© 2015 Association of Certified Fraud Examiners, Inc.

The War Against Herbalife: Pyramid Scheme

or Multi-Level Marketing Master?

James T. Conversano, CFE, CFA, CIPM

James T. Conversano, CFE, CFA, CIPM

The War Against Herbalife:

Pyramid Scheme or Multi-

Level Marketing Master?

Disclaimer

The opinions expressed in this presentation are those of the individual

author and do not represent the opinions of Berkeley Research Group, LLC

or its other employees and affiliates. The information provided in this

presentation is not intended to and does not render legal, accounting, tax,

or other professional advice or services, and no client relationship is

established with Berkeley Research Group, LLC by making any information

available in this publication, or from you transmitting an email or other

message to us. None of the information contained herein should be used

as a substitute for consultation with competent advisors.

Introduction

1) Overview of Ponzi Schemes, Pyramid Schemes, and

Multi-Level Marketing Companies

2) “Hallmarks” of Illegal Pyramid Schemes

3) “Safeguards” Identified in FTC v. Amway

4) Overview of Herbalife and its Business

5) Allegations against Herbalife

6) Responses from Herbalife

7) Conclusion

Overview: How Do Ponzi Schemes Differ

from Illegal Pyramid Schemes?

• Ponzi scheme investors typically believe they invested in an actual

security or investment.

• Ponzi victims are typically lured into Ponzi schemes by promises of

high investment returns with little or no risk, high or overly consistent

returns, month after month, year after year.

• Funds received from new investors in Ponzi schemes are typically not

invested in the security or investment as promised. Instead, those

new funds are used to pay purported returns to earlier investors

without the knowledge or consent of the new investors.

• Investors in Ponzi schemes expect to earn a return from

profitable investments.

Overview: How Do Ponzi Schemes Differ

from Illegal Pyramid Schemes?

• Funds received from new participants in illegal pyramid schemes

consist of one-time and/or recurring fees, which are used to pay

commissions to earlier participants for recruiting new members.

• Although illegal pyramid operators often conceal the true nature of the

scheme, participants are typically aware that they are responsible for

recruiting new members, and those new members’ fees will be the

source of profit for existing members.

• After their initial investment, Ponzi scheme investors are not actively

involved in the scheme. Pyramid schemes require more active

involvement, as existing participants are required to recruit new

participants to contribute to the scheme.

• Participants in illegal pyramid schemes expect to earn profits

from recruiting new members.

Overview: Multi-Level Marketing (“MLM”)

Companies

• MLMs are legal companies that sell legitimate products and services.

• Well-known MLM companies include Avon (1886), Amway (1959),

Mary Kay (1963), and Nu Skin (1984).

• MLMs utilize a “pyramid-like” sales and distribution structure.

• Participants in MLM programs earn commissions for products or

services they and the distributors in their “downline” sell to others.

• Your “downline” consists of the participants you recruit and their

recruits.

Overview: Multi-Level Marketing (“MLM”)

Companies

• MLM firms offer several clear advantages to their

participants:

– A ready-made product line to sell

– A product infrastructure that reliably delivers products to them to

sell, takes returns, and handles customer service inquiries

– A comprehensive IT infrastructure that manages logistics as well

as payments

– A compensation system that rewards distributors’ productive

efforts to sell products and to develop and mentor “downline”

distributors

Overview: How Do Illegal Pyramid Schemes

Differ from MLMs?

• MLM companies sell legitimate products and services

and their participants earn income primarily by the

commissions from sale of those products and services

throughout their distribution network.

• Illegal pyramid schemes typically do not offer legitimate

products and services and their participants earn income

from recruiting new members.

“Hallmarks” of Illegal Pyramid Schemes

(Source: SEC)

• No genuine product or service. No underlying product or

service being sold to others, or if what is being sold is speculative or

appears inappropriately priced.

• Promises of high returns and fast cash. May suggest that

commissions are being paid out of money from new recruits rather

than revenue generated by product sales.

• Easy money or passive income. Be wary if you are offered

compensation in exchange for little work such as making payments,

recruiting others, and placing advertisements.

