At yesterday’s big Herbalife investor day, the company paraded around Anne T. Coughlan, a marketing professor at Northwestern University, who proudly proclaimed that Herbalife is not a pyramid scheme. No, it is a legitimate multi-level marketing company.

In July, Coughlan published this paper on Herbalife, concluding that Herbalife is squeaky clean. Let’s be clear. Herbalife paid Coughlan to publish this paper. The paper notes:

This document was prepared with the financial and data support of Herbalife
Ltd.

I don’t want anyone to be fooled. This wasn’t a professor who just decided to write about Herbalife out of the goodness of her heart. She was paid to do so.

But lets talk about Coughlan’s conclusions. They’re wrong, and her paper is misleading, in my opinion. She did only a very limited analysis of Herbalife, one that was guaranteed to result in her concluding it was a legitimate MLM and not a pyramid scheme. Attorney Doug Brooks, one of the most knowledgeable people in the world on the topic of multi-level marketing, says that the analysis is superficial and full of misleading and inaccurate statements.

Let me be clear: Multi-level marketing companies have perfected the game of regulatory compliance. They know exactly what window dressing they need to appear to be legitimate. There are even attorneys (clowns?) who make their livings teaching MLMs how to make it appear that they are not violating laws prohibiting pyramid schemes.

Inevitably then, the “criteria” that Coughlan examined would all indicate that Herbalife is legitimate!

Ann T. Coughlan proves her theory with the following points in bold. My commentary follows:

Compensation is based on sales and not on mere recruitment – What Coughlan fails to realize is that compensation is not based on “sales” in any way shape or form. It is based on distributor orders of products from Herbalife. Commissions are paid when those products are ordered, and there is no correlation whatsoever to sales to consumers. Herbalife has no idea whether those products are sold or not.

And the word “mere” is something Coughlan threw in herself. She cited two important cases in her endnotes:

For example, The Webster v. Omnitrition case (Webster v. Omnitrition Intern., Inc. C.A.9 (Cal.), 1996) says that the “Sine qua non of [a] ‘pyramid’ scheme is [the] right to receive, in return for recruiting other participants into [the] product sales program, rewards unrelated to [the] sale of product to ultimate users.”

FTC v. BurnLounge (U.S. District Court, Central District of California, No. CV 07-3654-GW(FMOx), Statement of Decision, notes that “Inventory-loading pyramids are illegal not simply because there are wholesale purchasing requirements. They are illegal because the purchases are incentivized by commissions that result from recruiting others to join the scheme through similar purchases.”

But you see that neither of these decisions hinges on “mere” recruitment.  In the first, the problem is rewards unrelated to the sale of products to actual consumers. This is something many MLMs quietly run afoul of. Most MLMs pay commissions based on product orders by distributors, and the commissions have nothing to with any sale of products to ultimate consumers.

In the second, we hear about product purchases that are incentivized by commissions paid for recruiting others who make similar purchases. Most MLMs run afoul of this as well, again very quietly. Since MLMs are generally careful not to pay commissions directly tied to the act of recruiting, the recruits are persuaded to make product purchases to trigger the payment of commission. Again, it doesn’t matter if those products are sold, just that they are purchased by distributors.

And MLMs are even more clever when they require distributors to “qualify” to receive commissions. That is, the distributors can’t receive commission checks unless they have purchased a certain amount of product recently. MLMs are careful to say there is “no requirement” to purchase products, but the truth is that you don’t “qualify” to receive commissions unless you “choose” to purchase products.

Low enrollment fees – Most multi-level marketing companies have low enrollment fees. That is a carefully planned part of the operation.  A higher enrollment fee attracts attention from regulators. So they keep the fees low, and then offer separate “business builder” packages or product packages to extract more money out of distributors. A low enrollment fee proves nothing other than the MLM knows the types of things that can be red flags for regulators.

Scientific and product investment to create and manufacture sellable products – While Coughlan claims that Herbalife invests significantly in research and development (and now Herablife claims this too, as of yesterday’s investor party), Herblife’s own SEC filings show this is a lie:

The Company’s research and development is performed by in-house staff and outside consultants. For all periods presented, research and development costs were expensed as incurred and were not material.

Coughlan reports:

In 2011, Herbalife spent about $25 million combined on research and development, technical operations, scientific affairs, quality assurance and quality control, product safety, and compliance efforts. Beyond this, an additional $11 million was spent on nutrition affairs, product licensing, and strategic sourcing.

Herbalife’s investor day presentation gave similar information, reporting that $44 million was spent in 2012 on “R&D, quality assurance, products safety, and compliance, among others.”

