Tuesday, July 26, 2016

No. 172: Herbalife, the Federal Trade Commission, and a Wake-up Call for Primerica

Herbalife International of America, Inc. and its affiliates sell nutrition supplements and other products through a "multilevel marketing organization" of the type that is sometimes referred to as a "pyramid scheme." Herbalife's multilevel marketing organization is similar in many respects to the multilevel marketing organization that Primerica, Inc. uses to sell life insurance policies and other financial products. The Federal Trade Commission (FTC) recently completed a major investigation of Herbalife's multilevel marketing organization. I think the results of the investigation are a wake-up call for Primerica.

The FTC Complaint
On July 15, 2016, in federal court in Los Angeles, the FTC filed a "Complaint for Permanent Injunction and Other Equitable Relief" against Herbalife. The complaint alleges that Herbalife has been using deceptive acts and practices in violation of Section 5(a) of the FTC Act, which prohibits "unfair or deceptive acts or practices in or affecting commerce." (See FTC v. Herbalife, U.S. District Court, Central District of California, Case No. 2:16-cv-5217.)

The complaint has four counts: "unfair practices" (relating primarily to the compensation structure), "income misrepresentations" (primarily the advertising of substantial income opportunities), "false or unsubstantiated claims of income from retail sales," and "means and instrumentalities" (false and misleading representations). Here is the five-paragraph concluding section of the complaint:
145. In sum, Defendants' compensation structure incentivizes Distributors to purchase thousands of dollars of product to receive recruiting-based rewards and to recruit new participants who will do the same.
146. This results in the over-recruitment of participants and the oversupply of Defendants' products and exacerbates participants' difficulty in selling Herbalife products for a profit.
147. Participants in a business opportunity should have some reasonable prospect of earning profits from reselling products to consumers. However, most Herbalife participants earn little or no profit, or even lose money, from retailing Herbalife products.
148. In the absence of a viable retail-based opportunity, recruiting, rather than sales, is the natural focus of successful participants in Defendants' business opportunity.
149. 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.
The Proposed Settlement
Also on July 15 the FTC filed a "Stipulation to Entry of Order for Permanent Injunction and Monetary Judgment" containing a proposed settlement that is subject to court approval. It is common practice for an agency to file a complaint and a proposed settlement simultaneously.

The proposed settlement provides for numerous and significant changes in the operations of Herbalife. It also provides for Herbalife to pay a $200 million monetary penalty to the FTC.

The case was assigned to U.S. District Judge Christina A. Snyder, who was nominated in 1997 by President Bill Clinton and confirmed by the Senate that year. The FTC is represented by three of its attorneys in Washington, DC, one in Seattle, and one in Los Angeles. Herbalife is represented by two attorneys associated with Sidley Austin LLP.

On the same day the FTC issued a statement and a press release about the case. The press release is entitled "Herbalife Will Restructure Its Multilevel Marketing Operations and Pay $200 Million for Consumer Redress to Settle FTC Charges." The press release is subtitled "Company Must Tie Distributor Rewards to Verifiable Retail Product Sales and Stop Misleading Consumers about Potential Earnings." Also on the same day Herbalife filed with the Securities and Exchange Commission an 8-K (significant event) report. Major media outlets reported the settlement online the same day and in print the next day.

The Ackman/Icahn Struggle
Bill Ackman is a prominent short seller. He has long described Herbalife as a pyramid scheme that is headed for collapse. Carl Icahn is a prominent investor who has a large holding of Herbalife shares, and several of his associates are on Herbalife's board of directors.

For years Ackman and Icahn have been engaged in a public dispute about Herbalife. When the proposed settlement was announced, Icahn declared victory and Herbalife shares rose sharply. Those reactions probably stemmed from the fact that the FTC decided to enter into a proposed settlement rather than try to shut down the company.

I think the question of whether the proposed settlement is a victory for Herbalife and Icahn is yet to be determined. The settlement provides for complex and extensive revisions in Herbalife's business model. I think it is too early to tell whether Herbalife would be able to maintain its current level of profitability if the settlement is approved and if Herbalife makes the major revisions that are required in the settlement.

The Primerica Angle
Primerica, Inc., the successor to the A. L. Williams organization (ALW), sells life insurance policies and other financial products through a multilevel marketing organization that ALW developed in the late 1970s. Primerica's multilevel marketing organization resembles that of Herbalife in many respects and differs in some respects.

I think the biggest difference between Herbalife and Primerica is that the FTC has been barred by statute for more than three decades from doing anything about insurance companies. Indeed, the FTC is barred by statute from even investigating insurance companies without a formal request from a Congressional committee. Here is the current language of the statute:
The Commission may exercise such authority [to conduct studies and prepare reports relating to the business of insurance] only upon receiving a request which is agreed to by a majority of the members of the Committee on Commerce, Science, and Transportation of the Senate or the Committee on Energy and Commerce of the House of Representatives. The authority to conduct any such study shall expire at the end of the Congress during which the request for such study was made. [15 U.S. Code, Section 46—Additional powers of Commission.]
In addition, the Consumer Financial Protection Bureau, which was established by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, is barred from doing anything about insurance companies. See my post No. 137 dated January 4, 2016.

On the other hand, another section of the Dodd-Frank Act established the Financial Stability Oversight Council (FSOC). That section does not bar the FSOC from investigating insurance companies. Indeed, it provides for the FSOC to investigate "nonbank insurance companies." The FSOC has designated three major U.S. insurance organizations—American International Group, MetLife, and Prudential Financial—as "nonbank systemically important financial institutions." MetLife filed a lawsuit against the FSOC, a federal judge rescinded the designation, and the FSOC's appeal is ongoing. See my post No. 170 dated July 15, 2016.

Thus it appears that state insurance regulators are the only source of protection for insurance consumers against potential wrongdoing through multilevel marketing organizations in the insurance business. It remains to be seen whether the recent developments involving the FTC and Herbalife will have any influence on state insurance regulators. As far as the past is concerned, with a few minor exceptions, I am not aware of state insurance regulators showing significant concern about the potential anti-consumer aspects of the multilevel marketing organization that Primerica and its predecessor have used for many years.

Available Material
I am offering a complimentary 77-page PDF consisting of the 42-page FTC complaint against Herbalife, the 31-page settlement between the FTC and Herbalife, the three-page FTC press release about the case, and the one-page FTC statement about the case. Email jmbelth@gmail.com and ask for the FTC/Herbalife July 2016 package.