Saturday, January 2, 2016

$HLF v. Vemma: Pyramid Scheme Analysis; Part 5 of 6

Please read part 1, part 2, part 3, and part 4 before reading part 5 below.


51.  Having found that Herbalife's program grants rewards that are unrelated to actual sales to ultimate users, and encourages and incentivizes participants to seek those rewards, I next consider whether the company has “safeguard” policies and procedures that are sufficient to ensure that adequate retail sales to ultimate users exist and inventory loading is prevented.  As noted in Omnitrition (1996): "Where, as here, a distribution program appears to meet the Koscot definition of a pyramid scheme, there must be evidence that the program's safeguards are enforced and actually serve to deter inventory loading and encourage retail sales."  Such safeguards are necessary, as a structure with insufficient retail sales will inevitably generate a pyramid scheme that relies on ongoing recruitment to fund commission payments, matching the general economic characterization of of scheme described in paragraph 17.  As established in paragraphs 19-20, the Koscot test also hinges on the existence of significant sales to ultimate users.  In Amway (1975), the FTC found that Amway was not operating a pyramid scheme because it had adopted and enforced certain procedures to prevent inventory loading and to ensure that actual retail sales existed.  As noted in Omnitrition (1996), the safeguard “policies adopted by Amway were as follows: (1) participants were required to buy back from any person they recruited any saleable, unsold inventory upon the recruit's leaving Amway, (2) every participant was required to sell at wholesale or retail at least 70% of the products bought in a given month in order to receive a bonus for that month, and (3) in order to receive a bonus in a month, each participant was required to submit a proof of retail sales made to ten different customers.”  These safeguards must be stated, enforced, and effective.

52.  In the Amway case, the company’s retail sales were in the form of re-sales by distributors.  In Herbalife’s model, many retail sales outside the organization will likely not come from Distributor’s inventory, but will be in the form of direct sales to non-Distributors, induced by and credited to Distributors.  Because of this difference in business models, an effective Amway-type safeguard for Herbalife may look slightly different than the specific rules in Amway.  However, the objective would be the same - to encourage sales to ultimate users who purchase for the purpose of personal consumption.  I see no evidence of any safeguards in place that would be effective to deter inventory loading and encourage retail sales to ultimate users.

53. Herbalife’s 10 customer rule and their 70% rule are based on self-certification and includes stipulations to allow for downline sales / internal consumption to count as retail sales.  Moreover, not all distributors have to comply with the rules (the rules are required for Sales Leaders to qualify for commision payments).  In a July 5, 2012 letter to the SEC, Herbalife states that it does "not rely on the '70% rule' in any meaningful way" and believes it is “not material” to their business. In the Deposition of Jacqueline A. Miller in Herbalife v. Ford, Ms. Miller testifies that between 2006 and 2009, Herbalife disciplined fewer than 25 distributors for violating the 70% rule (fewer than 1 out of every 100,000 distributors).

54.  Return policy
Herbalife’s repurchase policy creates a cumbersome process and acts to limit distributors from returning product and thus fails to adequately protect distributors from losses.  As shown below, the return policy is not significantly different from Vemma's.

Source: Page 21 from Pershing Square’s presentation Side-by-Side: A Comparison of Vemma and Herbalife

55.  To summarize, there is no evidence that Herbalife has enforced and effective safeguards that would ensure sufficient sales to ultimate users and prevent inventory loading.  The absence of enforced and effective safeguards compounds an existing problem within the Compensation Plan, namely that compensation is based on purchase volume, regardless of whether the purchases relate to retail sales to ultimate users.  By encouraging participants through its marketing materials to purchase product for the purposes of bonus eligibility, and by basing its compensation on purchase volume, Herbalife has created a system that incentivizes inventory loading.

 Continue to part 6 of 6

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