Will the Herbalife Scandal Affect These Companies?

The case against Herbalife (NYSE:HLF) has gathered momentum since hedge fund manager Bill Ackman, who took a $1 billion short position on the supplement-maker, told CNBC in December that the company used inflated pricing, misleading sales information, and a complicated incentive structure to hide what he termed was “little more than a pyramid scheme.”

The U.S. Federal Trade Commission launched an investigation into the company on Monday after receiving more than 192 complaints against it in the past seven years, and CNBC published an in-depth expose on Herbalife’s business on January 9.

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Now another voice has joined the accusations. Daniel Ravicher, a law professor at the Benjamin N. Cardozo School of Law and Executive Director of the Public Patent Foundation, wrote a series of letters to participants who, according to him, played critical roles in Herbalife’s business, informing them of what he believed was their culpability in its pyramid scheme. He sent letters to eBay (NASDAQ:EBAY), FedEx (NYSE:FDX), and NYSE Euronext (NYSE:NYX), each of which helps further the company’s business to some degree. FedEx transports the company’s products, the New York Stock Exchange enables Herbalife gain additional participants in its scheme and build brand recognition,  eBay provides an outlet for Herbalife participants to unload unsellable products so that they can invest more money in the company…
In his letters, Ravicher told each company that it was “aiding Herbalife in maintaining and perpetuating that scheme and thus may itself be liable for injury caused by it.” He added that there was “substantial evidence that Herbalife Ltd. is an illegal pyramid scheme operating under the guise of a health products company.”

The primary issue of contention in the Herbalife controversy is whether its method of multi-level marketing, or MLM, can be considered a pyramid scheme. The U.S. Federal Bureau of Investigation has defined a pyramid scheme as a marketing and investment fraud where the “real profit is earned not by the sale of the product, but by the sale of new distributorships” and the “emphasis on selling franchises rather than the product eventually leads to a point where the supply of potential investors is exhausted and the pyramid collapses.” So the real question is whether Herbalife earns the majority of its profits from the sale of new distributorships or from the sales of its products…

The FTC’s former Director of the Bureau of Consumer Protection David Vladeck told CNBC that the commission’s view was that “it is an MLM [case] unless you can show that the commodity [being sold] is an incidental, remote part of the business.” This is an important view, as Herbalife’s chief executive officer Michael Johnson had complained that the FTC had not defined how much emphasis a company can legally place on recruiting, or the sale of distributorships. However, his argument is weakened by the fact that 90 percent of the company’s 2.7 million participants are failing to make money from selling its products.

Furthermore, as Ravicher mentioned in his letters, upon investigation, he found that “Herbalife pays more money to participants in its business to recruit new participants than it does for sale of its products.” He noted that this practice was illegal based on the precedent set by the 1996 legal case Webster v. Omnitrition Intern., Inc.

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