SEC Enforcement Understands Pyramid Operators and Recruiters are Co-Conspirators $HLF

On February 27, 2015 the SEC announced a little noticed pyramid scheme prosecution. You can find the press release here and the indictment here. While it is small game (I’ve previously said here (around the 8th paragraph) that the FTC, in particular, has a history of hunting small game pyramid schemes, and so does the SEC) this one is significant for the following reasons:

1. I believe it is the first time the SEC has prominently prosecuted both the company/executives and top recruiter/promoters. Connecting this to Herbalife, we need to go back to when Mark Hughes overdosed, the company was rudderless, adrift and for sale. Sales were stagnant or declining. But the price was right. JH Whitney and Golden Gate Capital paid approximately 4-6x Ebitda, contributing about $200 million of equity. In order to underpin the deals turnaround and growth, they made Top Recruiters their defacto partners (they are not “independent contractors” as the company would have the world believe) by sealing what is referred to as the Tirelli Agreement, etching in stone, among other things, the “6% Infinity Bonus”.  This 6% additional expense would not be paid by Herbalife, but added a new bogus Shipping, Processing & Handling charge was passed on to new recruits. The Tirelli cut the “Mega Recruiters” (Founders, Chairman & Presidents Team) in for 6% of Certain Revenue and turned them loose around the world to recruit millions and millions of new victims.  And recruit they did.  Over the years they found myriad ways to take advantage of every new advanced technology, including the Internet, to lure unsuspecting victims into their web and separate them from their money.

It is important to note the Tirelli Agreement cannot be modified without the approval of a majority of the Presidents Team and above (it’s a perpetuity for Top Recruiters.  Meaning:  if we build Herbalife into a juggernaut and you cash out, the company can never change the deal on us!)  And the Mega Recruiters did make JH Whitney and Golden Gate Capital rich – their most wildly successful deal.  Within 2 years JH Whitney and Golden Gate paid themselves a dividend almost equal to their entire equity investment, substantially mitigating their capital at risk.  (Remember, 2004 was a more benign regulatory environment, but it is still a pyramid scheme, so it’s a hot potato.)  Shortly thereafter they flipped the company to the public, and in short order sold all of their stock for well over $2 billion in profit.  Of course they sold it all… these are not eating sardines, these are trading sardines.  (Carl Icahn just got stuck with a mouthful of these nasty sardines.  That what you get when you’re selfish and greedy.)

2.  In the SEC complaint referenced above, the pyramid scheme did some curiously similar things to Herbalife:  (1) targeted Latino communities, (2) established a network of leading promoters (that’s why I elaborated on the Tirelli Agreement above), (3) recruitment surged through social media to promote “business meetings” (Herbalife, in its various iterations was all over the Internet), and (4) promoters also set up “storefronts” or “training centers” to attend presentations. (akin to Nutrition Clubs)

Of particular note… the SEC sought to freeze and repatriate foreign assets.  (The suggestion that Herbalife can simply truncate its U.S. business and liability is idiotic.)

The SEC must understand that Herbalife and its Top Recruiters are far more sinister and egregious in their criminal conspiracy and racketeering compared to the tiny pyramid scheme they shut down in February 2015.  I’m comforted to know the SEC understands the nature of these crimes and particularly how the Top Recruiters conspire with the company and management to pull off the scam.  I’m more comforted to know the Department of Justice, with their big giant elephant gun, is also on the case.

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$HLF Herbalife, SEC Division of Corp Finance, 10-K Disclosures, SEC Division of Enforcement

Well… it’s official. Fueled by speculating day traders, #Herbalife continues to march ahead on misinformation. With very little publicly traded float, Herbalife stock moves up or down, sometimes significantly, based on all sorts of idiocy.

The SEC Comment Letter(s):

There has been chatter about the SEC “clearing” Herbalife after a review of their 2013 and 2014 10Ks and disclosure of these letter letter.  The chatter was so intellectually lazy, I can’t even describe it as analysis.  In layman’s terms, the SEC Division of Corporation Finance was reviewing Herbalife 10-K disclosure for 2013 and 2014.  The SEC asks questions the company cannot dodge.  The company must go on record with a response.  The SEC doesn’t agree or disagree with anything the company says or does, either in response or otherwise.  However, based upon the direction of the questions from the SEC, a company will almost certainly make changes to their disclosures.  (If your Dad sits you down and starts asking questions about last Friday night, which you hadn’t mentioned or you mentioned only partly, you might want to fill in some more detail.  If he then says, “Thanks for the answers” or even “Thanks for being more forthcoming”, that doesn’t mean the hammer isn’t coming down.)

