Today I am happy to host a prominent figure in the anti-pyramid scheme movement, Rogier Fentener van Vlissingen. In the text which follows, Rogier gives both a novice introduction as well as a deeper understanding of the most recent developments in the area, pointing the way forward for legislation on the subject. Obviously, any opinions expressed are the sole responsibility of the author.
Clearly, the world needed a refresher on Ponzi-schemes, and it got Bernard Madoff. The question will be if the SEC, the USA, or the world, learned anything. Certainly, Harry Markopolos' book, No One Would Listen: A True Financial Thriller, highlighted the risks of regulatory capture. Madoff was smooth and seemingly respectable, and the SEC was not equipped to be looking for an operation like his, even though in retrospect the red flags were all over. So the problem becomes that the regulators protect the crooks from the public, and not the other way around, as Markopolos observes so succinctly. That is the problem of regulatory capture in a nutshell. The practical point, from the standpoint of law enforcement is to see that the appearance of respectability is no guarantee of anything, and a good fraudster will always try to create an aura of respectability. Madoff mastered the art, it was all smoke and mirrors.
Pyramid schemes are somewhat akin to Ponzi-schemes from an economic point of view. In a Ponzi, the underlying business is either non-existent or dysfunctional, and cannot produce the returns on capital raised, so that older investors are being pacified with good returns poached from the funds of new investors, not business profits, and the venture ultimately hits the wall, when at some point withdrawals overwhelm the rate of new investment. Recruiting may or may not play a role, as in the case of the feeder funds for Madoff, but most business tends to come from referrals. The argument for regulation stems from the predictability of the bad outcome, so that intervention by law-enforcement could limit losses.
In pyramid schemes the business is recruiting for a venture that is either yet to be launched, or non-viable, or simply a hoax, and the payments for recruiting are merely a way of syphoning money from money hungry prospects to the pockets of the organizers. Classic cases include Galaxy foods, Koscot, Omnitrition, Holiday Magic, and recently Fortune High Tech Marketing and BurnLounge. Until the fateful Amway '79 decision, the courts were very clear on the nature of a pyramid scheme, and why they were illegal. With the Amway '79 case the lines began to blur.
In Amway '79, instead of dealing with the finding of fact - pyramid scheme or not - the court allowed itself to get drawn into a negotiation of conditions what would presumably make Amway not a pyramid scheme, without even noticing that the conditions it agreed to were utterly unenforceable, and nobody had the intention of ever enforcing them. It was pure make believe. If a burglar or a rapist were to negotiate with the court over how many free passes they should get before they could be convicted for burglary or rape, the public would be outraged at the stupidity of the judge, but in the Amway '79 case the commercial equivalent of that negotiation succeeded. Then FTC Chair Robert Pitofsky, and Commissioner Elizabeth Dole, accepted the ruling as law.
The MLM-"industry" took flight from then on, and Herbalife became the first most memorable child-prodigy offspring from that illicit liaison of courts and criminals, in the form of the judicial error of the Amway'79 court. The culmination of that hubris came when Herbalife was taken private after that death of its founder, Mark Hughes, from a multiple drug overdose, for a short time (think legitimizing a scam) its interim CEO was one Frank Tirelli, now Chairman and CEO of Deloitte Italy. He held the operation together with an agreement (the "Tirelli agreement") with top distributors that is very likely illegal, but at least highly problematic, and was the basis for the company subsequently going public, with Michael O. Johnson as their CEO, and the new pied piper, showing that in America, crime does pay, and very handsomely. The secret to a successful crime, is to do it in plain view, right in front of the cops.
Most succinctly, in economic terms, the problem of MLM is that unlimited recruiting is substituted for sales by dint of the fact that recruiting incentives are greater than sales incentives in MLM marketing/compensation programs. The resulting behavior predictably is that people will recruit, not sell, and only conscripted consumption ("personal volume" required to qualify for commissions) will ensure a minimum of cash flow to keep up appearances for the sake of the regulators. The befuddled participants who even try to sell, will soon find that if they don't recruit their customers as distributors, that somebody else will, for the money is in recruiting not selling. Very soon therefore, retail margins will tend to collapse to zero, and ultimately product will even be given away as free samples in order to recruit the next prospect, and the wholesale cost of the product becomes another tax-deduction, and tax-deductions are the major product of an industry that produces 99% loss rates among participants.
