Business June 2014

Is Herbalife a Pyramid Scheme?

Wall Street’s $6 billion mystery: Big investors are making opposite bets about the company’s future.
Richard Drew/AP

Is Herbalife, the global nutrition company, a pyramid scheme? Its shares have lost about a fifth of their value in recent months, as news has spread that regulators are investigating whether the company broke the law. But this question is surprisingly hard to answer. It is, ultimately, an inquiry not only about markets, but also about human psychology.

Herbalife is a direct-selling company. That means you cannot buy its protein shakes and nutritional supplements in stores. Instead, Herbalife distributes its products exclusively through a network of 3.7 million “members” in about 90 countries. Members buy Herbalife products in bulk, and can then either consume them or try to resell them. They are paid based on a “multilevel-marketing model,” meaning that their compensation comes not only from the products they sell, but also from bonuses related to sales by new members they recruit: the more Herbalife protein shakes that members you’ve signed up buy, the more money you make. There’s a catch, however: you and your recruits need to buy several thousand dollars’ worth of shakes and supplements before these bonuses kick in. The risk is that if you don’t drink or resell the shakes you buy, or return them within a specified window of time (90 days for the first purchase), you will be stuck with them. Herbalife’s net sales last year were $4.8 billion; its market capitalization is about $6 billion.

Fundamentally, Herbalife targets our cognitive weaknesses, though which weaknesses is a subject of debate. The company’s executives extol the benefits of bringing together members in groups called “nutrition clubs”—social gatherings encouraged by the company where shakes are consumed and healthy lifestyles discussed. They say that Herbalife serves people who otherwise would succumb to fast food or vending-machine candy, and that its member networks—in addition to acting as a distribution system—offer support and positive reinforcement for people trying to lose weight.

In contrast, Herbalife’s critics deride the company’s products as overpriced and say Herbalife is exploiting poor people, who are tricked into paying thousands of dollars for products they will not be able to sell or want to consume. They say Herbalife is targeting groups who are easily victimized by false promises of riches.

The Herbalife drama stars many of the world’s top investors, and they sharply disagree. The hedge-fund manager David Einhorn kicked off the argument on a conference call in May 2012, when he asked Herbalife’s president, Des Walsh, how many sales were made outside the company’s network, to nonmembers. Walsh’s unsatisfying response, as summarized later on the company’s Web site—“We don’t track this number and do not believe it is relevant”—drew fire from more hedge-fund managers. Bill Ackman, the head of the hedge fund Pershing Square, bet more than $1 billion against Herbalife by shorting its stock in late 2012.

Bill Ackman has bet $1 billion against Herbalife—and has played a controversial role in highlighting the company’s potential misdeeds. (Scott Eells/Bloomberg/Getty)

Ackman has led the charge against the company, accusing it of deceiving recruits with wealth-soaked testimonials when in fact only a tiny fraction of members make money. “There is no profitable retail opportunity here,” Ackman told me. “In order to get people in, they have to mislead them.” Pershing Square’s investors will profit if Herbalife collapses, but Ackman has promised to donate his cut to charity.

Herbalife is fighting back. Its CEO, Michael Johnson, lambasted Ackman for “false and misleading statements.” Several prominent investors have supported the company, most notably Carl Icahn, who began buying Herbalife stock just hours after Ackman announced his huge short position and now owns a 17 percent stake. Icahn has called Ackman a “liar” and “the crybaby in the school yard,” and has labeled Ackman’s claims “complete bullshit.”

The biggest fireworks went off in March. First, a front-page story in The New York Times revealed that Ackman had lobbied public officials and contributed funds to anti-Herbalife advocacy groups, actions that Herbalife officials alleged were improper. Then, two days later, Herbalife publicly confirmed that it was being investigated by the Federal Trade Commission.

Both sides continue to smear each other and dig in their heels, as I learned from several recent conversations. Ackman told me, “I am 100 percent convinced that Herbalife is a global pyramid scheme. We think it is a criminal operation.” Herbalife’s chief financial officer, John DeSimone, told me in response, “I am 100 percent convinced Bill Ackman is wrong. I think he has gone beyond the legitimate role short sellers play and crossed an ethical boundary.” Both promised, “More evidence is coming.”

Plenty of pyramid cases are easy to resolve. A simple chain-letter-like arrangement, whereby new recruits pay cash upstream hoping to get more cash from their own downstream recruits, is manipulative and blatantly violates the law. The same is true of multilevel schemes that require large up-front payments for sham products. Conversely, Tupperware, which compensates its independent sales force based on carefully tracked retail sales, appears legitimate.

But what about cases in the middle, where people are motivated partially by wanting to consume a product and partially by the prospect of receiving money by building their own network? Regulators struggle with these grayer areas, where fraud can be camouflaged. The legal tests are confusing and inconsistent. Jeffrey Babener, a leading lawyer for multilevel-marketing firms, says they are like Supreme Court Justice Potter Stewart’s test for pornography: “I know it when I see it.”

Presented by

Frank Partnoy, a professor of law and finance at the University of San Diego, is the author of Wait: The Art and Science of Delay.

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