One way Herbalife could show it’s not scamming customers

Bill Ackman during a presentation on Herbalife last month. (Jin Lee / Bloomberg)
Bill Ackman during a presentation on Herbalife last month. Ackman has accused the company of fraud. (Jin Lee / Bloomberg)

Shares of Herbalife have fallen 23 percent since the company revealed it was under investigation by the Federal Trade Commission in March. The company has tried to reassure investors that it is not committing fraud, as its detractors claim, but investors are still worried. There is one strategy it hasn't tried yet that could calm the markets — if Herbalife is indeed on the level.

Herbalife is one of the more prominent of a group of retailers that have no regular sales force. Instead, these unusual firms, which include Amway and Avon among others, depend on their customers to sell their products. The industry is known as "multilevel marketing." Customers can sign up as members, who after paying a nominal registration fee can purchase products at wholesale prices. Members can also recruit others to join the company. If they do, they can earn commissions on purchases made by their recruits, their recruits' recruits and so on.

According to Herbalife, these customers are devotees of the product who join because they want discounts on the products. Herbalife wants to encourage them to gossip with their friends about, say, how much weight they've lost with the company's marquee protein powder, so it rewards them when their friends buy products as well.

If new members sign up because they like the products, that's great for Herbalife and the capitalist system. The company is just responding to demand, as any business should. On the other hand, as Wonkblog explored last week, it's a problem if the members of a multilevel marketing organization are really joining because they want to earn money on commissions. They might find some people who are willing to sign up to receive discounts on products, and others who also want to try their hand at earning commissions, but the chain of recruitment can't continue indefinitely. Most Herbalife members don't make very much, if anything, the company's figures suggest.

It is hard to see inside the heads of new recruits and know what they hope to get out of their relationship with Herbalife — whether that's a part-time job or boxes and boxes of supplements at discounted prices.

Bill Ackman is the wealthy hedge-fund manager who's done the most to force investors' attention on this problem. He accused the company of fraud in 2012, saying at the time that he had bet $1 billion that the company's stock price would fall.

Before his most recent presentation to investors last month, Ackman had basically promised incontrovertible proof that would put an end to the company's 34 years in business. At first, the market blew him off, and the price of shares in Herbalife, which had been declining for weeks in anticipation of what Ackman might say, jumped 25 percent. A few days later, however, Herbalife reported quarterly earnings below expectations, and the share price crashed again. Bond prices have plummeted, too.

The share price remains depressed relative to the company's balance sheet, many analysts say. On the other hand, the low price means that the investors who've put a total of $4.6 billion in the stock stand to make bank if Herbalife can answer its critics and convince the Federal Trade Commission that the company is playing by all the rules.

According to a statement that the company provides to all new recruits, about 78 percent of its members in 2013 in the United States — 408,640 people — have no recruits of their own. According to Herbalife, these 408,640 people are loyal customers who signed up to receive discounts. "Fundamentally, we've got millions of customers that enjoy the product, that use the product. That's indisputable," chief financial officer John DeSimone told CNBC last month.

According to the naysayers, these are would-be entrepreneurs who failed. Ackman has presented photos and videos that he says Herbalife members show to new recruits, touting the financial compensation that comes with being a member.

The company knows that investors aren't sure whom to believe. In an effort to clarify the situation, Herbalife announced a year ago that it would begin referring to its salespeople as "members" rather than "distributors," the term the company had previously used, which strongly suggested some kind of money-making purpose. Criticism of the company continued because the compensation plan did not change, nor did the reasons — whatever they might have been — for members to join.

It isn't too late for Herbalife to fix the problem. The company could offer new salespeople a choice between the current model and an alternative membership program that offered discounts, but not cash commissions. For the 78 percent of distributors without recruits, this alternative program would be preferable. They don't earn any commissions anyway, and they wouldn't have to sign a lengthy contract.

Versions of this kind of program are familiar in multilevel marketing. Companies including USANA Health Sciences, Nu Skin and Melaleuca offer something called a preferred-customer option. Their preferred customers can sign on as full members whenever they like. Generally, however, the firms do not disclose the percentage of their members who are only preferred customers. Herbalife would have to do so to assuage investors' concerns.

If this preferred-customer option were popular, the numbers would support Herbalife's case. It would allow the company to distinguish itself from the multilevel marketer BurnLounge, which sold music online and had a preferred-customer option. Only 3.2 percent of BurnLounge members chose the discounts instead of the cash, which was part of the reason that the Ninth Circuit Court of Appeals ruled the company a fraudulent pyramid scheme earlier this year. Almost all of BurnLounge's members had hoped to make money by bringing their friends and their friends' friends into the business, it seemed.

BurnLounge's preferred-customer option was essentially a referral program that offered discounts. It is a model used in other industries, and it is a natural way to use the word of mouth to attract customers. Think of an airline that adds miles to your account when your friend applies for a card, or a dive bar that offers you a $50 tab if you can bring ten of your friends through the door at happy hour.

Herbalife does not believe that it needs such a program to prove that its operations are legal. "While most members are in fact nothing more than preferred customers, our common membership application provides each member with identical flexibility," a spokesman said. In other words, the standard compensation program gives all recruits the choice of how they'll spend their commissions.

Last month, Herbalife announced the results of a study it had commissioned, which found that of the 61 percent of products sold inside the network, roughly two thirds were "consumed by members who join the Herbalife network primarily to receive product discounts for their own use or that of their family." When Wonkblog asked to see a copy of the study to get a sense of the data and methodology used, the company declined.

The spokesman also pointed to the company's consumer protection plan, calling it "the industry's best." To join costs as little as $60, and the company offers to refund distributors for unused, unsold products.

Yet critics say that even if the cost of entry is limited, distributors can ultimately pay much more to the company because of a requirement that that they (together with their recruits and their recruits' recruits) buy a certain minimum volume of product to maintain their rank in the organization and to qualify for commissions. Bruce Craig, a retired prosecutor, objected to Wonkblog's story last week because it did not make this distinction sufficiently clear. "Frequently, in addition to a lump sum, in order to continue to qualify, you have to then buy monthly installments of products," Craig said.

As for the refunds, a distributor who returns products must leave the company, and her sponsors must forfeit any commissions earned on the initial sale. Craig and others say that multilevel-marketing groups exert strong psychological pressure on the people in them, who are often connected by bonds of family and friendship, and that to avoid conflict, few distributors return products. (According to Herbalife, less than 0.5 percent of the products it sells in North America are returned.)

For Bill Keep, the dean of The College of New Jersey's School of Business and another critic of Herbalife, Herbalife's lack of a preferred-customer program raises questions. "My guess is that the reason they don't want to do this is if someone went in and looked at the data like they did with BurnLounge, it would be so obvious," Keep said. "By not distinguishing them, by not having a separate category, they get to perpetuate the myth."

Keep says the low rate of retention among Herbalife's distributors demonstrates that many of them are trying to make money and quit when they find they can't. More than 90 percent of distributors in the bottom levels of the organization dropped out in 2005, when the company last disclosed the figures. Herbalife says that the churn is because few people who are trying to lose weight can follow a diet for long.

Keep and Herbalife can't both be right. A business model that clearly separated those who just want discounts from those who want to make money could resolve the debate.

Max Ehrenfreund is a blogger on the Financial desk and writes for Know More and Wonkblog.
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