Saturday, January 2, 2016

$HLF v. Vemma: Pyramid Scheme Analysis; Part 4 of 6

Please read part 1, part 2, and part 3 before reading part 4 below.
Illustration of a Downline and Related Earnings

44.  The 2-4-1 Plan (sometimes referred to as the 4-2-1 plan) advocates monthly binary duplication with each member purchasing 500 volume points per month in order to get to President’s Team (>$8000 per month) in 10 months.  This plan is deceptive.  Herbalife’s 2014 Statement of Average Gross Compensation Paid by Herbalife to U.S. Members states that “During 2014, 31 U.S. Members achieved the level of President’s Team.  They averaged seven years as an Herbalife Member before reaching President’s Team, with the longest duration being 18 years and the shortest being less than three years.”

To demonstrate the implications of Herbalife's promoted 2-4-1 binary recruiting strategy.  Each entrant is assumed to purchase a Mini Herbalife Member Pack for $59.50, make personal purchases of 500 Volume Points (for every month after the month of enrollment), and recruit two individuals to do the same.  Assume the first entrant is Jane, where Jane recruits Bill and Tom within the first month.  Further assume that Bill and Tom then each recruit 2 individuals within a month after their enrollment, those 4 individuals recruit 8 within a month, and so on.  Figure 9 depicts Jane’s growing 2-team organization.

Source: Figure 9 from the Declaration of Stacie A. Bosley

45.  The first page of this Google Sheet depicts the advertised outcomes for Jane after 3 months of ongoing recruitment.  This scenario is modeled after the 2-4-1 plan, promoted by Chairman’s Club member Dan Waldron and others.  This scenario demonstrates that Jane experiences losses until she and her downline acquired substantially more than 8 cumulative recruits by month 3, at which time gains overcome the cumulative loss experienced from prior months.

46.  It can be assumed that members of Jane’s downline following the same strategy will also not reach profitability until they and their downlines accumulate substantially more than 8 cumulative recruits by month 3.  Accordingly, the overwhelming majority of participants are in a loss position at any point in the life of the organization, since participants in the lowest levels have yet to reach a positive cumulative net profit.  Though promotional materials use this illustration to show that a person can receive $8000 per month income by month 6, the materials do not disclose that, at any given point in time, the overwhelming majority of participants will not have achieved this result and will have actually lost money.

47.  The poor results for most participants (89% of distributors receive $0 in “gross compensation” according to Herbalife’s 2014 U.S. Statement of Average Gross Compensation) are predictable because the 2-4-1 plan incentives are based upon recruitment into a binary matrix (and 5x recruitment duplication for Club 100).  Table C1 in Appendix C of the Declaration of Stacie A. Bosley Ph.D.y contains a mathematical analysis of a binary progression, which is applicable to any binary compensation plan.  Table C1 shows that the percent of members in the bottom 3 levels of a binary structure converges to 87.5% after 10 periods.  Given the estimated expenses shown in the first page of the Google Sheet, which prevent participants from acquiring cumulative net profit until month 3, this means that at any given time in the life of the organization more than 87% of participants will need additional recruitment to cover personal investments.  Additional recruitment will be increasingly difficult to achieve as cumulative recruits have already grown exponentially.  It is important to stress that not all binary compensation plans are inherently deceptive or that any MLM that uses such a plan is necessarily a pyramid scheme.  A binary compensation plan that sufficiently emphasis retail sales may not be a pyramid.  My Google Sheet assumes no retail sales to ultimate users and illustrates the effects on participants when compensation is based solely on recruitment.

48.  It should be noted that the Google Sheet is a theoretical model and does not determine how the program actually operates in practice.  A variety of factors may affect the actual results.  For example, some participants may recruit more than two new participants and others may recruit none and drop out of the program.  However, it should be noted that Herbalife’s 2014 Income Disclosures (discussed in paragraphs 59-61, infra), which show that the majority even of Active Sales Leaders made minimal income, are generally consistent with the predicted results from this model.  The model illustrates that the structure of the program itself predictably leads to poor results for the vast majority of participants, regardless of accidental or external factors.  While many new businesses fail because of adverse business conditions, poor management, bad luck, or any number of other reasons, with this type of program, failure for most participants is inherent in the system.  This model provides a useful economic context to explain why courts have condemned pyramid schemes.

49.  Herbalife's claims that substantial wealth is available for participants are deceptive.  This is true whether the representations involve specific income claims ($42,000 per month as described in paragraph 5), or are more general (passive income as described in paragraph 9).  The pay plan depends on continuous recruitment, which results in the vast majority of participants not having sufficient “downline” activity to make any significant amount of money.  Herbalife's Disclosure Statements (discussed below) confirm that whole it is possible for some participants to make large amounts of money, the vast majority do not.

50.  It is clear from pages 80-150 of the Pershing Square presentation Who Wants to be a Millionaire that earnings received as rewards for recruitment are much greater than rewards for sales to ultimate users, and that an equivalent promise cannot be made and satisfied for each new Herbalife distributor given the dramatic exponential recruitment required.  The ability for the most recent Herbalife distributors to reach a positive cumulative net profit relies upon an ongoing and consistent ability to recruit new Herbalife distributors.  Returning to the economic definition of a pyramid scheme, the Herbalife business model, marketing materials, and Compensation Plan do appear to create a perpetual recruitment chain that dooms the vast majority of participants to financial loss.  As demonstrated, the business model requires ongoing recruitment as new entrants must recruit others in order to cover their own personal investment.  In terms of the Koscot test, I conclude that Herbalife's program, including its marketing, encourages and incentivized participants to seek rewards through recruitment rather than sales of product to ultimate users.

Continue to part 5 of 6

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