When the Albanian economy tanked in 1996/1997 because of pyramid schemes, the IMF did some very helpful work in warning the rest of the world about the obvious dangers of pyramid schemes, only to see their work filed away for reference, and ignored in practice. After all, "we" don't have a pyramid problem. That was just those dumb Albanians who did not know any better. They just escaped communism, and they mistook pyramid schemes for capitalism. And the world went back to sleep.
Then, in December 2012, there was a wake-up call, in the form of a short position initiated by Pershing Square Capital Management, against Herbalife (HLF), and made very public with a 300+ Power Point presentation at the Sohn investment conference. PSCM even created two websites to document their thesis, Facts about Herbalife, and Herbalife Pyramid Scheme. At the time when I read it, my first thought was: "It's a dirty job, but somebody had to do it," and I felt sort of grateful that the public listing of Herbalife and the opportunity to short the stock provided the market incentive to get the ball rolling. What happened next defies the imagination. In obvious reliance on the idea that Herbalife was actually a real business, actually an exchange-listed company, with ostenstibly $5bn in sales, Carl Icahn took the opposing view, and that is when I took notice, and in my first article on this spectacle on Seeking Alpha (free registration), here, I promptly assumed that Carl Icahn, would soon be facing substantial losses on the position, and I compared his position to Wil E. Coyote hanging over the ravine, and realizing he had no ground under foot. Little did I realize how long it would take for this episode to play out. I thought at the time my first article on the matter would be my last, but we're now at thirty and counting. I know now that my last article won't be my last, for when Herbalife finally collapses or gets shut down, a post mortem will be in order.
For those who are interested, Seeking Alpha has, for better or for worse, become the locus of some of the best research and analysis on the issue outside of the astounding material produced by Pershing Square on the two websites listed above, and by Christine Richard (who did much of the original research leading up to the Pershing Square short), explained in part in her own articles on Seeking Alpha, here, and here. It should be noted that a short position is a difficult investment decision, unless you have a very clear trigger mechanism that you can identify. Government action is not one of those. And, to a degree, Bill Ackman counted on such action, based in part on his MBIA short (and it should be noted that Christine Richard wrote the book, Confidence Game: How Hedge Fund Manager Bill Ackman Called Wall Street's Bluff). Other important contributors on Seeking Alpha regarding the Herbalife developments include:
- Matt Stewart, Quoth the Raven and Matthew Handley, all of whom have short positions, and collectively they have produced an astounding body of research and analysis, highlighting both legal issues and financial analysis.
- On the legal front there have been contributions from attorney Douglas Brooks (of Omnitirition fame), and former Wisconsin Assistant Attorney General Bruce Craig, who notable won a case against Amway in 1980, just after the fateful Amway '79 decision that would cripple the FTC for the next 35 years. In the discovery phase Bruce Craig found that of 20,000 Amway distributors in Wisconsin at that time, the top 200 lost $900 per year.
- As far as business and economic analysis, as well as some of the more in-depth aspects of the cult-like appeal of pyramid schemes, there have been important contributions from Bill Keep, Dean of the College of New Jersey, and Robert FitzPatrick, who runs Pyramid Scheme Alert, as well as some connecting commentary from myself.
- On the tax front, there is the fascinating research of Dave Ritchie, here, who confirms the tax research of Jon M. Taylor from IRS records. Loss rates are typically close to 99%. Tax deductions is the major product of the industry.
- As an additional angle to both the cult aspect of MLM, and its apparent business/investment promises, there was Kay Herbert, an MIT-educated mechanical engineer, who drew a statistical analogy between MLMs and the propagation of epidemics, to explain the "pop and drop" behavior when opening new markets or introducing new products, that even Herbalife management acknowledges in their public filings.
