Fine line between legitimate businesses, pyramid schemes

Pablo Caicedo became a distributor for Herbalife after trying the product and losing 35 pounds. The multi-level marketing company is once again under fire as are others like it.
Pablo Caicedo became a distributor for Herbalife after trying the product and losing 35 pounds. The multi-level marketing company is once again under fire as are others like it. Armando L. Sanchez/Chicago Tribune/MCT

Controversy is again casting a shadow over the multilevel marketing industry, as nutritional supplement company Herbalife Inc. has been publicly called a pyramid scheme by a prominent investor, an allegation the company denies.

Meanwhile, a different multilevel marketer, Fortune Hi-Tech Marketing, was shut down in recent weeks after a lawsuit was brought by regulators and several states alleging the company scammed consumers out of $169 million.

The scheme affected an estimated 100,000 Americans, and some Spanish-speaking consumers were targeted, the Federal Trade Commission alleged.

Most people outside the industry might have only a vague notion about multilevel marketing, also called network marketing and direct selling. It often involves personal sales of cosmetics, wellness products or home decor items - or as critics flippantly call it, "pills, potions and lotions" - usually sold through product parties hosted by friends or relatives.

For sellers, the companies offer the appeal of starting a business on the cheap with little training, working from home and being their own boss, if only for part-time money. Some might recruit friends and family to become sellers, which augments their own commissions and gives them a shot at the six-figure compensation many such marketing companies tout but few distributors attain.

The largest multilevel marketing companies, often known as MLMs, are household names: Avon, Mary Kay, Pampered Chef and Amway. MLMs have annual sales of about $30 billion, with about 16 million people in the United States selling their products, according to the industry group Direct Selling Association, which represents these firms and others.

The recent controversies might raise the question: What's the difference between a legitimate multilevel marketing company and an illegal pyramid scheme, in which only people who get in first - at the top of the pyramid-like structure - make money and everyone else is duped?

The harshest critics maintain there is no difference, that there's no such thing as a legitimate MLM and that the industry's secrets stay safe because of a cultlike mentality and a blind eye of regulators.

Jon M. Taylor, who was once a seller for an MLM company, said he has studied the industry for 18 years and analyzed more than 500 MLM companies. He maintains the website MLM-thetruth.com and offers a free e-book there.

"I have not yet found a good MLM - a good MLM is an oxymoron," Taylor said.

He said all MLM companies have the same flaw: They depend on endless chains of recruiting new members. "There is no more unfair and deceptive practice than multilevel marketing," Taylor said.

The Direct Selling Association says MLMs are legitimate businesses, and that the group has about 200 members carefully screened by the organization to ensure they are not pyramid schemes and don't use deceptive practices.

The Federal Trade Commission agrees there are legitimate MLMs. The difference between a legitimate business and pyramid scheme comes down to products.

If the company and its distributors make money primarily from the sale of products to end-users (and not boxes of product accumulating in a distributor's garage), it's OK.

By contrast, a pyramid scheme compensates those at the top of the pyramid with participation fees paid by those recruited at the bottom. It eventually collapses when the scheme can't recruit more people.

But identifying a pyramid scheme can be difficult because MLMs typically have product sales, along with recruitment fees and recruitment incentives.

"It gets cloudy when you have a situation where you have fees being paid for both," said Monica Vaca, assistant director of the FTC's division of marketing practices. "It's very nuanced."

While prosecuting an MLM can seem somewhat of a judgment call, cases have a common factor: deceptive promises about how much money distributors will earn, Vaca said.

Pyramid scheme?

Los Angeles-based Herbalife, a 32-year-old seller of weight-loss shakes and wellness products, became news in December when Bill Ackman, founder of Pershing Square Capital Management, made a $1 billion bet against Herbalife by shorting the stock. He has repeatedly called the company a pyramid scheme and gave a lengthy and public explanation of why.

Ackman's Dec. 20 presentation is available at FactsAboutHerbalife.com while Herbalife's Jan. 10 response is available at its website for investors, htttp://ir.herbalife.com.

In an interview, Herbalife President Des Walsh said the company is not a pyramid scheme because it sells "real products to real people" and doesn't directly pay for recruiting new distributors. He points to the company being in existence for three decades, operating in 88 countries and continuing to grow. "That growth has been based on more customers consuming our products every single day around the world," he said.

He said Ackman is "seeking to disseminate false and misleading information" about Herbalife to lower the stock price and profit from his bet against the company.

Pablo Caicedo, 38, of Chicago, said he started using Herbalife products, lost 35 pounds and felt like he had more energy. He learned he could get a discount on the products he used by becoming an Herbalife distributor, which he did. He began selling to friends as well. After three months, he was making enough money to quit his job as a parking valet, he said. And for 14 years since, he's sold Herbalife products.

However successful Caicedo is financially with Herbalife, others aren't nearly so.

In fact, 88 percent of Herbalife distributors earned no commissions in 2012, according to company numbers.

Why do so few make money? Herbalife says it's because 73 percent of its sales force only join as distributors to get a wholesale discount on products that they use themselves. For those people, paying the $59 or $109 to become Herbalife distributors, depending on the starter kit, is like paying a fee to join a Costco warehouse club to get better prices, Walsh said. The product discount for those distributors is 25 percent.

But even the vast majority of those who are sales "leaders" at Herbalife, the top 20 percent of sellers, don't earn enough to live. Last year, more than half of the 82,464 sales leaders earned $1,000 or less in commissions for the whole year, according to Herbalife.

Walsh said that's because most of them make Herbalife a part-time business, viewing profits as incremental income, perhaps to pay for a family vacation.

But like all MLMs, the very top sales people can profit handsomely. Of those who achieved the sales status of "leader," 0.7 percent make six-figure dollar amounts in commissions. And 194 distributors, 0.2 percent of leaders, had average gross payments from Herbalife of $724,030.

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