• Just prior to the Herbalife (HLF) earnings there was an FTC Panel discussion on "Fraud Affects Every Community."
• In the first FTC Fraud forum on 10/29, the SEC announced the formation of a new anti-pyramid scheme task force.
• An announcement of a (likely) settlement in the Dana Bostick class-action provided merely some dead-cat bounce ahead of earnings.
• Deterioration at AVON (AVP) further suggests that the MLM model is cannibalizing their business.
• There are growing signs of community action against Herbalife and other MLM companies.

The Herbalife earnings release is behind us, and it wasn't pretty, though the eternally bullish John Hempton, he of "They are scumbags, but they're my scumbags," manages to find something to like. Then again, he also opined on Skype that night that the first acts of the new SEC anti-pyramid task force and the FTC's "Fraud Affects Every Community" road show would be to let Herbalife off the hook. Unlikely.

Meanwhile, the settlement in the Bostick class-action provided a little bit of dead-cat bounce on the day before earnings, but is now causing protests, including from LULAC (League of United Latin American Citizens), and could yet come unraveled, while another class action suit may be taking shape.

The company's inconsistent and presumptuous discussion of settlements with the FTC sound increasingly hollow, as Matt Stewart has argued here, where he points out four very different comments from the company about the likelihood of a settlement with the FTC. More recently, some have thought those statements were intended to press for a settlement in the Bostick class-action. Meanwhile CFO John DeSimone clarified in interviews that there was no new news in those reports, that they were merely reiterations of the company's position that they expect to be substantially exonerated.

Meanwhile, my interest in MLM in general and Herbalife (HLF) in particular, led me to send in the following question to the FTC panel on 10/29, about How Fraud Affects Communities (slightly edited):

I would like to ask the panel: Why can't FTC issue clearer guidelines about pyramid schemes? After all, prosecutable or not, every MLM is a pyramid scheme, because they all sacrifice retail to recruiting by design. The question of whether or not they are technically legal or illegal is of academic interest only to consumers. The fact is that in all cases the probabilities are hugely stacked against consumers. There is a reason why the SBA won't finance MLM-based business plans. What can be done to clear up the information, and make it more relevant to consumers?

In all, it pays to realize that what we are looking at is not so much a business problem, as it is a law enforcement problem, and thirty-five years of failure to enforce the anti-pyramid laws have resulted in people thinking MLM is a legitimate form of product distribution. At the same time this presumption of normalcy by a large group of people results in extreme abuses, and it seems Herbalife maybe the biggest target, in part because it is public, and Pershing Square took aim at it, but Vemma is bringing up the rear. Vemma's recruiting is increasingly causing mayhem in the millennial generation, and reports from college campuses are ugly, leading to bans on some campuses. It was already banned in Italy on a pyramid charge. This devastation is also coming to the attention of the FTC. 

The resistance to Herbalife has been organized slowly but surely, and it should be noted that LULAC president Brent Wilkes was on the FTC's panel on Fraud Affects Every Community. LULAC has been a prominent voice against the devastation that Herbalife has brought to the Hispanic community, and various other Hispanic organizations are joined in the fight. In New York City, City Council speaker Melissa Mark-Viverito, State Senator Adriano Espaillat, and Council members Julissa Ferrero and Annabel Palma have been vocal in supporting a probe by the AG. With Vemma, college presidents and disenchanted millennials can be counted on to be very vocal about their loss-making experiences, and file lots of complaints. I recently met a young economics student who is trying to make a movie about the whole MLM phenomenon, and Vemma was his biggest inspiration.

What the Earnings Release means

The Venezuelan problem is now fifty percent accounted for by shifting to the Sicad II rates, which is used in most other financial reports at the moment, at 50 Bolivars to the Dollar, and at least defensible for now, but still likely to have to be revisited as the deterioration in that country continues - the "street" exchange rates are more like 100 Bolivars to the Dollar, and there is no assurance Herbalife can actually repatriate moneys at the Sicad II rates. While John Hempton's analysis rationalizes that the YOY volume growth is not that bad, Matt Stewart dives deeper, and observes that the YOY rate of growth (recruiting trends) is negative in all markets except EMEA. And the marginal rate of growth is everything, for it tells us the growth trends, or in this case mostly shrinkage, a negative.