• No demonstrated revenue from retail sales. Lack of financial

statements audited by a certified public accountant or similar

objective documentation.

“Hallmarks” of Illegal Pyramid Schemes

(Source: SEC)

• Buy-in required. The goal of a legitimate MLM program is to sell

products. Be wary of mandatory “buy-in” fees to participate in the

program.

• Complex commission structure. If you do not understand how

you will be compensated, be cautious. Be wary if commissions are

based primarily on in-house sales.

• Emphasis on recruiting. If a program primarily focuses primarily

on recruiting others to join the program for a fee, it is likely a pyramid

scheme.

• Inventory loading. A company’s incentive program forces recruits

to buy more products than they could ever sell, often at inflated

prices.

“Safeguards” Identified in FTC v. Amway

• There should be no entry or “headhunting” fees.

• There should be no large inventory purchase requirements.

• The venture should adhere to the “70% Rule,” whereby each

distributor should be required to sell, at wholesale or retail, at least

70% of its purchased inventory each month.

• The venture should adhere to the “10 Customer Rule,” whereby each

sponsoring distributor should be required to make at least one retail

sale to each of 10 different customers each month.

Safeguards Identified in FTC v. Amway

• Distributors should be required to buy back any unused and

marketable products from their recruits upon request to mitigate

against a charge of inventory loading.

– For instance, legitimate MLMs should have a 60-day, 100%

money-back guarantee.

– After 60 days, the MLM should accept returned inventory (unless

perishable or seasonal) with a 10% restocking fee.

• Legitimate MLMs should not falsely represent, expressly or by

implication, the amount of earnings or income that can be, or which

are likely to be, derived from participation in the applicable MLM.

Overview: Herbalife and Its Business

• Herbalife is a global nutrition company founded in 1980 that develops

and sells weight management, healthy meals and snacks, sports and

fitness, energy and targeted nutritional products, as well as personal

care products.

• During 2014, Herbalife had net sales of $4.957 billion and net

income of $308.7 million, based on sales of over 150 products

encompassing over 5,300 SKUs in 91 countries.

• As of December 31, 2014, Herbalife had approximately 7,800

employees, of which approximately 2,100 were located in the United

States.

• Herbalife’s shares are traded on the New York Stock Exchange

(NYSE: HLF).

Overview: Herbalife and Its Business

• As of December 31, 2014, there were approximately 4 million

Herbalife Members.

• Members can earn profits by:

– Purchasing Herbalife products at (discounted) wholesale prices

and reselling those products; and

– Earning commissions and bonuses by establishing and

maintaining their own sales organizations (i.e., sponsoring other

Members).

• To become a Member, a person must be sponsored by an existing

Member and must purchase an International Business Pack, which

typically includes product samples, training and promotional

materials, rules of Member conduct, etc.

California Allegations and Subsequent

Settlement

• March 1985: Herbalife was sued by the California Attorney General

and two other California regulators, alleging that the company made

false claims about its diet products and employed an illegal

“endless chain” to market them.

• May 1985: Herbalife’s founder Mark Hughes was subjected to hostile

questioning by members of a U.S. Senate subcommittee on

governmental affairs.

• October 1986: Herbalife announced it had agreed to pay $850,000 to

settle the suit brought by the California regulators. Herbalife

admitted no wrongdoing in the settlement, but did agree to change

certain disclosures, remove certain products from its product line, and

place certain restrictions on testimonials made for its products.

Ackman’s Stunning Allegations

• December 19, 2012: Activist investor William Ackman of Pershing

Square Capital Management, L.P. publicly confirmed that he is

“betting” against the stock of Herbalife because the company is

operating a pyramid scheme.

• Later that day, Herbalife Chairman and CEO Michael O. Johnson

responded by saying, “The allegation that Herbalife is a pyramid

scheme is bogus. Make no mistake: Today’s announcement isn’t

about Herbalife’s business model. It’s about Bill Ackman's

business model.”

• December 20, 2012: Mr. Ackman made a 334-slide, 3-hour

Presentation titled “Who Wants to be a Millionaire, a Short Thesis on

Herbalife, Ltd. (NYSE: HLF)”.

