financial fraud

Scams: Multi-Level Marketing, Herbalife

Carl Icahn and Bill Ackman - WSJ

Carl Icahn and Bill Ackman – WSJ

Not to seem unduly negative, but sometimes they are out to get you.

Abuse of social ties to rope people into schemes to enrich a few is still common, and now we have the extended social networks of the Internet to entice us into trusting people we shouldn’t. One example: the Kickstarter boys who took $40K to develop a game and then squatted in an AirBnB apartment in Palm Springs.

But much financial fleecing still happens because we trust someone in our community or network of friends. Very commonly financial fraud artists will prey on a religious community, where being “one of us” seems to lead to blind trust; biggest example, Bernard Madoff’s pyramid scheme which took mostly Jewish investors for billions of dollars.

We’ve all experienced the “friend” who starts pressuring us to buy products from the multilevel marketing scheme they’ve signed on for; in the 70s, it was Amway distributors you avoided at parties. Some of these schemes burn out and collapse, but others go on to become more honest businesses. But most start out dishonest and stay dishonest, pushing products that are inferior or fraudulent like the “ion water” (water with a trace of salt) a friend of mine swore by. These companies mine the enthusiasm and greed of the unwary and get them to fleece their friends as well, destroying social ties and trust. One thing you know about anyone who tries to use friendship to sell products: they’re not very bright and they don’t understand friendship.

The Washington Post has a good story about the consequences for those who go all-in to do multilevel marketing:

Enrique Martinez didn’t like chocolate, but he was eating as many as 10 pieces a day, drinking chocolate protein shakes and rubbing a chocolate-based skin cream on his face. It was expensive chocolate, too. Martinez and his wife, Michelle, were going through $2,000 in chocolate a month.

The debt they accumulated this way — more than $100,000 over five years — is now with a consolidation company. Their credit is ruined. There is a crack in the driveway at their home in Albuquerque from a 14-wheeler that once delivered 12,000 cans of chocolate energy drinks to their garage.

The chocolate came from MXI Corp., which uses a controversial business model called multilevel marketing. MXI has more in common with Avon Products, Herbalife and Amway than with a conventional candymaker such as Hershey. These are companies without a sales force that recruit their customers to sell products, often in bulk to other customers, who might in turn sell to other customers, and so on.

Critics accuse multilevel marketers of using slick pitches to persuade the unwary to buy goods in bulk, promising them that they’ll make money by selling those products to others. In this way, the companies are paid upfront, and the rank and file bear a good deal of the financial risk.

Defenders of multilevel marketing say the business model makes sense. They say the customers are largely enthusiasts who initially join to buy their favorite products at wholesale prices, not to make money. They add that, in any industry, satisfied customers often make the best salespeople.

The FTC has tried for years to make multilevel marketers be honest about costs and probabilities of success for people who join them. It turns out that companies can be scrupulous about disclosing the costs and low probabilities of profit, and still find willing victims. So the best recourse is educating everyone; only losers join multilevel marketing schemes.

Meanwhile, the large and successful multilevel marketer Herbalife is under attack from short sellers. In short selling, an investor borrows the stock of a company, sells it to pocket the cash, then hopes that the price of the stock drops so it can be repurchased with only a fraction of the cash received from selling it. Ideally the company collapses completely and the shares never have to be returned. So short sellers look for companies which are scams or fraudulently misleading investors with fudged financial numbers, sell the stock short, then publicize the ugly data they have found. This is healthy for the system, since there are already buy-side investors eager to promote glowing news about companies, and the short-sellers bring balance.

The Economist has a detailed writeup on the story to date:

The “death blow” that Bill Ackman promised to land on Herbalife this week raised expectations of a dramatic ending to one of the most remarkable battles in the history of Wall Street. On July 22nd the billionaire boss of Pershing Square, a hedge fund, delivered a three-hour presentation that he said would kill off the seller of nutritional shakes and foods by showing it to be a criminal enterprise that preys on the poor. But as he spoke, Herbalife shares ticked steadily higher. The low-point for Mr Ackman—whose fund has reportedly made a $1 billion “short” bet on the company’s share price falling, was when his father asked how close he was to proving that Herbalife is a pyramid scheme. He replied, wearily, “Dad, if you don’t know it by now…”

Appearing before an audience of nearly 500, plus 10,000 or so viewers online, Mr Ackman, at times tearful, attacked targets ranging from Carl Icahn, a rival billionaire so bullish on Herbalife he has put five directors on its board, to David Beckham and Lionel Messi, two footballers whose shirts have borne the firm’s name, Madeleine Albright, a former secretary of state who also champions it, and PwC, its auditor.

It remains a possibility that Mr Ackman, who first went public with his attack on Herbalife in December 2012, has delivered a mortal blow of the Shakespearean kind, deadly in the end but only after much fighting talk and rolling around. He has spent $50m on an army of investigators to look into the firm’s activities around the world, in particular its “nutrition clubs” that focus on poorer people. Mr Ackman says that most of those attending these clubs are “fictitious customers”.

Who they are goes to the heart of the matter. If they are genuine retail customers, buying nutritional shakes and other products because they want to consume them, that supports Herbalife’s claims to be a legitimate multi-level marketing company. Neither side disputes that Herbalife’s main retail channel has a structure in which participants share in revenues generated by the salespeople they recruit, as well as revenues generated by the recruits of those recruits. But Mr. Ackman says his investigations show that the vast majority of nutrition-club “customers” are people paying through their consumption of Herbalife products for training they need to qualify to open a nutrition club of their own, in the hope (for most, false hope, he says) that this will provide a decent living and perhaps one day make them rich.

Having studied a sample of clubs in New York, Mr Ackman claims that they lose $12,000 a year on average, even before taking into account all their running costs, and that the accounting system used for the clubs greatly overstates any income earned by the self-employed people running them. Herbalife’s own figures show that barely 7,300 of the almost 409,000 people in its sales channel earned more than $5,000 in 2013. The company says that is because the great majority join up to get a discount on its products rather than to make money selling them.

Mr Ackman points out that in recent months, while Herbalife has been carrying out a share-repurchase programme, some of its executives have been selling their shares. In May its boss, Michael Johnson, sold shares worth $15m. Mr Ackman says Herbalife bought its own stock during his presentation to make its price rise.

Herbalife says all of Mr Ackman’s allegations are baseless and that it complies with all laws. On July 22nd it called his claim about the nutrition clubs’ earnings “completely false and fabricated”. It pointed to a study by an economist it hired, which concluded that 39% of Herbalife’s sales were to people outside its network and a further 41% to people who had joined it mainly so they or their families could buy the products cheaply, and that therefore the products “have significant intrinsic value and market demand.”

Mr Ackman called on Herbalife staff to blow the whistle on any illegal practices they know of, and reminded its directors and advisers of the legal risk they would run were the firm found to be fraudulent. That is now a question before the Federal Trade Commission, the Department of Justice, the FBI and at least two state attorneys general: all of them are reportedly conducting investigations into the firm.

Also of interest: Wonkblog’s take.