This week, response briefs were due from the defendants in the case of Medifast v. Barry Minkow, Fraud Discovery Institute, Robert FitzPatrick, Tracy Coenen, and Sequence Inc. I was dismissed from Medifast’s SLAPP suit (see information on the lawsuit here), and my brief  in the Medifast appeal can be found here. The brief of Minkow and Bob FitzPatrick was also filed this week, and sheds some light on the allegations that Take Shape For Life (TSFL) and Medifast are offering a pyramid scheme to distributors (called “health coaches”).

The entire brief filed on behalf of Minkow, FDI, and FitzPatrick is found here (10MB file). Below I highlight some of the most relevant (and most interesting) portions, particularly the bits regarding the allegations that Medifast’s multi-level marketing business is a pyramid scheme or endless chain recruitment scheme.

First, an explanation of SLAPP suits (Strategic Lawsuit Against Public Participation):

Defendants’ motions argued that Plaintiffs’ complaint is a classic SLAPP suit intended to chill their exercise of First Amendment rights. Under California’s anti-SLAPP statute, Plaintiffs’ claims must be stricken unless Plaintiffs can demonstrate a probability of prevailing. Defendants argued that Plaintiffs could not make such a showing for many reasons, including: the statements were nonactionable facts; Plaintiffs could not demonstrate that Defendants made false statements and certainly not with malice; Defendants had immunity in republishing on the internet statements of others and their statements were privileged; the derivative claims for market manipulation and unfair business practices depended on constitutionally protected statements; Defendants did not intend to induce stock market activity and, with the exception of Mink ow, they did not participate in market activity; and, conspiracy is not an independent tort. [ER 299,332-335, 364-365.]

On Multi-Level Marketing and Endless Chain Schemes:

Multi-level marketing (sometimes “MLM”) is an increasingly controversial business model. Both California’s Attorney General and the Federal Trade Commission (“FTC”) have cautioned consumers about MLM companies. The FTC warns consumers to use “a healthy dose of caution” before buying products that offer miracle health, particularly when diet plans are coupled with “opportunities” to become distributors. [Supplemental Excerpts of Record (“SER”) 552-553.] Recruited distributors are enticed with commissions or rewards for both their personal sales of the plan’s products and those of others they recruit to become new distributers. The right to recruit is extended to new participants in an unending chain with commissions flowing to the top. These MLM programs frequently offer benefits that never materialize, or worse, urge consumers to invest their own money as part of the plan. [SER 552-53.] TSFL’s scheme does both.

California’s Attorney General explains that there are thousands of variations on unlawful pyramids, and that it is often difficult to tell the difference between a pyramid scheme and a legitimate MLM program. An illegal pyramid or “endless chain” is a plan “in which a person pays money or buys merchandise for the chance to receive money when additional participants are introduced into the
scheme.” [SER 560-61.]

Promoters frequently use group psychology to pitch pyramids “at recruitment meetings which create a frenzied, enthusiastic atmosphere where group pressure and promises of easy money prey upon the potential victim’s rational mind and fear of missing a good deal.” [SER 560.] Pyramid schemes can collapse at any time because there must be an endless supply of new participants for everyone to profit. For as long as they operate, the majority of the last to join suffer losses. The participant’s family and friends are typically victims because they too have been recruited. [SER 560.]

Medifast’s complaint admits that its subsidiary TSFL combines Medifast’s product line with commissioned “health coaches.” [ER 30, ,-r21.] “TSFL offers its clients an opportunity to increase their income if they chose to become a TSFL health coach.” The TSFL client distributors purchase the “Application Pak or Career Builder Pak” for a cost of $199. “Once certified, health coaches can sell Medifast products to others, and can also, if they choose, recruit other health coaches to join their team.” [ER 31, ,-r,-r 26,29.] Health Coaches receive a residual commission “on sales of Medifast products by the recruited health coaches” [ER 32, ~32] and a series of reward bonuses [SER 999-1001]. Medifast also hosts annual conventions at resort locations to hype the TSFL program.