Anyone who has been through this SEC review process knows they don’t say things like…(in the case of Herbalife) “we don’t think you have more than 50% retail sales, we think you’re in violation of the California injunction, we think Pedro Cardoso lied about his Brazil indictment and therefore you’re in violation NYSE rule or he shouldn’t be a Board member, we think you have problems in China and we think the Tirelli Agreement is problematic.”  At this point, the SEC Division of Corporation Finance does exactly as the letter states… encourages the company to make complete and accurate disclosure of all material facts and withholds any decision on enforcement action.  Having had the opportunity to look into the company books and records, and review the disclosures, if they find anything amiss they can/will refer it to the SEC Division of Enforcement.

SEC Division of Enforcement has opened an investigation into Herbalife.  If that investigation was closed by specific letter from the Division of Enforcement, rest assured Herbalife would have held a prime time press conference, put a copy of the letter on their “anti-Ackman” website and been propaganda tweeting it from on high!

There is so much misinformation and intellectually lazy thinking about Herbalife, sometimes I think I’m in a time warp.  e.g. “When the FTC rules on Herbalife….”  The FTC doesn’t rule on anything.  Here’s the thing:  The FTC uses it power (now in use re Herbalife with Civil Investigative Demands) to gather information.  If the FTC Commissioners determine “a proceeding is in the public interest” because the law is being or has been broken, then the FTC goes to a court and asks a judge to temporarily stop the bad stuff (in the case of pyramid schemes, that would typically be: stop the recruitment of new members into any specific program the FTC believes violates the law AND the payment of commissions/royalties/etc. thereon.  That is an important nuance – the FTC doesn’t have to say all of Herbalife violates the law.  They can say, “We are only seeking injunction against specific programs, not an injunction against all the retail customer sales activity Herbalife boldly claims to have!”  That’s what the FTC did with Burnlounge; they just went after the Mogul program.  But interestingly, the appellate judge said (paraphrasing) “the proof was in the pudding.  When the recruiting stopped, the company collapsed.”

I’ve argued that the Sales Leader and Nutrition Club programs (in the aggregate) violate the law.  If the FTC sought to substantially restrict or enjoin the recruitment and/or payment of commissions on those programs, Herbalife would collapse.

In virtually every case where one is requested, a temporary restraining order is granted.  Then a hearing is held to convert the temporary order to a permanent order and ultimately a trial is held, a judge makes a decision, then an appeal.  That is where it gets tricky for the FTC and Herbalife.  The FTC has historically hunted small game and the small quickly fold up their tent.  But Herbalife is an elephant with a multi hundred million dollar war chest and an army of lawyers and lobbyists ready for battle.

The MLM Attorney Kevin Thompson has said the FTC doesn’t have the firepower to go after Herbalife.  I understand his point.  In MLM/Pyramid schemes, if you stay small, you get prosecuted and shut down.  But if you can run the gauntlet and get really big, you can persist in the criminal activity for a very long time.  Herbalife is a criminal racketeering enterprise… and the FTC alone may not be up to the task.

There is also recent chatter/speculation about the FTC “wrapping up its investigation” after the summer.  I don’t understand why this would be perceived as a good thing for Herbalife.

In the most recent 10-Q Herbalife disclosed the Department of Justice has sought information about the company, certain individuals and certain of its distributors.  (Give me a little creative license here.)  Here’s the scenario:  the FTC has used its CIDs to gather information and shared that information with other agencies.  The SEC (both Division of Corporation Finance and Division of Enforcement) has gathered information and shared that information with other agencies.  The SEC Corporate Finance has closed the disclosure review file and made referrals, if any, to Enforcement.  The SEC Division of Enforcement has not closed the file and has gathered enough information.  The FTC has gathered enough information.  Same with whatever state AGs are on the case.  Now… the Department of Justice…

