HERBAL.docx

Ferrell, O. C. (2018). Business Ethics: Ethical Decision Making & Cases (12th ed.). Cengage Learning.
1. Why has Herbalife’s multilevel compensation model been accused of being a pyramid scheme?
2. Describe the differences between a legitimate business model and a pyramid scheme.
3. How has Herbalife demonstrated social responsibility?

18-1 Introduction

Herbalife International is the third largest direct selling, multilevel marketing company in the world. Its product line consists of weight management and nutrition products. These products are not sold in retail stores; rather, consumers interact with independent contractors, who are often everyday people like themselves, to the products. Herbalife’s headquarters are located in Los Angeles, California, and it operates in many countries throughout the world. Herbalife is a publicly traded company that is both loved and hated by investors and consumers.
This case first discusses the history of the company from its founding to its present status, followed by a description of the types of products Herbalife offers. Then we will get into a discussion of multilevel marketing and the role of independent contractors in the direct selling model. Next will be an analysis of pyramid schemes and why they are often confused with the multilevel marketing model. We then examine Herbalife to determine whether it is a pyramid scheme.
We will illuminate the role of hedge fund investor William Ackman, who has prominently accused Herbalife of being an elaborate pyramid scheme, in the backdrop of Herbalife’s business model and describe his contentions with the company. The case shows that while Ackman’s accusations may be the most widely known, Herbalife has had to face similar allegations (mostly referring to pyramid schemes) throughout the course of its existence. The case then briefly overviews Herbalife’s social responsibility program and finally ends with overall conclusions.

18-2 History

Herbalife is a company that focuses on nutrition, weight management, and personal care products with independent contractors selling in more than 90 countries. Mark Hughes founded the company in 1980 out of a desire to create a safe alternative to other weight loss products. Herbalife’s first sales were made from out of the trunk of Hughes’s car in Los Angeles, California. Two years later the company reached $2 million in sales. Herbalife was taken public in 1986 on the NASDAQ stock exchange. Since then, Herbalife has become a multibillion dollar global company.

In 1999 Hughes planned to take the company back to the private sector by purchasing all of its remaining shares, but this attempt was stopped when investors sought legal action. The next year, Mark Hughes died unexpectedly at the age of 44. Christopher Pair, who was Herbalife’s former chief operating officer (COO), then became president and chief executive officer (CEO) of the company. His reign at Herbalife was cut short when he stepped down one year later.

An Internet retailer, , made a bid of $173 million to acquire Herbalife, but the Mark Hughes Family Trust rejected the offer. In 2002 the investment firm J.H. Whitney & Co. purchased the company along with another investor and took it back to the private sector. However, in 2004 Herbalife went public once again and was traded on the New York stock exchange. Michael O. Johnson became Herbalife’s CEO in 2003. The company currently has 2.3 million independent contractors throughout the world.

18-3 Products

Herbalife sells weight management, targeted nutrition, energy and fitness, and personal care products, all intended to support a healthy lifestyle. Formula 1 Nutritional Shake Mix is a protein and fiber shake with minerals, vitamins, and nutrients offered in a variety of flavors. Formula 2 Multivitamin Complex is a multivitamin that contains over 20 vitamins, minerals, and herbs essential to healthy living. Formula 3 Cell Activator promotes absorption of minerals and vitamins while improving energy levels. These three core products are at the heart of the Herbalife product line and serve as the baseline for customer nutrition and weight management goals.
The weight management line consists of a variety of Formula 1 protein shakes, supplements, weight loss enhancers, protein bars, and snacks, all serving the purpose of helping customers attain their weight goals. There are three weight management program sets, each with a combination of shakes, supplements, and enhancers designed for different types of weight management needs. For instance, the Personalized Protein Powder and the Protein Drink Mix offerings provide an alternative to traditional meals while supplying energy and curbing hunger cravings, whether consumers want to lose or maintain their weight or build muscle mass.
Targeted nutrition products include dietary and nutritional supplements that contain herbs, vitamins, minerals, and other natural ingredients to strengthen specific areas of the body that tend to be problematic for many people. For example, Tri-Shield helps the heart stay healthy by maintaining good cholesterol levels and providing antioxidants, while Ocular Defense Formula and Joint Support Advanced offer nutritional aid for the eyes and joints of aging adults. Herbalife also offers nutrition products specifically designed for women, men, and children.
In addition, Herbalife provides energy and hydration options for those engaged in sports and fitness activities. Customers can choose from drink mix-ins such as the H 3 O Fitness Drink, which enhances clarity and rehydrates the body, or they can go with supplements such as N-R-G Nature’s Raw Guarana Tablets, which also promote mental clarity. Herbalife24 is an athlete-focused program set, including drink mix-ins, shakes, and supplements, that includes formulas for hydration, prolonged endurance, restoration of strength, and recovery.