There were the usual objections on Twitter that the "saturation" theory is hard to prove, but the epidemiological model of Kay Herbert suggests otherwise, and John Hempton's look-back at growth in 2011, contrary to his intention, suggests indeed that we have seen the top. In short, with the underlying data suggesting long term deterioration, the revised outlook the management is offering for the full year and 2015 are likely optimistic, even aside from the almost binary possibilities on the regulatory front.

The outcomes there are likely between some kind of settlement that includes changes to the business model, likely to cause a slow death, or a criminal prosecution and a complete shutdown . Total exoneration seems a highly improbable outcome, resting on an assumption that American regulators are forever toothless. How all of this is reflected in the price is always a tricky argument, but ignoring it is not an option, and the 92% drop in earnings is an important warning, even if some of the adjustments are arguably of a "one time nature."

Community Action against HLF

Quite in line with my question to the FTC panel above, here is an example of grassroots action against Herbalife from Lawnsdale, IL, and there is more going on just like this. The FTC panel on 10/29 (for the full video see here) focuses on how communities are affected by fraud. The FTC is taking it on the road. Perhaps the most significant part of that news was the announcement of a new Pyramid Task Force at the SEC, perhaps the first sign of a change of course.

Personally, I am finding in my local community in the Bronx that the level of fatigue, disenchantment and disgust with the persistent lack of prosecutions and enforcement actions are mounting. In a community with many ethnicities, the evidence of affinity fraud is unmistakable, and when one of these MLM hurricanes passes through, you are left whole groups of people who collectively lose prodigious amounts of money.

Hiding behind the law

While the government has not helped by continuing to foster the fallacy that there is such a thing as a "legitimate MLM," even though the things MLMs do are illegal, the companies, Herbalife included, are doing their own thing, pretending to be legal as long as they have not been prosecuted. In the memorable words of John DeSimone, they have full confidence in their business model, even though it was only theoretically legitimized by the Amway case in '79, because de facto MLM companies, Herbalife included are not living up to the requirements, particularly the 10 customer rule, for the simple reason that their business models are designed for recruiting, not retailing.

For the everyday person, and Herbalife's prospective customers, it remains a confusing situation, and the persistent lack of enforcement has seemed to legitimize obviously illegal business practices. MLM is designed to recruit, and there is no such thing (stipulated in the Bostick settlement) as "discouraging recruiting." Limitless recruiting is the DNA of MLM, that is where the money is, and it inevitably results in too many retail distributors chasing a dwindling prospect set, resulting in disappearing retail margins, or even outright giving away of product as free samples to try and recruit people (see below).

Then there is currently a new wave of new MLMs that are attacking the advance fee fraud feature of MLM, and making it seem as if removing that element solves the problem. I myself thought for a long time that this model had to be legal because it seemed totally innocuous. After all, how can you lose the money you don't invest? But the truth is that the constant income misrepresentations that are used to promote these schemes induce people to over-invest time, effort, money and their good name.

The extra fees that some of them charge just add insult to injury, and are a cheap way of financing that does an end-run around the securities laws, and perhaps franchise laws. After all, if you know statistically that 9 out of 10 people will quit, even in the case of Herbalife with merely a $59 to $95 cost to join, the company raises $600 to $1,000 up front or every "successful" member (who stays at least one year). In the current quarter Herbalife's attrition was 100%. Some companies have $500 to $1,500 of first year fees, or even more. This gives a graphic insight into an industry that thrives on the losses of others that are extracted under false pretenses. Bill Ackman's use of the term "predator" for Michael Johnson was well chosen, and it is true of all MLM, not just Herbalife.

