Pyramid Schemes II

The prohibition of pyramid schemes does not amount to a prohibition of all multi-level marketing (MLM). Tupperware lawfully sells storage and serving products branded with its name and the well-known “burp” on the one hand. It also lawfully offers to some individuals the right to offer its products to other potential customers in return for initial entry costs (in effect, purchasing a Tupperware franchise) on the other. That much is uncontroversial. Nor is the sale of a Tupperware franchise a security requiring registration as such.

Where controversy begins to enter the picture is when these individuals are themselves empowered to sell the right to sell the product to third parties, creating another downstream level, and where the second level retailer not only thereafter gets a commission from the sale of the company’s products herself; she gets a share of the downstream profits: she shares in the proceeds of sales made by individuals she recruited to be sales people.

This kind of arrangement can, critics contend, shift the incentive from selling to recruiting, and that in turn makes the payment of the upfront costs seem like the purchase of a security, arguably running afoul of such precedents as a decision of the U.S. Court of Appeals, 5^th Circuit, SEC v. Koscot, (1974). The participants buy into it as an investment contract.

The distinction between Tupperware and Koscot is a tricky one, a matter it seems of degree. Note the following points: the fact that an actual product is involved does not save Tupperware from the charge that it is a pyramid scheme. Koscot, too, sold products: ‘Kosmetics.’ Also, the fact that there is a financial incentive for recruitment is not by itself forbidden. What is forbidden is [more] and what saves Tupperware from condemnation is [more].

Even constitutional law seems to have conspired to make this tricky, because advertisements for a Tupperware Party were central to an important first amendment case, and were found to be protected by that amendment. The case is SUNY v. Fox (1989).   

All this brings us naturally to a recent controversy about Herbalife (HLF) and its accounting practices. Herbalife (NYSE: HLF) sells nutritional and skin care products through an international MLM network. It’s headquartered in California, though it is incorporated in the Caymans. The recent controversies over whether its MLM has crossed over the rather fuzzy line into pyramid scheming became Big News in May 2012, soon after David Einhorn asked pointed questions during HLF’s May 1 earnings call.

This was the same David Einhorn who, in May 2008, gave a very perceptive an accurate talk at the Ira Sohn Investment Research Conference about how Lehman Brothers would be the next big bank to come under pressure. Since then, when Einhorn talks, people listen. Further, Einhorn had made a very influential bearish case about Green Mountain Coffee Roasters in October 2011 in a slideshow he presented to the Value Investing Conference. The point Einhorn was making in connection with HLF is a close kin to the method he had employed in regard to Lehman Brothers in 2008 and Green Mountain in 2011: he laid special emphasis on what he plainly saw as the accounting trickery involved.

Einhorn asked first, “How much of the sales that you’d make in terms of the final sales are sold outside the network and how much are consumed within the distributor base?” This is important. If the distributor base is consuming much of the product itself, that’s a ‘tell,’ indicating that the distributors see buying the product as part of the dues they pay in the hope of making real money themselves by … expanding the distributor base. If people outside of the distributor base are actively buying Herbalife in big numbers, that is obviously better news for the company.

After a little back-and-forth, HLF’s CEO, Michael O. Johnson, admitted to Einhorn that the company doesn’t “have an exact percentage,” though it believes it is selling approximately 70 percent of its products to customers. 

Just by asking the questions, Einhorn set off speculations that he (a) thought HLF an unsustainable pyramid and (b) was short its stock – or was about to go short – on that presumption. Two days later, the stock price was near $46 (before the conference, the price had been above $70). 

What happened next? Nothing much … for some time. HLF proceeded to treat $46 as the floor of a new trading range. It back and forth between there are $55 over the next few months.