Herbalife’s personal care products include skin cleansers, moisturizers, lotions, shampoos, and conditioners. In this product line, Herbalife offers program sets called Herbalife SKIN, containing groups of cleansers, moisturizers, and creams customized for different types of skin from dry to oily. There are also a variety of individual Herbalife SKIN products, such as Energizing Herbal Toner and Firming Eye Gel. Another group of products, called Herbal Aloe, is comprehensive, including Strengthening Shampoo and Conditioner, Hand & Body Wash, Soothing Gel, and more, and is advertised to improve the look and feel of hair and skin. Other items include antiaging products and specialized skincare products such as Body Buffing Scrub and Contouring Creme.

18-4 Multilevel Marketing

Direct selling is the marketing of products to end consumers through person-to-person sales presentations at non-retail locations such as consumer homes, jobs, or online. This should not be confused with on-site salespeople such as at car dealerships; direct sellers go to the consumer, such as at their home or job, to sell the product. Also, direct sellers are generally not actually employees of the companies they represent but rather are autonomous individuals who enter into independent contractor agreements with a company to sell its products.
People are attracted to becoming direct sellers for many reasons. Some are passionate about a product and want to promote the company. Others want to receive a discount on their personal s, a common perk of being a direct seller. Many find working as a direct seller to be a flexible, part-time opportunity for extra income. Additionally, a lot of direct sellers simply enjoy the social aspect of the job.
Within the direct selling model are two compensation models: single-level marketing and multilevel marketing. Single-level marketing is when direct sellers only earn commissions for sales they make themselves. Multilevel marketing, sometimes called network marketing, means direct sellers earn income from their own sales of products as well as commissions from sales made by those they have recruited. The multilevel marketing model is permitted in nearly all countries but is often strictly regulated and/or closely scrutinized due to its capacity to be abused and become a fraudulent pyramid scheme (discussed later in this case). In for a multilevel marketing company to be legitimate, it cannot force sales or recruitment. It should also not be necessary for direct sellers to recruit others in to earn a profit; this should merely be a choice available to sellers if they want to increase their earnings.
Nearly 75 percent of Herbalife members are single-level distributors, meaning they do not sponsor other Herbalife sellers. These single-level Herbalife members simply buy products from the company at a discount and resell to customers and/or consume the products themselves. Since many of these members simply want a discount on these products for their personal use, they may not be as interested in making profits but simply enjoy the opportunity to receive these discounts. See Table 1 for the top 10 global direct selling companies.
Table 1

Top 10 Direct Selling Companies

Company Name and Product Line

2016 Revenue (USD Billions)

1

Amway
Nutrition, Beauty, Bath and Body, Home,
Jewelry, Food and Beverage, Fragrances

$8.80

2

Avon
Cosmetics, Skin Care, Fragrance,
Personal Care, Hair Care, Jewelry, Gifts

$5.70

3

Herbalife
Nutrition, Weight Loss
Management, Personal Care

$4.50

4

Vorwerk
Household Appliances and Cosmetics

$4.20

5

Mary Kay
Cosmetics, Skin Care, Body and Sun,
Men’s Products, Fragrance Gifts

$3.50

6

Infinitus
Health Products

$3.41

7

Perfect
Health Food, Household,
Beauty, Skincare Products

$3.06

8

Quanjian
Natural Medicine

$2.89

9

NaturaCosmetics

$2.26

10

Tupperware
Food Storage and Preparation, Cookware,
Serving Items, Cosmetics, Beauty Products

$2.21

Source: Direct Selling News, “2017 DSN Global 100 List,” Direct Selling News, 2017, http://directsellingnews.com/index.php/view/dsn_announces_the_2017_global_100#.WST8dWjyvIU (accessed May 23, 2017).
This aspect of direct selling, where the seller purchases products at a discount from the firm for his or her own use, is known as internal consumption. Internal consumption is common in many industries; for example, most retailers provide internal consumption incentives by offering discounts to their employees. Department stores, automobile manufacturers, and airline companies provide incentives such as discounts that encourage internal consumption. Many direct selling customers become resellers to get discounts on the products for their own use. They believe in the brands, use them, and want to “spread the word” by creating a broader sales and communication network. Some do not even necessarily care about making a profit from their status as a reseller. This is a common and legal approach for direct selling products around the world. In fact, most direct selling companies use multilevel marketing and permit or even encourage internal consumption.