Part of the changes in the industry is that free "preferred customer" programs are becoming the norm, and Herbalife's method of signing everyone up as a distributor for $59 or $95, and then simply treating the 70+% of inactives as discount buyers, and re-labeling them as "members," not distributors, even if they have paid the fee and signed the agreement, appears dubious going forward. Regulators may take issue, but also, their existing or prospective distributors could move to other programs that offer these free preferred customers programs.

In short, for a business that makes such a big deal about being "legal," it is very interesting to note that so many companies make such an effort to hide their MLM-nature. They are "not like Amway," "not like that company where you can't say the name" (still Amway), "not one of them pyramids," an "affiliate company" (Vemma), or even "a product broker" (MarketAmerica), "not like that last company (fill in the most recent case) that was shut down," or even "not MLM" - anything to continue the same thing by a different name while deflecting the negative image of MLM.

Profits from failure as the epidemic rages on
The sad fact is that the constant churn of distributors is not just a financial statistic (this quarter 540K coming and going, for a net growth of zero), but actually a clue to the fact that the company makes money from failure, which alone dooms the company itself to failure in the end. Interestingly, in a recent article on Herbalife competitor Vemma in Rolling Stone, one of the "leaders" in that business says exactly that: "People have to fail for us to make a profit."

Kay Herbert has proposed an epidemological model to understand the "pop and drop" phenomenon of MLM, and not only does this explain why most people lose money, but also why in the end companies are unstable and burn out. Granted, the Amways of the world have managed to hang in there for a long time, but the trend of MLMs to sell more and more products is not sustainable. There is no future in which we're all paying three or four times as much for our groceries for no reason. 

What makes detection harder, and allows the casual observer to think that MLM companies are real businesses, is that there is not just one "pop and drop," but many, depending on the number of products and markets that can foster the illusion of a viable business. Think of the "drop" and the "pop" of Anthony Powell moving from Herbalife to Vemma, bringing in up to 16,000 of his HLF downline. And there was another big player in Malaysia doing the same this year, moving from Herbalife to some other company. All of which led me to an earlier observation of the widely dispersed pattern of gradual failure in MLM, which I labeled the "fractal nature of failure." In short, the end is a scorched earth situation, similar to over-fishing, for the recruiting incentives drive sales to levels far above what is sustainable, until at least some people start to realize they are losing money and begin to quit. Moreover, the sheer number of MLM companies are adding to MLM-fatigue in the population.

Graft and Corruption are right around the corner

Recently, the New York Times did a major piece on increased lobbying of state Attorneys General, and the connection of New York AG Eric Schneiderman to his ex-wife, an Herbalife lobbyist were prominently featured. The alarms should be going off about the potential damage if he should even think of dropping the ball on Herbalife. The situation is not easy for a state prosecutor, given that the federal government has been so ambivalent about the business of financial fraud and illegal pyramids, and that the official 'advice' constantly keeps the door open as to MLM being legal in any form. This may be changing as evidenced by the new initiatives at FTC and SEC.

Still, the truth is that the visibility of the Herbalife situation makes it impossible to ignore, and the idea that it would get shuffled under the rug is only slightly more attractive than walking through a minefield for someone in AG Eric Schneiderman's position. The truth is and remains that the fundamental design of MLM is to reward recruiting over retailing, which will always mean that the retailers are thrown to the wolves, the retail "opportunity" exists in name only, and the mass promoters/recruiters win. Therefore, the economic reality is that every MLM program is a pyramid scheme, regardless of how easy or hard it may be under current law to shut them down. Selling a product was never the purpose, money transfer was - the product is just the means of doing it and maintain an appearance of legality. That much is not a matter of interpretation, but of sheer economics, and pyramid schemes are illegal, the legal process will always need to base itself on the underlying economic facts.

We may take note of the history of the S&L scandal, and William K. Black's book The Best Way to Rob a Bank is to Own One, is recommended reading. The fact is that the legal and regulatory skirmishes happened ahead of the issue, which was not really dealt with by regulation, but driven by the tsunami of fraud that was happening, making it unavoidable to deal with it. We've seen the same with Herbalife, lots of arguing about case law has taken place, but now the population is showing scam-fatigue, and regulators are starting to pay attention. As Tip O'Neill used to say, in the end all politics are local, and right now it's the local politicians who are giving voice to the complaints.