- Blog by investor Tom Salvatore, which has shown very astute analysis and profound comprehension of the legal, business, and criminological elements that have made up the story of MLM/pyramid schemes.
- Blog by British MLM-critic David Brear, whose own family was torn apart by the Amway cult, and who has put forth the most comprehensive body of historical analysis of thought control with fake "opportunity," going all the way back to beguiling misrepresentations and advance fee fraud of Hitler in his Volkswagen program, basing himself firmly on the razor sharp insights of George Orwell.
- The classic sources include Jon M. Taylor's site www.mlm-thetruth.com
which includes such gems as his analysis of the tax losses of MLM-participants, as well as his documentation of regulatory capture of the FTC, that are masterpieces in themselves. Taylor has researched over 500 MLM companies, and found the structure to be always the same in effectively syphoning moneys from a multitude of losers to a few at the top. Robert FitzPatrick's sites are www.pyramidschemealert.org and www.falseprofits.com. A newer voice is that of E. Robert Smith, author of the book Downline... an intolerable potential to deceive, with his website www.amway79challenged. com. The title of his book was a statement of Paul Rand Dixon, a former FTC commissioner, which he made in one of his own MLM-rulings. The author's own conclusion, after five years of 6-figure earnings in MLM was that he had become a professional liar. He did not like it, and he chose to write the book instead.
- The mainstream press has mostly missed the story, or failed to cover more than the headlines, but some highly competent coverage should be mentioned, including a five article series on Al Jazeera, which included some powerful commentary by William K. Black, he of S&L fame (The Best Way To Rob A Bank Is To Own One), excellent coverage in Rolling Stone of MLM-company Vemma, and somewhat older but very worthwhile coverage in a four-part series in The Nation, here (part 4, and you'll find the links to parts 1, 2, and 3 referenced at the start of the article). The Nation does a very good job on the regulatory capture and political corruption aspects of the issue, including how the GWB-administration put the fox in charge of the hen house in the form of making Amway-lawyer Timothy Muris head of the FTC, promptly stopping all MLM-prosecutions, and starting an FTC tradition of obfuscation in their public policy statements, that misled the public into thinking there is such a thing as a 'legitimate MLM.'
- Finally, there is the incomparable Salty Droid, whose material provides rich documentation of various scams, including extensive material on MLM in general and Herbalife in particular.
One of the issues that has gone nearly unnoticed is this matter of regulatory capture, although it has been well documented. Rationally, it is the first and most obvious problem in dealing with crime. Only the latest example is the Dodd-Frank Act in the US, and its offspring, the Consumer Financial Protection Bureau (CFPB). Effectively, it was a way of blaming the banks for the political corruption of vote-getting with the lure of 'low income' home ownership under the Clinton administration, but with plenty of Republican believers as well. This issue was recently documented by Peter J. Wallison in a new book, Hidden In Plain Sight. Personally, I tend to think that the abolition of Glass-Steagal was the beginning of the problem, but the cynical view of the whole matter is that the CFPB today is a captive regulator from the outset, to justify why the root causes of the sub prime scandal were never dealt with. As William Black put it, Financial Frauds Had A Friend In Eric Holder, and instead of thousands of criminal prosecutions, as we saw in the S&L scandal, nobody went to jail. The USA laughed in the 90's about Japan's inability to deal with the financial engineering by its biggest corporations, and its failure to deal with the bad banks in a forthright manner. The US has now officially taken that title. Japan bought itself two lost decades, sofar. The US has set itself up for two lost centuries. As author Gore Vidal, the unofficial biographer of the USA, put it so succinctly, the US has become a country not of laws, but of lawyers.
