The Fortune Hi-Tech Lawsuit May Actually Help Herbalife Ltd. (HLF)

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The turmoil surrounding Herbalife Ltd. (NYSE:HLF), a health products multi-level marketing company, seems to get increasingly interesting. First, there was the on-air verbal joust between celebrated investor Carl Icahn and hedge fund manager Bill Ackman. Then, it was reported that at the request of the Federal Trade Commission (FTC) and three states, a federal court halted an allegedly illegal pyramid scheme. The case alleges that multi-level marketing (M-L-M) company, Fortune Hi-Tech Marketing, defrauded more than 100,000 consumers since 2001.

The news of the FTC action seemed to pressure M-L-M stocks but surprisingly might help Herbalife’s assertion that it is not a pyramid scheme.

Herbalife Ltd. (NYSE:HLF)Here’s why:

The case against Fortune Hi-Tech seems to rest on two key points.

1. Fortune Hi-Tech falsely claimed consumers would earn significant income for selling its products and services.

As alleged, there is evidence that Fortune Hi-Tech promoted itself as a way for average people to achieve financial independence. Some representatives claimed they earned more than 10 times as much as their previous earnings in their second and subsequent years with the company. One person claimed that another representative earned more than $50,000 in his sixth month and millions of dollars in subsequent years. At its 2012 national convention, the company called its top 30 earners to the stage to present them with a mock-up of a $64 million check, which several of them shared as a photo on social networking websites.

2. Fortune Hi-Tech’s business model emphasized recruiting new sales representatives over the sale of products and services.

The complaint indicates evidence that new entrants must pay at least $250 to be eligible for commissions and pay $250 annually to remain a commissioned rep. Further, they must purchase a “starter pack” to receive commissions. These packs typically cost between $130 and $400 and require the sales rep to agree to a “negative option continuity plan,” whereby the rep is automatically billed monthly for products and services unless the rep affirmatively cancels the plan.

There is also evidence that Fortune Hi-Tech’s compensation program has both recruitment bonuses and commissions earned from product sales.

Once eligible, reps can earn a Customer Acquisition Bonus of at least $100 for each new individual they personally recruit to join, as well as for each individual recruited by other reps further down the line. This compares to a fractional amount earned from selling product. The complaint gives examples where the monthly amount available to a rep for the sale of a satellite TV package is $0.80 and the monthly amount for the sale of a cellular telephone contract is typically $0.50.

Given these facts, there doesn’t seem to be any meaningful evidence that Herbalife resembles Fortune Hi-Tech Marketing at all. I haven’t seen any consequential proof that Herbalife undertakes or endorses the notion that selling its product is a way to get rich quick nor have I seen any persuasive evidence that the company’s business model emphasizes sales rep acquisition rather than product sales.

The latter is a key point. Unlike what some in the financial media espouse, multi-level marketing companies who emphasize the sale of product are legitimate firms. That discernment is important and the distinction is even stated in the latest FTC complaint, “Unlike a legitimate multi-level marketing business, FHTM’s (Fortune Hi-Tech Marketing) business model emphasizes recruiting new Reps over the sale of products and services.”

I think it might be reasonable to conclude that the significant differences with Fortune Hi-Tech, in addition to the differences from two other critical M-L-M pyramid scheme cases, may be helping Herbalife to increasingly prove itself legitimate and set itself apart from M-L-M frauds. (For info on the other two cases, see this article.)

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