The main stream press continues to miss the boat

The mainstream media have been largely absent from this situation which is potentially larger than the S&L scandal, and with as much or more political intrigue. Similar to S&L, the current skirmishes only seem to be about legalities, and what case law does or does not say. Ultimately however the real iceberg is the underlying economics of MLM, which has to be dealt with now or later. Thirty-five years of FTC failures to enforce existing laws has resulted in a mushroom cloud of white collar fraud, in which increasingly people get caught up unawares, because they assume this is all normal, and they don't know the law. Ignorance of the law was never an excuse, a pyramid scheme by any other name, including MLM, is still a pyramid scheme.

Recent coverage by Al Jazeera on MLM was brilliant, ground breaking stuff, and now Rolling Stone has followed up with a piece that likewise is totally ground breaking, while the main stream media stand by lead-footed. Any coverage there has been has been totally inane. A choice quote from one of the main Vemma leaders quoted in the Rolling Stone article:

"Did you see what the president of Amway said the other day?" Everyone shakes their heads no. "He said, 'Right now is the scariest time ever to be in our business.' People in my hometown think I'm Bernie Madoff."

and in the same article, complete with a prize quote from an anonymous FTC staffer:

Herbalife is the regulator's biggest target since a case was brought against Amway nearly 40 years ago. "People wonder how Amway and Herbalife can be in business for 30 years," says one agency lifer. "There's one answer: The FTC hasn't done its f'ing job."

There are a lot of reasons why it may not be just sword rattling we're seeing from the agencies. There may be a real regime change going on. There are noises in the press of "undue influence" of Bill Ackman, for drawing attention to what he believes is a pyramid scheme of epic proportions, but that seems rooted in the belief that short-selling is the root of all evil. Perhaps these reports would like to stop this type of law enforcement altogether, in order to permit the uncontrolled looting of the population, but in the real world there are increasing signs we may finally see action. For contrast listen to this interview with Robert L. FitzPatrick.

Meanwhile, the Rolling Stone article also makes mention of Vemma's introduction of some cosmetic changes, resulting from which they now portray themselves as yet another not-MLM MLM, or as company founder, B.K. Boryeko puts it: "We want to stay off the regulator's radar, because they're the guys with guns." In the meantime the realities of Vemma seem to be that they are triggering more complaints than Herbalife, and exploding the need for change. At the time when B.K. Boryeko first made that statement, I was speaking with Rod Cook, who is a well known consultant in the MLM-world, and told him that the man just painted a huge bull's eye on his chest for the FTC to aim at. By all appearances, the FTC may be getting ready to take aim.

Avon (AVP) may be making the case for us

As Robert FitzPatrick has noted in an article on Avon, in its current form it's not that different from Herbalife, and contrary to the intentions of Andrea Jung, switching to MLM in 2005 has not stemmed their decline. Indeed, the latest earnings show further decline, which only makes sense once you understand that the MLM model cannibalizes their existing direct-sales business model, and throws the retail sellers under a bus. After all, the constant recruiting will eventually destroy the business of the Avon lady - if you don't recruit your customers, somebody else will. Notice also that in the Vemma article in Rolling Stone quoted above, the "leaders" are giving away product. They don't even bother to try and sell it, making a joke of the retail "opportunity." Recruiting is the ONLY point, so what if you have to give away the product, that's just a cost of doing business.

More analysis of how the MLM model is cannibalizing Avon's basic business, and worsening their problems instead of solving them, is definitely in order. One could hope that with the departure of Andrea Jung, and the company's recent decision to leave the DSA, evidently for being a tyranny of the lowest common denominator, they set the first step to addressing the real issues. Now they need to recognized that MLM was the problem and not the solution. The winners will be the companies that successfully evolve the direct sales model into the Internet age, and MLM is not the answer. There is a place for the joining of skill, know-how and product sales, and the Internet can be a great way to empower that type of economically productive activity, it may be time to bring the Avon lady back.