Despite the general acceptance of multilevel marketing as a legitimate business model, a few countries have sharply restricted or even banned multilevel marketing, limiting direct selling to single-level marketing only. China, for example, only allows international direct selling companies to do business within its b s if they sign contracts saying they will not employ the multilevel marketing aspect of direct selling. It believes multilevel marketing is indistinguishable from or too closely linked to fraudulent activities such as pyramid schemes. There are key differences between pyramid schemes and multilevel marketing compensation models. For example, sellers caught up in pyramid schemes can generally only make a profit by recruiting others, as the product being sold has little value or is highly overpriced. Pyramid schemes also reward recruitment whether or not the new recruit sells anything, whereas multilevel marketing companies do not. The similarities and differences between the pyramid scheme and multilevel marketing are discussed in detail later in this case.

18-5 Herbalife’s Direct Sellers

There are 2.3 million independent contractor direct sellers of Herbalife products. Most, if not all, of them personally use these products as well. Many are attracted to the low startup cost of selling Herbalife, which begins at about $60 for a kit. For this price, new sellers will receive the Mini Herbalife Member Pack, which includes forms, applications, a tote bag, and samples of various Herbalife products. The pack includes informational and training materials which educate the contractor on using and retailing the products, business basics, and how to build a sales and marketing plan. The next step up for a new contractor is the Full Herbalife Member Pack for about $90, which includes everything in the mini pack as well as full-sized products (not just samples). Of course, once the new distributor starts selling, he or she will have to begin purchasing inventory to resell, but a member kit is the only purchase required to become a Herbalife network member, begin receiving discounts on Herbalife products, etc. There is no “fee” to join; the only money spent is for the value of the kit.
Sellers enjoy discounts on Herbalife products ranging from 25 to 50 percent depending on the level of contractorship (contractors move up levels by achieving certain sales and recruitment goals). Herbalife sellers usually purchase inventory themselves and then resell it to buyers; however, it is possible for the distributor to make the sale and then have Herbalife ship the product directly to the buyer. Contractors can sell the products at any price they want and can generally make most decisions on how they want to position and sell their Herbalife inventory, although they are subject to both legal and company rules and restrictions. The more successful an Herbalife seller, the higher up he or she moves on the contractorship ladder, gaining corresponding benefits at each step such as increased product discounts and networking and training opportunities. Seller success is measured by “Volume Points” and “Royalty Override Points.” Volume Points are awarded when the seller purchases Herbalife products for resale or has Herbalife ship products directly to a buyer, and Royalty Override Points are accumulated based on the volume of products sold by the seller’s personally sponsored recruits. Royalty Override Points, however, cannot be earned until the seller has already reached a certain contractorship level through his or her own sales.
To go from basic distributor to the Senior Consultant level, a Herbalife member must accumulate a minimum of 500 Volume Points in one month. To keep the Senior Consultant designation and perks, the member must maintain that minimum level of sales monthly. The second level of Senior Consultant requires 2,000 Volume Points in a month, or a seller can be named a Success Builder for the month by arranging a single sale valued at over 1,000 Volume Points. Levels after these include Qualified Producer (2,500 Volume Points accumulated within one to three months), Supervisor (either 4,000 Value Points in one month, 2,500 Value Points in each of two consecutive months, or 5,000 personally purchased Value Points within 12 months), and World Team (either 10,000 Volume Points in one month, 2,500 Value Points in each of four consecutive months, or 500 Royalty Override Points in one month). Once a contractor reaches the Supervisor level, he or she unlocks the maximum product discount of 50 percent as well as the ability to earn Royalty Override Points through sales of his or her recruits.
In the event that a contractor no longer wants to sell Herbalife products, the company will buy back any remaining inventory the contractor has on hand. Herbalife goes beyond the Direct Selling Association’s ethical guidelines for buying back products by reimbursing the distributor for everything he or she initially paid for (100 percent buyback policy). The company also limits the amount of inventory a seller can initially buy in to avoid association with inventory loading, defined by the Federal Trade Commission (FTC) as requiring a contractor to make a large upfront purchase of nonreturnable inventory (a fraud-inviting tactic often used by pyramid schemes). To renew their membership, contractors pay a $10 annual membership fee to Herbalife.