Ackman Presentation Highlights

• Herbalife overstates the amount of income that is likely to be made by

new participants and masks the low probability that this income will

be achieved.

• Herbalife’s Statement of Average Gross Compensation of U.S.

Supervisors and other recruiting materials are materially deceptive.

• Herbalife distributors experience an abnormally high failure rate.

• Taking all expenses into account, including the cost of “business

method” materials, the substantial majority of distributors lose money.

• Distributors are incentivized to recruit if they wish to achieve “financial

freedom” and the Herbalife “lifestyle.”

• Herbalife’s top 1% of distributors earn the vast majority of rewards.

Ackman Presentation Highlights

• Recruits must “apply” to become Distributors and agree to a complex

set of rules simply for the right to buy commodity products at a

discount to the Company’s highly inflated Suggested Retail Prices

that have little relationship to actual retail prices at which products

can be resold.

• Herbalife has been sued numerous times for being a pyramid scheme

and, in some cases, has been found to be a pyramid or to exhibit key

characteristics of pyramids.

• Herbalife distributor compensation scheme is substantially more

“pyramidal” than typical multi-level marketing companies.

• Herbalife testimonials overstated opportunity for profits.

Ackman’s More Recent Allegations

• March 11, 2014: Pershing Square Capital Management, L.P.

presented a new presentation arguing that Herbalife is violating

Chinese direct-selling laws by doing the following:

– Paying multi-level, royalties based upon unlimited downline levels.

– Paying royalties and commissions totaling more than 30% of sales

volume.

– Incentivizing Distributors to recruit a potentially infinite downline in

order for Distributors to reap sales-based Consulting Fees.

– Permitting and incentivizing individual Distributors to recruit other

participants.

Ackman’s Stunning Bet Against Herbalife

• During the December 20, 2012, presentation, Mr. Ackman verbally

disclosed that he had an “enormous” short position in Herbalife’s

stock. The presentation also included the following written

disclaimers:

– Pershing Square currently has a short position in Herbalife Ltd.

(“Herbalife”) common stock. We do not own any options on

Herbalife common stock.

– Pershing Square will profit if the trading price of Herbalife common

stock declines and will lose money if the trading price of common

stock of Herbalife increases.

• It was later revealed that Mr. Ackman had taken a whopping $1

billion short position on Herbalife stock, betting that shares in the

company would fall.

Investment Bias?

• Loss Aversion. Losing $100 is more painful than the utility of gaining

$100.

• Commitment Bias. Once you have publicly committed to a (huge)

position, it is difficult to retreat. Reputation and pride likely to be

contributing factors as well.

• Conflict of Interest. Financial gain (only) if share prices drop +

publishing research that suggests company is a fraud (i.e., shares

overvalued).

Daniel Loeb’s Bet In Favor of Herbalife

• Soon after Ackman made his bet against Herbalife, another well-

known investor, Daniel S. Loeb of Third Point Management, took a

large long position on Herbalife stock, effectively purchasing more

than 8% of Herbalife, betting that shares in the company would rise.

– Mr. Loeb reportedly stated Mr. Ackman’s thesis was

“preposterous” and defended the company, citing its revenue,

profit, earnings per share, and free cash flow.

• In addition, in mid-January 2013, another well-known activist investor,

Carl Icahn, took a substantial long position in shares of Herbalife

similar to the long position taken by Mr. Loeb.

Herbalife’s Responses

• December 20, 2012 (Herbalife press release):

– Today's presentation was a malicious attack on Herbalife’s

business model based largely on outdated, distorted, and

inaccurate information. Herbalife operates with the highest ethical

and quality standards, and our management and our board are

constantly reviewing our business practices and products.

Herbalife also hires independent, outside experts to ensure our

operations are in full compliance with laws and regulations.

Herbalife is not an illegal pyramid scheme.

Herbalife’s Responses

• January 11, 2013 (Herbalife presentation to analysts):

– Distributors do not drop out at the rates asserted by Mr. Ackman,

and of those who do drop out, 61% retain a positive image of the

company.

