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Pyramid or Brokerage Scheme? Herbalife vs. Bill Ackmaan

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By Aly Miller

Originally published in Food Politic

How did Herbalife, a company that sells nutrition and energy supplements, become the center of a rivalry between billionaires, and the subject of recent investigation by the Federal Trade Commission?

To start, Herbalife operates on a multilevel marketing structure of distributors -- over three million of them -- who try to sell their weight-loss products to other people, usually friends, who they might also recruit into salespeople. Other multilevel companies include The Pampered Chef, Avon products, and Juice Plus, another line of dietary supplements that generates controversial results. Herbalife's start-up cost ranges from $60 to $96, which is just below the $99 median start-up cost across the industry. The  $6.7 billion company grew especially fast in recent years, drawing the attention of hedge-fund investors like Bill Ackman.

For a long time, Ackman has been campaigning against them, believing them to be a pyramid scheme whose net worth is actually $0. In December of 2012, the billionaire investor presented a three-hour presentation supporting this belief. Ackman's one-year investigation led him to believe that the majority of distributors lose money, claiming that only one in five thousand actually make what the company advertises they will. The report was made public, and still exists alongside other reports at FactsAboutHerbalife.com. He has vigorously lobbied members of Congress to call for an investigation by the F.T.C., and in February, Senator Edward Markey from Massachusetts wrote to the SEC to complain that some of his constituents were losing money as distributors for the company.

Having bet $1 billion against them in December of 2012, he has personal and financial duties to see the company's stock fall. When brokers sell shorts, they borrow shares of stock and then sell them in the public market, anticipating that the shares will cost less to buy back in the future. If the share value does indeed drop, they will net a profit when they buy the same number of shares back. What's unique about this situation is that short sellers rarely believe to such an extent that the company is doing something wrong.  Ackman is essentially trying to profit off of his belief, which the FTC may or may not confirm, that Herbalife is a pyramid scheme.

By January 2, 2013, the stock rose in value and Ackman lost $400 - $500 million. Should Ackman profit in this high-staked game, he will donate his share of profits to charity.

Meanwhile, Herbalife's largest share-holder, billionaire investor Carl Icahn (whose net worth is more than Ackman's), is working to refute Ackman's arguments while buying more shares of Herbalife. He now has 17 million shares, at $58.03 a share as of today.  It's unclear whether he truly believes in Herbalife or whether he is just in it to compete with his billionaire rival. Since Icahn's public involvement, the Herbalife shares have gained greater value.

What makes an illegal pyramid scheme different from a multilevel marketing system is the mode through which people are compensated: through recruitment or sales. In a pyramid scheme, money is made through recruitment, at which point new salespeople are typically required to buy products that might be difficult to sell outside the network.

Ackman contends that the Herbalife operates in such a way. He claims that distributors, to make money, must recruit salespeople to sell the shakes and supplements who are encouraged to hire salespeople beneath them, so that the distributor at the top of the pyramid makes money off of every sale down at the bottom.

A multi-level marketing company, on the other hand, can prove itself legitimate if compensation is sales-based, showing real demand outside of the company for its products. In other words, investigators must find that Herbalife products matter, and are desired by outside consumers. And Herbalife, of course, argues that their products are very worthwhile. A recent report of theirs headlined that 3.3 percent of adults in the U.S. have purchased Herbalife products for personal use in the past three months.

Herbalife denies all pyramid scheme allegations, claiming that Ackman's attack was "malicious" one, based on "outdated, distorted and inaccurate information." They counter that many people join the company because they want discounts on the products.  It's up for the FTC to determine if that is a legitimate path of retail.

Over the past year, Herbalife has been hard at work proving itself legitimate. In June of 2013, one of their studies revealed that 87 percent of consumers responded that they did not purchase as a distributor. It's unclear whether they later became distributors themselves, but either way, it shows that the products are desirable, and points to the need of having an investigation led by outsiders. On their website,  Herbalife contends, however vaguely, "not only does Herbalife's compensation plan fail to reward mere recruitment, but its products are in fact sold broadly to non-distributor end-users as well as to distributors for personal consumption."

In the coming weeks, the FTC must determine whether Herbalife is a pyramid scheme by identifying who their customers actually are. Who buys more Herbalife products -- the public or insider distributors? Why aren't distributors making any money? Although there is not a legal definition for what this proportion should look like, their findings could influence how multi-level marketing companies operate in the future.

Stakes are high and the pressure is on, for both Ackman, and an increasing number of Herbalife protesters. In L.A. on Friday, while Herbalife hosted a sales event for thousands of Latino distributors, civil rights activists protested outside with signs with messages like "Making $ off the backs of Latinos!" Organizers were led by League of United Latin American Citizens (LULAC).  It's known that Ackman has paid civil rights organizations at least $130,000 to document who has been victimized by Herbalife, sending leads to regulators like the SEC and the FTC, and paying for their transportation to an anti-Herbalife rally in Washington. Wilkes, national executive director of the League of United Latin American Citizens, appears to believe just as strongly as Ackman, that Herbalife is a pyramid scheme, made apparent by LULAC's recent move in returning Ackman's $10,000 contribution to their campaign. Wilkes told The New York Times, "It's not the Latino groups that are helping Bill Ackman. Bill Ackman is helping the Latino groups. He has elevated this battle."

What began as a charged presentation of 350 slides against Herbalife is now an expansive lobbying campaign that is working now to incite anger and protests among Latino activists, further obscuring whether Ackman is right or wrong. His commitment to donate any profits to charity sounds like proof that his involvement comes from a personal, even ethical stance against illegal pyramid schemes.  From the start, he sided with families who were losing money at Herbalife. But even if he earns profits and donates, the members at Pershing Square Capital Management still keep profits to themselves; the power of his own company will further increase. Ackman is part of a large activist hedge fund whose only clear goal is profit, with whom regulators may or may not wish to side.

With all unknowns aside, Herbalife products are marketed to lower-income populations who might lack access to the key components of physical health: fresh produce and exercise. The very ability for products like these to be in demand shows the way that people in the U.S. approach food as fuel. The teas, extracts, and shakes, all relatively affordable at $1.17 a serving for a soy shake, all purportedly improve peoples' sense of well-being, which is important. But in that dependency, people grow less and less in touch with cancer-fighting and phytonutrient-rich fruits and vegetables. If Herbalife and its supplements disappear, people will seek other nutritional quick-fixes. With or without Herbalife, the underlying issue at hand is the hunger that Americans have for affordable, real, nutrient-dense food.

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