Is Herbalife a Pyramid Scheme? Investigation Continues

Herbalife Ltd., a multilevel marketing business that sells weight management products, agreed last week to pay $15 million to settle a class action lawsuit alleging it operated an illegal pyramid scheme. While Herbalife denied any wrongdoing and agreed to settle the case to “put it behind” them, the class action – filed by a former distributor – is the least of its worries.

For the past several months, Herbalife has faced allegations from Pershing Square Capital Management CEO Bill Ackman that the company is nothing more than a giant pyramid scheme doomed to fail. Ackman’s so convinced, in fact, that he’s placing millions of his own money on the line, betting that a Federal Trade Commission investigation will find Herbalife guilty of unfair or deceptive business practices and reduce the value of the company’s shares to $0. In a dramatic twist, long-time rival to Ackman, investor Carl Icahn, has made an opposing bet by going long the company’s stock and publicly backing Herbalife, setting the stage for an expensive and epic showdown between two billionaires, with Herbalife – and its status as a legitimate company – as the prize.

First - What’s a Pyramid Scheme?

Good question – but the answer’s a little tricky. On the face of it, a pyramid scheme is an illegal business that recruits salespeople to sell a particular product, but requires that they buy the product in bulk using their own money. Individuals can then encourage others to join the company, selling the products “down” to those salespeople while also taking a cut of any sales made by the new recruits. The pyramid grows as more and more people join, with money moving up through the levels. The problem is that, rather than selling to end-users (customers with no link to the company), pyramid schemes encourage you to sell the products to other salespeople, who can re-sell it to another salesperson, and so on and so forth. Pyramid schemes are doomed to collapse as soon as the newest recruits are unable to find enough new salespeople, causing the money to dry up and no one left who actually wants to buy the goods. A pyramid can then collapse, with everyone losing money except for those at the very top.

It seems simple, but pyramid schemes are just one form of multilevel marketing, which isn’t itself an illegal way to run a business. Legitimate multilevel marketing companies include Avon Products and Mary Kay – and the important fact here is that the company makes more money by selling its products to the public than it does from selling products to new recruits, who in turn have to re-sell everything they buy. The Federal Trade Commission (FTC) puts it like this:

“If the money you make is based on your sales to the public, it may be a legitimate multilevel marketing plan. If the money you make is based on the number of people you recruit and your sales to them, it’s not. It's a pyramid scheme. Pyramid schemes are illegal, and the vast majority of participants lose money.”

So, Is Herbalife a Pyramid Scheme or Not?

Right now, the answer’s a bit unclear. The Federal Trade Commission defines a pyramid scheme as a multilevel marketing program in which income is based on recruitment rather than sales of a product to the public. In its guide to the telltale signs of a pyramid scheme, however, even the FTC acknowledges that there’s no black and white way to tell at a glance whether a company is operating an illegal scheme or a viable multilevel marketing program (defined somewhat generally as a business in which “individuals sell products to the public — often by word of mouth and direct sales.”)

Herbalife – which recruits salespeople to sell its weight management products – has so far managed to avoid prosecution, but the FTC’s investigation is not yet complete. According to an article published by Fox Business in October 2014, Herbalife bosses are confident the company will survive the investigation, but do expect some disciplinary action. The FTC won’t comment on ongoing investigations, but previous investigations into questionable companies have ended with total shutdowns. Whether Herbalife survives may come down to whether it can show that the majority of sales are to genuine customers, rather than just other salespeople recruited to keep the company going.

What About Bill Ackman and Carl Icahn Fighting over the Stock? What’s That About?

This is where Herbalife’s FTC investigation, class action settlement and financial security gets a bit more complicated. Herbalife has divided investors, who can’t seem to decide if it’s a pyramid scheme or not. Bill Ackman, a hedge fund manager with serious financial clout, is convinced the company is illegal and doomed to fail and, to back up his claim, he’s committed a staggering $1 billion to short Herbalife stock – meaning he stands to make money as long as the stock value goes down, but would lose it if the company survives. Not one to do things half-heartedly, Ackman has been outspoken about his conviction that he can short Herbalife’s stock all the way to $0, even giving a 342-slide presentation to support his claims.

Not everyone agrees. A number of hedge fund managers have since gone long on Herbalife stock – betting, essentially, that the company will survive and the stock will rise. Carl Icahn, a long-time rival of Ackman, is on this side of the bet and is predicting that Ackman will lose his money when the FTC allows Herbalife to continue doing business.

If nothing else, this is all a sign of how hard is can be to prove beyond any doubt when a company is operating as a pyramid scheme.

So, What Happens Now?

Herbalife’s stock has been volatile, and those betting against the company have made money this year, as the company’s stock has dropped from a high of $83 to approximately $40 a share. There aren’t any settlement negotiations between the company and federal regulators, meaning we have no clear picture of when the FTC investigation will conclude. Some commentators have suggested that the length of the investigation – it first started in March – is a sign that Herbalife will survive, citing the FTC’s record of acting quickly to shut down illegal companies. Others have suggested that sanctions and fines could hit Herbalife even if the FTC chooses not to rule on whether it’s a pyramid scheme or not. The $15 million class action settlement was sought on behalf of a class made up of individuals who claim they were injured by participating in the company’s scheme, and last year U.S. District Judge Beverly Reid O’Connell refused to toss the case, finding that Herbalife’s business model did fit the definition of a pyramid scheme submitted to the court.

If you’re ever worried about a business operating as a pyramid scheme, the FTC encourages you to ask questions and exercise doubt. It’s easy to confuse a genuine business with one that will lose you money – and, as you can see, sometimes even regulators have a hard time telling the two apart. If something seems too good to be true, in the end, it probably is.