Following is a guest post from attorney Kevin Thompson with an early analysis of the FTC settlement with Herbalife.
By Kevin Thompson, Thompson Burton PLLC
After a two year investigation, Herbalife has agreed to pay a $200 million fine to the FTC and act in accordance with prescribed measures. With this morning’s announcement of a settlement, investors and proponents/opponents of the MLM industry alike are attempting to process what it all means for the Company’s future. Before we provide you an in-depth analysis of the stipulations found within the FTC’s Order for a Permanent Injunction and Monetary Judgment, it’s important to remember that these prescribed actions only apply to Herbalife and not multi-level marketing companies collectively. In response to a question in which she was asked what kind of implications the settlement will have on the network marketing industry , FTC Chairwoman Edith Ramirez stayed mum on its long-term implications and stated rather plainly that the FTC would soon be providing additional guidance on legitimate network marketing companies. That aside, let’s get down to business and clarify what the FTC’s order does and does not say.
The Biggest Takeaways
At the company level, 80% of Herbalife’s revenue from product sales needs to be generated via a combination of retail sales and “Rewardable” internal consumption. “Rewardable” is defined as a quantity less than $200 per month per distributor. The amount of “rewardable” internal consumption cannot comprise of more than 1/3rd of the total revenue, or else Herbalife is forced to reduce its payout by 10% (which basically works as a tax on the top earners). This restriction is a bit odd. The formula is basically a strange way to ensure that 50% of the company’s revenue comes via retail sales. And candidly, it’s not the most problematic for Herbalife long-term. The public appears to be seizing on this 80% metric, thinking that Herbalife must cease operating if the 80% metric is missed. As explained above, the only penalty on Herbalife is a 10% reduction in what it can pay out.
From the micro-perspective of an individual distributor, Herbalife in the future CANNOT pay any distributor who fails to have at least 66% of his or her total sales (personal and downlineincluded) come from retail customers. Where am I getting this from? From the line in the Order that states, “Rewardable transactions (i.e., compensation) shall be limited such that no more than one-third of the total value of a participant may be attributed to [internal consumption] transactions.” If you will recall the restrictions imposed on Vemma, the FTC in conjunction with court approval currently allows Vemma to pay commissions to distributors ONLY IF 51% percent of a distributor’s downline sales originate from retail customers (I’ve previously referred to this as the “Vemma overlay” when I strongly suspected negotiations were stalling because the FTC wanted to impose Vemma-like restrictions…..I was right, BTW). Herbalife’s restriction is more burdensome than the Vemma overlay.
The FTC’s limitation on allowable (“Rewardable”) internal consumption mandates that a participant can only self-purchase: (i) no more than $200 worth of products per month for the first 12 months following the enactment of the Order; and (ii) post-twelve months of the Order’s enactment, no more than the greater of EITHER $125 worth of products per month OR the calculated average amount of what three-fourths of Preferred Customers are buying over the previous twelve months. No more than one-third of a participant’s compensation originate from his/her personal consumption or the personal consumption of the downline. This measure is implemented to prevent inventory loading.
As a continuation of its efforts to place the onus on Herbalife to acquire meaningful retail sales, the FTC put forth a very meaningful stipulation on rank and bonus qualification. To the extent that Herbalife requires its participants to meet any sort of target or threshold in regards to rank advancement, bonuses, etc., a participant may only do so EXCLUSIVELY through retail sales. This is highly significant and illustrates the FTC’s statement that Herbalife will “restructure [its] US business operations.” While only time will tell how Herbalife will choose to go about effectuating this particular stipulation, this sends a loud message that distributors who are interested in climbing rank and thus becoming eligible to earn larger commissions must do so on the basis of their ability to generate customers and train downline members to do the same.
Verification of Retail Sales
Some smaller but nonetheless important details from the Order deal with how the Company will track retail sales and its disengagement from certain industry norms. In order to verify retail activity, Herbalife must take “reasonable steps” that include “random and targeted audits.” These audits will monitor retail sales and ensure sales occur in the manner in which they are reported. Speaking of such reporting, the Company will have to collect retail sale information from participants detailing: the method of payment; the product and quantities sold; the date; the price paid; first and last name of purchaser; contact information including information like telephone number or home address; and the signature of the Customer for any paper receipt.
Monthly Volume Requirements
Herbalife must discontinue practices commonly associated with network marketing companies. The Company can no longer require a participant to have a minimum quantity of products. Additionally, the FTC is outright banning Herbalife from providing participants with autoship, even an OPTIONAL autoship. After what happened in Vemma and now this, it appears safe to say that regulators greatly disapprove of personal volume quotas and autoship requirements. Just for the record, I called on the DSA 2 years ago to modify its Code of Ethics to prohibit companies from requiring monthly volume quotas (See item #2). The idea gets shot down whenever I bring it up. Regardless of the narrative spouted by companies, gravity naturally pulls distributors to train other distributors to simply “buy to qualify” i.e. “get on autoship to stay qualified and recruit others to do the same.”
While there are other restrictions imposed by the order, the items referenced above are more worthy of our time and study.
Largely hailed as a victory in the general media on account of the pyramid label omission, Herbalife faces significant challenges to its domestic survival. With participants now facing the requirement of having two-thirds of their sales originate from customers and the Company being required to operate with a pay plan that more closely resembles a rubik’s cube than an MLM pay plan, the FTC’s game plan is crystal clear: (1) take money off the table today without firing a single shot ($200,000,000); and (2) force Herbalife to prove its legitimacy over the next several years.
The FTC’s avoidance of the pyramid label is very interesting and surprising. As I’ve said since January of 2013, the FTC has weak pyramid arguments against Herbalife. If they would have sued on that basis, they would have lost. When it comes to prosecuting pyramid schemes, the current body of case law makes the FTC’s job more difficult to impose its own vision of “fairness.” Put another way, the FTC is not happy with the current state of the law. Instead of going down the pyramid road, the FTC is making a broader argument, stating simply that Herbalife’s plan is likely to cause harm because it’s inherently unfair. What’s an “inherently unfair” compensation plan? It appears the FTC is going to argue that an unfair pay plan primarily incentivizes recruitment over retailing. Did the FTC avoid the pyramid word by way of negotiations with Herbalife? Or was it done with specific intent to avoid the challenges associated with a pyramid argument? We’ll find out soon enough.
The FTC got a big bite at the apple. They got a lot of money up front. And they got Herbalife onto a different wrestling mat. Instead of alleging Herbalife to be a pyramid scheme, which would be like nailing Jello to a tree, the FTC can simply call upon this order in the future if Herbalife fails to comply. It reminds me of the old adage, “Good matadors never go after a fresh bull. They stick it a few times, let it bleed, then strike.” Herbalife is going to bleed under these restrictions. But they’ll honor the terms of the deal while focusing on their international operations. If they can scale those operations fast enough, the growth overseas will exceed the losses they’ll likely face domestically. And who knows….maybe Herbalife can thrive with this new model. We’ll learn a lot in the next few quarterly reports.
What does this mean for the industry? Pay plans need to be revisited, sales cultures need to be re-trained and expectations need to be managed. Slow growth is the new fast growth. And the DSA needs to adjust its sails, big time.