In fact, Avon may have a wonderful opportunity now to put the whole MLM experience behind it, and re-launch with an improved version of its original business model, just in time when a ton of NuSkin and other ex-MLMers will be scrambling for a good home. If they can figure that move out, they did not leave the DSA for naught. All it takes is a few people on their board with enough sense of economics to understand that the MLM program will continue to decimate their existing business and muddy their reputation.

USANA is not the answer either

As far as public MLMs go, NuSkin (NUS) has had its own problems, but USANA (USNA) has seemed to be the shining star of the sector, but all may not be as it appears. Certainly there is plenty of information on the specifics of USANA for those who bother to look, and the pyramid issue is the most important one.

Ralph Cramden can safely retire

Yes, Alice, there is a Santa Claus, and I've joined an MLM - you could almost hear him say it. Maybe Ralph wanted to lose some weight. Some companies pay salaries, and there is a place for commission sales in some industries, but the realities of the MLM model are that the overwhelming majority lose money. It is not a model where you start out making small money and build up over time. No, in MLM you swim under water for a long time before you make any money - hence the statistic that 99% fail. And people won't continue to work for the song and dance that is invariable misrepresented in "opportunity meetings." They are becoming the butt of jokes. The whole model focuses on misrepresenting the possible as the probable, and exaggerates earnings (of the few "leaders" who act as shills), and ignores or denies expenses of time, money, effort and reputation. This is readily evident in the newest wave of deceptions and dissimilations that pretend that the up-front fees are the only problem. The MLM-concept itself is the problem, and there is nothing you can do to fix it and make it a legitimate business model, because it is an economic and mathematical fallacy. The advance fee scam is just the icing on the cake for many companies, but it is not necessary to create the false promises that appeal to people's gambling instincts, not productive entrepreneurial instincts.

Conclusion: Economic realities will win in the end

Much like the economic realities forced action in the S&L scandal, and the actual failure of Madoff's Ponzi scheme forced the SEC to show up, so also arguing the case law relating to MLM is less relevant than the economic realities which will force change. In short, arguing the twists and turns of case law has its limits, broadly MLM hangs by a thread in the form of the '79 Amway ruling, with which no company complies anyway.

1. Herbalife is now having to reflect the underlying business deterioration in its reporting, and as noted, the trends suggest downward revisions of forward guidance are more likely than positive surprises. The economic forces at work are inescapable. Moreover saturation is an industry phenomenon, as the research of Prof. William Keep and Dr. Peter vanderNat has shown - increasing numbers of MLM participants are chasing dwindling MLM dollars.
2. It is a fact of simple economics that MLM is based on a fallacy, and creates an unsustainable model that consists of a series of feeding frenzies, that can only lead to the now well known "pop and drop," growth spurts, but not a sustained business. It all boils down to a deliberate overcrowding of "distributors," and a massive channel conflict, which results in retail margins going to zero, thus exposing the underlying pyramid scheme. Recent actions by Amway, Tupperware, Herbalife, and Oriflame to control "rogue sales," demonstrate that fact. Again, economic realities will prevail. 
3. A third issue is that the proliferation of MLM companies is such that Herbalife's attrition can only worsen, for assuming no regulatory action people will leave when the grass seems greener on the other side of the fence.

Eventually therefore, the model will self-destruct, and even if the regulators continue to do nothing, the business model is not viable in the long run, not least because the population is becoming smarter about these frauds, and communities are starting to organize, if nothing else because there are too many of these programs. It's fraud of the week time, and people aren't buying it any longer. Educated consumers in this case will not be the best customers. They will run for the hills. The slide continued overnight after the earnings release, with the stock opening up 14% below the last pre-earnings release close, and closing 21% down on the first full day of trading after ER. For Herbalife the time has come for the dumb money to leave.