The Herbalife business model has succeeded due to the company’s excellent products and customer support. Most of its distributors do not have a physical store location but practice direct selling from home. They are not employees but independent businesspeople who choose how they want to operate. However, there are strict company policies and legal requirements that contractors must abide by regulating product information, sales techniques, advertising, lead generation, social media, and related issues. For instance, members used to be able to sell online on their own websites, so long as they followed certain rules. In 2014, however, in response to regulatory scrutiny into its distributors’ online marketing statements, Herbalife disallowed independent online selling. Instead, it created a centralized e-commerce section on its website which, when a customer places an , randomly connects the customer to a suitable distributor to complete the sale and follow up with the classic person-to-person interaction of direct selling. This is now the only way Herbalife contractors can sell online. Contractors are also not permitted to resell products in retail stores (other than in China, where retail store sales are permitted).
Herbalife’s selling policies are guided by the principles of the World Federation of Direct Selling Association (WFDSA) and the Direct Selling Association (DSA) in the United States. The WFDSA promotes ethical practices in direct selling globally through advocacy and strong relationships with government, consumers, and academia. The DSA also emphasizes ethical practices and requires that members such as Herbalife adhere to the DSA’s code of ethics (see Table 2). This code of ethics recognizes the importance of a fair and responsible approach to direct selling, since direct selling requires sensitive and personal one-on-one interaction that can lead to undue pressure placed upon consumers. The code has no tolerance for deceptive or unlawful practices regarding recruits and customers; requires that direct sellers provide accurate and truthful information about the price, quality, promotion, etc. of the products; illuminates and enforces the need for a clear record of the sales made by contractors; necessitates that warranties and guarantees be fully acknowledged; requires sellers to clearly identify themselves to customers and maintain the confidential information of their customers; prohibits signature pyramid scheme practices; and provides guidelines on inventory purchases, earnings reporting, inventory loading, fee payments, and training.
Table 2

Direct Selling Association Code of Ethics (Summary Version)

As a consumer you should expect salespeople to:

Tell you who they are, why they’re approaching you and what products they are selling.

Promptly end a demonstration or presentation at your request.

Provide a receipt with a clearly stated cooling off period permitting the consumer to withdraw from a purchase within a minimum of three days from the date of the purchase transaction and receive a full refund of the purchase price.

Explain how to return a product or cancel an .

Provide you with promotional materials that contain the address and telephone number of the direct selling company.

Provide a written receipt that identifies the company and salesperson, including contact information for either.

Respect your privacy by calling at a time that is convenient for you.

Safeguard your private information.

Provide accurate and truthful information regarding the price, quality, quantity, performance, and availability of their product or service.

Offer a written receipt in language you can understand.

Offer a complete description of any warranty or guarantee.

As a salesperson, you should expect a DSA member company to:

Provide you with accurate information about the company’s compensation plan, products, and sales methods.

Describe the relationship between you and the company in writing.

Be accurate in any comparisons about products, services, or opportunities.

Refrain from any unlawful or unethical recruiting practice and exorbitant entrance or training fees.

Ensure that you are not just buying products solely to qualify for downline commissions.

Ensure that any materials marketed to you by others in the salesforce are consistent with the company’s policies, are reasonably priced and have the same return policy as the company’s.

Require you to abide by the requirements of the Code of Ethics.

Safeguard your private information.

Provide adequate training to help you operate ethically.

Base all actual and potential sales and earning claims on documented facts.

Encourage you to purchase only the inventory you can sell in a reasonable amount of time.

Repurchase marketable inventory and sales aids you have purchased within the past 12 months at 90 percent or more of your original cost if you decide to leave the business.

Explain the repurchase option in writing.

Have reasonable startup fees and costs.

Source: Direct Selling Association, Consumer Protection Toolkit, http://www.dsef.org/wp-content/uploads/2015/03/DSEF-Consumer-Protection-Toolkit.pdf (accessed May 25, 2017)
A 2013 independent survey conducted by Nielsen, a reputable global information and measurement company, showed the number of end consumers Herbalife serves in the United States. The study, which took place online over the course of two months, sampled 10,525 consumers and was balanced in terms of demographics, income, and geographic placement. The results indicated that 3.3 percent of the general U.S. population made a Herbalife purchase sometime within a three-month period. This percentage of the population translates into 7.9 million customers. This number does include Herbalife’s direct sellers as internal consumers, but the number of U.S. contractors at the time was only approximately 550,000, indicating that the number of end users was much higher than the number of independent contractors. This is a good sign for the strength and legitimacy of the company’s model, as pyramid schemes generally do not make significant sales outside of their own networks. Additionally, the study showed that those who had made a purchase in the last three months tended to make Herbalife purchases consistently (approximately every two months) and that the most popular products were those dealing with weight management (making up 95 percent of purchases recorded by the study).
One aspect of Herbalife’s model that has raised concern is its approach to line commissions or the way sellers can make money off the sales of their recruits. Currently, Herbalife contractors can earn commissions on what every recruit below them buys or sells, including not only the recruits they themselves sign up but also those brought in by their recruits, and so on down the line. This structure, known as “unlimited down lines,” means that those at the very top of the recruiting structure can make large amounts of money simply through recruiting, a classic warning sign of a pyramid scheme. Many other multilevel marketing companies limit commissions to, for example, three levels down line only, to avoid this issue.