You have to read these statements carefully. There is a whole lot of stuff thrown into this $36 million to $44 million. It  includes all sorts of costs related to manufacturing as well. What does that prove? That they’re not manufacturing products in dirty plants? So the company spends about 1% of revenue on all things R&D and manufacturing, and this is supposed to be a “significant” investment?

Bill Ackman’s point in his presentation was that Herbalife claims to be a products company, but they do relatively little research and development. That hasn’t been debunked in the least.

Coughlan goes on to say that the result of Herbalife’s research and investments is a sellable product! An illegal pyramid scheme wouldn’t care about having a product!

Again, this is one way that multi-level marketing companies give themselves an air of legitimacy. They provide a legitimate product that can theoretically be retailed. They can say “no, no… it’s not about recruiting, it’s about retailing.” But the truth is that the products are incidental to the scheme as a whole.

Willingness to take back unsold product when a distributor resigns – Yes, Herbalife is benevolent because it has a product buy-back policy, and since almost no one participates in that program, it must mean that the quitters are all happy. What Coughlan doesn’t mention is that several state laws require buyback policies, so MLMs have these  policies to ensure they can do business in all states.

Coughlan theorizes that an illegal pyramid scheme would have a bogus product and would experience high rates of return.  This whole line of thinking is wrong. In my years of researching MLM, I’ve found that most distributors don’t participate in the buyback program because of one or more of the following reasons:

• they don’t want to lose what little downline and commission income they have (or think they may have in the future)
• they are coerced by their upline to not return products
• they are given misinformation by their about the return process, the rules, and the money they can expect to receive
• they fear that the subtractions the company makes from their potential refund will make it “not worth it”
• they don’t want to be prohibited from joining the company again in the future
• they’re too embarrassed to admit failure and return their products

Discouraging distributors from inventory loading –  Coughlan claims that Herbalife discourages distributors from stocking large amounts of inventory (often called “inventory loading” or “frontloading” in the MLM world) that they cannot sell or consume in the near term. That sounds great, but is it true?

It depends on how you look at it. Again, we go back to the issue of “qualifying” for commissions. MLMs like Herbalife require distributors to purchase products at regular intervals, or they do not qualify for commission checks. They can plausibly deny any inventory loading by saying that distributors should only order what they can sell or consume.

But if you’ve studied multi-level marketing for any length of time, you have seen that these minimum purchases add up quickly. So even if a distributor doesn’t place a large initial order, making the required minimum purchases on a regular basis can easily cause the distributor to stock more inventory than he or she needs. The MLM will say distributors should be selling these products! But this ignores the fact that there is a teeny tiny market for MLM products outside of the distributors.

Consumption by non-distributor versus by distributor end-users is not a valid criterion – Coughlan claims that it doesn’t matter if anyone outside an MLM wants to buy the products. Sales are sales, and sales inside or outside the pyramid all count equally. Even though Herbalife doesn’t track actual retail sales (inside or outside the distributor network), surveys show there is retailing to third party customers!

First, it is important to understand that multi-level marketing companies do not track actual retail sales for a reason: The lack of retail sales outside the distributor network would go a long way toward supporting pyramid scheme allegations. These companies claim there is no way to track such sales, but that’s not true. They have a vested interest in not tracking retail sales, and so they do not track retail sales.

A problem with Coughlan’s claim that we should ignore retail sales to third parties is that it conflicts with the earlier claim that there are sellable products. Indeed, if the products were the focus, then sales would be occurring outside the distributor network. If the sales are only (or mostly) occurring within the distributor network, then I think you’ve got evidence of a recruiting scheme rather than a company focused on retailing.

Anne Caughlan’s presentation at Herbalife’s investor day added one amazingly foolish statement in addition to showing her “conclusions” from this article:

MLM can persist indefinitely and is not dependent on recruitment for survival.

That’s simply not true. If Coughlan had read Herbalife’s own comments in its last 10-K relative to this issue she would have been better informed.  The company says it has a high turnover rate amongst distributors.

What does that mean? In order for the company to survive, it needs new people to be recruited. Without new recruits, the organization would dwindle to nothing. All that would be left are higher level distributors, who get the bulk of their compensation from the purchases of the recruits below them. As those recruits dwindle, there will be no one and no compensation left.

One other point I found interesting from Herbalife’s presentation yesterday:  Herbalife cites “independent” research that shows 5% of U.S. households have purchased an Herbalife product within the last 3 months. How then, can it be, that during Bill Ackman’s presentation, only one audience member said they’ve ever purchased Herbalife products? Curious, isn’t it?

Notice also that Herblife provided no information relative to any of the questions I suggested they answer at the end of this article. How’s that for transparency and disclosure?