Health Coaches Pay for the Right to Sell Medifast and Receive Compensation for Recruiting New
Coaches:

According to Bell, Health Coaches focus on clients, not recruiting, by getting them to eat Medifast products and teaching them lifestyle changes – for which the clients do not pay the Health Coach. [ER 1005, ,-r22.] This begs the question how do Health Coaches make any money? Bell says the coaches get paid when clients make direct purchases of Medifast products from the coach. A person could, of course, purchase Medifast products without a coach, but then no commission  would be paid. [1006, ~~ 23-25.] So, to make any money a person must become a Health Coach and to become a Health Coach, a fee must be paid.

A Health Coach must be sponsored by a “Business Coach.” Until the fee is paid and the Health Coach is “trained” they cannot receive commissions. Business Coaches in tum are trained by “Business Leaders.” Each level cultivates clients, but unless Health Coaches enlist more Health Coaches their income will be limited to their personal sales. When sales are made, the Health Coach and the Business Coach make money. [ER 1007, ~29.] The percentage of commission drops as coaches move up the levels, but the volume more than makes up for it as the expanding chain capitalizes on the sales of down-line coaches.14 [ER 1007, ~30.] Those at the bottom, however, made only an average of $96.90 per month in 2009. [SER 337.]

His point that most product orders are placed by clients, not Health Coaches, misses the issue. The salient fact in Bell’s declaration is that Medifast distributes its products through a scheme whereby the Health Coaches pay consideration for the chance to obtain commissions by introducing more Health Coaches. That is prohibited by California’s endless chain law.

Health Coach Attrition Reveals the Endless Chain

As FitzPatrick stated in his 2009 Report, Medifast had not disclosed in its SEC filings the financial condition of coaches, the turn-over rate, or the business costs incurred. TSFL instead was enticing new layers of Health Coaches on its website by showing the disparity in income potential between a “Client Focused” and a “Client & Team Building Focused” strategy. [ER 78; SER 938.] The “client” strategy would generate monthly income between $100 and $7,500 per month and then plateau. By contrast, the “client and team building” strategy would generate between $1,000 and $25,000 per month and thereafter escalate vertically. [ER 78.]

Similarly, Bell did not tell the District Court essential information about the attrition rate of Health Coaches and led the court to believe that the number of coaches was rapidly expanding. [ER 1008-09, ~~33-34.] He states that from May 2009 through April 2010, TSFL added 6,356 new Health Coaches, and that as of May 2010, the total number of coaches was 8,000. However, he does not disclose that Medifast already had 4,000 coaches at the beginning of the period. [SER 746, ~~64-64; RJN, Ex.8, p.13.] That meant 2,356 coaches had quit – a remarkable 60% attrition rate.

The flurry of numbers Bell recited to the District Court has little significance under California’s statute. The ratio of recruited Health Coaches to clients, or of retail sales to internal sales, does not matter. Medifast charges a fee for the right to recruit and compensation is received from those recruited who are offered the same business opportunity for the same right. This recruitment-based incentive scheme includes purchases of Medifast products by the Health Coaches themselves, for which the up-line coaches receive commissions. This meets the definition of an endless chain under California law, and would under FTC case authority as well.

Medifast admits that the TSFL business may be characterized as a pyramid scheme in its SEC fiings:

Regarding TSFL, Medifast knowingly engages in controversial business and marketing methods. It acknowledges, in its restated 2009 1 O-K to the SEC, the risk that its selling method might be interpreted to be a “pyramid” or “chain sale” scheme. [SER 1021.] Nevertheless, it issued press releases touting its success in bucking industry trends led by TSFL using “multi-level marketing techniques.” [SER 593-94,602-03,608,614-615.]

FitzPatrick Showed That Bell’s Explanation of TSFL’s Pay Plan Confirms the Endless Chain:

Bell states that Medifast’s retail sales are at a percentage where the plan cannot be considered a pyramid scheme. [ER 1009, ,-r35.] However, the law in California does not set percentages. [SER 738, ,-r34.]

