The Cosmetics of Substance

I'm convinced that Ackman's investment in Allergan is somehow an allegory warning us about cosmetic beauty as an aspirational goal. Should we be aspiring to achieve cosmetic perfection or ground ourselves in substance? As is the case with much of what I say, it always sounds more poetic in my head, although I'm convinced Ackman's Herbalife thesis is the plastic, duck-lipped, attention-loving blonde Hedge Fund equivalent of Heidi Montag.

A landmark opinion written by George H. Wu was filed today in California's Ninth District Court of Appeals and left little room for cosmetics. The substance of the opinion was decidedly bad for BurnLounge and decidedly monumental for Herbalife and other established MLM companies. It was monumental because the Court was very careful to review all relevant case law, as well as Kohm's FTC advisory letter from 2004, and the opinion should establish clear guidelines for MLM companies as well as regulatory agencies assessing the legality of such companies.

In the opinion the Court noted that

• the rewards BurnLounge paid to Moguls were primarily in return for selling the right to participate in the money-making venture—the Mogul program. The merchandise in the packages was simply incidental.

• We agree with the district court that BurnLounge was an illegal pyramid scheme in violation of the FTCA because BurnLounge’s focus was recruitment, and because the rewards it paid in the form of cash bonuses were tied to recruitment rather than the sale of merchandise. (I added emphasis)

Interestingly the court also put the kibosh on both the FTC's and BurnLounge's arguments regarding internal consumption. The Court said that:

• BurnLounge is correct that when participants bought packages in part for internal consumption (to obtain the ability to sell music through BurnPages and to use the package merchandise), the participants were the “ultimate users” of the merchandise and that this internal sale alone does not make BurnLounge a pyramid scheme. But it is incorrect to conclude that all rewards paid on these sales were related to the sale of products to ultimate users. 
• Whether the rewards are related to the sale of products depends on how BurnLounge’s bonus structure operated in practice. See Omnitrition, 79 F.3d at 781. In practice, the rewards BurnLounge paid for package sales were not tied to the consumer demand for the merchandise in the packages; they were paid to Moguls for recruiting new participants. (I added emphasis)

In the Court's opinion they also cited the FTC's test for determining whether a MLM is an illegal pyramid

“a pyramid scheme is characterized by the payment by participants of money to the company in return for which they receive (1) the right to sell a product and (2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of the product to ultimate users.”

When I read the opinion a couple of very important distinctions came to mind with respect to Herbalife:

• Purchases bought in part for internal consumption defined "ultimate users" and internal sales did not constitute a pyramid.
• the rewards BurnLounge paid for package sales were not tied to the consumer demand for the merchandise in the packages;

Effectively, purchasing an IBP and signing up as an Herbalife distributor does grant the right to sell a product, however distributors are rewarded for the sale of products to ultimate users, not for recruiting. When an Herbalife distributor sells an IBP to a new distributor member there are ZERO volume points associated with the sale of this fully refundable starter pack. Volume points (which sets up the compensation structure for Herbalife distributors) are based on sales of consumed products, NOT on starter packs. This is an extremely important distinction because BurnLounge moguls were compensated based on the sale of starter packages, whereas Herbalife distributors are paid on the sale of products but not the IBP. When an Herbalife distributor signs up a new member to their downline they are required to sell the IBP to the new member without markup. In addition to earning no volume points a distributor has to sell the IBP at cost. Distributors make no money on the sale of IBP's at all. Furthermore, unlike BurnLounge, there is also no requirement for Herbalife distributors to sell a minimum number of IBP's. In fact many Herbalife distributors will NEVER sell an IBP. You only need look at Herbalife's 10K's and 10Q's to quickly determine that the overwhelming majority of revenues flowing into Herbalife are based on sales of products and not starter packages.

Interestingly the Court also seems to agree with the Vander Nat intent in that internal sales for the purpose of use are full fledged legitimate sales to end users. The Court also noted with respect to BurnLounge,

Rewards for recruiting were “unrelated” to sales to ultimate users because BurnLounge incentivized recruiting participants, not product sales

The short side could have saved themselves a lot of pain and suffering had they simply heeded Northwestern University's Professor of Marketing Anne Coughlan when she astutely outlined in July 2012 why Herbalife is a legitimate MLM.

One has to wonder how an organization like Herbalife that...

1. pays absolutely nothing for the recruitment of a distributor/member, 
2. that has robust internal consumption, robust external sales(evidenced by at least 30% of sales are directly drop-shipped to customers that are not distributor/members) and 
3. that compensates distributors solely on the basis of product sales 

...could ever fulfill the FTC's own guidelines for what constitutes an illegal pyramid scheme?

After today's written opinion, Bill may need more than botox to smooth out those frown lines. If he's not careful, he may subject himself to yet another Loeb colonic, followed by a tummy tuck, liposuction and chemical peel courtesy of Herbalife, Bill Stiritz and Carl Icahn.

So again..."I have to ask how the Shorts sleep at night?"