The SEC and the FTC have been asleep at the wheel in relation to MLM/Pyramid schemes, taking only occasional action, by culling some minnows from the oceans of fraud, but it is a travesty that pension money should be invested in a complete scam like Herbalife, or that it should be allowed to be publicly listed in the first place. This 'industry' has now grown into an international $150 billion dollar fraud. The FTC has only intermittently pursued a few smaller operations, such as Fortune High Tech Marketing. In the case of Fortune High Tech case ran for 10 years and had at least 200,000 victims before it was stopped. Herbalife makes 2 million victims a year, and some of the stories are heart-rending, such as one I learned of recently of a 72-year old woman who operated Herbalife 'nutrition clubs,' which are a pyramid within a pyramid, and losing $150,000 doing it.
One of the interesting side stories is how the DSA, the Direct Selling Association, was taken over from the inside by MLM companies, displacing the original Direct Selling companies, and so to complete the disguise of MLM, as a direct sales company. (This would make a good definition of MLM: MLM is a pyramid scheme disguised as a direct sales company.) The DSA was instrumental in corrupting the political process and the regulators in the US, and internationally the same has taken place. I received a response to an inquiry to the Dutch Ministry of Justice, in which they maintained that protecting the citizens from fraud was not their business, for limiting the freedom of contract was a priority concern, and the citizens should sort out for themselves which companies were fraudulent. In short this is the police protecting the right of the crooks to defraud the public. This view is only possible if it is assumed that MLM is ever a legitimate business model, but of course any business method that produces 99% losses for its practitioners, is not a business mehtod, but a fraud.
More recently, back in the USA, both Tupperware and Avon have quite publicly quit the DSA, making it clear that they were concerned it was overrun by pyramid schemes. However, neither company has (yet?) taken the next step to seriously reform their business models, and Avon in particular exhibits a deterioration in its financial results that seems strongly correlated to its adoption of an MLM model in 2005, which has predictably cannibalized the traditional sales business of the Avon lady, with the recruiting madness of MLM. Economically it is clear, that if recruiting drives the bus, retail sales is thrown under the bus.
It should be noted that a proliferation of public satire about MLM/pyramid scams is indicative of the fact that the public is getting tired of the scams, so that even if the regulators continue to be slow in acting, the population is so scam weary that enthusiasm of these programs is waning. I am personally involved in some public education in my area, including presentations in the Police precinct council meeting of my precinct in the Bronx, for with fraud, two pennies of crime prevention is certainly worth more than a pound of cure (never mind a dollar's worth) of cure.
Clearly, in the US the FTC is supposed to protect consumers, but the only means it currently has to fight MLM is under section 5 of the FTC act, "Unfair and deceptive business acts and practices" (UDAP), which works only to a point, as the FHTM case showed. It makes no sense that these companies should have the opportunity to run, as in the FHTM case for 10 years, and make 200,000 victims, before they can be stopped. In the Herbalife case the total run time up to the present is 35 years, and the victims are in the multiple millions.
Presumably the SEC would know enough not to let a Ponzi scheme become publicly listed, but there is a long list of publicly listed MLM companies, or MLM companies owned by publicly listed companies, including Warren Buffett's Berkshire-Hathaway. This means pension funds also own these illegal rackets directly or indirectly.
The good news is that there still is a strong foundation in US law to pursue these companies, and in a very interesting development AARP just filed an amicus brief for a class-action RICO lawsuit against Ignite/Stream, which is a private MLM/pyramid company in the de-regulated retail energy industry. The company had sought to appeal both the RICO and class-action status of the lawsuit, and AARP is supporting the class-action status. It should be noted that the RICO dimension in a private lawsuit opens the door for triple damage claims. The first use of the RICO laws against MLM was by Prof. Robert Blakey in Amway's case with Procter and Gamble, and the current case against Ignite/Stream will make for an interesting development. He originally drafted the RICO statute to fight the mafia, and the similarities with how the MLM industry operates are eerie. The AARP brief is a masterful summary of the current legal framework in the US, which still provides ample grounds to pursue these frauds. The material would be equally applicable to Herbalife in its entirety.
Rogier Fentener van Vlissingen lives in Bronx, NY, and is active as a consultant in renewable energy retrofits, and an author on finance, energy, and spirituality. His website is www.vliscony.com.