Herbalife and its Top Recruiters (Founders, Chairman, Presidents Team etc.) are akin to the MAFIA.  Together (acting in concert) they run a criminal racketeering enterprise that breaks laws up and down the FTC, SEC and States.  Any one of those agencies or States could put a stop to it.  But the Department of Justice is on the case.  And they are the big dog.  The fact that the stock has rallied from $30 to $55 in the face of disclosure that the DOJ is IN FACT requesting information from the company AND Top Recruiters is (again, in the infamous words of Dan Loeb) preposterous.  But then again, as Co-Conspirator/Top Recruiter Geri Cvitanovich said at the Extravaganza to a room full of aspirational recruits, “It’s the Herbalife version of reality.”

One side note: It’s morally wrong to support an illegal enterprise.  Providing capital, however temporary and in whatever form (debt or equity), is providing support.  It undermines the function of secondary markets by depriving capital to other productive enterprise.  It undermines capital markets and society.  Not only is it right for participants to root out illegal and corrupt enterprise, it is their duty as participants, if they can find a profitable way to do it.  It is nonsense to criticize Ackman, in the same way it would be nonsense to criticize Markopolos.  In any event, Herbalife has been surrounded by a mob of amoral and immoral speculators for as long as it’s been in existence.  That’s nothing new.  Herbalife attract them like bees to a honey pot.

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@John_Hempton Recent Blog Fails to Understand $HLF Racketeering & Money Laundering

A defining characteristic of racketeering and money laundering is concealing illegal business within some legal business.  John Hempton’s recent blog described his visits and experience with #Herbalife Nutrition Clubs in tiny markets by revenue, telling us they are not illegal (except a few minor exaggerated medical claims; which I understand his point… those claims are understandable in the context of real weight loss).  Nonetheless, he would have us believe these few tiny markets and Clubs are typical of the whole Herbalife Club model and Herbalife as a whole is not an illegal enterprise. He noticeably fails to point out that the overwhelming majority of Herbalife Clubs are in Latin/South America, Mexico and heavily Latino U.S. communities (approx. 50,000 Clubs in those overwhelmingly poor areas) versus less than 1,000 total Clubs (less than 2%) in the countries Hempton visited.  Herbalife trumpets/promotes this purportedly “legal” portion of their business in order to give credibility to the whole.  Criminals have been doing that for… well, for as long as they’ve been committing crimes.

Among other bad things, Herbalife is running a 50,000 Club fraud racket in the poorest World Bank countries and Hempton is spouting off about the wonderful shake bars he’s visited in a handful of tiny markets and telling us the whole company must be fine.  In the infamous words of Dan Loeb… it’s preposterous.

I have 7 Nutrition Clubs in my small heavily Latino working class community on eastern Long Island, New York. The patrons of these Herbalife “Club 100” Clubs are EXACTLY as Christine Richard described… they go “to consume” (a seemingly benign response for native Spanish speakers to a company sponsored survey question… if the survey is not designed to probe for the truth.) The Clubs are recruiting and training venues and therefore they are frauds.

Hempton said he visited Clubs in 7 countries/cities (Miami, Sydney, Malaysia, China, Cambodia, Thailand, Israel), but excluding Miami, they collectively have less than 1,000 Clubs (maybe 2% of the total).   He then draws a glaring contrast to the heavily Spanish Club 100 programs (referenced by Ackman in the U.S. communities and by Christine Richard in Latin/South America and Mexico)…. and concludes Herbalife is not a pyramid scheme because of his experience “on the ground”.  He may be on the ground, but his head is in the clouds.

Latin/South America, Mexico and Latino communities in the U.S. represent approximately 50,000 Clubs, almost exclusively operating the Club 100 model and are the dominant driver of revenue and profits for the Herbalife Club segment.

By managements own admission, and their public statements, the vast majority of Nutrition Clubs failed within a year when the owner was soliciting true retail customers.  Converting the Clubs to recruiting and training venues was the solution to a multi-fold problem; it drove product volume through the clubs (money; revenue), provided access to a lower socio-economic target market (new market, the “fortune at the Bottom of the Pyramid”), and gave the illusion of retail customers (criminal defense).

