Herbalife and the Federal Trade Commission (FTC) have come to an agreement. In exchange for $200 million, the nutrition and weight management company will not be known as a pyramid scheme.
The settlement announced on Friday finally puts an end to the ongoing investigation of the company over serious allegations regarding how the business operates.
Although the settlement seems to be a victory for the company, it does not mean that Herbalife comes out of the mess in the best light. The fine that must be paid under the settlement is partially for misrepresentations made to its sellers, and it must fully restructure its business and be more transparent when it comes to compensation for its distributors and retail sales.
Even so, the company's shares increased by 18 percent in early trading.
To understand how it reached this settlement, it's important to first take a brief look at what happened to get here.
Who Is Herbalife, And What Is Its Business Model?
Herbalife sells popular protein shakes, nutrition, weight management and fitness products, but instead of selling these in stores like GNC, the products are sold via independent distributors worldwide. Distributors make money both on their sales, as well as when recruiting other distributors who then work for them. This is known as multilevel marketing (MLM).
The problem is that research and analysis of the company's operations found that Herbalife was not in effect following the MLM model but a pyramid scheme instead.
The FTC's definition states that, in a pyramid scheme, the company promises "consumers or investors large profits based primarily on recruiting others to join their program, not based on profits from any real investment or real sale of goods to the public. Some schemes may purport to sell a product, but they often simply use the product to hide their pyramid structure."
This model could mean the company promises its recruited members that they have the ability to move up the ladder and make a substantial living with the company, yet only a few distributors make it to the top of the pyramid to reap the big pay checks. Most instead lose money.
Distributors often lost money after buying inventory that they could not sell.
According to a report by Walter H. A. Vandaele, Ph.D. of Navigant Economics, LLC, only an estimated 2 percent of distributors are eligible for performance payments. It is possible to make it to the top, if that employee sticks around. The report found that 64 percent of the highest level members were in that position for 10 years or less.
The FTC Investigation
In 2012, investor and hedge fund manager William Ackman called out Herbalife and accused it of operating as a pyramid scheme, as well as not even having underlying sales. He had bet $1 billion against the stock and led the crusade against the company and Herbalife's rich investor Carl Icahn.
The FTC got involved when it started an investigation against the company in March 2014. It then issued a Civil Investigative Demand (CID), which is like a subpoena, only the company could be required to both produce documents and be interrogated or give testimony under oath.
The FTC's complaint stated the following:
Most Herbalife participants earn little or no profit, or even lose money, from retailing Herbalife products.
In the absence of a viable retail-based business opportunity, recruiting, rather than retail sales, is the natural focus of successful participants in Defendants' business opportunity.
Thus, participants' wholesale purchases from Herbalife are primarily a payment to participate in a business opportunity that rewards recruiting at the expense of retail sales.
Herbalife responded at the time, welcoming the inquiry and said it would cooperate. In May, it began negotiations with the government to come to an agreement.
It appears that negotiations worked out in favor of Herbalife, which dodged a major business bullet as its shares continue to increase.
Herbalife will now hand over $200 million, which will eventually go back to the pockets of employees who lost money after buying the company's products in bulk, as well as rework the way it compensates its employees, including eliminating paying distributors for recruiting others.
"This settlement will require Herbalife to fundamentally restructure its business so that participants are rewarded for what they sell, not how many people they recruit," FTC chairwoman Edith Ramirez said. "Herbalife is going to have to start operating legitimately, making only truthful claims about how much money its members are likely to make, and it will have to compensate consumers for the losses they have suffered as a result of what we charge are unfair and deceptive practices," she said.
The company agreed to pay the Illinois attorney-general $3 million as part of another agreement.
"The settlements are an acknowledgment that our business model is sound and underscore our confidence in our ability to move forward successfully, otherwise we would not have agreed to the terms," Herbalife's CEO Michael O. Johnson said.
Herbalife believes many of the allegations against it are incorrect, but the settlement is "in its best interest."
Source: The Wall Street Journal