– Many of the people the company calls “distributors” are in fact end

users, and sign up for the role to get discounted product to use

themselves.

– Herbalife’s investment in R&D, the lack of which was cited by Mr.

Ackman, is in line with other major nutrition companies.

– Herbalife is fully compliant with SEC-approved accounting

practices.

– Herbalife’s price points are in line with those of other major

nutrition brands.

Herbalife’s Responses

• July 22, 2014: Herbalife released findings of analysis conducted by

the former Assistant Director for Regulatory Evaluation, Bureau of

Consumer Protection at the FTC:

– Herbalife’s U.S. business operations are consistent with the

socially beneficial MLM model and inconsistent with the socially

harmful pyramid scheme model.

– An estimated 97% of Herbalife’s U.S. product volumes are

purchased from Herbalife for end-use consumption.

– Herbalife products have significant intrinsic value and market

demand.

– The investment required for Members to join Herbalife is not large

and is mostly recoverable.

– For those who choose to participate, the Herbalife business

opportunity offers a reasonable prospect of operating a financially

successful business.

Herbalife’s Responses

• October 22, 2014: During an interview, Herbalife’s CEO Michael

Johnson declares Herbalife was at “war” with Ackman.

• April 13, 2015: Herbalife responded to recent statements made by Mr.

Ackman at an investor Summit in New York:

– There is simply no truth to Bill Ackman’s statements and this is

just another stunt in his campaign, a campaign that is reportedly

under criminal investigation by the FBI and the Department of

Justice, to drive down the stock price in an effort to enrich

himself and his investors in advance of options expiring on

Friday. Unfortunately, we have seen this pattern of activity before,

especially before the third Friday of each month, when certain

options expire.

Other Activity: Class Action Settlement

• October 31, 2014: Herbalife agreed to pay more than $15 million to

members of its sales force who filed a class action accusing the

company of being a pyramid scheme, according to a proposed

settlement filed in California federal court.

– The company didn’t admit any wrongdoing in the deal, but said

it would pay the class $15 million and up to $2.5 million in

returned products that its sales people bought, according to the

deal.

– The company continued to publicly assert that the suit was

meritless.

Other Activity: Market Manipulation

Investigation

• March 12, 2015: Prosecutors in the Manhattan U.S. attorney’s office

and New York field office of the FBI reportedly have been

investigating potential market manipulation of Herbalife stock.

– The investigation is looking into whether people, including some

hired by Mr. Ackman, made false statements about Herbalife’s

business model to regulators and others in order to spur

investigations into the company and lower its stock price.

– Mr. Ackman stated he has spent more than $50 million to

research and publicize his fund’s negative view of Herbalife. He

hired a team of lobbyists and consultants to contact a host of

politicians and regulators and encourage investigations into the

company.

Other Activity: Market Manipulation

Investigation

• April 1, 2015: Federal prosecutors reportedly now have expanded

their investigation of market manipulation of Herbalife stock to include

statements included in Pershing’s March 2014 presentation.

– One area of focus is the work of a consultant, Aaron Smith-Levin,

who helped with the March presentation. He was commissioned

by Mr. Ackman and his fund to scrutinize Herbalife’s business in

China.

– Up until March 2014, Mr. Ackman reportedly had lost an estimated

$500 million in mark-to-market losses based on his short

position on Herbalife.

Conclusion

• One of the most fascinating aspects regarding the allegations against

Herbalife is that multiple sophisticated institutional investors took

opposing viewpoints and backed it up with multimillion/billion dollar

bets on their beliefs about the company’s prospects.

• Even more fascinating that Ackman is now under criminal

investigation.

• An SEC 2013 Investor Alert states: “Pyramid schemes cannot be

sustained and always collapse eventually.” Could Herbalife really be a

decades-long fraud, similar to Madoff? What do you think?

James T. Conversano, CFE, CFA, CIPM

End of Presentation

Thank You - Enjoy the Rest of

the Conference!

© 2015 Association of Certified Fraud Examiners, Inc.

The War Against Herbalife: Pyramid Scheme

or Multi-Level Marketing Master?

James T. Conversano, CFE, CFA, CIPM