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.”

Consider the so-called 70 percent rule, an industry standard based on a 1979 finding that Amway was not a pyramid scheme in part because it required distributors to sell at least that percentage of the products they received each month. Herbalife’s version is limited to products a member “holds for resale.” But how are regulators to determine how many of the shakes in various members’ basements are for resale versus personal use? Bill Keep, the dean of the College of New Jersey’s business school and a leading expert on pyramid schemes, is skeptical about Herbalife’s approach: “What does this mean? It could vary from 0 to 100 percent.”

Even one of the most obvious tests for an illegal pyramid scheme—whether a business is “unsustainable”—is problematic. Simple chain letters and the like inevitably fail when the pool of new recruits evaporates. But the risk with established companies is different: not so much that they will die, but that they will commit fraud while they are alive. Herbalife’s pyramid structure, whatever you might think of it, has been sustainable. The company has been in business for 34 years. Even though each year the company loses about half the people who have qualified for bonuses, it has so far been able to replace them. Ackman and Herbalife officials disagree about whether it can continue to do so.

Certainly, some Herbalife recruits have received unrealistic promotional materials from top distributors, such as the video of a member named Doran Andry driving a red Ferrari and talking about his nearly $100,000-a-month income. The company recently began disclosing financial information to prospective members; in 2013, only 704 U.S. members received more than $100,000 a year (not a month) from the company, and the vast majority received less than a few hundred dollars. But even now, Herbalife’s disclosures do not differentiate revenues from profits, or say how expensive it is to run a distributorship.

When I asked Walsh, Herbalife’s president, about member expenses, he was even more evasive than he had been in response to David Einhorn two years ago. He talked about which shakes he drinks (cookies ’n cream at breakfast, mint chocolate at lunch), how much he weighs, and what his marathon times have been. But here is what he said about expenses: “We don’t have visibility, but for a substantial part of our distributors there are only nominal expenses. These are independent businesspeople; their expenses are proprietary to them. We don’t have access to that information.”

The murkiest part of Herbalife’s distribution system, which accounts for much of the company’s growth, is the nutrition club. John DeSimone, the CFO, praised the clubs and told me he wished people would pay more attention to their advantages: “The clubs benefit the community. It’s a weight-loss regimen tied to a social dynamic.” Attendance can be expensive, but for some people, the psychological benefits of the meetings might make the cost worthwhile.

Ackman isn’t persuaded. He says, “Nutrition clubs are simply a recruiting venue for Herbalife to reach low-income distributors.” Pershing Square officials have also criticized nutrition clubs outside the United States, where Herbalife has reported substantial increases in sales. Last year, Herbalife members in Venezuela confronted currency restrictions and severe economic turmoil, yet Herbalife, citing the growth of nutrition clubs, reported that its sales in Venezuela shot up 87.6 percent. Some information suggests that in Mexico, the company’s second-biggest market—with an estimated 40,000 nutrition clubs—Herbalife accounts might have been used by drug leaders to launder money. (An Herbalife spokesman told me that in 2013 the company’s board of directors responded to allegations about money laundering in Mexico by hiring a third-party investigator, who found no support for the claims.)

Herbalife discloses little detail about its operations in Venezuela, Mexico, or elsewhere. In its financial filings, Herbalife warns that it gives “no assurance that our members will … comply with our member policies and procedures.” Company officials say they audit about 2 percent of Herbalife’s retail sales, focusing on what they call “high-risk transactions.” They could collect details about members’ expenses, as well as records of every sale, purchase price, name, and address. Currently, they do not.

The Herbalife saga illustrates another cognitive weakness: the bias against short sellers. People like Ackman who bet against companies have long been vilified because they seem to be trying to do harm. Yet short sellers play an important role in the markets. They can afford due diligence that regulators often cannot. Research suggests that short sellers help make markets fairer and more efficient by identifying fraud and introducing information that corporate executives otherwise would not disclose. If Pershing Square did not have a concentrated financial incentive to investigate Herbalife, we would know a lot less about the company today.

DeSimone, Herbalife’s CFO, told me he doesn’t oppose short sellers generally, but he thinks Ackman has gone too far. Des Walsh says Ackman has waged “an orchestrated campaign to demonstrate misinformation and lobby at all levels to present a biased and non-fact-based theory about a legitimate 34-year-old company. We believe this is fundamentally wrong.”

Certainly Pershing Square should not be permitted to violate lobbying or political-contribution rules, just as short sellers should not be allowed to sabotage a company’s products to drive down the stock. But Ackman has not been accused of breaking the law, and says Herbalife has outspent his fund eight to one on lobbying.

The Supreme Court’s decisions in Citizens United and subsequent rulings permit corporations to spend vast resources trying to influence the political process. If corporations can exercise such free-speech rights, why is it “fundamentally wrong” for the people who short corporations’ shares to do the same?