18-6 Pyramid Schemes

A pyramid scheme is a fraudulent business model that eventually inevitably collapses, with the vast majority of participants losing their investments while the few at the top of the “pyramid” profit. The four defining characteristics of a pyramid scheme are laid out by the Koscot Test, the foundational legal analysis used in the United States to determine whether a business is a pyramid scheme. These characteristics are
· (1)
people pay the company to participate;
· (2)
in return, they gain the right to sell a product or service;
· (3)
they also are compensated for recruiting others; and
· (4)
this compensation is unrelated to whether or not any of the product or service is actually sold.
In other words, participants have little or no incentive to sell products but only to continually recruit others into the scheme. Each person recruited pays an up-front fee (usually expensive), and these fees trickle up the pyramid to be collected by the fraudsters at the top. Newcomers continue joining because, as explained by the FTC, they are promised large profits for buying in and continuing to recruit others. The Federal Bureau of Investigation (FBI) warns of pyramid schemes that come in the form of apparent marketing and investment opportunities where the individual is offered a contractorship or franchise to market a particular product. The key is where the real profit is earned; if it is not by actual product sales but by sales of new contractorships, it is likely a pyramid scheme.
Pyramid schemes and legitimate multilevel marketing businesses are both based on recruiting new participants into selling the product. The California Department of Justice explains the difference as the following: In a multilevel marketing model, money is primarily made through the eventual sale of the product to an end user, whereas in an illegal pyramid scheme, money is primarily or only made through recruiting new sellers. The participants at the top of the pyramid earn money when new members are recruited through the newcomers paying membership fees and/or buying initial product inventory. Each new member is then incentivized or required to recruit more new participants. As this cycle continues, the possible pool of untapped participants shrinks, making it hard for those at the bottom to gain a return on their investment (as the only money for them is in further recruitment). Because of this, a pyramid scheme will always ultimately collapse due to a lack of new recruits and is therefore unsustainable. Another important point is that the products offered by pyramid schemes are usually low quality or very overpriced, again making recruitment the only financially viable option for those involved. The recruits are being sold on an idea or model that, in reality, is unprofitable.

18-7 Is Herbalife a Pyramid Scheme? Ackman’s Allegations

Herbalife, like most other multilevel marketing companies, has been accused of being a pyramid scheme more than once. However, considering the firm’s long and successful history, these claims were given little weight until 2012, when prominent hedge fund manager and billionaire investor William Ackman announced that he and his company, Pershing Square Capital Management, had spent a year studying Herbalife and concluded it was an elaborate pyramid scheme. Ackman is known as an “activist investor” and claimed it was his civic duty to expose Herbalife as fraudulent. Of course, his company also stood to profit heavily, having invested $1 billion in a short sale off Herbalife’s stock (a complex investment strategy that earns money if the stock price falls, rather than rises). Ackman’s target stock price for Herbalife was $0. In other words, he believed the company should and would fail. He has since continued to campaign and advocate against Herbalife and has plunged the company into a never-before-faced level of controversy over its legitimacy as a business.
Ackman’s accusations against Herbalife were initially laid out in a three-hour, 342-slide presentation, the result of months of research and analysis by his team. The accusations included the following:
· (1)
the majority of contractors for Herbalife lose money,
· (2)
Herbalife pays out more for recruiting new contractors than selling actual products, and
· (3)
only the top 1 percent of contractors earn most of the money.
Ackman argues that Herbalife recruits contractors under false pretenses by unrealistically suggesting they can earn the income of those few at the top. Furthermore, he alleges that the real money in Herbalife comes not from selling products but from recruiting other contractors, as all the top earners make the vast majority of their income through down line commissions from the sales of those in their recruiting chain. Although Herbalife has published results showing that the majority of its money is made through product sales, Ackman believes this information is false and/or misleading, instead estimating sales to be only 3 percent of Herbalife’s revenue, with the rest made via recruiting.
Ackman also contends that when people go to purchase Herbalife products, the sellers usually try to convince them to become recruits rather than remain only customers. He claims that the only thing keeping the company running is new recruits, and it will soon run out of available people to bring into the business—which is why it keeps entering new countries.
Supporters of Herbalife point out that many consumers and organizations buy and use Herbalife products and see them as high quality and credible. …