The FTC vs Futurenet is one reason Herbalife’s Nutrition Club model is illegal. The Court’s Final Order with respect to distributor training said: “Compensation related to recruitment is any form of compensation that is conditioned upon, derived from or related to recruitment of new persons to any business opportunity involving any multi-level marketing program.  This term includes, but is not limited to, compensation paid or provided to participants in a multi-level marketing program as a result of or related to any type of training provided to either new or existing participants in a multi-level marketing program.” (emphasis added) Nutrition Club participants striving up the pyramid, who recruit their friends and family in support of their efforts, would not be there “to consume” (as Christine Richard quoted patrons, and as I know the same to be true) were it not for their training.

Club 100 advancement in the program is conditioned upon, derived from and related to bringing friends and family to the Club to drink shakes the participant prepares as part of their training; it is all part of “the Club 100 success system”… all of that runs afoul the Futurenet Court with respect to compensation related to recruitment.

You cannot look at individual Clubs or a tiny segment of Clubs, as Hempton does, and draw a conclusion about the whole.  You must look at a much larger segment.  Frauds, and pyramid schemes in particular, are masterful at diverting your attention to the outlier.  It’s a common fraud tactic, diverting your attention away from what would otherwise be obvious.  The vast majority of Herbalife Clubs are recruiting and training related venues. Management admitted… when they tried to build Clubs straight, virtually all failed.  So they went to the TRAINING model!  The Futurenet Court said any product sales conditioned upon, derived from or related to training is NOT RETAIL.

Hempton says Christine Richard suggested a huge number of people must be drinking 5-7 protein shakes per day which is not just conscripted consumption but forced consumption to the point of vomiting, in order to get to her numbers.  It may have made for funny reading, but what Christine accurately described, and what I’ve know first hand as well, is Club(s) occupied by “students in training” bringing 3-5-10 friends and family who are “consuming” as part of a conscripted program to help their family member/friends move up the “ladder of success”.  And by the way… many of these people may or may not want to lose weight too.  But the primary reason they joined and go to the Club, is in support of their family/friend/student-in-training.  Without the recruiting and training, sales of product would plummet.  Period.

A word about Sales Leaders.  In round numbers from the 2014 Statement of Average Gross Compensation, Herbalife says it pays out 72,000 “independent” Sales Leaders an average $5,500 per year or $400 million. Michael Johnson makes this sound so attractive, “about $500 per month part time income. That’s real money in these tough economic times.” But Johnson is a masterful liar and deceiver.

Herbalife includes in the Statement of Average Gross Compensation a tiny group (2.2% of participants eligible to receive payments) who earn virtually all the money, are the mega-recruiters  (not retailers and not independent of Herbalife) and whose business model bears little resemblance to what they are pitching the audience/targets/recruits.  Herbalife also excludes a very large group (about 37.5% of participants eligible to receive payments) that earn nothing.  The result of this charade is to deceive “business opportunity” seekers about (1) the probabilities of success (they skew the numbers) and (2) the pathway to success (they make it look like retailing is the successful, when in fact, it is recruiting).

In order to mitigate this deception, 3 things should change in any Statement of Average Gross Compensation:

(1) Exclude the Top Recruiters income… the equivalent of Founders, Chairman, Presidents/GET Team etc… in the case of Herbalife, that’s 2.2% or 2,628 member/participants eligible to receive payments.  It takes an average of 7 years to get to Presidents Team and these mega recruiters distort the disclosure statement which is intended for new recruits who are evaluating the business opportunity.  Shouldn’t they be told what they can reasonably expect to earn “retailing” in the next 1-2-3 years, and not have it distorted by the lopsided income of 7,10,20,30 year senior mega recruiters? ;

(2) If you’re qualified and eligible as a Sales Leader you get included in the calculation, even if you haven’t added a single downline or earned a nickel.  Herbalife had about 45,000 Sales Leaders who earned $0… so of course they exclude them;

(3) If you’re qualified/eligible to receive payments, you get included in the calculation.  Period.  In 2014 Herbalife had 2,966 Non-Sales Leaders with a downline, 1,821 made an average $48 and 1,156 made $0… Herbalife excluded them all. How convenient.)