FitzPatrick reasserts in rebuttal that the fundamental elements of an endless chain inherent in TSFL’ s scheme are not invalidated by Bell’s selective statistics. While Bell contends that Medifast’s focus is all that matters, FitzPatrick counters that the elements of an endless chain have been revealed. TSFL distributes its dietary products in a scheme whereby participants pay for the chance to receive compensation for introducing other participants.

Bell admits that consumers can become Health Coaches by paying consideration, currently $199, and that the coaches also pay a renewal fee of $30 every six months. [ER 1013-14, ,-r,-r49-50 & 53.] That is valuable consideration under California law. Medifast’s authorized Health Coaches then receive the right to obtain commissions from their sales, including sales to new coaches they recruit. [ER 1006, ~~ 24-25.] That is compensation for introducing new participants under California law.

Although the rudimentary facts that Bell admits alone reveal an endless chain, the scheme is more elaborate. Health Coaches can become Business Coaches by acquiring more clients and health coaches. In doing so, the Business Coach gets a percent of the revenue generated by the Health Coach, which might be a smaller percent, “but it is on a larger volume.” [ER 1006-1007, ~~ 24-26 &30.] This satisfies California’s alternative definition of an endless chain because “it is a chance to receive compensation when a person introduced by the participant introduces a new participant.”

Bell further acknowledges that TSFL uses a bonus structure. Among them are: an “acquisition bonus” for obtaining five retail customers, which would include those that become coaches; a “client-assist bonus” if a coach sponsors another coach who obtains five new retail clients; and “growth bonuses” of various types when senior coaches “grow their businesses” by either “volume” or “structure” which means recruiting by downline coaches. [CR 1016-17, ~~ 59-63.]

FitzPatrick prepared a chart to show how the bonuses aggregate to benefit the highest levels of Health Coaches. [SER 339.] The bonus structure also satisfies the definition of an endless chain.

FitzPatrick explained in rebuttal that although TSFL’ s rewards are made through a complex formula of commissions and bonuses, Medifast does not deny that it includes significant rewards for expanding the base of participants who pay to join. This underlying fact remains despite Bell’s parsed statistical data. [SER 743, ~~ 50-51.]

FitzPatrick Rebutted Bell’s Half-Truths With Additional Facts Exposing the Endless Chain:

Medifast’s failure to make a prima facie showing is more apparent when FitzPatrick added missing facts to reveal TSFL’s dependence on recruiting to replace the dwindling ranks of entry-level Health Coaches. The attrition rate of participants is not a specific factor considered by California law, but it does reflect a business structure dependent on an endless chain.

Bell states that from May 2009 through April 2010, TSFL enrolled 6,356 new coaches, and that as of May/June 2010 it had about 8,000 coaches. He adds that during the time period TSFL also gained 102,505 new ordering clients. [ER 1 008-09, ~,-r33-34.] This by itself establishes nothing because Bell does not state how new “clients” became coaches. Equally important, he does not disclose the attrition rate of coaches.

In rebuttal, FitzPatrick explained that Bell omitted the critical starting-point data. Bell states that 6,356 new coaches were added resulting in a total of 8,000 coaches. But, he does not say how many coaches existed at the beginning of the time period. FitzPatrick found that information in Medifast’s report to the SEC where Medifast stated it had 4,000 active coaches enrolled as of March 31,2009. That meant 2,356 coaches, or about 60%, had quit (4,000 at the start + 6,356 new = 10,356 – 8000 at the end = 2,356 attrition). [SER 746, ~~ 63-64.]

This churn rate of Health Coaches is an earmark of an endless chain that would have to expand in ever growing numbers if Medifast were to continue its reported revenue growth rate of 94%. TSFL is dependent on recruiting coaches in a market that is limited and diminishing. FitzPatrick not only rebutted any prima facie showing that Medifast might have made, but he also showed that Bell concealed information reflecting the opposite of what he claims to have proven.

Is Medifast running a pyramid scheme with its Take Shape For Life division? You decide.