would inject cash into the system by paying initiation fees, paying to participate in training events, buying large amounts of products, etc. FTC said that among the specific changes Herbalife has agreed to make that will bring them into compliance on this point are:
- The company will now differentiate between participants who join simply to buy products at a discount and those who join the business opportunity. “Discount buyers” will not be eligible to sell product or earn rewards.
- Multi-level compensation that business opportunity participants earn will be driven by retail sales. At least two-thirds of rewards paid by Herbalife to distributors must be based on retail sales of Herbalife products that are tracked and verified. No more than one-third of rewards can be based on other distributors’ limited personal consumption.
- Companywide, in order to pay compensation to distributors at current levels, at least 80% of Herbalife’s product sales must be comprised of sales to legitimate end-users. Otherwise, rewards to distributors must be reduced.
- Herbalife is prohibited from allowing participants to incur the expenses associated with leasing or purchasing premises for “Nutrition Clubs” or other business locations before completing their first year as a distributor and completing a business training program.
Cutting its losses
Herbalife characterized the decision as a way to cut its losses. It a statement it said it “believes that many of the allegations made by the FTC are factually incorrect, the Company believes settlement is in its best interest because the financial cost and distraction of protracted litigation would have been significant, and after more than two years of cooperating with the FTC's investigation, the Company simply wanted to move forward.”
Herbalife said it has created an oversight committee to monitor compliance with the agreement and has appointed appointed Jonathan Leibowitz, partner in the law firm of Davis, Polk and Wardell, and former Chairman of the Federal Trade Commission, as a senior advisor to the board. The company said it also foresees that the settlement will set a benchmark for best practices within the industry.
Shock waves
The decision is sure to send shock waves through the dietary supplement industry, where network marketing is approaching a 20% slice of the overall sales pie. Herbalife, founded in 1980, sells a wide variety of weight loss, sports and general health support supplements and meal replacements. The company, with more than $4.5 billion in annual revenue, is by far the biggest network marketing operation focused solely on nutritional products. Amway, by far the largest network marketing company in the world, derives a large amount of its revenue from its Nutrilite line of dietary supplements and other large players include Usana and Advocare.
But the end of the FTC affair was strongly welcomed by the market. News of the settlement sent Herbalife’s stock price soaring by more than 13% to $70 a share, before it retreated a bit to more than $66 a share. Still to come will be potential questions about Herbalife’s results and how the new accounting practices will affect stated revenue. Herbalife’s roller coaster stock market ride started in 2012 during an earnings call with analysts when activist investor David Einhorn asked a couple of pointed questions about how the company tracked sales between distributors and end users, an interaction that sent the company’s stock price reeling by more than 40% in one day. Ackman took his first short position on the company in the wake of that event.