Recasting Herbalife’s 2014 U.S. Statement of Average Gross Compensation looks like this:

Members % of Total Avg Gross Pmts
2,209 1.9% $15,393
2,858 2.4% $7,060
12,483 10.7% $2,242
43,214 36.9% $288
56,428 48.2% $0
117,192 100.0% $807

The Average Gross Compensation is really more like $807 ANNUALLY (not $5,500)

95%+ are spinning their wheels, losing money, time and reputation after considering the cost of becoming a Sales Leader and running their business.

85% make less than $300 per year, gross.   Nearly 50% make $0.

Herbalife would have us believe (by faith alone) that ALL these people are out there successfully retailing their product to a vast network of millions of unknown and unproven consumers.  Again, in the infamous words of Dan Loeb, that is simply preposterous.  And besides, the burden of proof (of end consumers) is upon the company Herbalife, NOT the government or anyone else.  Yet Herbalife claims this information is not material.

The true Business Opportunity is… Herbalife and co-conspirator Top Recruiters are fleecing new recruits for hundreds of millions of dollars every single year.

In addition to (1) (2) (3) above, The Statement of Average Gross Compensation should disclose the 1, 2, 3, 4 and 5 year Member average income (and must include everyone qualified/eligible to receive payments of any kind.)  Basically, tell new recruits: if you join as a Sales Leader, this is what you can expect to make in the 1st, 2nd, 3rd, 4th and 5th year based upon the most recent recruits (and disclose how many quit!)

In the blog referenced above, John Hempton describes President’s Team members as company recruiters (“they are keen to recruit you and get you to do the same”), although he’s quick to point out they are “independent contractors”, which would be laughable if it wasn’t illegal and harmful in its conspiracy and racketeering.  Hempton further describes Chairman’s and Founder’s level as nearly untouchable. I agree.

Let’s be clear about something, Top Recruiters are NOT independent consultants.  That, too, is preposterous.  They are hired guns for Herbalife.  They are in cahoots with Herbalife management in perpetrating this fraud.  They are as independent of each other as Mafia Bosses (Michael Johnson & Team), Underbosses (Founder/Chairman level) and Capos (President’s Team) in a crime family.  Herbalife/Management is La Cosa Nostra (The Commission with Don Michael Johnson), and the Founders/Chairman run “families” and the President Team run “crews” that have myriad ways of separating aspirational and hopeful human beings from their money.

For an otherwise intelligent guy, John Hempton has been duped by a pyramid scheme. That is understandable. My brother is an extremely intelligent surgeon and was the victim of Equinox in the mid-1990s.  I told my brother it was a pyramid scheme.  He vehemently defended the company, it’s products and mission… right up until the Government shut it down and put the executives in prison. Like value investing, in my experience, people either understand it right away or they never seem to understand it at all. Rarely do they come around slowly.  The worst part is, the fraudsters are great at spotting a credible outsider to promote their fraud.

Where do we go from here?

Here’s an interesting scenario:  The FTC uses their Civil Investigative Demand (CIDs) in conjunction with the more recent Dept. Justice inquiries/subpoenas of Top Recruiters and Herbalife and the outcome is a multi-jurisdiction (FTC, DOJ, SEC and multiple State AGs) criminal case for Conspiracy, Racketeering, Money Laundering and Fraud.  (And the DOJ Office of Foreign Litigation gets involved to seize foreign assets, issue executive arrest warrants, just like FTC v Fortuna, which was a 60 country pyramid fraud, until all foreign assets are returned to U.S. custody.)

Few people thought SAC Capital, the largest, most successful and influential hedge fund in the world would be stopped for its criminal activity… despite persistent rumors and attempts by other prosecutors.  SAC had a stable of former federal prosecutors on staff and a multi million dollar annual compliance budget. Then one day, seemingly out of the blue, Preet Bharara held a press conference and declared SAC Capital a long dated breeding ground for criminal activity; recruiting, incentivizing and rewarding criminal behavior; turning a blind eye toward it; and paying lip service to enforcing compliance with the law…and Preet Bharara said “today it stops.”

I’m still waiting for the day a true leader in our government, with a moral compass and armed with the facts, (Preet Bharara, James Comey, Edith Ramirez, Mary Jo White, Eric Schneiderman, Lisa Madigan, Kamala Harris) has the backbone to stand up to the criminals running  and promoting Herbalife, who prey upon the hopes and aspirations of other human beings in the U.S. and around the world.

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